A Real Catalyst For Real Estate

I like to look at charts and talk to people.  Prices are pretty much the only thing that make sense to me.  While the markets were crashing in January and February, real estate held pretty firm.  Prices in Manhattan and California did not blip.  A few weeks ago WeWork raised money at $16 billion.  It’s the only ‘unicorn’ that keeps raising money at higher valuations.  Last week the Hotel Del Coronado (I like to call it my guest house) was purchased by a Chinese insurance company.  I asked my friend Danny Jassy (aka SpyderCrusher) who is a Level 3 Candidate in the CFA Program (he’s studying hard for hopefully his last test this June), to help me explain what seems to be a major growth catalyst for Real Estate prices that I find myself smack dab in the middle of on Coronado.  If I were to start a hedge fund today it would be to buy my neighbors homes.

The rest of this post is Danny’s words…he did great.

 

A Context To Start

The S&P500 index is down 37 basis points this year.

From “the worst start ever 1”, to the now ubiquitous FOMO (fear of missing out) V-shaped rally that typifies market recoveries of the past four years, it’s been tough to escape the morass.

Adding the market volatility to the concrete corporate effects of a Sanders2 or Clinton presidency, ever-present Euro 3 and China issues 4, Fed Actions, Oil, Dollar strength (weakness?), and you have a tough 5 investing environment.

What’s a manager to do?

Fortunately, Congress, in their ceaseless pursuit of operational efficiency has provided an as-of-now underreported panacea to our woes.

 

A Real Catalyst for Real Estate

For the event-driven investor, there’s nothing like a good catalyst to spur a thesis along.

Analyst upgrades and downgrades dominate the daily news (daily noise?) cycle, but are fleeting and ephemeral. The big money is made exploiting longer-term repricing (read: trends). These can include earnings surprises (up & down), and major corporate events (mergers, acquisitions, and/or credit changes).

Least common of all, the granddaddy of repricing catalysts, is regulatory change.

Regulatory changes that both inherently change return on investment, and apply the change in favor of the risk-taker are exceedingly rare. For REITS, this rarity, the white whale of investment theses, occurred at the start of 2016.

 

Background

In December of 1980, President Jimmy Carter signed the Foreign Investment in Real Estate Property Tax Act (FIRPTA) as part of that year’s Omnibus Spending Bill. The purpose was to afflict a punitive exit tax on all foreign investments6 in real US property to disincentivize the purchase in the first place.

How punitive, the inquisitive reader asks?

The law treats any sale, regardless of holding length, as effectively connected income.  This can increase the incremental taxes due, in some cases, by greater than 50% 7.

For all the consternation in the ‘90s of the Japanese buying our prized golf courses8, and less anachronistic concerns about the Chinese gobbling up NYC real estate 9, it may be a shock to learn of this nearly four-decade barrier to market entry (or exit, as it were).

 

What’s New?

The 2015 Omnibus Spending Bill, passed on December 18th, 2015, vastly reformed the act, constituting the first changes since it was passed in 1980

A summary10 of the changes11:

  • Full repeal for interests held by foreign retirement or pension funds. This is huge. 12
  • Increases the FIRTPA exemption from 5% ownership of a publicly-traded REIT to 10%
  • Now assumes the “presumption” of Domestic Control, which in some cases, is exempt from FIRTPA. Another big change.
  • Changes the nature of dividends received from these investments

The net effect is it’s a bullish driver for new foreign investment in US Real Estate, because it increases liquidity, which in turn will increase demand. Understanding this is a long-term catalyst, knowing one can sell without incurring high taxes itself will provide an incentive to consider more exposure to the asset class.

 

Real Estate Today (chart fest)

Thus far, the Dow Jones All REIT Total Return Index (which includes dividends) is up nearly 4% this year (as of March 20th, 2016).

High Quality Version Here

Dow Jones REIT Total Equity Return YTD

Data courtesy of TradingView.com and SPYderCrusher Market Research

 

Measuring returns from the recent intraday low on February 11th, 2016 up to March 20th, 2016, the Dow Jones Real Estate ETF (IYR) is the second best performing sector, up 16.52%.

High Quality Version Here

Sector Returns From Intraday Low on February 11th, 2016

Data courtesy of TradingView.com and SPYderCrusher Market Research

 

Big picture, looking at the Sector Trends and Rotation Heatmap, Real Estate as a sector has led for the last several bounces. This daily model shows what percent of each sector is trending at any given time.  This is explained further in the on-chart annotations.

High Quality Version Here

Sector Trends And Rotation Heatmap

Data courtesy of TradingView.com and SPYderCrusher Market Research

 

Other Issues to Consider

Real estate has several pros and cons, and most of the advantages are better suited for longer-term investors. This doesn’t preclude a short-term trade (I’ve been bullish13), but the purpose of this article is to inform of a longer term, hopefully persisting, bullish catalyst.

Pros:

  • Real Estate offers a hedge against inflation
  • Real Estate offers diversification benefits to a more staid equity / bonds portfolio
  • REITs are liquid, offer more homogeneity than direct investments in real estate14, and can be purchased with less money
  • Boosted by lower rates, and with a never-ending chase for yield, REITs may continue to outperform

Cons:

  • A strong dollar may dissuade, in the short term, some investments 15
  • Cyclically, there is some concern that cap rates have peaked 16
  • This analysis is broad, while the nuance of real estate is often location specific

 

Don’t Tell the Feds

Enterprising lawbreakers may figure that given the breaking of Swiss bank secrecy laws17 to combat money laundering and tax evasion, it’s possible that setting up shell corporations to invest in real estate is a viable money-laundering alternative. In all reality, this is an incremental source of demand, however unseemly. The problem is real enough that New York Attorney General Preet Bharara has specifically identified it as a focal area for investigation18.

 

Conclusion

It’s a good time to be a real estate investor. Legislative benevolence (which is likely to ease further, given the floodgates are now down) has created what should be a persistent buyer of desirable real estate assets – foreign money – for the foreseeable future. Considering that many nations are devaluing their currency, getting a USD denominated hard asset looks particularly attractive.

 – Danny Jassy

[disclosures: I own several REITs, though they are not mentioned in this article.  I am a partner with TradingView.com, and provide subscription leases for SCMR Trends™, software my company owns, which is shown in the charts above. I earn compensation from these sales].


Footnotes

  1. These types of metrics in most cases amount to data-mining, but nonetheless they make for good headlines. http://www.marketwatch.com/story/dow-set-for-triple-digit-drop-as-oil-breaks-under-30-2016-01-15
  2. Sanders has the more aggressive plan of the two Democratic nominees, but Clinton’s attack on the Biotech Industry sure hasn’t been a consolation to those long the space.
    http://www.thestreet.com/story/13319434/1/if-socialist-candidate-bernie-sanders-was-president-here-s-what-would-happen-to-the-u-s-economy.html
  3. http://www.bloomberg.com/news/articles/2016-03-18/imf-s-lagarde-says-negative-rates-have-helped-global-economy
  4. Gundlach ain’t buying it http://www.businessinsider.com/gundlach-on-china-trade-and-gdp-2016-3
  5. Ultimately, too many topical concerns to reasonably link to in one article
  6. Basically, any foreign person or corporation is subject to the exit tax https://en.wikipedia.org/wiki/Foreign_Investment_in_Real_Property_Tax_Act#Persons_and_property_subject_to_tax
  7. This article is addressing offshore hedge funds, but in the context of what if the Feds treated them as Foreign Corporation, so for purposes of the example, it works.
    http://www.law360.com/articles/701645/effectively-connected-income-a-close-look-at-the-rules
  8. http://www.nytimes.com/1990/09/07/business/japanese-buy-pebble-beach-golf-course.html
  9. http://www.nytimes.com/2015/11/29/business/international/chinese-cash-floods-us-real-estate-market.html?_r=0
  10. Not only am I not a tax expert, I also am not a legal expert, nor a congressional expert, or your financial advisor.  Take those and other precautions under consideration, as it’s possible in my ambition to write this article for Howard, I’ve overlooked something.
  11. https://www.mcguirewoods.com/Client-Resources/Alerts/2015/12/Congress-Passes-FIRPTA-Reforms-Foreign-Investment-US-Real-Estate.aspx
  12. Both of which can invest either in publicly traded securities like REITs, direct investments, or other arrangements like CREFs & Private Equity
  13. Just some self-aggrandizing here:
    http://stocktwits.com/SPYderCrusher/message/49803171
    http://stocktwits.com/SPYderCrusher/message/47986161
  14. Think “Location, Location, Location”. Not all office / mall / properties are created equal
  15. My view is the dollar weakens further, but if the Fed is right on looming inflation, and rates or expectations of rates increase, it will likely resume the dollar uptrend we saw in 2014
  16. Filed under anecdotal, some smart managers I know are disposing of more cap-rate sensitive properties right now…http://nreionline.com/office-owners-and-developers/part-5-are-cap-rates-peak
  17. https://en.wikipedia.org/wiki/Bank_secrecy – Bradley_Birkenfeld_Whistleblowing_Case
  18. http://nymag.com/nymag/features/foreigners-hiding-money-new-york-real-estate-2014-6/index5.html

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