The general market's misconceptions are the key to achieving alpha as outperformance requires getting something right where others were wrong. A strong understanding of some key metrics both protects us from being the part of the market getting it wrong, and affords recognition of the related opportunities. Following, is a list of critical market statistics and the intricacies of which make proper valuation a tricky endeavor.
While price/book provides a nice snapshot of value, there are numerous aspects which can make book value differ materially from the actual value of the assets. Upon acquisition, each property is usually set up with a depreciation schedule. The rate of scheduled depreciation varies, as does the actual rate of depreciation. In many cases, these rates do not match and a discrepancy arises. An extreme example of this is Sun Communities (NYSE:SUI) which currently trades at a price/book of 203. Anyone seeing this would know something is up, but what precisely is the cause of this? Well, manufactured housing is thought to lose value faster than regular housing, so it is set on extremely fast depreciation schedules. SUI's homes have proven to maintain actual value far better than would be indicated by such a schedule as they are able to re-sell homes after the initial contract ends, even though the book value is approaching zero. On the other side of the coin are properties which actually appreciate in value. Strategic Hotels (NYSE:BEE) recently acquired The Essex (a beautiful NYC landmark hotel) which may gain value over time if it is properly maintained as its location and architecture make it nearly irreplaceable. So, we can use this metric only to gain a preliminary understanding, and must dig deeper into the nature of a company's properties if we are to base any decisions off of it.
#3 Debt to equity
This is a matter of perspective. From a lender's point of view, debt to equity is spot on as both preferreds and common are junior to loans and mortgages in the capital structure. Thus it provides a reasonably accurate portrayal of how much equity is truly backing the loans. From an investor's perspective, however, it can be wildly misleading as a company could have a very small debt to equity ratio yet still have little or nothing left for common shareholders In the event of liquidation. A more accurate formula would be (debt + liquidation preference of all preferreds) divided by equity attributable to common shareholders. For many companies the difference is fairly irrelevant, but for companies, such as MPG Office Trust (NYSE:MPG), that have a large portion of their equity as preferreds, it becomes necessary to know the difference. MPG's 10Q lists its equity at a deficit of $828mm as of June 30, 2012. To common shareholders, it is actually a deficit of $1.145B once we factor in the 9.730mm shares of preferred A at its per share liquidation price of $25 and the accrued dividends of $7.625 per share.
#2 Yield at cost and cost basis
What matters is current price vs. current returns. When and at what price you entered into the stock has absolutely no bearing on the actual value of the position, with exception to tax consequences. While these metrics are nice for measuring the success of a position, we must be careful not to base decisions off of them. Assuming perfect liquidity, the current market value of a position can be considered the opportunity cost of holding it. If the value of a different security of the same opportunity cost exceeds that of the current position, they should be swapped. Of course it is not actually this simple as other factors such as market exposure, liquidity, and countless others must be considered. Given how much weight investors seem to place in these metrics, I want to stress again that yield at cost and cost basis have absolutely no effect on the current value of a position and only reflect how well or poorly it has done since it was purchased.
To capitalize on today's favorable interest rates, REITs have executed a slew of acquisitions at various cap-rates. The market typically responds to high cap-rate or low cap-rate acquisitions with a price increase or decrease respectively to the corresponding stock. The acquisitions of STAG Industrial (NYSE:STAG) and Associated Estates (NYSE:AEC) illustrate this point nicely.
· STAG has been making numerous acquisitions in the 7-8% cap-rate range and its stock has gone up dramatically from $11.47 at the end of 2011 to its current price of $16.20.
· AEC announced the acquisitions at cap-rates closer to 5-6% and the market did not like it. In fact, its price dropped from $15.95 at the end of 2011 to its current price of $15.12.
Of course we cannot say that this pricing behavior was entirely due to the public's response to the acquisitions, but it is fairly consistent. The point I want to make about this is that these reactions are in some cases unfounded. It is very possible for a 5% cap-rate acquisition to actually be superior to its higher cap-rate counterparts. A quality asset in an excellent location can generate far more revenue down the road, even if it was acquired at a low cap-rate. Accurately evaluating an acquisition is incredibly difficult, but for an investor equipped with the tools to do it, the market's occasional misevaluations are often the source of opportunity.
Disclosure: 2nd Market Capital and its affiliated accounts are long AEC, SUI, STAG, and MPG-A. This article is for informational purposes only. It is not a recommendation to buy or sell any security and is strictly the opinion of the author.