How to Earn a 78% Return with Real Estate Stocks

If you read the February 18 article in Asia Economy titled “Five Major Financial Groups Lose 1 Trillion Won on Overseas Real Estate Investments”, there is a line that reads, “Separate from overseas real estate funds and the like sold to customers, these were investments executed directly by the financial groups themselves, and the total principal amounts to 20.3868 trillion won.”

What this means is that most of the overseas real estate assets that alternative investment teams at financial institutions bought more or less without a plan ended up being sold, in the form of funds or REITs (Real Estate Investment Trusts), to ordinary people like us and to the National Pension Service, which is supposed to support our retirement. There is plenty to criticize about how Korean financial firms bid against one another, calling out ever-higher prices (thinking, “the National Pension Service will buy it anyway”) for North American and European commercial buildings (mainly offices) at the very peak of the market. But lately I have been accused of being too insensitive and overly critical, so I will leave it at that.

The article goes on to say, “Excluding loan receivables, the five major financial groups invested a total principal of 10.4446 trillion won across 512 investments such as beneficiary certificates and funds.” In plain language, roughly half of that was equity investment. It is easier to understand if you think of equity as stock and debt as loans. Loans have a relatively low probability of principal loss, but with equity, if the value of the real estate falls, you are guaranteed to take a loss. That is because creditors have priority in terms of claims on the assets.

According to the article, the overall mark-to-market return for the five major financial groups is -10.53%, translating into a loss of around 1 trillion won. Of course, that is the loss realized so far, and I believe that as fund maturities approach and assets are reappraised or actually sold, the probability of even larger losses is high.

The reason I started a story about making money in real estate stocks with this article is that I wanted to make the point that without proper analysis, real estate can also be a very risky investment. A textbook example is the Mirae Asset Maps REITs product covered in an E-Daily article titled “From Up 20% to Down 50% in a Day… Overseas Public Real Estate Funds You Can’t Trust”.

So which company delivered a total return of 78% (including dividends) to the AW portfolio, and why did it perform so well even though it owns the same type of commercial real estate assets? The secret lies in arbitrage between the private and public markets.

The company in question is a REIT listed on the New York Stock Exchange called SL Green Realty (ticker: SLG). It owns a portfolio of office buildings very similar to those Korean financial institutions piled into in the late 2010s. We added it to the portfolio on June 21, 2023, and exited on February 14, 2024.

This is SLG’s share price over the past year, and you can immediately see that the stock plunged sharply in March. Looking back, last March was when Silicon Valley Bank (SVB) collapsed and concerns about U.S. regional banks were at their peak. Regional banks had large exposures to commercial real estate loans, and as market interest rates and office vacancy rates rose in tandem, asset values fell. Fears mounted that these banks would inevitably be hit as well. SLG, which holds a commercial real estate portfolio heavily weighted toward office buildings, saw its share price collapse from that point along with the regional banks.

This is where I spotted an arbitrage opportunity: investors, gripped by extreme fear, were indiscriminately dumping even SLG, which owns high-quality buildings.

As of the first quarter of 2023, the office vacancy rate in New York City was 22.2%, historically very high. At that time, the combined occupancy rate of SL Green Realty’s office portfolio was 90%, meaning its vacancy rate was only about 10%. That is because the company’s assets are Class A, what the industry commonly calls prime-grade.

The building shown in the first photo of this article is One Vanderbilt, the most expensive office building in New York City in terms of rent, and an asset owned by SL Green Realty. It is a new building in a core Manhattan location, with high-end offerings such as a Michelin three-star restaurant, and it is environmentally friendly, with LEED certification and the like. Demand for these prime-grade buildings mainly comes from blue-chip firms such as bulge-bracket investment banks, top law firms, and big tech companies. For these firms, one of the strategies for attracting talent is to offer offices in prime locations with best-in-class amenities. Because they are relatively resilient to recessions and have a high willingness to pay for quality office space, they are unlikely to “downgrade” to cheaper Class B offices even if those rents fall. That is the reason SLG was able to defend a 90% occupancy rate.

At the time, I believed that SLG’s office portfolio was far superior to that of Korean public real estate funds, which are composed of more typical New York office buildings, and that the sharp share price decline had created a mispricing where the company’s asset value was not being properly reflected. It is reasonable to recognize that SLG’s prime-grade office buildings had fallen about 5–10% from their peak values, but because transactions for other Class B office buildings were occurring at roughly 30% below their peaks, SLG was likely being lumped together and compared on the same footing.

So after confirming that the share price had bottomed in April–May, we initiated a position on June 21. Then, on June 26, SLG announced that one of its buildings had been valued at 2 billion dollars—about 7% below the peak—and that it had attracted an equity investment from Japan’s Mori Trust. From that point, the share price began to trend upward.