real estate vs other asset classes
Unbelievable, I did my first real estate deal today. I have generally always avoided this asset class as the ROI didn’t meet my criteria – buying a house at a 5% rental yield is and was a waste of money for me. That’s why I never bothered even to buy my own apartment to live in since renting made sense to me. But I finally found a way how to improve ROI significantly with blending in some development as well.
I bought an unused attic in an apartment building today, where me and my building partners will develop two pretty exclusive apartments with roof top terraces. I acquired two garages in the building as part of the deal as well. I paid around $260k to acquire the property. Redevelopment will take about 9 months and will cost around another $320k. So total cost around $580k. Then I plan roughly another 6-12 months for the apartments to sell for around $1.3 million. This kind of ROI suddenly makes sense to me, so I might do some more of this stuff in thefuture…
I see a lot of domainers diversify into real estate when they start making money. They view it as something similar to domains. The truth is that they would have been much better off if they would have kept re-investing in domains or other businesses.
My perception is that real estate investments are a sinful waste of money, money that maybe yields 5% per year. For us domain investors that is a petty return. If I would have a choice, I would prefer to have money in the bank than in real estate. Because it’s liquid and available for opportunistic deal making and this liquidity outweighs the forgone yield for me.
The main arguement made by domainers is that real estate is a very secure investment. Every domainer has paranoias that his domains might be taken away but he knows that nobody is going to take his house away. Hence they sacrifice yield in favour of security.
The big secret is that you do not have to sacrifice yield in exchange for security. The answer is diversification. If you have a diversified portfolio of high yielding investments (like domains) or businesses (obviously running the risk that some of these may default/go bancrupt) you will still be better off in the long run than if you plow money into real estate.
I like to illustrate things with analogies, so here’s one from the bond market. In the long run, a well diversified portfolio of junk bonds will perform better than a portfolio of tripleA rated bonds. Some of the junk bonds will obviously default, but the higher yield of the others will more than compensate for this in comparison to the AAA’s.
I really like destroying commonly held perceptions. So here’s another shot: The future of domaining doesn’t lie in domaining per se, but in finance. Finance is where the new domain fortunes will be made. Knowing the domain game won’t be enough to make you rich anymore.
Let’s look at the development of domaining from a slightly historical perspective. The first guys in the biz (such as Scott Day) saw the value of domains as brands, gateways to the internet, that should be valuable one day. That was their edge. Then guys like Frank Schilling and Kevin Ham came in that understood the value of type-in traffic and built their empires around that (banking on the assymetry of information – most people didn’t understand it). That was their edge. Then came the big tasters. Their edge (already understanding type-in traffic) was in technology, acquiring tasting data and seeing the opportunity that many did not see. From this “historical” point of view we can basically break this down into three evolutionary steps, let’s call it generations – that made a killing in the domain business.
So what is the fourth generation, the next evolutionary step? I believe it is going to be about combining domaining and modern day finance. That’s where the fourth generation domain fortunes will be created.
And that’s exactly where I think my edge is (not that I would want to put myself in the vanguard of this next generation ). You see, when I came into the domain business a little over two years ago, I saw it through a different lens than most people in the business. I simply saw domains as any other asset that creates a cashflow stream (predominantly from PPC). So there was a huge arbitrage opportunity.
This lied and still lies on the ability to raise debt for cheaper than the yield that a domain generates. Say you would buy a great generic for 10 years revenue for $1 million. The cashflow stream is hence $100k per year. Now if you have the ability to raise that amount in debt say at 6% p.a., servicing the debt is going to cost you $60k per year. So you get to pocket the difference (+you have the added benefit of the capital appreciation of the domains). Then you just need to find a way to scale this to make a lot of money. Obviously raising the debt against domains is very difficult so you really have to get creative.
Bringing in aspects of financial engineering is where the new fortunes in domaining are going to be created. However with the introduction of leverage, some fortunes may be also lost (that is the downside). So if you want to make a lot of money in domaining, stop reasearching just domains and look into how private equity works.
Lookig forward to hear your thoughts in the discussion.
One thing that has been puzzling me for some time is the lack of institutional money in any structured way in the domain business. More institutional money is clearly a prerequisite for higher domain valuations.
When you look at it today there is only a little bit. Marchex/Fabulous/Tucows are publicly traded. Oversee, Demand Media, Skenzo, Name Media have all taken aboard funding, very decent amounts. Then we also had iReit, which sort of flopped. Various domaining companies managed to take on some debt such as Reinvent. Domain Capital at least brings a little leverage effect into the business (they have $30 million loaned out). But that’s pretty much it.
But why don’t we have more hedge fund-esque operations that would take on investor’s money, maybe even tie in a little leverage to increase ROE and start buying up portfolios? The only exceptions I sort of know of are DomainIvest.LU (they have raised their first 10 million Euro fund, which is now invested I hear), mad.biz runs some kind of private partnerships, where they bring in limited partners. I do a little bit of that as well. Maybe InternetRealEstate does some of that as well.
So what are the main reasons behind this lack of structured institutional capital?
One factor is that the first round of institutional capital that poured in sort of got burnt. This was before Google/Yahoo started heavily cutting payouts via various quality related claims, before the downturn hit etc. To really illustrate this: If you bought a portfolio in 2007, today it would be probably making 60-80% less on PPC than it did at the time of purchase.
Second is transparency. Michael Gilmour sums it up pretty well in his article here, so no need to elaborate further.
Another issue may be size. When you really think about it, the domain industry is pretty small. My estimate is that Google/Yahoo combined probably pay out about $40 million a month to the domain channel now. That’s already not much, again taking the more macro perspective (compare it to say the size of the bond market). Worse, the market is highly fragmented. There is not probably a domain portfolio owner that would own 10% of this market. Probably Oversee, Reinvent etc may be close to the 10%, but more likely in the 5-7% range, when it comes to their owned and operated portfolios. The domain biz may simply be too small to get on the radar of the big various funds.
And lastly, there is the issue of risk. There is the monetization risk (that ppc will further decline or a big upstream ad provider leaving the space and not syndicating its feeds to the domain channel), maybe a degree of type-in traffic fading away (more long term) and then there is the legal risk. I hope eventually somebody smart will find a way how to securitize the cashflow from domains and create domain derivatives that could for example separate the the yield of a portfolio and its risk. The same way that for example in the bond market you have credit default swaps (through which you can basically separate the yield of a bond from the risk of non-repayment). Doing this would be a huge boost for the business and would really help institutional money to flow in in masses.
So will be see an influx of institutional money coming into domains in the next 3 years?
I really think so. PPC is certainly not going to fall as much as it did in the last 2 years – I actually think it may be relatively stable and new monetization techniques (refer to previous post) may actually even bring a little bit of upside. I also think there is going to be a new breed of domainers-turned-domain fund managers that will start bringing in the institutional money – because the industry is so complex it’s rather difficult for an outsider to do that. And lastly, with us getting out the recession I think investors will have a higher appetite in risk again and start exploring more alternative investments again.