The importance of asset allocation, or deciding what percentage of a portfolio to devote to various asset classes, cannot be overstated. Especially equity and corporate bond investors spend enormous efforts on picking individual investments, while they spend relatively little time on deciding what types of stocks or bonds to buy into their funds. Numerous empirical studies have shown that a large part of money managers’ performance can be explained by asset allocation, not by their selection of individual stocks. Therefore it should be just the opposite. Investors should spend most of their time on overall asset selection and ignore individual investments for the most part. When a stock performs well, invariably stocks from the same asset classes follow in parallel. The primary goal should be to pick the right asset classes in order to outperform. Asset allocation is not easy and requires completely different skills than the selection of individual investments, but it is less detailed, and it rewards skilled investors generously.
Before 2001, credit played a minor role in the asset allocation of private as well as institutional investors. This is due to the fact that there was no easy and cost efficient way to replicate the performance of credit markets appropriately.
Derivative contracts, in particular credit-linked notes on corporate bond indices, have a variety of uses: to gain synthetic exposure, as an arbitrage tool, to effect overlay strategies and to invest cash balances efficiently. The growing popularity of JECI and Trac-X as well as the exchange traded funds on the iBoxx Euro Liquid Corporate Index and the Goldman Sachs USD InvesTop Corporate Bond Index demonstrate the rising sophistication of market participants in the credit markets. They have realized that using a benchmark index that also has a liquid derivative contract can be of great benefit to investors.
The index market is becoming increasingly competitive and commercial. With little differentiation in construction methodology, competition between index providers is focusing on brand. Nevertheless, investors have to keep in mind their intended usage, be that fund management, trading, advice or research.
More and more investors are beginning to focus on transaction costs, and in less liquid market segments also on market impact costs. Clearly, good liquidity is an important factor in reducing market impact. International investors in particular are increasingly looking for liquid benchmarks and securities. This is reflected in the large cap bias found in many of the newer indices and exchange traded funds that are often based on very focused indices like, for example, the iBoxx Euro Liquid Corporate Index.
Investors’ benchmarks, strategies and horizons change. Indeed the pace of change has accelerated in recent years, be it moves from pure government benchmarks to aggregate indices, from broad market to large cap benchmarks, or to indices that include issuer constraints. In these circumstances, institutional investors are becoming more focused on transition costs as they change their benchmarks. Index series that encompass a wide range of benchmarks and styles with similar methodologies have an advantage here.
Histories of indices will be used by investors and their consultants to formulate strategic allocation policies. Asset allocators and academics also have an interest in long data histories when building allocation models. The asset–liability modeling exercises that many pension funds and insurance companies now undertake on a regular basis to review strategic benchmarks, all tend to use historical volatilities and covariances that are derived directly from index histories. There may be some advantage to investors in using the same index for the ongoing fund management benchmark as that used in the prior modeling exercise.
Conflicts of interest can only damage the standing of an index. Suspicion surrounding the motives of interested parties is almost as bad. The involvement of investment banks in index compilation tends to create such suspicions, particularly around constituent review time. Most bond indices are proprietary indices that use trader pricing. Thus they are susceptible to be biased by the positioning of the trader. For short positions, for example, the trader has an interest in pricing the bond on the lower end of the market.
Even the absence of positions on the trading book can distort an index, because those bonds are not marked actively. Indicative prices are highly susceptile to be erroneous. Hence, indices that are owned by exchangesor rely on the pricing of more than one investment bank are more likely to be accepted as independent. Especially among institutional investors the iBoxx index family has attracted a lot of interest, because it relies on pricing information of seven investment houses.
Capitalization rate? I know you’re thinking this is starting to sound complicated; definitely third-year college accounting. Well before you close the book, allow me to explain. First, it sounds way more complicated than it is. In numerical terms, the capitalization rate is the net operating income divided bv the purchase price:
Capitalization Rate = Net Operating Income -T- Purchase Price
So now you’re thinking, “Ken, how can I calculate the capitalization rate when I don’t have a purchase price yet? That’s what I’m trying to figure out through this whole exercise after all. Don’t tell me algebra is involved!” No, algebra is not involved. This is actually really easy. The purchase price here is actually the purchase price trends for a comparable building in your market. So this very complicated sounding word is actually something you can get very easily from brokers, real estate agents, or even the pro forma document for the property. The people in the business—your team members—will either know the capitalization rate for your market or help you calculate it, and that’s all there is to it.
Keep in mind, at this point in the process your goal is to get an idea of the ongoing services and repairs as well as upgrades the building may need. Later in the process, you’ll go into lots more detail. This is the time to put rough numbers on paper and analyze if the cost of the needed repairs will still allow you to be profitable. There is a real balancing act between spending enough to get the place in shape and overspending. Again, your property management representative can help you determine many of these costs.
The goal throughout this whole exercise is to get a picture of where your expenses are and try to find ways to do things better, smarter, and for less money. Those increase your net income and increase your profitability. So what are the expenses? To answer that question, we’ll turn to the pro forma expense table. It shows the seller’s anticipated expenses for the coming year (the pro forma column) and the actual expenses for the prior year.
Regardless of whether you will be using a property management company or not, calling one to visit the property and help you assess everything involved in running the place is a good idea, particularly if you are looking at a multi-unit building. Just call and say, “I’m looking at buying an eight-unit building, and I’m not sure if I want to run it myself or hire a company to do it. I’d like to show you the building and talk with you about it.” The hour or so you spend with the property management representative will be a good investment of time. And if you have to pay that person an hourly consulting fee, it’s worth it. Make the objective of the meeting twofold. First, you’ll want to learn what it will take to run the property, and second, you’ll want to get insight on how to minimize expenses.
Expenses are the second important variable to consider. As I mentioned earlier, the definition of net operating income is income minus expenses. In the previous section, we showed you the specifics you need to review to estimate the income potential of a property. In this section, you’ll see how to assess the expenses.
Just as we did when we verified income, you’ll want to get a picture of the current expenses. Unlike the income calculation where our goal was to be 100 percent on the money in terms of accuracy, with expenses the goal is to get reasonably close. We’ll find out all the minute details later in the game. This is another area where your team of pros can help you.
As I’m sure you have guessed, when I formulate my offer I disregard the other two income numbers and use my own projected figure, the one that takes into account the real property rents. The best part of this strategy is that because the numbers are real, they are easy to defend during the negotiation process.
This is how easy it is to verify income and how easy it is to catch these kinds of inconsistencies in the numbers. As I mentioned, income is often inflated, so don’t be shocked if the difference be¬tween the numbers on the pro forma and the numbers you project are in the thousands. That is common.
Before we leave the topic of income, let’s address future potential income. Recall that future potential income is the total income the property could generate at today’s market rents, 100 percent occupancy, and by taking full advantage of all other income opportunities. You may find through your income verification process that the reported rents are well below the market. This could be your ‘Advance to Boardwalk” card, so keep it close to your vest. It’s this kind of upside potential that property investors dream about. With income verified, it’s now time to turn our attention to expenses.
Common sense will tell you that if an apartment is not rented, it is not producing income, and that reduces your cash flow. Even if the vacancy rate is listed on the pro forma, verify it with the property manager on your team. He or she will be able to tell you if the va¬cancy rate listed is at, above, or below the average of the market and will know this because vacancies are mostly a function of supply and demand within the market. You can also find this information by looking at the monthly rent rolls and move-in dates on the leases.
The income section on the pro forma is where the seller lists the property’s income and the vacancy rate. It shows the income from rent, minus the average vacancy for the property, and adds to it the other income the property generates. The typical pro forma income table looks like the one below, which contains numbers taken directly from the property in Phoenix. In this real-world example, the seller or broker is reporting a total income for the property to be $45,120 per year, using a 7 percent vacancy rate and $480 in other income. That seems pretty good.
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