In the world of finance and economics, the term “arbitrage‟ means attempting to profit by capitalizing on price differences of identical or similar financial instruments in different markets or forms. For example, a hedge fund manager could buy a group of securities that he believes are under-valued, and execute a short sale on a different set of securities that he believes are over-valued.
The advantage of this strategy is that there will be minimal volatility, and a very significant upside if the valuation analysis is correct. The downside is that if the analysis is incorrect, you could be hit with a “double whammy” from losses on both sides of the transaction. In addition to this, there is a risk that if the security value stays flat, the interest costs from borrowing for the short sale shares will erode the return of the transaction before anything happens.
One factor that makes it difficult to find and capitalize on potential arbitrage opportunities is market efficiency. When a market is “efficient‟’ the rapid flow of information results in prices being perpetually pushed toward their “true‟ value as all of the public information is discounted into the price. Typically, homogeneous investments such as stocks and bonds tend to be priced very efficiently. Generally speaking, this makes it very difficult to realize returns above what is “average‟ for the market since the efficiency makes it very difficult to accurately pick winners, unless you are lucky.
The reason why superior opportunities exist in real estate is because “All Real Estate is Local” . . . Since real estate markets are fragmented, they present great opportunities for those who know where to invest and what to avoid. The flow of information does not immediately move out to the global market-place, as with stocks or bonds. Fundamentally, this means that the opportunity implicit within real estate will vary significantly depending on which markets you choose for your investments.
This is very important because investing in the wrong market can produce insufficient cash flow from rental income to cover normal expenses and your portfolio will be dependent on appreciation for returns. (As we have seen, appreciation can be very volatile.) However, if you invest in the right market, it will generate sufficient cash flow relative to your capital investment to cover the expenses of the property.
This creates a genuine arbitrage opportunity since the cash flow will limit downside exposure if market values contract, while maintaining an upside opportunity if values increase, and a hedge against interest rate increases that push people into the renter pool because of the resulting increase in cash flow. In addition to this, it creates an inflation hedge from the fixed-rate mortgage payments that will stay flat over time as inflation pushes up the rents and value, while allowing you to repay your expenses over time in de-valued dollars.