“Life is divided into three terms – that which was, which is, and which will be. Let us learn from the past to profit by the present, and from the present, to live better in the future.” – William Wordsworth.
Welcome to the supplement. I’ve been lucky enough to have a few days of “lighter duties” this week (time “off off” is a luxury I am not afforded, because of the life I have created – like everything there are pros and cons) and there’s been some great conversations and some time for reflection. I was influenced by an article I read some time back about the difference in 200+ top entrepreneurs was summed up in about four hours a day – one of those hours was devoted to something that was called “dream-setting” by the authors but it didn’t sound like dream-setting at all. It is more like focus on an alternative pastime or “side hustle” – I read it as trying to break into a new market, new sector or new geography. What it did really sound like, to me, was strategic thinking.
I know from experience of consulting to property businesses that this is something people struggle with. This is definitely not limited to property businesses, and is absolutely something I’ve struggled with over the years. There feels like so much to do, every day, when you work for yourself, that the time to kick back and think, and plan, and also improve, and educate, and develop are simply not taken seriously enough. This is a great way for something that could be done in 3 years to take 10 – so, it can be damaging to your time, which is the most precious and scarce commodity of them all.
Any strategic thinking exercise at the moment is particularly hard work. Why? There’s as much uncertainty about the near future as there ever is, realistically. The fear factor dials are turned up to full, in the media, because that’s what’s kept people gripped to the television, or radio, or clicking the articles over the past couple of years. There are a number of incongruent things going on in the global asset markets, alongside some nasty-looking macro indicators, particularly inflation, and this is a near-global problem. That suggests a relatively risky time to be taking leaps across markets, sectors and geographies – but similarly, the competition will be thinking the same – so opportunities may well be far larger.
It is also wise to consider how the highly successful might consider this problem. The main man himself, Warren Buffett, would happily tell you how he doesn’t ever see a rich economist (the counterpoint to this view, and I rarely disagree with the Sage of Omaha, is that Ray Dalio is about the best Economic practitioner of all time, of course). The point is sound, overall, however. If you spend all your time in a dark room predicting this and that, then it will prevent you from taking action – and one of the great weapons you have in investment is time. Time is a great healer – your entry point and strike prices will make large differences to your returns over 1-2 years but when looked at over 30 years, will have a more limited impact. You would be better considering how volatility would impact your efforts, and looking at your risk of ruin. What would put you out of business? Hopefully, the answer is a set of events that would put so many people out of business before you that the government would step in to take actions that would save your business. If that’s not the case, hopefully your business is making fantastic returns on limited working capital (i.e. it has limited assets compared to the amount of money you have invested), so you have a limited amount at risk in the event of a significant market shock.
At a really simple level Buffett has done a few relatively basic things that, when combined, are particularly clever with Berkshire Hathaway, his company. Why the insurance business? Because generally, it collects money up front for the year and then distributes a percentage of that money back in claims. Like any such business, it needs to price risks correctly, and then variance will have some impact. You need significant volume for the “law of large numbers” to take effect. That model provides liquidity, however. Then, the business buys stock in other businesses, and entire other businesses too. But it is in itself a business, that can raise debt funding via the issue of bonds. So – it can own businesses (which themselves have their own debt funding via bonds) with a mixture of debt and equity – double leverage, without the appearance of taking particular risk.
Further than this – it issues bonds, but does not really own them much, if at all, these days. It has cash at more than 5 times the level of its bond holdings, which is a particularly different structure especially for an insurance company – but this has made massive sense over the past decade as bond returns have fallen into negative real yield territory; the use of equity for 75%+ of the Berkshire Hathaway payout “float”, based on low-volatility businesses that pay regular dividends like Coca-Cola or Heinz, has meant that they can stay ahead of the game.
The beauty of all of this is that this information is transparent, available, and no doubt could and would be analysed in a different way by a different analyst. The next step is to work out how you can utilise some of these theories in a mega-cap company and distil them down to being useful for you – whether that is doing things differently from the rest of the competition, and gaining better returns by doing so, or finding a way to leverage twice over without taking inordinate risk/whilst staying liquid – or something else.
At a high level Apple innovated very little when it came to the smartphone – there were plenty of operators in what was already a fragmented market, but they took all the component parts and innovation and put them together in a way that no-one else had with a real focus on the user experience, and that in itself was the innovation – and that led to competitive advantage. They were brave enough to bring a tablet to the market when no-one even realised they wanted or needed a tablet – something which showed their versatility and also the strength of their brand. They’ve not succeeded at everything straight away – the Apple Watch was a high profile flop although now is the world’s leading brand with over 50% of the market – and the Apple Car will no doubt be interested as and when it becomes a reality (Tesla may well be so far down the track by 2024+ that it will be hard to challenge, but in terms of global brand strength, Tesla is unlikely to have entered the top 10 by 2024 and Apple is the incumbent leader, so that cannot be underestimated).
What does that teach us? Well, that we don’t always need to reinvent the wheel to come up with a great product, or a great offering when it comes to services – but also that we can, in the right circumstances, take leaps of faith and be immensely profitable and successful when we do so. This changing of gears is much easier for a large multinational, you might say, but the agility to switch what you are doing, and the ability to gain a competitive advantage in a micromarket such as “HMOs in Newtown” is actually far easier for an SME developer – and the risks and time investment can be much lower.
So – thinking strategically and reflecting on what’s been achieved. I’m a huge advocate of this when looking at any performance and I thought it would be a good time to share a suggested framework. This needs modifying for most people, one way or another, when analysing a property business, but I will split it into two, hopefully useful, sections.
Firstly, let’s consider the investment business. The strategy is to hold stock, for the long run, in order to grow and protect wealth, and to generate income as a secondary objective (or even to simply ensure cashflow services existing operations/cash burn). This would be set-up for maximum growth, reinvestment of all monies in further purchases, etc., which of course is by no means the only way to do it – but it makes the most of the company structure, compound interest, and the old adage of “time in the market, not timing the market”.
Performance analysis can come at the individual asset level – how is that particular property performing? Metrics including yield, return on capital employed, return on (realisable) equity, and a suite of others would be considered. This could be analysed monthly, quarterly or annually. It can also come by separating the “alpha” and the “beta” to steal a phrase from the financial services industry – let us borrow but redefine the terms. Alpha could be considered everything that has been added through skill, in a project – so, it is a backwards-looking metric. This is very similar to its financial markets definition. This could be through buying well, it could be through delivering a project well in terms of cost control – it could be through maximising the opportunities on a site, whether that be as simplistic as turning a 2-bed house into a 3 or a 4-room HMO, or as complex as you like on a multi-layered development site. Ideally, it would contain more than one of these elements of value-add.
Beta in financial markets would normally measure the noise of a single stock – i.e., at a beta of 1.2 what that’s saying is that historically, a 10% gain in the market has matched up, on average, to a 12% gain in this single stock (the same goes for a 10% loss). This is solely on average. We could use that to define beta in, for example, prime central London versus Inner, versus outer, versus the East Midlands, versus Scotland (for example) – which would be useful. However, I’d consider a better backward-looking metric here to be one that encompasses what the market performance has been, so that you can apportion the performance of an asset to your own skills (alpha) and what the market has done (beta) if we accept that distinction. It is, like all metrics, imperfect – so, for example, what if you have identified markets that should outperform other areas, and then you are proven to be correct? (well, you could take this a step further and look at your predicted performance versus achieved performance – or indeed, look at the historical beta from the financial markets definition before you bought an asset, and then the beta for the period from when you purchased it to today – and this would be a useful thing to know, but still, some would be luck and some would be judgement).
Property behaves differently to stocks as well. Far fewer data points (land reg data points updated monthly, for example, via ONS/the HPI). Far less volatility. Fewer down periods (bear markets). So – we can’t lift the metrics across and expect them to be the correct ones, although some methods and metrics do translate particularly well (IRR, NPV, discounting to name but 3).
Still, you can understand the point. Of performance – what has been luck and what has been skill? You might also consider what you would have done with the equity had you liquidated certain assets, and measure those theoreticals (as long as you do that in a disciplined fashion and use the real numbers, not allow your mind to play tricks on you). In stocks, buying and selling is extremely low cost in this day and age – in property, not so much. 10% of the value of a property can easily be burnt in frictional costs of buying and selling it, so this can be a major performance drag on the asset’s performance if this is undertaken relatively often or over a shorter time frame.
Understanding the liquidatable value and also the free cash flow of an investment company are two very important metrics – you could ask 10 people about how to calculate the liquidatable value and they could give you 10 different answers, all with pros and cons – whereas the free cash flow can be forecasted and also looked at historically (again to assess forecasting against reality).
This is a distinction that I rarely, if ever, see made in discussions of property portfolio performance. I accept it may not be the most scintillating subject for the dinner table, but as Bob Sugar says in Jerry Maguire – “It’s not show friends, it’s show business.”
For the sake of clarity, let’s imagine looking at last year’s performance:
Alpha (valued added) – expressed as both a raw £ value and as a percentage of new acquisitions and projects that were already in the pipeline, and as a percentage of cash deployed/equity deployed.
Beta (value gained) – expressed as a raw £ value and as a percentage on last year’s number, on debt, on equity, and anything else you think worth looking at (increase in realisable equity, for example – raw and %).
This keeps your feet on the ground. It also goes some way to draw a distinction between active and passive income. It stops short of navel-gazing but provides some good intelligence.
I’d argue that this approach is even more important in a development-led business. It can be done project-by-project. It can look at forecast GDV versus GDV at point of sale (unless selling up front/off-plan of course) and then sales prices achieved. Where were the overruns, what did you achieve versus what you forecast, and where did you make more money than expected?
This sort of analysis is very important. Some of us have a tendency to beat ourselves up when something doesn’t go right. In property that’s dangerous on many levels, and might well prevent a long and illustrious career. Even more of us don’t assess our successes and think what we could replicate, what was luck, what tweaks we might make to our pipelines or business development strategies to get more exposure to that sort of deal. This is good for balance, good for the soul, and good for the business ultimately.
How does this manifest itself? Well, between say 2010 and 2015 it was as easy as it ever gets to be a developer in London. You saw all the hallmarks – the taxi drivers were doing it, etc. etc. As soon as the market stopped carrying the chaff, things got an awful lot harder. The smartest saw this coming and moved geography, or tenant type, or property type, or some or all of the above. But it was more than that. That also manifests itself in a queue of people willing to bid up properties, sites and the likes. When the market has been adding 10%+ per year, then if you assume that will always continue (which it never can, of course), you can buy a project at nearly no margin in anticipation of that. I don’t think that’s how anyone ever frames it, but the behaviour that manifests itself has the appearance of that being the case.
We have a break coming up – a few days of quiet, over Easter. Some reading this will be thinking “there are few breaks, something might happen” – and sure, it might. If you are heavily involved in direct property investment, that is definitely the case. What I hope you will take away from today is that it might be an idea to do some subconscious reflection over some of these strategic points, have a look at how you analyse performance at the moment, and consider whether your reporting could be, and should be, better.
Until next week’s egg-cellent efforts (sorry)…..