When I meet with one of our capital partners/investors these days, I almost always get the question: “Are we in another housing bubble?”

Given our successful acquisition history through the economic downturn, and the fact that we avoided acquiring properties during the bubble’s rise, some of our investors seem to think we have a crystal ball. Well, we obviously don’t have a crystal ball, but we do rely on some simple parameters that have proven to work well for Urban Development Partners, and prior to UDP, for our principals. These parameters were derived from an unlikely source….

When people ask me about my favorite book or resource on real estate investing, I sometimes surprise them when I say “The Intelligent Investor” by Ben Graham, a book about public equity and bond investing. I respect Benjamin Graham’s work so much because he focused on a couple of ideas that are core to UDP’s investment philosophy: Margin of Safety (focus on purchasing at a reasonable cost) and Buy to Hold (long-term perspective). Together, these two tenets provide a powerful framework for analyzing investments. How do we apply these value-investing tenets to commercial real estate investment?

Establishing a margin of safety means purchasing property at or below long-term intrinsic value. This is as much about what Phillip Fisher calls “scuttlebutt” as anything.  It is about being in the market, shopping for assets, and understanding value. It is a lot about financial analysis, discounted cash-flows, and a basic understanding of the capital asset pricing model—as well as having a historical context for understanding the results of financial analysis. “Spreading numbers” in Excel to find the net present value of an income stream will give you a common “apples to apples” comparison of income-producing assets, but it does not tell you whether something is a good value.  Determining value when shopping for investments is much like determining value when shopping at your local retailer.

When you buy a car, and are intentional about getting a good value, you likely develop a list of features for all cars that you are considering, so that you can create some type of apples-to-apples comparison of cost versus value. But even more importantly, if you are a professional bargain shopper, you have been in the market for a car for years, and know when prices are generally down for cars—all cars. For example, 2009 was a good time to buy a car. Dealers were providing incredible incentives. And if you had been in the market shopping for cars since 2004 (or in our principals’ case, with real estate for 20 years), you would know that it was a good time to buy. This is where the buy-to-hold strategy and long-term perspective come in.

Short-term strategy dominates the professional investing world these days due to Wall Street’s obsession with quarterly earnings reports and corresponding incentives. Short-term motivations inhibit an investor’s ability to create a margin-of-safety. Short term investors are always in the market to buy and always looking for the best bargain of the day. But, what if it is 2006, the market is hot, and there are no real bargains to be had from a long-term historical context? The short-term investor is largely agnostic to this historical context, instead looking for the best bargain of the day—even if it is not a good long-term investment, and even if there are no assets for sale that provide an adequate ‘margin of safety’ from investment losses. A short-term investor would never consider getting out of the market and abstaining from buying for four years, or even one year. Why? Because most professional investment managers depend on acquisitions to generate income from transaction fees, pay the bills, and report quarterly profits.

This is why it is so difficult for most investors to maintain a long-term perspective and develop a historical context—doing so requires an incredible amount of discipline and resolve. I would suggest that the investment industry is not starving from a crisis of intellect: after all, we have some of our best and brightest working in the industry. Rather, the investment industry is starving from a crisis of discipline and a broken incentive structure that rewards investment managers for buying assets, regardless of the assets’ long-term value.

With this in mind, let’s return to UDP: though we do not have a crystal ball, we do apply the basic value-investing tenets of quality, cost, margin of safety, and long-term perspective to real estate investing. In doing so, we have developed an investment strategy that largely protects us from real estate bubbles.

More about that in three upcoming posts…