Are You Playing To Lose?

Did you play musical chairs as a kid? 

I played in Sunday School, and I don’t think I ever won. It was painful, but I’m okay with it now. 

For the uninformed, the game started with a circle of outward-facing chairs. Kids march around outside the ring to queue up the music while the teacher grins slyly, her hidden hand poised on the record player’s arm (c. 1970) to stop the music at any time. When the music stops, all the kids sit down in the closest chair. 

But there was one problem. There’s always one less chair than kid, which meant someone had to get ejected from the game. With one less player, the next round also started with one less chair. It would repeat until there was a final winner—typically the aggressive, pushy bully I never liked.

The lesson of musical chairs is that there are multiple paths to losing. We typically talk about the multiple paths to victory, but it’s about losing in this case.

You may see where I’m going with this and ask, “Why is Paul being so negative? He seemed like a nice guy on the videos.” 

Why so serious?

This post is another warning about the craziness in today’s real estate market. We are seeing an unprecedented runup in asset prices and the associated risk that comes with it. There are many ways to lose in this market and fewer ways to win than I have seen since pre-2008. 

I will let you know why I think the risk is so high. Then I’ll tell you a few stories supporting my point. Then I’ll wrap up with a thought about how to win in this market or any market. And no, it’s not by sitting on the sidelines. 

Why is the real estate world so risky right now?

It’s quite simple. When paying an extraordinarily high price for an asset and adding the associated transaction fees and friction costs, you count on a future where revenues must be increased far above current levels to generate solid investor returns. But paying top dollar means buying an asset with the tiniest margin of safety, therefore, the highest chance of failure. 

This sounds to me like the best time to sell an asset. Not to buy one. (And we’re about to see that’s what many of the pros are doing.) The best time to buy is when blood is running in the streets. And that’s certainly not now. 

I recommend that everyone read Howard Marks’s classic Mastering the Market Cycle: Getting the Odds on Your Side. Buffett reads every word Marks writes, so perhaps we can learn something as well.

Marks, manager of the extraordinarily successful Oaktree Capital, was being interviewed by a reporter when blood was running in the streets in the autumn of 2008. He explained why he was buying half a billion in troubled assets per week. The confused reporter said, “Wait, you mean selling, right?” Marks said, “No! I’m buying. If not now, when?” 

We are currently at the extreme opposite of this moment where Marks seeded billions in profits for himself and his investors. I think Howard would say, “No! I’m selling real estate. If not now, when?” 

I have no idea if there’s one chair or three chairs left in our musical chairs game. But I think it’s prudent to act as if there could be one and the music could stop at any time. 

This doesn’t mean I’m not buying. My firm is investing in real estate right now. But the way we are doing it is quite different than the mad rush I’m witnessing. 

Three examples of a market going mad

Example #1: Storing up risk

An unnamed friend (we’ll call him Aaron) recently told me about a deal he lost. This guy is a self-storage pro. He’s been on the BiggerPockets Podcast twice in the past four years, and he has an excellent track record of creating fantastic cash flow and wealth for his investors. 

Aaron was bidding on a large self-storage portfolio. He stretched to get to a bid of about $70 million. This was as high as his prudent underwriting allowed. He lost the deal to another syndicator. A syndicator who was much newer to the business and hadn’t experienced years of ups and downs like Aaron has seen. A syndicator who is a fantastic promoter with a great investor following. 

But Aaron didn’t lose this bid by a million or two. Or even five. The winning bidder reportedly paid well over $20 million above Aaron’s high bid.  

Think about it. This buyer is paying over 30% more than a pro thinks could work. In addition, he’s probably saddling his investors with debt at approximately the full level of the property value (per my friend’s $70m valuation). On top of that, he’s paying all of the associated fees, commissions, and more. 

“More” in acquisition fees and other syndicator profit centers. These fees are likely at least $5 million, from what I’ve been told. These fees and costs are piled onto an already precarious situation that must go very, very well to rescue unsuspecting investors from ruin. 

I hope inflation allows the operator to raise rates exponentially for the investors’ sake. It may, and my fears may be proven wrong. Maybe that’s what the syndicator is counting on. But that sounds like speculation to me. Not a game I want to play anymore. 

Example #2: Can you really outmaneuver the godfather of multifamily?

Another one of my friends is perhaps the most experienced multifamily syndicator I know. A real pro. In his fourth decade as a real estate investor, he has done hundreds of millions of multifamily deals and over a billion dollars in other transactions. We’ll call him Johnny. 

Johnny told me about his worst multifamily deal since the Great Recession. It was rough. His experienced team could not raise rents by a single dollar in nearly three years of focused management. The prospects for investor profits were grim. 

But never fear. Johnny was approached by another syndicator who corralled his lender and likely clueless investors to buy this asset for $10 million more than Johnny had paid. 

Again, when adding acquisition fees, property management fees, lender fees, and closing costs, this buyer saddled his investors with a massive burden. 

I must ask: If Johnny’s experienced team could not make a profit on this deal, how is this new, likely less-experienced team going to raise rents and income? Especially when starting in a hole well over $10 million deep? 

By the way, Johnny is in the Howard Marks reversal stage, selling almost all of his properties. He believes that with interest rates rising and cap rates likely following suit, it is the best time in history to take chips off the table. If this is how the pro of pros is thinking, shouldn’t we take notice? 

I asked Johnny for permission to use his story. He informed me that this situation happened again recently. He said he sold another property that barely covered the mortgage at around 2% interest. The buyer got a bridge loan at around 5% interest and paid him about 50% more than he paid. How does that work? 

Johnny said: “To be clear, I didn’t sell because I don’t believe in the market. I had a few struggling properties, and I got offers that created a great opportunity for me to sell. 

And for properties that are performing great, when prices run up this fast, selling is smart because it maximizes the internal rate of return (IRR). Holding would reduce the IRR and return on equity, especially in a rising interest rate environment. I will say that with inflated pricing, it is really hard to find properties to replace these assets right now.” 

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Example #3: Vegas-style real estate investing

I recently heard about this third example from a residential subdivision developer friend at church. He recently developed a 36-lot subdivision near the beach in South Carolina. He was preparing to build 2,200 square foot homes with an all-in cost around the $360k range. A 1,600 square foot 2021 house across the road sold for about $450k last summer, so he planned a respectable 20% potential margin of about $90k per home or more. 

But last fall, he learned that the same $450k home had been resold a few months later for about $660k. He learned recently that it was pending for another resale in the range of $825k. 

For you old-timers investing in real estate over a decade ago: does this sound familiar? 

“History never repeats itself; at best it sometimes rhymes.” – Mark Twain

Yes, I agree that inflation may float everyone’s risky craft to the golden shores. But do you really want to count on inflation to ensure your deal goes right? To assure your investors make a profit or even recover their principal? 

I don’t. Fortunately, there’s a more reliable way to make a profit. 

Value investing – Real estate style

About a century ago, Columbia professor and fund manager Benjamin Graham developed a methodology that was later called value investing. His best student, Warren Buffett, took the practice to a new level, creating hundreds of billions in wealth for him and his investors. 

The bottom line here is that Graham and Buffett and those who follow in their steps spend their efforts searching for hidden intrinsic value in the assets they invest in. They seek out and acquire assets that have latent value invisible to the casual seeker. 

And they hold these assets to create a growing margin of safety. This margin of safety is a byproduct of increasing profits in good times, and more importantly, it allows investors to weather bad times safely. 

It allows investors to obey Buffett’s first two rules of investing: 

“The first rule of an investment is don’t lose money. And the second rule of an investment is don’t forget the first rule.” – Warren Buffett

My company has built our investing thesis around these principles. We partner with commercial real estate operators who seek out off-market deals with hidden intrinsic value that can be harvested over years to come. We enjoy an ever-widening margin of safety between net operating income and debt service. 

These operators further lower the risk by refinancing out lazy equity to give back to investors or reinvest in other deals along the way. We purposefully diversify across different asset classes, operators, geographies, strategies, and properties.  

Yes, we miss some screaming deals, like the third example (East Coast houses) above. I have watched many smart and lucky amateurs make more profit than me by flipping deals in months or a few years. 

But I don’t have to rely on hope as a business strategy. I don’t have to:

I also don’t have to play musical chairs with my funds and the capital entrusted to me by investors. 

I sleep better at night, and I don’t have to be mad at the pushy guy who always got the last chair. (I wonder whatever happened to that punk, anyway?)

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