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.
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.
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.
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.
At this point, we have verified the actual potential income for the pr< >pcrty. Remember that’s the income the property could generate at current rents with 100 percent occupancy. But certainly, it is highly unlikely that this property is or will be 100 percent occupied every day of every year from now until eternity. So we have to take into account vacancy and turnover from residents moving in and out. And while we’re at it, we should consider any other income generated from sources like laundry facilities, parking, and so on.
The typical pro forma lists these values as well. And surprise! these numbers, too, I have found to be inaccurate most of the time. Vacancies are usually understated and other income is usually over-inflated. The key here is to try to project what the vacancies and other income will be in the future. It’s nice to know where you’ve been, but where you’re going is really more important. That’s why the windshield is so big and the rearview mirror is so small.
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