Investing in Property Stocks 102

I decided to distill the findings of my dissertation, and write it in a research analyst style, because I wanted to try and merge academia with business. As promised in an earlier post, I shall offer three key investment ideas. The nature of this post (both content and style) deviate significantly from that which my readers may have become accustomed to. If the subject matter bores you, I apologize in advance. The direction however, is in line with my goal to be a multifaceted person, with diverse skill sets across various fields. So here goes..

Investment Idea 1: Buy a property stock when it is trading at a NAV discount

Since a NAV discount represents a profitable arbitrage opportunity, then investors should capitalize on this market mispricing to land themselves bargains. A NAV discount essentially means that the assets of the property company are being sold on the stock market for less than what they are worth on the property market¹ ! If the investor accumulates enough shares in the company such that he becomes the majority shareholder, he can exert influence on the managers to divest underperforming assets and reap capital appreciation gains.
 
However, the investor must first understand the typical NAV discount behaviour of the property company. For instance, he may justify his decision to buy the share on the premise that it is trading at a 5% discount to NAV. Upon closer scrutiny, he realizes that over the past 10 years, the company has traded at a long term NAV discount of 50%. To better understand its tendency to trade at discounts or premiums, he classifies the company into five separate categories², and finds that it has traded consistently or mostly at a NAV discount. Therefore, the smart investor will know to buy at an even greater NAV discount from what is normally observed. If buying at a NAV discount represents a margin of safety, then buying at an even greater NAV discount offers better odds.
 
Studies have conclusively proven that stock prices undergo a ‘mean reversion’ process, i.e. stock prices may deviate in the short term, but in the long run they revert to fundamental values. This study has found that NAV discounts were the largest and fluctuated the most during periods of crisis. So if an investor puts these two pieces of knowledge together, the rational conclusion is that he should buy property stocks during crisis, since prices will normalize in the long run! Of course, this is subject to the caveat that a background check on the company does not turn up too many red flags, e.g. over leveraged balance sheet, rapid human resource turnover in upper management, cash flow problems, etc.

Now that we know that we should buy during periods of crisis, the next two investment ideas will let investors know what types of companies to buy. 

Investment Idea 2: Buy property hybrid companies during times of economic uncertainty

Basically, property companies undertake different types of business activities. Some build properties for immediate sale. Some develop properties to derive rental cash flows. According to the proportion of development versus investment properties held on their balance sheets, they can be classified into property development or property investment companies. Property hybrid companies have a mix of both types of properties.

Generally, property investment companies trade at a NAV discount and a low Price-Earnings Ratio (PER). This is primarily attributed to the onerous task associated with releasing all their properties onto the market at once in the event of company liquidation. On the other hand, property development companies are profit generators, and trade at a NAV premium and a high PER. In the past, the tendency has been for property development companies to use profits to accumulate a more stable investment property portfolio, after which the latter evolves into the former.

For Singapore and Hong Kong, the biggest three property companies by market capitalization are Capitaland (CL), City Developments (CDL), Keppel Land (KL) and Cheung Kong (CK), Sun Hung Kai (SHK), Wharf (W) respectively. Out of these six premier companies, four (CL, CDL, KL and SHK) are property hybrid companies, while one (CK) is a property development company and another (W) is a property investment company.
 
These top property companies were previously mostly property investment companies. The trend in recent years is for them to take on development projects, which while more risky, yields much higher profit margins. As seen from their annual reports, in some years the profit margins from development activities can hover as high as 50%. It is an open secret that companies like CL adopts an aggressive capital recycling strategy, often selling trophy buildings to chase even higher returns. There are no sacred cows in the CL portfolio.

The findings also revealed that over the period of study, property hybrid companies were favoured most by investors, as evidenced by the highest average PER ascribed to them. A tentative conclusion is that in times of economic uncertainty, the balanced portfolio of property investment companies provides diversification benefits, and investors are attracted to such a ‘best of both worlds’ scenario. However, the same can also be said of it being the ‘worse of both worlds’ - that it is neither as profitable as a pure property development operation nor as secure as a pure property investment operation. Ultimately, it depends on the investors’ view of the market’s direction. If he expects a property boom, then he should place his bets with property development companies and ride on the bandwagon to riches. If he expects a property bust, then he should hedge his stake with property investment companies and seek assurance with high quality tenants and committed leases.

Investment Idea 3: Buy property companies with a sizeable market capitalization and a decent track record

Studies have found statistically significant relationships between NAV discount performance and size, and NAV discount performance and return-on-equity (ROE) for Singapore and Hong Kong property stocks. Put simply, the bigger the company, as well as the better the past ROE, the better the NAV discount performance.

This is not surprising, given how the premier property companies are also often the biggest. They have strong balance sheets, are well capitalized, and can dictate more favourable credit terms with banks. They have the financial muscle to take on huge development projects, and reap cost savings from  economies of scale. They have a monopoly on talent – the best and brightest brains are attracted to work for them. While they may maneuver slowly, they are big ships which can weather the storm in bad times, and gather momentum to barrel ahead in good times.

In short, so long you invest in property companies with a market capitalization of more than S$500million, as well as offer a ROE in the range of 5-10% over the past few years, you should be on the right track.

Notes: 
¹ The property appraisals are conducted by independent and licensed property valuers, who provide their professional opinion on how much that property is worth at that point in time. 

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Trading Behaviour Classification	Trading Behaviour Description
Trading consistently at NAV discount	Trading at NAV discount more than 85% of the time
Trading mostly at NAV discount	Trading at NAV discount more than 60% of the time
Fluctuating between NAV discount and premium	Trading at NAV discount from 40% to 59% of the time
Trading mostly at NAV premium	Trading at NAV premium more than 60% of the time
Trading consistently at NAV premium	Trading at NAV premium more than 80% of the time