Is a bird in the hand worth two in the bush?

In 600 BC, Greek fabulist Aesop described the essence of investment decision-making as, "A bird in the hand is worth two in the bush."

To flesh out this principle, Warren Buffet added insight with three questions:

1. How certain are you that there are indeed birds in the bush?

2. When will they emerge, and how many will there be?

3. What is the risk-free interest rate compared to the expected risk and reward for the birds in the bush?

Right now, many investors are choosing to keep the bird in the hand, and rightly so, given the market's risk profile has escalated significantly. A bird in the hand is subject to the beholder's view, be it an equities portfolio that has reduced dramatically in value of late, and it certainly may also be cash. However, the issue with cash is the escalating inflation rate. Whilst cash has the benefit of liquidity; its severely reducing value means diminishing buying power, which adds complexity to an increasingly complex investment outlook. One absolute is that there's a significant lack of visibility as the domestic and global inflation, interest rate, currency, and geopolitical tectonic plates continue to make seismic shifts and impact fundamentals.

Last week, I had lunch with an investor who spoke about the sting of having their wealth reduced by USD 50m after recent share market volatility. Their immediate reaction was to convert most of their liquid portfolio to USD, a favoured hedge strategy of this particular investor and one that has served him well over the years. But, with pressure on the USD and currency volatility in general, there is an emerging question mark over cash as a store-hold of wealth.

In another catch-up with a partner investment group, the discussions focused on sentiment and how one of their primary investors had just taken a $1b hit on their $4b net worth also due to recent share market volatility. As a result, investment decision-making comes from a place of conservatism, with a high probability of further losses resulting from the evolving investment landscape.

The hunt for a safe store-hold of wealth continues

Out of the array of emerging risks in the investment-grade real estate space, interest rates arguably sit at the fore. An increase in interest rates will likely impact cap rates across the board, meaning an eventual softer sale price may be likely. However, higher-quality assets will likely retain a premium due to the sector's competitive buyer audience and the more stable and predictable asset class behaviour. As it is unlisted, the asset class is not correlated to the listed markets and does not suffer volatility. Several historic assets we have exposure to have interest rate hedges - a risk mitigant implemented at the execution of the deal to protect against an increasing interest rate environment. Also, leases generally are indexed to inflation which serves as a valuable hedge in times like now.

Moving into this recent, more volatile, and higher interest rate environment, there is less of a spread (and a lower distributable monthly Yield to investors) when an asset is geared to the average, say, c. 50% with bank or other debt. However, if cap rates start to blow out due to the rising interest rate environment, this will mean that distributable income may also improve on an incoming acquisition.

Having control of our time and our money

When it comes down to it, all any investor (or person for that matter) wants is to control their time and money. Looking at Maslow's hierarchy of needs, feeling safe is one of the most fundamental human needs. With the recent volatility in the market, there will likely be discounted buying opportunities that will present; good ones, as well as others that look good on the surface but are not so good in reality. As in any market, on the other end of those deals, the counterparty will likely suffer; as they say, 'pain in the market' is what creates good buying. It also means emotions will be running high in general, which is a doubled edged sword because bad decisions can be made when emotions run high.

I am reading a fascinating book, 'A Whole New Mind' by Daniel H Pink, which talks about how increasingly important the attributes that come from the right brain are, i.e. intuition. Whilst the more analytical left brain has been more highly valued in the industrial age, computers, automation, and cheaper offshore labour are replacing much of the 'left brainpower'. Intuition plus the ability to plug into and accurately read the emotion or 'the play' of the situation and intuit the likely next steps is increasingly vital as our world evolves. Bringing this back to the current property market, if the market does soften and seemingly well-priced opportunities arise due to pain in the market, intuition will be one of the more valuable indicators of whether the validity of a deal is a good one or not. A gut feeling might be' off' even if the numbers tell a compelling story supporting an investment decision. No matter how invested MPFunds Management is in moving forward on a deal, we will hold off if it doesn't feel 100%.

Bricks and mortar

As a relatively predictable store-hold of wealth, one of the fundamental points in assessing the unlisted investment-grade property sector (or any property asset) is acquiring at or below replacement value. In addition, investment success will come from ensuring depth to the user market for that specific property and not an oversupply of vacant space. Further, it's making sure that that particular property has identifiable and unique attributes which make it more attractive to the specific user groups vs other properties competing for the same user type.

Safe and sensible decisions

Rigour around process and defined principals and parameters is the first base to drive decision-making accuracy. Having these principles and procedures well-defined helps during periods when markets create stress, or there is pressure to act quickly. Aside from a range of other various checks and balances, we follow a simple Warren Buffet approach; where is the quality? Where is the moat or the unique selling point for that specific asset that will make it more highly sought after than its peers in the market from both a leasing and a capital perspective? Where and what are the barriers to entry for other space providers attempting to take your market share?

I often get investors sending me deals they want to invest in as a quick 'check and balance'. I recently had a transaction sent to me that, on the front two pages, looked like a sensational deal buying a commercial office tower $20m below current valuation, with a forecast IRR of 20%+ and a quick turnaround time. The plan was to re-lease the half-vacant building and sell it at a premium within two years.

As I skimmed through the pages of the IM, there was no information on the supply-demand fundamentals or the leasing strategy, no information on the competing vacant space of a similar grade, no information on the unique selling proposition of the subject asset, and no commentary on the higher levels of office vacancy post-COVID. The tight IRR-driven turnaround time on disposal was subject to significant leasing, so really providing hard data around the leasing strategy, the depth of market, supply and demand fundamentals, and the unique positioning of the asset was the crux of the business plan to achieve the investment value. All of this information was missing. There was also no sensitivity analysis around the possibility/high probability that the exit cap rate would blow out due to the increasing interest rate environment, which would impact the overall investment returns. The other key point is that a valuation is only ever worth the paper it's written on if there is potential for market volatility and shifting fundamentals that may affect that specific property type.

A bird in the hand or the two in the bush?

With many investors becoming as liquid as possible during this period to take advantage of the potential of a higher volume of mispriced opportunities in the property sector, visibility is limited as to whether there will be significant pain resulting in high volumes of quality deal flow. It's also yet to be seen how the market fundamentals will fare overall.

What is clear, however, is that with the change in interest rates, pricing across the board will change, and cap rates will adjust as a result.

Having liquidity in this market is essential but also a double-edged sword. If you were liquid all last year, you would have lost 6% on inflation which doesn't look to be improving. So, cash offers excellent liquidity but is like a hot potato due to inflation's value and buying power erosion. We are starting to see a more compelling opportunity than in previous years. We are also readying our birds in the hand if we believe the birds in the bush are worth the trade on a risk-adjusted basis after rigorous due diligence and stress-testing.

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