Soapbox: Algorithms vs. Arithmetic

There are security analysts and financial advisors who have no fear about taking positions in derivatives based on arcane algorithms. But for some reason, these same analysts seem to have fear and loathing when it comes to analyzing investments based on commercial and apartment real estate rentals.

Curiously, most of us would cheerfully admit we do not have the capacity to grasp the very complex math that underpinned the subprime derivatives. On the other hand, most of us have an understanding of apartment rents. We’ve all stayed in a hotel, and people have worried about hotel occupancy since the inns in Bethlehem were so occupied the latecomers got put in the stables. Many of us have sent kids to college. We know how to look at student housing rents, but also can think about amenities, and of course whether security is being provided. We all know colleges are full to overflowing. It’s not hard to understand that good private dorms near colleges often open 100% leased in the fall. If you haven’t had to worry about the options for senior housing yet, you almost certainly have talked with someone who has if you are old enough to be managing money. We all know that baby boomers are approaching retirement age, so we can understand the growth in demand for senior housing in our guts, not needing advanced math to get a grip on it. We’ve built post and beam construction since before Hammurabi, but the bright young whiz kids on Wall Street have found it easier to analyze hi-tech, Internet, nano-technology, Genzyme, and Motorola than a simple neighborhood shopping center REIT.

Writers who should know better lump single-family homes with shopping centers, hotels, storage facilities, office space, and rental apartments, when the simple truth is that all real estate is not alike. Advisors who should know better think all retail REITs are in trouble and do not distinguish between REITs owning high-end malls with Nieman Marcus, Tiffany, and Gucci as tenants (showing signs of serious strain) with REITs that own neighborhood shopping malls anchored by grocery stores (which on the whole are doing pretty well).

Even street-smart analysts and successful investors can’t seem to get their hands around evaluating the balance sheets or earnings durability of many of the financial institutions. On March 11 of last year, Jim Cramer, no stranger to Wall Street, said: “Bear Stearns is fine… Bear Stearns is not in trouble. Don’t be silly… don’t move your money.” He was talking about money being held for an investor, not the stock itself, but a week later Bear was toast.

Not too long thereafter, the bitter Wall Street joke was: “The problem with investment bank balance sheets is that on the left side nothing is right and on the right side nothing is left.” But an office REIT like the well-run Boston Properties, which still has nice big buildings you can go look at and kick the bricks, and a balance sheet that’s hardly rocket science, gets little respect from the gunslingers. Smart guys said when KIMCO refinanced it would hurt the stock but, in fact, it went up. The unhappy analysts thought the “smart” play by the numbers was to avoid issuing more shares and maximize forecast IRR. A majority of investors decided that raising equity to pay down debt was making the company a safer bet.

Private real estate investment has, over time, had the lowest volatility in the real estate industry, even less volatile than REITs used to be before the current hedge fund speculation increased their volatility. This may be because the people who make private investments have more realistic expectations about how durable real estate earnings can be, and have not been as easily swayed by the gunslingers.