Investing for a Recession (Part II)

Having outlined how I have made some useful money from the recession to date, it would be worth now moving to my current main investment at present, so that there is some context when I update on this going forwards.

Apart from putting a proportion of my funds into a gold ETF, which is an excellent hedge both against recessionary worries, a devaluing dollar and future inflationary concerns from all the quantitive easing taking place, I have also placed a significant sum into something that is much less obvious in these turbulent times: US commercial property.

You might think that is insane, and is totally contrary to what everybody else is putting their money into at the moment. But part of investing is looking for value, and sometimes that means looking beyond the conventional wisdom. I have bought into something called a Real Estate Investment Trust (REIT) - these are essentially US commercial property companies, which by and large have plunged by enormous amounts in the last 6 months.

As such, several are rumoured to be on the verge of bankruptcy, and one in particular is down a staggering 97% since the summer of 2008. When you factor in a fall of that magnitude, you have to start looking at the price and ask why, and whether this is rational or fueled by other factors. The underlying reason is the credit crunch, combined with investor fear of a Chapter 11 bankruptcy filing.

To give some background here, REIT's have by and large used a previously acceptable business model, whereby they were highly leveraged and routinely took out large levels of debt to increase their asset base and buy up more property. They then serviced this debt, steadily paying it off while periodicially refinancing this - without problems in a normally functioning credit market. Of course, everybody now sees US property as having been in a huge bubble, and all associated loans as necessarily toxic. As such, suddenly some enormous commercial property companies are on the brink of bankruptcy - including the particular REIT I have invested in called General Growth Properties (GGP).

To put it into context, GGP is the second largest mall owner in the US. That is not an insignificant statistic in itself, and should it fold there would be enormous ramifications for the US retail sector, not to mention a political backlash. I would actually not mind if it did file for Chapter 11 within the next few weeks, for reasons summarised well in this Reuters article.

Estimates suggest that GGP's assets exceed liabilities on the balance sheet by several billion dollars already. Additionally it has no problems servicing its actual debts, just refinancing them. In effect the problems of GGP are not with solvency, as with normal bankruptcy risk, but liquidity - this is a direct result of the banks own liquidity issues that have made them more risk averse.

What is most interesting with GGP is also that the balance sheet is not fully marked to market, which means that if its assets are valued at today's prices instead of when purchased there will be a change. Many properties on its books were bought years ago and have never been revalued, so it is reasonable to expect many will be worth more than marked, even with the current woes of the US property market. As such, assuming GGP were to go bust, what does that mean for ordinary shareholders? Normally it is a disaster and means no money, but in this case it should mean that the US courts would order the banks to agree refinancing terms, after which GGP would emerge out on the other side without that perceived stigma. Meantime the shares will continue trading on the stock exchange.

Since the Reuters article, all indications are that GGP will not file for Chapter 11 however, with its banking consortium of lenders bending over to give multiple loan extensions (including one over the weekend through to mid-March). There are many factors at play in whether full refinancing of the loans due in 2009 will take place - that is what would remove the market risk of bankruptcy that has so severely depressed the share price.

The main sticking point for lenders is several billion dollars of loans that are currently unsecured (i.e. have no assets backing them up), which are due for refinancing. Understandably the banks want assurances they would have some collateral to offset should GGP go under at a later date, and at present the unsecured loans are not acceptable to them. As such GGP is looking to either sell assets to pay those off, or negotiate terms. Both are possibilities, but at this stage it is unclear which is the more likely.

Another factor is the recent extension of uses for the Troubled Asset Relief Program (TARP) by Barack Obama, to now explicitly include money for Commercial Real Estate. This bill has passed through congress, and the campaign is continuing - again it provides political pressure on the banks to lend and not push under a company as significant as GGP.

Once terms are agreed, or GGP manages to sell off a number of assets to enable refinancing, I expect there to be significant upwards movement on the stock price. I have gradually increased my long position on GGP from $1.61 down to $1.03 in the last 2 months, although it is worth adding that a recent sell off last week on fears ahead of the loan deadline (prior to extension again) lead to a sharp fall back to around 55 cents a share. As of yesterday, GGP's share price bounced up 30% on the news of the loan extension, and is now currently at around 80 cents a share as I type.

So I am sitting on an unrealised loss at present. Since I bought into this REIT in December, the share price has risen by 80% at its peak, and fallen by 50% from where I entered at its lows. I turned down the chance to cash in a £50k profit in early January because I am more interested in the bigger picture here. That's how trading works - I have a strategy which does not include day trading this stock, because I do not know when the news will be announced that will make the crucial difference.

To give you an idea of the potential rewards at stake here, if the share price were to rise back to just $3.50, where it was in October, I would make in the region of £150k from the trade.

I should add a cautionary note that this is considered a speculative play. I am speculating on the most likely outcome based on extensive research - what makes this unusual is that there appears to be significant upside regardless of whether GGP files for bankruptcy protection or not. To me the share price of GGP is significantly undervalued, and at some point the market is going to realise that.

Most people are not prepared to accept this level of risk, and that is entirely right, although it is worth pointing out that you can take a zero off the figures and it could easily be you making (or losing) these amounts. In my case, if everything goes as well as I expect, I could make over £1 million from the trade. Admittedly that is unlikely and would require me holding for a couple of years. I am looking at cashing in £250k as a more realistic profit, but it gives you an idea of how risk vs reward works in the markets.

I will keep you updated on the progress of this particular hot potato in the coming months. Anyway back to work.

Dinner Time Conversation Killer

It is ironic that the current dinner table conversation killer these days is exactly what most over-extended people wouldn't stop twittering on about for the last 5 years.

By that I'm talking about house prices of course. Apart from a recent evening when I was forced to endure looking through a photo album of a friend's baby for an hour, I can't think of anything more boring. However there were a whole raft of people who took delight in measuring their own success by how much money they had 'made' by virtue of their house value - and telling the rest of us ad infinitum. Of course we can all see this was an illusion now, but I was one of a long-suffering minority who chose to sit out of this particular party as I could see what was coming.

If you are one of those with everything you own tied up in a house or flat, then you need to understand that housing always has and will be the British public's great illusion of wealth. An Englishman's home is his castle as they say. Yet in truth the only time housing should be seen as an investment is when it's a buy-to-let. Otherwise a house is a place to live and use - with the added bonus it can be sold on at some point of time in the future.

However ask yourself a question, what do you DO with all that money you've got tied up in a house you live in? The answer is, absolutely nothing. Money that could be making you a lot of money elsewhere is instead used to avoid paying rent. Where the Great British public justify over-extending themselves is in the naive argument that rent is "dead money" - so you have to get on the property ladder as soon as possible.

Nothing could be further from the truth, and for proof you only need look at Germany, where house ownership is something like 20% of the population. Germans are no poorer than the British - in fact given Sterling's recent collapse (more on that in a future post), they are a good deal wealthier when measured by earnings. So how can that be? The answer of course is that the money you don't stuff into a house can make you as much (or hopefully a lot more) than by simply following Average Man On The Street. Ask yourself one question: if housing is such a great investment, and everybody does it then why aren't more people rich? No, it's not just down to the amount people earn, it's what they do with it.

Unfortunately as we've seen, most people get excited by a rising number attached to their property in a housing boom, and then pretend that they have 'made' that money. Bzzzzt. As novice traders in the City learn on their first day, one of the golden rules of investing is that an unrealised profit is nothing more than a possibility at that moment in time. Not only have people spent the last 5 years happily falling under this illusion of wealth, but worse some have then borrowed more money against their house (on these unrealised profits) to spend.

That's all fine while those profits can still be realised, but the moment the market does what it does every 18 years or so and crashes, we're left with a large number of people who are about to learn this lesson in the most painful way. Point fingers of blame at the government and housing industry for allowing this to happen.

For even the many who were not so overextended but nonetheless followed the British norm of assuming buying a house or flat was a must do with their money, they are yet to learn another of the golden rules of investing - namely it is vital to detach emotion from an investment decision. Just because your house used to be valued at a certain amount doesn't mean digging your heels in and refusing to sell now if you want to move is a sensible idea.

There is currently a belief amongst home owners that reeks of desperation - namely that the market is simply going to bounce like a ball off its bottom and start shooting back upwards. Nothing could be further from the truth: house prices historically always have a sharp peak at the top as the boom becomes unsustainably fast and then sharply reverses. However that is followed by a near-equivalent fall down on the other side. House prices will continue to fall fast and then that pace will decline until it slows gradually to zero and only gradually begins a rise years later.

We have at least another 20-25% to fall before house prices reach the bottom, and when they do, they will do little other than stay at that level for another 3-5years. That means we won't start to see significant rises in house prices again until around 2014 or 2015.

But most people don't think rationally through the process. Most people don't take the time to research the housing market before buying to understand what has always happened before, and hence try to work out will happen again in such a cyclical market. Nope, we're going to grit our teeth and hold on for another year... as I said, it's that Average Man On The Street mentality which is why most people end up without much money.

No, for anybody debating whether to sell right now the answer is a resounding yes. Be realistic, take that perceived 'hit' compared to the price at the peak, and then put furniture into storage and rent for another 18-24mths. Why sit around holding a falling asset all the way to the bottom if you know it's going to fall?

With stocks, amateur investors often make the same mistake. I certainly did in my earlier years, falling in love with a particular company's product or idea and buying the bullshit press releases to convince myself that I should hold on. It's knowing when to realise your gain (or loss) and get out that is even more important than knowing when to get in.

Nobody should be looking to go into the housing market until mid-2010 at the earliest. In the meantime there are much more profitable places to put your money, but that's for another post.

Meantime I'm sitting here putting off tidying up the house before my fiancee, L, gets back from her extended visit to see her family. She's been away for a week, busy planning for our wedding later this year. Naturally I find the whole process incredibly tedious and am feigning interest throughout as all men do. Wish me luck tomorrow - when I pick her up from Heathrow I suspect it's going to be a day that feels like the baby photo album all over again...