THE UTILITIES OF REAL ESTATE INVESTMENT AND THEIR EMPLOYMENT BY DEC
By: Michael T. Radcliffe, Chairman
DEC Investment Group, Inc.

          Real estate is a core asset class which provides diversification and non-correlation to a well constructed portfolio of financial assets. The use of non-correlating assets can reduce the volatility (risk or standard deviation of returns) of a diversified portfolio. Properly employed the use of real estate assets in portfolio construction provides a powerful tool with which to control volatility.

          A simple example of the importance of non-correlation can be derived from a two asset portfolio composed of equal investment in an S&P 500 index fund and real estate. A single investment in the S&P 500 with historical returns would yield 11% per annum with a standard deviation of returns of 20.3%1. An unleveraged real estate portfolio would yield 9.4% with a standard deviation of returns of 6.9%2. Combined, the portfolio would yield a 10.2% return with a standard deviation of returns of 11%3. Comparing the combined portfolio with the S&P 500 only investment indicates that while yields have been reduced by 7.3% risk has been reduced by 45.8%.

          Perhaps real estate's most important contribution to portfolio construction is its use as an inflation hedge. This dynamic contribution can be seen in its strong historical correlations with inflation4. Using a still simple, but more academic approach, look at Tobins "q", the ratio of market value to replacement cost5. In a perfect market the q for real estate (and all other financial assets) should equal 1. Although there is frequent divergence from 1 - informing such judgments as whether to develop or buy existing assets - over longer periods of time this relation should converge at 1. This means that if replacement costs increase because of inflation the market value of existing assets should increase as well.

          DEC is in the business of structuring high quality, privately held real estate investments designed to meet the needs of sophisticated financial investors. DEC believes that with the judicious use of leverage (financial structuring) and the application of its strong active management capabilities it can produce robust returns representing a premium over long term equity returns with a lower level of risk than equities. Outsized returns are obtained by using reasonable and sustainable levels of leverage coupled with sufficient liquidity to withstand the inevitable dislocation occasioned by pricing volatility and capital costs. DEC may reset leverage levels prudently throughout the life of an investment in order to reflect operating income performance, thus enhancing internal rates of return. At the same time, DEC brings to bear its experience base in areas such as project identification and due diligence, construction and repositioning of existing assets, market analysis, restructuring of asset ownership, asset and property management, disposition (using a variety of exit strategies), contrarian (distressed asset) strategies and working in complex legal environments.

          Use of active management capabilities is evident from recent portfolio activity. Moonrise was a 224 unit apartment project located in the Starr Pass development in Tucson, Arizona. For the calendar year ending 2005, Moonrise had net operating income of $609,000. Applying a market normal cap rate of 5.5%6 would suggest a pre-debt, pre-tax valuation of $11,073,0007. By pursuing the intricate process of conversion to condominiums the owners were able to increase the pre-debt, pre-tax valuation to $25,798,000. A 133% enhancement over its apartment value.

          A second example demonstrates the use of DEC's contrarian investment strategy of buying out of favor assets in out of favor markets at deep discounts. In December of 2006, DEC and its investors purchased 1,8458 residential lots in Huber Heights, Ohio (a suburb of Dayton) for $5.7 million9. City roadways, lighting and utilities had already been installed and the acreage awaited subdivision and lot completion. After deducting the value of other assets received in the purchase, the cost of these lots is estimated at $2,500 per lot. Prior to acquisition of these lots DEC researched the public documents of companies with similar assets. It concluded that the replacement cost of the lots was at least $10,000 per lot10. Our purchase represents a discount to replacement costs of $7,500 or a q of 4 to 1. Over time, we believe that our values will converge with replacement costs.

          In its acquisition process DEC normally looks for assets to which it can add value and properties which trade at significant discounts to replacement cost. In a number of cases it has found both. Also important are properties which are especially sensitive to upward movements in inflation such as residential assets11. Niche markets where pricing is "inefficient" are also of interest12. DEC believes that cap rates will frequently reflect the yield curve for Treasury bills and bonds, plus the historic risk premium for real estate. Where cap rates for an investment idea appear to be above that, our further interest is engaged. Quantitative analysis is further informed by judicious consideration of macro economic conditions such as GDP and job growth, demographic trends, supply constraints and inventory levels. Submarket characteristics are given serious consideration.

          DEC believes that its privately held investments, structured using "Best Practices" principles, represents a better proxy for real estate investment than publicly traded counterparts such as REITs. REITs have shown remarkable divergence from asset values over short periods of time and seem to move less with inflation than their privately held counterparts13. While 10 year Treasury Notes are highly correlated with inflation the NAREIT index shows almost no correlation with the Treasury Note averaging only .01 over the ten year period from 1995 to 200414. Purchasers of REIT shares may also pay a liquidity premium which is not useful to investors with long-term portfolio duration. REIT shares appear to have trading patterns which mimic equity markets blunting their value as non-correlating diversification tools15.

          By using Best Practice policies DEC eliminates the disadvantages and misalignment of interests typical of private investing. These practices include no up front load, fees designed only to meet the organizational costs of the manager (no profit), profit participation only on returns above a benchmark16, significant coinvestment, prudent investment size, concentrated investment exposure and closed funds at times where markets do not offer sufficient risk adjusted returns.

          DEC welcomes your interest in our carefully crafted real estate investment products. We hope to find a place in your portfolio.

1. David F. Swenson, Pioneering Portfolio Management (New York: The Free Press, 2000), p. 174.

2. David F. Swenson, Pioneering Portfolio Management (New York: The Free Press, 2000), p. 219.

3. Computation by author using Single Period Mean Variance Optimization software from Ibbotson. Correlation is derived by averaging the ten year results of the NAREIT Index and the National Association of Realtors Medium Home Price since 1970. Although the correlation data do not match with the returns and risk duration, it is believed that the correlation component is adequate for the illustrative purposes of this example. See David M. Darst, Mastering the Art of Asset Allocation: Comprehensive Approaches to Managing Risk and Optimizing Returns (New York, 2007), pp. 172 and 173.

4. David F. Swenson, Unconventional Success (New York: The Free Press, 2005), p.78.

5. David F. Swenson, Pioneering Portfolio Management (New York: The Free Press, 2000), p. 98.

6. cr = NOI/PP

7. For purposes of this example, debt and capital accounts are ignored. All amounts are approximate. Gross proceeds on 11 unclosed units are estimated.

8. Total lots may decline somewhat upon completion of the Development Agreement. The value of other collateral of $1.0 mil. may vary significantly from $0-$1.0 mil.

9. Total costs include $5.1 mil. for the base property, property additions of $.5 mil. and closing costs of $.1 mil.

10. Author's estimate.

11. Certain retail, office and industrial properties are typically subject to mid to long-term leases. These properties exhibit more bond-like qualities and are subject to analysis based on yield, duration, credit quality and volatility levels in the interest rate markets. Short-term leases are more "equity-like" in that they have shorter term leases and larger tenant pools than other product types. They respond more quickly to increases in inflation. For a discussion, see David F. Swenson, Unconventional Success, p. 67.

12. Small properties and properties in second and third tier smaller markets are frequently mispriced because of lack of institutional interest and illiquidity.

13. In 1990 REIT stocks traded at a 36% discount to fair value. Three years later they traded at a 28% premium. David F. Swenson, Uncommon Success, p. 69.

14. David M. Darst, Mastering The Art Of Asset Allocation: Comprehensive Approaches to Managing Risk and Optimizing Returns, pp. 200 -201.

15. David F. Swenson, Pioneering Portfolio Management (New York: The Free Press, 2000), p. 220.

16. 250 basis points above Treasuries of comparable duration.