Income with Safety

New White Paper Available: The Great Housing Workout

The Great Housing Workout White Paper

Arixa Capital has released a new white paper focused on the U.S. housing market and single family homes as an asset class for investors to consider. The white paper is based on Arixa's concrete experience investing in this area in recent years, working with local operators who buy properties in a specific geographic area, renovate them, and either lease the homes or resell them.

The white paper explains various ways that investors can gain exposure to this asset class, which Warren Buffett recently endorsed as underpriced and attractive. The author explains the advantages and disadvantages of various investment strategies for both active and passive investors.

The white paper also explains that the activity of thousands of local operators is already helping to work through the backlog of foreclosed homes. Attracted by appealing profits, local operators will help the housing market to heal over the next several years. Policies that aim to solve the problem on a mass scale are neither needed nor advisable.

For a copy of our white paper, please click here.

Arixa Capital 2012 Spring Newsletter

First Quarter 2012 Newsletter
First Quarter 2012 Newsletter

This edition of Arixa's newsletter includes:

  • The growth of our investment programs and the launch of our second fund
  • Our annual panel discussion at UCLA in conjunction with the Ziman Center and the Anderson School
  • An update on Arixa's first assignment as a court-appointed receiver; and
  • Information on a new white paper by Jan Brzeski
 

2012 Annual Real Estate Panel Discussion

This year's event is set for Wednesday, February 8 at 6:30 p.m. at the Anderson School. For details, including speakers and registration, please visit the conference website: http://arixacapital.com/conference. What Makes this Event Special Last year, our event drew over 220 attendees for networking, refreshments and a lively panel discussion among some of Southern California's most established and interesting real estate investors. The reason our event has succeeded while other conferences sometimes draw limited attendance include three main factors:

(1) Great Panel. The panel discussion is unusually candid, as we track a core group of investors through the full real estate market cycle. This "longitudinal study" aspect of our event is unique. We are told each year that our panel is one of the best, or the best, among all the California conferences.

(2) The Price is Right. At only $20 per person ($15 with pre-registration), including food, beer and wine, there is no better value than our conference. We thank our key sponsors including the Ziman Center at the Anderson School, and Gibson, Dunn & Crutcher, for keeping the cost to a minimum.

(3) Excellent Networking. Our event starts with a one-hour reception during which you will meet valuable contacts in a collegial atmosphere. At the reception and after the discussion, you can meet the panelists and other professionals and investors in our industry.

Register for the 2012 Annual Real Estate Roundtable Discussion

Join Arixa Capital Advisors and five established real estate investors for our seventh annual real estate investment panel discussion at the Anderson School at UCLA on February 8, 2012. To learn more, click here, or register at http://arixacapital.com/conference/

A Real Estate Investor's Approach Towards Chimera Investment Corp.

Chimera Investment Corporation (CIM) is a $3 billion mortgage REIT with an 18% dividend yield. In an article for Seeking Alpha, Jan Brzeski analyzes Chimera the way we at Arixa Capital would analyze a real estate investment, focusing on the income it generates, the dependability of that income stream, and how the investment is financed. To read this article, please click here.

How Risky Is Annaly Capital?

With a dividend yield of more than 14%, it is hard not to be interested in Annaly Capital (NLY), the largest mortgage REIT.  At Arixa Capital we manage a portfolio of real estate loans...a miniature version of a mortgage REIT.  In a two-part article for Seeking Alpha, Jan Brzeski applies his expertise as a real estate fund manager to analyzing the risks inherent in Annaly Capital's business model. To read part 1, please click here.

To read part 2, please click here.

2 Roads Diverge In Commercial Real Estate

Jan Brzeski is a contributor to Seeking Alpha. The article below is a copy of what he posted on August 30, 2011. To access his article on Seeking Alpha, please click here. Real estate investors know that generalizations are of little value when describing the real estate investment market. Some markets see rising rents while others see the opposite. Results vary by asset class as well.

Today we are seeing an unusual divergence in values as indicated by the two charts below.

The Broad Commercial Real Estate Market: Still on the Floor The first chart is the Moody's/REAL All Properties commercial real estate index:

The index from which the chart above was made tracks repeat sales of all properties across the U.S. where the sales price was $2.5 million or above.

The Institutional-Quality Commercial Property Market: Bubbly Now let's look at the Green Street Advisors Commercial Price Property Index (CPPI). This index tracks the price at which public REITs are buying and selling real estate. This index also gives higher weight to higher dollar volume transactions, whereas the first index gives equal weight to every transaction (only repeat sales of the same property are tracked in the Moody's/REAL index; the CPPI tracks all large transactions by REITs, including those that are not repeat sales).

Mixed Signals The index of REIT-quality properties is up almost 50% since it hit bottom in early 2009. Meanwhile the broader index that includes many smaller, lower quality properties has actually gone down since 2009.

Consider for a moment that the broader index, which is still near its bottom, includes some large transactions where the price is presumably up 50% from where it was two years ago. This must mean that the prices of all non-large properties are down substantially since two years ago, in order for the broader index to be flat.

Imagine if the Dow Jones Industrial Average were up 50% in the past two years while the Wilshire 5000 Index was flat in the past two years. That is more or less what this data says.

Possible Explanations Let's examine some possible explanations of this dramatic divergence. Note that I am not advocating for the superiority of one or another explanation below, only trying to draw out arguments that could explain what we are seeing.

Explanation #1. The income of Class A buildings has gone up 50% in the past two years, while the income of all commercial property as a whole is flat. This explanation, if true, would be satisfying. It would suggest that the indexes are diverging for sensible reasons. However, that is not the case. On page 4 of the 2010 Annual Report of Vornado Realty Trust, "same store sales" EBITDA for Vornado's office properties rose 3.2%. And that includes more than a 5% increase from Vornado's big investment in the government bubble market of Washington D.C. which benefitted from stimulus spending during the period.

Explanation #2. Large, institutional quality assets are experiencing a bubble and are over-bought. Interest rates for both individual savers and institutional investors such as pension funds are near all-time lows. As investors look for yield, they are buying high quality REIT stocks, driving the dividend yields on those companies to very low levels. In turn, the REITs have issued huge quantities of equity on favorable term. If they only need to pay investors 2-4% dividend yields, they can afford to pay very low capitalization rates (very high prices) when they go shopping to invest the cash they raised. Of course if they are going to pay top dollar, they want to buy only the highest quality properties.

Explanation #3. Smaller properties will from now on be relegated to their appropriate place "on the wrong side of the investment railroad tracks." There has always been a gap between the value of a dollar of cash flow from a San Francisco or New York high rise and a dollar of cash flow from an Ohio shopping center or an Arizona mobile home park. The gap has now widened and will remain huge forever.

My Own Interpretation Personally, I think the rise in REIT stocks, and the related jump in values for top quality real estate assets, is part of a larger flight to safety. Investors are scared. They lost a huge amount of money on real estate in recent years. They need to get back into real estate because there is no way to fund retirement with a 1% or 2% yield from government bonds.

As Warren Buffett said, "be fearful when others are greedy, and be greedy when others are fearful." The best way to apply that advice in commercial real estate today is avoid pricy REIT shares and to embrace the healthy income that can be had from less prestigious properties. Small is beautiful in real estate today.

Disclosure: Our own strategy is to make loans to investors who are buying properties at beaten down prices. This provides healthy income with a margin of safety because the borrower's equity acts as a cushion for our investment in case values fall. I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The Case for Single Family Homes (Part 2)

Jan Brzeski is a contributor to Seeking Alpha. The article below is a copy of what he posted on August 30, 2011. To access his article on Seeking Alpha, please click here. In the first article in this series, we explored how "replacement cost" analysis suggests that single family homes in Phoenix are undervalued, and why they are much more likley to go up in value in coming years, rather than moving down.

In this article, we explore a second, independent, strong signal that single family housing in some areas is undervalued. For this article, we will switch to inland Southern California rather than Phoenix, since I know the rental economics better in this area.

Single Family Rental Economics Below is a home about an hour from Los Angeles that was purchased for a little over $100,000 in early 2010.

The buyers of this home are a father and son team who have purchased about 100 homes in the same area in the past two years. They have sold about sixty homes after rehabilitating them, and they have held onto the other 40 homes to create rental income.

They spent about $13,000 rehabilitating this property, so their total cost basis is about $115,000. Today, the house is rented for $1,450 per month. Assuming one month of vacancy each year, rental income is about $16,000 per year. Operating expenses are about $5,000 per year. Net income is about $11,000 per year. On their cost basis, the owners are getting about a 9.6% cash-on-cash return ($11,000/$115,000).

If they bought a similar home today, in need of repairs, direct from a bank, the market is more competitive and they would pay more--probably $130,000 instead of $100,000. Even so, they would still have well over a 7% cash on cash return. Once rehabbed, the property would be worth in the high $100s. This property is appraised at a retail value of $195,000 today.

A Quick Look At Multifamily Rental Economics Let's compare the single family home "fix-and-rent" strategy with buying apartments.

If one were to buy a 100 unit "Class B" apartment building in the same area as this home, it would trade at a capitalization rate of about 6.5%. That is, the income before debt service would represent a yield of about 6.5% as compared to the purchase price.

Given today's low interest rates on multifamily properties courtesy of Fannie Mae (currently under 5% for a 10-year maturity), the cash-on-cash return would be okay from the apartment property--probably about 5% after accounting for principal payments required by the mortgage, reserves and other factors.

However, if interest rates go up, or Fannie Mae stops subsidizing the apartment market by providing such low rates for apartment owners, the value of such assets could easily drop. Investors look at their cash-on-cash returns after debt service, and apartment values have been driven up by very low interest rates for apartment loans. If these rates were to go higher, apartment values would drop, just like bond values.

The Risk Of Buying Apartments Today The bottom line for apartment investors is, they can enjoy low single digit cash-on-cash returns. However, in my view, there is a substantial chance of capital loss, even if rents keep going up, because higher interest rates will lead to higher capitalization rates which means lower values.

For example, suppose we have a change in cap rates from 6.5% to 7.5% (which is historically a more typical cap rate for Class B apartments in secondary markets). A property with annual cash flow before debt service of $300,000 drops in value from $4.6 million to $4.0 million--a 13% drop in value. Now suppose that the property has a loan of $2.3 million. The $600,000 drop in value now equates to a reduction in equity from $2.3 million to $1.7 million, or a 26% drop in equity.

Apartments are currently a favorite asset class for real estate investors, but as the numbers show, there is real risk for apartment buyers when cap rates are at historic lows, as they are now.

Apartments vs. Single Family Home Rentals If, instead of buying a 100 unit apartment building, one were to purchase, say, 60 homes in the same area, there would be certain advantages and disadvantages.

The apartments would be much easier to manage, since they are all grouped together and there are economies of scale. Also, it is easy to get financing to buy apartments, while financing to buy single family homes as an investment is difficult to find and expensive.

The single family homes have the advantage that the current yield (cap rate) is a little higher than the current yield on apartments. Say, 8% vs. 6.5%. They also have one other important advantage. The homes can be sold individually, and if they are purchased from a bank by an experienced operator, they can be bought at "wholesale" prices.

As a result, a home bought for $130,000 and rehabbed for $15,000, for a total cost basis of $145,000, might be worth $185,000 once it is fixed up, because it can then be purchased by a family and once fixed up, the home will qualify for Fannie Mae or HUD financing (which increases the affordability for families substantially). After accounting for broker fees, there is still maybe $25,000 or $30,000 of equity created in the home, by virtue of a favorable purchase and an efficient rehabilitation, both of which create real value.

By contrast, there is almost no way to purchase apartments at "wholesale cost", at least not within an hour's drive of Los Angeles. Anything worth owning will become a competitive auction led by the large number of opportunistic investors who have been trying to buy apartments since the downturn began. The most common complaint from these savvy investors is that there is too much competition, and not enough product available to buy.

Conclusion Most members of the Seeking Alpha community have no interest in being landlords, let alone being landlords for a portfolio of single family homes. The point of this article is two-fold:

The attractive economics of the "fix-and-rent" market today, as compared with the apartment investment market, suggests that home values are near a floor in the most beaten down areas of the Southwestern U.S. It is hard to see values falling much further when already the numbers are compelling for investors to purchase these properties at current prices, given current rents; and The "fix-and-rent" strategy outlined in this article can be accessed by passive investors as well, but only if they know the right people. The key is to find trustworthy operators with a demonstrated track record, and to be able to structure a mutually favorable program to deliver cash flow and a portion of any equity created to the investors. And to insist that the operators have real "skin in the game" in the form of capital alongside the non-operator investors. The Best Of Times For Single Family Home Investors Who Can Execute

For those seeking to gain exposure to real estate intelligently, "small is beatiful." In other words, unglamorous investments like a portfolio of single family homes in a blue collar neighborhood trumps "trophy properties" like pricy Manhattan office buildings--if one is looking for current cash flow and solid risk-adjusted returns.

Several years from now, many investors will look back at the investments that are being made today by obscure but hard-working teams like the father and son team that bought the property pictured above, and they might ask themselves, "why didn't I put some money into that?"

The answer is, this is a truly contrarian strategy and it is non-scalable, so you won't hear about it from any mainstream firms who need to invest on a large scale.

Equity Residential's Implied Cap Rate, And Why It Matters

Jan Brzeski is a contributor to Seeking Alpha. The article below is a copy of what he posted on August 22, 2011. To access his article on Seeking Alpha, please click here.

I am a full-time investor and fund manager focused on non-traded real estate investments. Right now I am focused on investing in real estate loans with a nice margin of safety, but that fall outside of bank lending criteria and therefore offer much higher yield than one would expect.

Every now and then, I take a look at traded real estate assets, and frequently the results amaze me. Today, we'll look at Equity Residential (EQR). All analysis in this article is based on the latest quarterly report on the company's website. To see the source document, click here.

Before we go into the details, I'll tell you the bottom line: public market investors pay a huge premium for the liquidity that they enjoy. To my mind, they are paying far too much, especially if the goal is to have steady income and there is no compelling reason for the investor to be able to liquidate an investment from one week or month to the next.

How Much Cash Flow Do EQR's Apartments Produce? In this article, we are not going to analyze EQR the way Wall Street analysts do. Instead, we are going to analyze it the way experienced real estate investors do. And we are not going to be extremely precise about the numbers. A rough estimate will give us a good view of what is happening.

In the latest quarter, operating income was about $146 million. But that is after deducting $159 million of depreciation, which is not a cash expense. If we add back the depreciation, we see the approximate cash produced by the portfolio of apartments owned by EQR, before debt service, is $305 million. Annualizing that number, we have about $1.2 billion of cash flow from operations (roughly the equivalent of "net operating income" to put it in real estate terms).

What Does it Cost to Buy EQR? EQR's balance sheet shows about $10 billion of debt. According to Yahoo Finance, the market capitalization is another $17 billion (rounding). There is a bit of preferred equity, but it seems to be small enough to ignore for our big picture analysis. So the approximate enterprise value of EQR is $27 billion.

The Implied Capitalization Rate Now let's look at the implied capitalization rate of EQR. That is the net operating income of its portfolio of apartments, divided by the price we need to pay to own that portfolio. The answer is, $1.2 billion/$27 billion, or about 4.4%.

Does that represent a good cap rate or a bad cap rate? It depends on one's perspective, but a seasoned real estate investor would tell you that, given EQR's portfolio, which includes plenty of units outside of the coastal land-constrained markets, a 4.4% cap rate is mighty low.

In other words, those who limit themselves to investing in real estate via today's public markets may be overpaying by a wide margin, relative to what's available to those who are willing to cut out the middlemen on Wall Street and in REIT corporate offices.

I am not advocating buying any old apartment building... only pointing out that yield hungry investors in the public markets should take a look at the underlying numbers once in a while and compare what they can get on Wall Street with what is available on Main Street.

As I will outline in future articles, the best risk-adjusted returns for investors seeking yield from real estate today are not in the REIT universe, and they are not even in the universe of acquiring individual real estate assets (except for a small number of very special situations). Instead, the best risk-adjusted returns can be had from making short-term real estate loans. Currently, banks refuse to make loans on certain types of real estate transactions, allowing private lenders to earn higher returns than would normally be possible.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Case Study: A Junior Loan on a Fix-and-Flip Project

Those investors comfortable taking more risk may want to consider making a junior real estate loan, which can provide more equity-like returns (both on the upside and the downside) as opposed to the steadier returns on lower-risk first trust deeds. This podcast outlines a specific project in which we made a junior loan. This investment has now paid off and it was successful.

Jan Brzeski's Article Appears on Seeking Alpha

Jan Brzeski's first contribution to the Seeking Alpha investment research community has been published. In the article, Jan argues that public REIT shares such as those of Equity Residential are trading at a premium to the value of their underlying real estate. He explains that investors seeking yield from real estate and related assets can find better risk-adjusted returns outside of the public markets. To access the article, click here: http://seekingalpha.com/article/289077-equity-residential-s-implied-cap-rate-and-why-it-matters

Things That Can Go Wrong when Investing in Trust Deeds

This podcast addresses problems that can come up when investing in real estate loans. The most common problem is a default, but other problems include natural hazards, fire and bankruptcy by the borrower, to name a few. All of these issues can be mitigated with property structuring, however many investors are afraid of having to deal with these types of issues, which helps explain why investors in real estate loans get paid well for the amount of risk they take.

WSJ: Home Market Takes a Tumble

This article details that house prices continue to drop in the U.S., down 3% in the past year on average. Standard Capital is a bridge lender to builders who buy homes from banks and rehabilitate the homes before re-selling them for a profit to families that occupy the houses. The drop in home values means lower profits for our borrowers. We see affordability becoming attractive which should help create a floor for home values even as prices continue to ease in the next 12 months or so. In our view, as long as the Federal government continues its policy of providing low-cost mortgages, the market is unlikely to drop dramatically from current values. Click here to access the article on the Wall Street Journal website. -or- To access a PDF of the article, please click here: WSJ_Home Market Takes a Tumble

Purchasing Loans Secured by a Trust Deed

This podcast addresses the secondary market for short-term, small balance real estate loans. Some companies originate loans and then sell the loans to investors seeking yield. These companies can then re-lend their funds to generate origination fees. This is a niche market with only a small number of players in each region. Please watch our blog as we will be posting one new podcast roughly every week. There will be about 30 podcasts total in this series. If you are interested in learning more about what we do, please sign up for our newsletter at www.stndcap.com or give us a call at 310-846-1754.

Our Blog is Live!

Please check this space now and then for company news, events and educational opportunities. If you check in once a month, we promise to have something new and interesting here each time you visit. We strive to add value to the Southern California real estate investment community and look forward to maintaining a dialogue with you here.