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CRE Finance World, Winter 2014

Momentum The rules for the momentum strategy were even simpler than the value strategy. When the current level of the index was greater than the average of the previous 12 months, a buy signal was given. This represented the concept of buying when momentum is positive. The strategy stayed invested until momentum turned negative, or when the current index level was lower than the average of the previous 12 months. When momentum was negative, the strategy invested in cash. A simple smoothing mechanism was added to avoid quick switches between positive and negative momentum, which would be unrealistic to implement for a private market real estate investor. US REIT data was available from December 1973 to August 2013. The value strategy as outlined requires 15 years of lead data before signal generation, putting the start date of the study period at December 1988. Both the value strategy and momentum strategy were long only, representing the inability of commercial real estate investors to take short positions in hard assets. The only leverage considered was the inherent leverage in the underlying REITs themselves. Finally, all returns are presented on an inflation- adjusted basis and before transaction costs. I ran simulations under reasonable-assumption transaction cost environments2, and found that the momentum strategy remained effective. However, given the highly subjective nature of transaction costs, I have chosen to present my analysis on a pre-cost basis. Value Works Howard Marks was right: value works. Over the test period, use of the value strategy outlined above produced, on average, annual returns of 2.6% in excess of a strategy that simply bought and held real estate (hereafter “Buy and Hold”). Furthermore, the return improvement was even more impressive on a risk-adjusted basis, as the Sharpe Ratio3 improved from the 0.41 of the Buy and Hold strategy to 0.67 for the value strategy. Finally, value investing improved risk as measured by maximum 12-month drawdown, with a figure of 41% for the value strategy compared to 58% for the simple buy and hold. Beyond the numbers, these results seem in line with the behavior and performance we would expect from successful value investors in real estate. As can be seen in Chart 1 below, the investors go through long periods of holding cash before deploying capital at opportune times, such as during the Savings and Loan (S&L) Crisis, the Tech Bubble, and the most recent Great Financial Crisis. CRE Finance World Winter 2014 88 Also apparent is that in every case value investors enter before the market bottoms out and exit a few years before the next crash takes place. Chart 1 Value Strategy Performance Graph Momentum Works Too Perhaps more surprising is the fact that momentum investing has worked, and by some metrics, even better than value. Return improvement over the Buy and Hold strategy was also strong, at 2.1%. More striking is the fact that the Sharpe Ratio doubled from 0.41 for the Buy and Hold strategy to 0.82 for the momentum strategy. Maximum drawdown showed the most dramatic improvement, dropping all the way to 16.6%. Imagining a successful momentum investor is actually not as hard as it first seems. The momentum investor would have waited until the end of the S&L Crisis and sentiment turned positive before making any acquisitions. While this investor missed the best bargains during the crisis, she also avoided throwing cash in to a downward spiralling market. On the other end of the cycle, the momentum investor stays invested long after the value investor has left the market, exiting shortly after the market peak (see Chart 2 below). In the recent cycle, Blackstone Real Estate served as a good example of momentum investor behavior. Blackstone continued its acquisition spree through early 20074 before selling the majority of its real estate holdings before the end of the year. While value investing competitors such as Grayken’s Lone Star began buying in late 2008 and early 2009, Blackstone waited until late 2009 (when momentum was once again positive) to re-deploy capital5. Should All Real Estate Investors Be Value Investors?


CRE Finance World, Winter 2014
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