In trying to figure out what investment assets to purchase, and when to purchase them, the data available for analysis today is overwhelming. Analysts can spend hours sifting through—and analyzing—data. But despite all of the information that is at our fingertips today, at UDP we like to rely on tried-and-true value investing principles and relatively simple analysis.

We can start with a very simple equation for return.

YIELD = INCOME / COST

Here I use INCOME to mean current and future cash-flows, and COST to mean the purchase-basis of the asset. I leave out the greek letters that would signify income stream.

Our aim from the strict investment sense is to maximize YIELD, which means we want to maximize INCOME and minimize COST.

INCOME tends to be volatile, especially over the short-term, as I discuss below. In real estate, we also have limited control over the supply and demand of our product, which is also volatile over the short-term.  However, COST is fixed. Once you pay for an asset, you are stuck with that purchase-basis forever. You cannot go back to the seller and ask for a re-trade because you paid too much. This is why, in very basic terms, we focus our analysis on long-term nominal INCOME numbers (rather than short-term current INCOME numbers), and we focus on COST.

Value investing icon Ben Graham committed much of his writing to defensive investing and what he calls margin of safety. Margin of safety means purchasing assets at costs that are below their (long-term) intrinsic value. Doing so creates a margin of safety to protect from losses if the (short-term) market-value of the asset drops significantly. Put simply, margin of safety means purchasing assets at a good price. Ben Graham focuses on the purchase price (COST), and making sure it is below the asset’s intrinsic value. Therefore, determining intrinsic value of the asset is very important.

Determining the intrinsic value of assets, and therefore the right COST, requires:

• basic technical analysis—generating an apples-to-apples comparison of different investment assets.
• a long-term perspective—understanding the historical context to recognize when assets are trading at market-values below their long-term average.

• projections about the asset’s future cash-flow growth or contraction.

With adequate technical analysis, and a historical context with which to compare pricing, the margin of safety is most vital in compensating for foggy, hard-to-predict cash-flow projections.  Humans do not have a great track record for projecting future cash-flow streams, so we need a cushion to protect us from our own limitations. Margin of safety is that cushion.

A long-term perspective greatly simplifies the estimation of the numerator of our equation:  INCOME. Gross revenue streams, and their determinant supply and demand curves, will fluctuate greatly over short-term periods. But over the long-term, supply and demand curves tend to converge on a nominal value that we can use in our technical analysis. In other words, trying to determine the INCOME, and fair value, of an asset over a 1-year period can often be much more difficult than determining the average INCOME, and fair value, of an asset over a 10-year period. This is because the 1-year analysis must rely on volatile short-term supply and demand curves, while the 10-year analysis relies on less-volatile nominal supply and demand curves.

So, to summarize, we have no crystal ball. Our long-term perspective permits us to analyze INCOME based on long-term nominal averages that are given to us. We therefore focus on COST, to determine what and, importantly, when, to buy. This approach gives us a high probability of meeting a target yield that will satisfy our investors.

Now, back to reality. What are the indicators we use to determine if current pricing is inflated (i.e. if we are in a bubble), or if prices have fallen below intrinsic value and it is a good time to buy? We use nominal income numbers, and for development projects, a combination of land and construction costs. For existing operating assets, we simply look at the market-prices at which they are trading. We have a long-term yield requirement (long-term perspective again), so we simply plug in long-term nominal income numbers and the current cost basis into our basic yield equation. If the yield number is higher than our long-term nominal target, we buy and/or build. If it is lower, we do not.

An important note about building: development projects are riskier because of long entitlement, permitting, and construction periods. Developers typically commit to purchasing land 18 to 24 months before the completion of the project. When focusing on cost, the entitlement and permitting period is particularly harrowing, because construction costs can rise while you wait for the building to be approved. When development cycles start stretching to 3 or more years, we can end up with deliveries of new construction long after the market has signaled that it is already saturated. So, the longer the development cycle, the higher the risk we overshoot the market demand. This latency, and subsequent bull-whip effect, can lead to oversupply problems and ultimately recessions, damage to the economy, unemployment, and loss of productivity. Therefore, cities should be wary about increasing permitting periods, as it comes at a real cost.

To help protect ourselves from this risk, and anticipate increases in construction costs, we use land-pricing as a leading indicator. Except for in the biggest asset bubbles, land pricing, in itself, rarely makes a project infeasible. However, it is a leading indicator of rising construction costs. Therefore, we pay a lot of attention to it.