The Investor's Consigliere

Some More Real Estate: The Danger of the Personal Guarantee

My real estate self-education project continues.  Again, I'm trying to see if I can apply value-oriented manager selection to real estate investing.  There will likely be a lot to do in real estate in the next few years, both in public and private markets.  Many new funds have been and will be formed to take advantage of all the bargains that are widely assumed will be available.  My suspicion is that many of those hoping to take advantage of the bargains will be the same people who "took advantage" of all the non-bargains in the last days of the boom by buying overpriced properties.  I want to stay away from those people.

Steve Roth of Vornado alluded to this in his 2008 letter to shareholders, under the heading "Price Does Matter":

It sounds trite, but buy low still works.  A good friend of mine and Mike's, who runs a large real estate opportunity fund, years ago made an observation which I still remember.  He said they analyzed every deal in every cycle and concluded that everything bought in the first half of a business cycle was profitable to super-profitable, while everything bought in the second half was a struggle or worse.

If the way it works is this stark, ideally you want to invest with someone who

a) Knows exactly when the first half of the cycle is about to become the second half
b) Does his buying only during the first half, and
c) Does his selling (and his golfing, fishing, traveling, etc.) during the second half.

An unattainable ideal, but that's why the margin of safety was invented.

Margin of safety is especially important in real estate because almost all real estate is bought with leverage, often a lot of it.  In real estate investing, skill at building the right side of your balance sheet is as important as skill at building your buildings.  Because leverage magnifies returns both on the upside and the downside, and because of the idea expressed in the Steve Roth quote above, the stakes are very high when it comes to evaluating a real estate investor's use of financing.  It's often said that the secret to getting rich as a real estate developer is to use Other People's Money.  Don't forget the corollary: the secret to getting rich investing with a real estate developer is to remember that Other People's Money to him is Your Money to you.

Wednesday's Wall Street Journal featured a long article about the Cababie family, one of Mexico's most successful real estate developers (who I'm sure trace their routes to the Jewish quarter of Aleppo, Syria, which isn't so Jewish anymore, if you know what I mean.  It sometimes seems that if you fled from Aleppo to Latin America there was something wrong with you if you did not become extremely rich).  To finance their move into US real estate, the Cababies crossed an investing Rubicon by issuing personal guarantees on two major real estate deals, a huge condominium project in downtown Miami and a portfolio of 56 office buildings in Southern California.

A personal guarantee is just that--an individual or family personally guarantees to repay a loan if it cannot be paid back otherwise.   The WSJ elaborates:

Personal guarantees can cause problems for real-estate developers because they give creditors enormous power to go after all of their assets in the case of a default. During the real-estate collapse of the early 1990s, personal guarantees helped create huge financial problems for Donald Trump and took down scores of others, including William Zeckendorf Jr. Easy money during the last boom enabled most real-estate borrowers to stay clear of such guarantees, but a few, like New York developer Harry Macklowe, used them and have been forced to sell properties to pay them off.

To a value-oriented manager selector like me, an investor who issues personal guarantees, even if it backstops money you yourself are investing, is a red flag.  Not automatically bad, but something to take a close look at.  Manager selection requires you to create a kind of psychological profile of the investing temperament of the person to whom you're giving your money.  A personal guarantee on the right side of an person's own individual balance sheet can be revealing.  If it's guaranteeing the 250th enormous condominium project built in downtown Miami (not even on the beach!) in the last few years, then it's very revealing.  The combination of boom-time psychology, optimism, and testosterone that leads someone to expose their own money to that kind of risk must make you suspicious about what they are exposing your money to. 

The same principle applies to REITs or other real estate corporations, and even corporations as a whole.  The mix of recourse vs. non-recourse debt, as well as cross-guarantees and cross-default provisions, must be evaluated carefully, as it is a key factor in the shareholder's margin of safety equation.  Warren Buffett, who has been a closet genius at using leverage his entire career, pulled back the curtain a little in his 2005 letter to shareholders, in the section called "Debt and Risk."  Read the whole thing, but the guiding principles are that the more debt you take on, the more secure the income stream (not asset value) to service it must be, and significant debt must always be non-recourse to the rest of the enterprise.  John Malone, who has been an out-of-the-closet genius at using leverage his entire career, has used the nautical metaphor of the compartments of a ship's hull, separated by bulkheads--if the hull is breached in one compartment, it may flood with water, but the bulkheads prevent water from penetrating the other compartments, which could take down the entire ship.  Even during TCI's most heavily leveraged days, Malone was always careful to use as much non-recourse debt as possible, so if water flooded one "compartment" (i.e. an individual cable system could not service its debt) it would not threaten the entire ship (TCI and its shareholders as a whole).

 

Is "Sexy Swiss Real Estate" a Contradiction in Terms?

My initial working hypothesis (it will evolve, so bear with me) about investing in existing real estate (as opposed to new development) is that success is largely a function of successful financing.  Just as a good banker knows that his job largely consists of borrowing at 3 (%), lending at 6 (%), and hitting the golf course at 3 (o'clock), real estate investors know that if you can just borrow low and rent high, the battle is half won.* 

Check out this chart from April's Economist.  Among other things it shows that in Japan and Switzerland, house prices are more affordable than they have historically been, as expressed both by the price-to-rent and the price-to-income ratios.  Both ratios are indexed to 100 rather than expressed in absolute terms, but it's a fair bet that in those two countries, cap rates are also higher than they have been historically.**  High cap rates are the "lending at 6" part of real estate investing.

What about the "borrowing at 3" part?  Looking at the back page of this week's Economist, I see that 10-year Japanese government bonds yield all of 1.37%, while in Switzerland they yield 2.20%.

These are big ifs, BUT: If mortgage rates in those two countries are correspondingly low, and mortgage financing is available, then real estate investors in Japan and Switzerland may earn good returns in the years ahead by borrowing and renting at currently available rates.  Not a recommendation, but rather food for thought. 

*To give a sense of what a real buying opportunity looks like in these terms:  In 1986-1987, as China prepared to take over Hong Kong, investors were convinced the former British colony would go to the dogs.  Real estate was severely depressed, and rental yields (which were also rising) on office property exceeded financing costs by 5 percentage points.  Into this situation stepped the Chandler brothers of New Zealand, betting most of their modest $10mm fortune at the time on four heavily financed office buildings.  Prices of course recovered, Hong Kong stayed Hong Kong, and the Chandlers sold the buildings in 1991 for more than $110mm,increasing their own net worth to over $40mm.

**Why do I think that historically low price-to-rent ratios translate into historically high cap rates?  Here is my crude math:

1)  Expressed in absolute terms, the price-to-rent ratio is the price of a property divided by the gross annual rent that can be earned from that property.  A property worth $100,000 that can be rented out for $10,000 per year has a price-to-rent ratio of 10.  As an aside, the average price-to-rent ratio in the US for the period 1987-2007 was about 15.

2)  Invert the price-to-rent ratio and you get something called the gross rental yield.  Remember the gross part.  In our example above it's 10% ($10,000 / $100,000).

3)  If the price-to-rent ratio is historically low, by definition the gross rental yield is historically high.

4)  Now the cap rate:  The cap rate is similar to the gross rental yield except it deducts from the numerator the operating expenses of running the property (maintenance, real estate taxes, insurance, etc.).  It makes the gross yield a little less gross, and is a more accurate representation of how much a landlord can expect to earn from a property because, as every landlord knows, those operating expenses are real money out the door.

5)  As long as operating expenses as a percentage of gross yields stay more or less the same over time, and I think they have, then it's fair to say that a historically low price-to-rent ratio translates into a historically high cap rate. 

New Category: Real Estate

Introducing a new category: Real Estate (actually I sort of pre-introduced it already).

Like a good value investor, during the global property boom I completely ignored real estate.  Now that values have fallen in many places, continue to fall in others, and are about to fall in still others, the asset class is getting interesting. 

Between all the REITs that trade publicly and the many private equity/opportunity funds that invest in real estate, there is ample opportunity to practice real estate investor manager selection.  And for those who do it right, the rewards are ample too:  If you'd invested in Vornado when Steve Roth took over, you didn't have to do much else.  If you'd had the foresight to invest in a young Barry Sternlicht when he first went out on his own, as the Pritzker and Burden families did, you would have done well too.  If when the Shorenstein Group started taking institutional money you invested some with them, as David Swensen did, you are not complaining.

To evaluate real estate investors, you have to know how to evaluate real estate investments.  So stay tuned as I try to educate myself about how this world works.

Barry Sternlicht Bloomberg Interview

Watch it here.