called for the value investor to liquidate his positions by March 2004 and return to cash. However, this seemingly prudent decision would have cost the value investor over 100% of returns captured by the trend-following momentum investor over the subsequent four years. It is also important to note that momentum signals turned negative in June 2007, allowing the momentum investor to divest when the real estate market was still liquid. This would have allowed her to avoid the massive drawdown that occurred shortly afterward (see Chart 6 below). Chart 6 Comparative Performance Leading up to Financial Crisis Liquidity Assets that work best for value investing are the opposite of those that work best for momentum investing. Most often, the best deals are found in illiquid assets that other investors cannot fairly value. For example, a vacant suburban office building outside Dallas is more likely to be subject to mispricing than a Class A trophy office property in Manhattan. On the other hand, momentum investing requires the ability buy assets quickly as price trends show positive signals, and conversely to liquidate assets rapidly as soon as prices begin to decline. The result of employing both value investing and momentum investing is a portfolio diversified both in geography and asset size. Leverage By its very nature, value investing requires deploying capital when economic outlook is bleak and other investors have left the market. Unfortunately, this also means that real estate lenders are unlikely to provide financing during these times. As we saw in 2008, not only did CMBS issuance dry up completely, but spreads widened massively, making any bank financing available extremely expensive. CRE Finance World Winter 2014 90 Chart 7 CMBS Spread and Issuance Data Source: Commercial Mortgage Alert and Morgan Stanley Momentum investing, however, requires buying only after asset prices have shown an upward trend, generally indicating both positive investor and lender sentiment. Therefore, it is more likely that assets will be acquired in times when financing is more readily available. However, as in all strategies, the use of leverage must be approached with prudence. Aggressive financing could lead to forced liquidation in the event that an investor is not able to divest positions quickly enough as momentum turns negative and prices begin to fall. Potential Portfolio Implementation Given that value investing and momentum investing work in such different ways, I explored the idea of creating a real estate portfolio that respected both. This strategy would take advantage of value cycles in markets while simultaneously remaining sensitive to price trends. To implement this, I created a hypothetical portfolio manager that started with $100 million to invest in real estate in December 1988. This manager allocated $50 million to a value investing team and then $50 million to a momentum investing team. These managers followed the simple value and momentum rules outlined in the Data and Methodology section. Once a year, the portfolio manager rebalanced capital between the two groups. The performance of this hybrid portfolio was quite striking. Returns over the period were 11% on average, with an impressive Sharpe Ratio of 0.90. The maximum drawdown also showed massive improvements over the Buy and Hold and value investing strategies, nearly reaching the risk reduction levels of the momentum strategy. Diversifying across these two simple strategies would have resulted in a portfolio worth $1.3 billion by June 2013. In contrast, if the manager had allocated to private value-add and opportunity fund Should All Real Estate Investors Be Value Investors?
CRE Finance World, Winter 2014
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