Basics of Investment in Real Estate

With the current housing recession in North America, investors are scared. Even bargain hunters are scared, since there's no telling whether or not the market has found its bottom.

But a savvy investor needs not seek the bottom to find good value. After all, what matters is the absolute return on investment, which can come from the capital gains from the sale or the continuous cash flow from renting.

Here is one of the most popular recipes for real estate investment:
  1. Buy a property with as little down as possible
  2. Optionally make improvements to it, to increase its resale appeal
  3. Wait for price appreciation
  4. Sell it and collect the gains.
What's the problem with this? The main problem -- and this is where speculators and unsophisticated investors got hurt the most in this downturn -- is that this relies heavily on the direction of the market -- a market which doesn't necessarily abide by sound principles, but that fluctuates based on sentiment.

By now everyone knows that the real estate market doesn't always go up. On top of that, adding leverage (the debt from the "little down" part), magnifies the effects of possible losses if the market doesn't cooperate.

This recipe worked for a while, but no more.

Is there a sound alternative?

Absolutely. How about this for a new framework:
  1. Lower your entry price
  2. Choose a stable to growing market
  3. Sell it for a profit or collect rent on the lower entry price.
Sounds similar, but the difference is on insisting on an absolute return based on fundamentals, not market sentiment. Let's take this in parts.

Lower the entry price. This can be accomplished by either building from scratch and thus controlling the costs ahead of time or by buying deep fixer-uppers and re-doing them, having a detailed budget beforehand.

Choose a stable to growing market.
This requires on-going work monitoring the fundamentals of the market in various parts of the world, or trustworthy direct contact with those who do. The real estate market is very local and opportunities may exist in remote places (other countries) or unique circumstances (special construction, unusual locations, islands).

Sell it or rent it.
Selling for a quick profit may not yield the best return on investment. If you do your homework and plan for buying or building something that can reasonably be expected to yield an absolute return on investment by renting, then selling becomes an option, not a necessity.

An investor close to me recently asked me about buying an apartment where the rent yield was around 5% after deducting most expenses. On an absolute basis though, this is not an impressive return. An investor ought to do better. And hoping for price appreciation to boost the return doesn't qualify under my definition of a safe investment. So I recommended a pass.

In my next post, I will describe how I'm following this alternate plan: building instead of buying ready-made, focusing on a foreign country with a growing market, and planning for the investment to make sense based on renting rather then relying on the whims of the market to bail me out. Stay tuned.


Watching for Overcapacity in the Shipping Business

In investing, the good returns of the past may not always bode well for the future. The reason is that high returns and high margins attract competition. And competition drives prices lower which eats into margins and profits.

Unless of course, your business is protected by an economic moat (we will get into details of moats in another post). Most businesses aren't.

Shipping oil in oil tankers is one such business that has no moat. All it requires is a shipping vessel, a crew and more demand for oil in a place than there is local supply for. There are no barrier to entries since anyone can operate an oil tanker after passing a regulatory compliance check.

Since the supply of oil is pretty much concentrated in a few places on Earth and demand is everywhere, shipping is a business in demand. But demand for oil is not infinite. So one of the main things to watch for in an oil tanker business is the supply -- not of oil, but of tanker ships.

If there are too many tanker ships in the market and a steady demand for oil the freight prices will come down and so will the profit margins, given that the cost of transporting the goods is determined by the distance to be navigated and the cost of fuel.

All told, the economics of an oil shipping business depend mostly on three items:
  1. The cost of operating the fleet.
  2. The price of oil.
  3. Amount of competition.
In the cost of operating the fleet we must factor in the debt such companies have. Most need a lot of debt to finance buying their tankers, which are expensive and require regular maintenance.

The price of oil influences both the cost of the fuel used in the trips and the price received for each trip, since tankers usually get paid a price proportional to the value of the goods transported. Recent high oil prices have been a boon for tanker companies.

Finally, the number of ships available in the market can drive prices charged per trip up or down.

Consider Nordic American Tanker (NAT). NAT owns and operates 15 crude oil tankers. Only one of them is on a long-term contract while the others operate on the spot market. That means they fetch whatever rate is available at the time.

NAT has no debt, which puts it singularly at the top of the shipping business quality. By having no debt they can better weather recessions or otherwise slow business activities. They are also less sensitive to pullbacks in the price of oil given that their servicing costs are lower than that of their competitors. At the end of the day, NAT will have an easier time providing the lowest cost service.

NAT has good profitability compared to its peers. It churned its assets 3.5 times more than the industry's average (asset turnover is an important efficiency metric for asset-heavy industries like oil shipping).

NAT also pays a juicy 6-7% dividend.

But that leads us to the main point of this article: overcapacity. NAT, as well as its peers, will see an increase in tanker supply in the coming years. An increase in the number of ships of 39% is expected by 2012, given the current backlog. This is certainly a red flag to watch out for. The oil tanker business will likely not be as profitable in the future as it has been in the past.

And oil prices coming down from recent record highs only adds more downward pressure on companies like NAT.

The bottom like here is that when profitability is high, watch out for incoming competition.

Disclosures: No position in NAT at the time of writing.

Related: Shipping your dollars away, by Saj Karsan.


Arbitrage Opportunities

Arbitrage is the market-risk-free bet that two securities will converge in price. It's market-risk-free because it involves the selling of one while buying the other and hence fluctuations in the market price either up or down won't affect the outcome if the two securities do close their price gap.

A popular form of arbitrage is when companies buy each other. The arbitrage, in this case, involves selling short the shares of the acquirer and buying shares of the target company, under the assumption that the acquirer is paying a premium for the target company.

Several web services post the expected returns available on pending acquisitions. Recently, two such opportunities caught my eye.


The first one is AT&T's (T) bid to buy Centennial Communications (CYCL). AT&T offered $8.50 cash per share of CYCL, but CYCL is still trading for around $7.60. By betting that the transaction will close, an investor can make a lot of money for little downside risk. The risk involved is, of course, that the buyout won't close.

In the case of T & CYCL merger, odds are really good that the transaction will close, because:
  1. Shareholders of both companies have authorized the deal.
  2. A closing date is set (third quarter 2009).
  3. The transaction is not subject to financing.
(Of course, in all merger arbitrages, one should only invest after the deal has been confirmed. Trading on rumored acquisitions is never a sound investing strategy.)

The risk remaining is the authorization by the Federal Communications Commission (FCC).

As far as I could see from both company's disclosures, there isn't anything more than regulatory formalities into the FCC investigation.

If all goes according to plan, there's about a 12% real return on the table for the next month or two, yielding an annualized 147% gain.


PepsiCo (PEP) recently announced its intention to buy the remaining fraction it didn't already own of both of its largest bottling companies, PepsiAmericas Inc. (PAS) and Pepsi Bottling Group Inc. (PBG). Both offer a little more than a 2% spread between the acquisition price and their current market prices. Since both transactions are planned for late 2009 or early 2010, the returns should be modest but still decent, at around 5% annualized.

Both transactions have been authorized by all three companies and all that's pending is regulatory and shareholder approval (I note that PEP owns 33 and 43% of PBG and PAS respectively so the odds of a shareholder approval are tilted in PEP's favor).

Interestingly though, there's a twist to juice up the returns here. It involves options and thus market risk -- hence, this is not an arbitrage opportunity as much as a "trade" based on the acquisition's pricing and timing.

March 2010 $35 put options for PBG are trading at $2.00. This means that the market is pricing in close to a 36% chance that the transaction won't close by March 2010 -- that is, that the stock will be below $35 by March 2010.

Since PBG shares are trading for $35.50 now, the only way a put seller can lose money is if the transaction is canceled before March 2010 and the stock drops below $33 ($35 minus the $2 premium). Even if the transaction does not close by March but as long as it is still planned, there's no reason why PBG should trade for less than $35, making the selling of these puts an interesting way to leverage your returns.

The risk, of course, is having to fork $3500 for each $200 received for the put options sold. But at the same time your $3500 would be exchanged for 100 shares of PBG, which, by itself, is not a terrible business to own: it has guaranteed business with Pepsi, sports a 2% dividend at current levels and would probably be Pepsi's acquisition target again in the future.

Don't forget that selling puts can hinder your returns as much as it can juice them up, since it's a form of leverage. But nonetheless, in this case, it seems like a safer bet than usual. Proceed at your own risk.

Disclosures: Short T, long CYCL, long PEP. No other interest in the above mentioned securities at the time of writing.


Source of Income: Where Your Company's Money Comes From

In a previous post, I mentioned how CenturyTel (CTL) has kept dividends too low for too long.

Now, I want to dig deeper into CTL's finances, since it does sport a nice 9% dividend and what looks at first to be a sustainable 6% EPS growth -- which could in theory support a similarly growing divided.


About 12% of CTL's revenues come from government subsidies. The majority comes from a program called USF -- Universal Service support Funds. These programs are intended to subsidize pricing of telecommunication services (phone, cable, internet) on rural areas, to make rates charged rural customers more comparable to those charged in urban areas. The program is funded by taxes imposed on urban carriers and given to rural carriers such as CenturyTel.

If this were a political or economics blog, I'd point out the absurdity that subsidies typically are, this one included. I'd even point out that this Robin Hood program is nothing more than yet another tax -- a tax on urban users of phone, internet and cable.

However, this is an investing blog, and as such, I should only point out that while 12% of revenues is not "a large fraction" it is not an insignificant fraction either. If this subsidy were to be cut, the effect on the bottom line could be a reduction in EPS of about 57% due to their leverage! That's not peanuts.

In the annual report, management discusses in great details the risks of losing this subsidy:
These governmental programs are reviewed and amended from time to time, and we cannot assure you that they will not be changed or impacted in a manner adverse to us.
To add insult to injury, CTL has about 1/3 of its debt commitments -- about a billion dollars -- coming due in 2010 and 2011. If the subsidy is cut or reduced, they could have trouble paying this debt and would need to raise money. With the credit markets the way they are, there's no saying how that would turn out.

Also from the annual report is their policy on dividends:
[W]e plan to continue our current dividend practices. (...) Our board is free to change or suspend our dividend practices at any time. Our common shareholders should be aware that they have no contractual or other legal right to dividends.
I admire them for explaining the obvious -- that the board has the right to cancel dividends at any time. And I think that they just might have to use this very right in the near future.

For now, I'm staying away from this high dividend payer.

Disclosure: no shares held at the time of writing.


The Best Investment: In Yourself

Warren Buffett once said that the best investment one can make is on him or herself.

I agree.

I sort of always knew that, even before I stopped to do the math. Education is something that no one can take away from you. Knowledge can't be taxed no matter how quickly it compounds in you over time.

The "investment" doesn't necessarily need to be in a formal education or an expensive one. It doesn't necessarily mean going to a top-quality college or getting a PhD in something. Not that a quality education is irrelevant -- it isn't -- but one's education is much better when it's actively wanted and actively sought after. Going to college because "it's the natural next step" or "because I have to" might not be as good an investment as seeking education via other means if the reason is "because I want to" and "because I enjoy learning that".

In other words, it's how you approach education that counts the most, not the source of education itself.

My own personal experience confirms that. Not that my path should be a model for others -- it probably shouldn't as some pieces of my education took too long and weren't as useful as I had hoped. But nonetheless, here's my story.

I've always been a learner. I read whatever I could get a hold of. And I still do. After self-learning how to program computers at the age of 12 (again, because I really enjoyed it), I sought to learn other computer languages and tools. My first "job" was when I was 14. I operated a dBase database at a small business, which I had self-learned because I actively wanted to. I also built a few applications that I sold to third parties. That knowledge was all self-thought and it cost me almost nothing other than a few books and magazines.

In college, I held several part-time jobs. One summer, I had three -- two half-time jobs and one consulting job. They were all learning experiences, and I got paid for them -- education at a negative cost!

When I finished college I had some money saved. It wasn't a big deal, but at the time I believe it was more than what my friends had. It was hard to depart from that hard-earned money, but I did spent almost all of it on a month-long trip to Europe. I note that I earned this money in a weak currency, which I had to convert to expensive British Pounds, German Marks, Swiss Francs, French Francs, etc. There was no Euro back then.

After college, I went to grad school. The rate at which I could earn money initially dropped, since grad school was a full-time job with very low pay (and here "pay" is a nice word to describe grad school stipend). But nonetheless, I managed to work summers and do little things here and there to save a little.

When I finished grad school in 2005, I had an amount X saved. Today, less than 4.5 years later, I have 38X saved, not including my house. That's a 124% annual rate of return!

How was this possible? Well, I did start from a low X, so doubling or tripling that was not as hard as it may seem. Also, a large part of that had to do with luck and timing since some of that came from stock options from my employer.

But even without the stock options and without the salary scale I landed in due to my extra years of graduate studies, I calculate I would still have managed to reach 18X during the same time frame due to the nature of the skills I had developed and actively sought after.

In other words, due to my investment in myself, I got at least a 90% annual rate of return -- much better than any stock market or hedge fund I could have put my X dollars, even if I had kept adding the savings from an average entry-level salary along the way.

Of course, getting an education doesn't imply you need to find a job to get this kind of return. Warren Buffett, Bill Gates and many others educated themselves to become their own bosses.

Nor should you stop learning once you get an initial high rate of return. My own education didn't stop after getting a job. I continue actively seeking to learn useful skills such as how to wisely invest my savings. I'm currently using my job to learn what I can about my field of work. But I'm also learning something very valuable while getting paid to work: through my job, I'm learning how to run a successful business -- one day it might be useful to know that.

Stay focused on your education, make it pay for itself and reinvest the dividends in you know what -- in yourself!