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16Jun 2016

Russell Chaplin

Chief Investment Officer, Property

Property's margin of safety

Property's margin of safety

Famous value investor Seth Klarman (founder of The Baupost Group) wrote “Margin of Safety” 25 years ago; the book is now out of print but a copy is for sale on Amazon for $1,670. The central idea is that market prices fluctuate, but that in the long term, fundamentals are what drive performance. If you can work out how strong the long-term fundamentals are for an asset and attach an appropriate long-term risk premium, then you can estimate roughly how much something is actually worth (the “intrinsic value”) rather than what the market says it is worth (the price). You only buy with a margin of safety–that is, at a price that is somewhat below your estimate of the intrinsic value of the asset. So, where is the margin of safety in today’s UK property market?

As far as we can work out, the UK property market is over-priced on average; in other words, property is worth less than you have to pay to buy it. If you are buying at a price which is more than an asset is actually worth, there is no margin of safety since, by definition, the net present value is less than zero. It isn’t an investment at all at that point, but rather a “deployment of capital,” or more impolitely “spending” or “speculation.” There is nothing inherently wrong with any of those things, but it is not an investment. So, in an over-priced market, how do you execute with a margin of safety? The answer comes in the phrase “on average.”

Standing at a barbecue one day, a mathematician friend of mine stared long and hard at the sausages on the grill and said, “On average, they are all cooked.” He was right, but I would not have wanted to have been blindfolded and asked to pick one to eat. Luckily, it was pretty simple to identify which sausages were edible and which were not, but were you to have chosen one at random, you might have ended up feeling quite ill. Similarly, when it comes to “stock selection,” it turns out that averages aren’t very good at indicating what to do. The average would imply that there is no margin of safety in an overpriced market, when in fact, using a bottom-up process, you can still find individual properties that under-priced, albeit fewer of them.

This is good news for property investors as we do not trade in averages. Instead, we hold, buy and sell individual assets. However, it is bad news when the market is overpriced as we believe it is today, since the chances are that, without any skill, you are going to find an over-priced asset. The question then is one of skill and whether you have the process, people and resources to identify and underwrite consistently the (scarce) properties that remain under-priced, or at least reasonably priced. This takes a lot of time, systematic hard work and a great deal of patience. Just now, identifying properties that have any margin of safety is incredibly hard, but not impossible.

Important Information

Investments in property may carry additional risk of loss due to the nature and volatility of the underlying investments. Real estate investments are relatively illiquid and the ability to vary investments in response to changes in economic and other conditions is limited. Property values can be affected by a number of factors including, inter alia, economic climate, property market conditions, interest rates, and regulation.

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