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).
