Deriving Alpha in a High Risk Real Estate Market

The Real Estate community is well aware of the challenges it has forecasting the gap in housing and commercial properties.

What's the cost of financing a Real Estate project? The common risk to most Real Estate projects is certainty of returns from rent/sale/mortgage earnings. There are many ways to derisk the market and increase portfolio returns. If we can learn and leverage exploratory data, we can detect patterns and make better decisions on how to optimize these assets, thereby increase our portfolio valuations.

If the real economy GDP is 2.3 and CPI is 11.6. If value of 3 bedroom property on sale is $300,000 average rent per month is $300, CAGR is 12% and ROI is 30%. This should generate a good yield isn't it? Under an intelligent fund manager, I bet he'll do just fine if he's able to increase the level of occupancy rate in real estate assets.

Now, let's do a bit of meditation.

Let's take a deeper look at the mortgage market. The rate of change of mortgage pricing helps to correct the abnormalities and reduce the risk of exposure. Profit is maximized where the benefits outweighs the cost and risk. The risk is the bias here. If Portfolio performance is a function of earnings and risk, eliminating every bit of it should bring us to 100% estimated portfolio return.

Would you rather watch your property rotten while your next neighbour is smiling to the bank just because he's able to rent out or sell his property at an effective market price determined on a fair value basis? I'll ask most of the property owners this question.

The risk rate taken by a property developer/owner is too high to make economic sense. Derisking the market brings about a unified yield year-on-year that makes the market favourable.

Market Efficiency

The market is more liquid when there are trades willing to hedge their positions. Profitability is maximized when risk is minimized. The wider the gap from risk to reward, the greater the intrinsic value.

The question is how do we get our markets to be fast, efficient and liquid? We need Options. The African markets is far too thin, narrow and susceptible to shocks. Our transactions need to be more sophisticated, deepened and hedged.

Loan-to-value Ratio

The outrageous property valuations in African markets is dysfunctional. This automatically result in low housing ownership, high rental value, low liquidity for property owners, increased vacancy rates and low property yield. This becomes unattractive to investors. Currently bank loans to real estate dropped by over 25% in 2018.

The Risk-Free Rate Anomaly

One of the ways to derisk a market, is to take positions by reacting timely to the opportunities. A market has a high chance of being efficient when it can absorb and react to all kinds of movements, long and short. The average risk-free rate in African markets is 8%. There's positive correlation between high risk-free rate of return and yield rate.

How can we build markets beyond spot transactions. Many of my friends say our markets are not deep enough for these sort of complexities. But the question is, do we have enough price transparency in our markets to conduct futures transactions? The answer is yes. However, the market data is not a true reflection of the market activities.

Predicting Prices

The variations of risks in African markets are very high. Optimizing profitability requires careful approach. Refinancing cost, default risk, political & legal risk all contribute to high country risk.

In a market with trillions lying around, we need to take more positions, not just the riskless ones. Many of the REITs are not performing. The inefficiency level is huge.

I've heard conversations that the regulatory bodies in our markets guide against speculative transactions. The truth is, derivatives is largely a speculative instrument. However, it also possesses inherent mechanisms to correct the price differences in underlying assets. Actually, it's the perfect instrument for price anomalies.

Looking for one thing in a big bet is highly risky. What are your chances of finding a needle in an haystack? You need Options. To price risks into asset valuations with lots of hyper-parameters to consider, you need fast systems. Achieving successful short-term alpha-driven strategy require faster systems for execution.

In a very fast changing world, you need faster computers. Welcome to a whole new world. The IBM Q!

Kayode Odeyemi is part of a global intelligence team specialized in AI, Cloud, Data Analytics, IoT and Financial Derivatives.