Market Approach

Everything starts with and depends on price. There are times when certain types of investments are “hot” and other times when they are not. The key with any investment is to evaluate its true intrinsic price and buy below it. As Warren Buffet famously says, “it’s hard to go wrong when you buy a dollar for less than a dollar”.

So the mission becomes how to sort out those components which allow for a sober assessment of an asset. In fashionable sectors and frothy markets such a disciplined analysis is first slowly and then quickly abandoned in favor of optimistic projections. These tend more and more to rely on “capital appreciation” with no basis other than an expectation that a buyer will come along with even more optimistic assumptions. Some refer to this as “the greater fool theory”. Everybody can repeat the “buy low and sell high” mantra, but when it comes to execution most will “buy high” and hope to “sell higher”. This is a certain formula for capital demolition which we have seen played out over and over again, sector after sector, from tech to debt to real estate to everything in between.

For almost three decades our area of expertise has been real estate. Our rules for purchasing are detailed under “Investment Principles”. Suffice to say that our philosophy is not to join crowds nor conversely to claim to be geniuses by merely going against them. Our philosophy is to find and follow the facts which sometimes lead us far from exuberant crowds into lonely and unloved places.

Close to thirty years ago, the Savings and Loans crisis led to a collapse of real estate felt acutely through the U.S. Southeast and in particular in Texas. So that is where we went. We accumulated a portfolio of residential real estate and ten years later sold it to a large U.S. REIT. Similarly, after a period of instability in Quebec during the late 90’s and early 2000’s due to fears of separation, we built up a portfolio of properties, some of which we sold to a local REIT at prices we felt were impossible to resist.

Then came what is being referred to as “The Great Recession”. The world became negative on parts of the U.S., particularly the Midwest, where common knowledge declared it a “dead place”. We specialize in “dead places”. Sellers are often all too eager to get rid of assets at fire sale prices believing the dire tone of the current apocalypse du jour narrative. In June 2011 we closed on our first U.S. purchase in twenty five years, a portfolio of three commercial properties compromising 175,000 SF in Fort Wayne, Indiana (yes, far from Silicon Valley and New York City and other such “gateway markets” where so many currently love to be). The seller was GE Capital who let the asset go for a third of the mortgage it held on it and for a quarter of what was built twenty years before.

At our purchase price we positioned ourselves to undercut the competition, comfortably pay full commissions to leasing brokers on both ends (thus incentivizing traffic our way), pay for TI’s and fill up our space – doubling our NOI and the portfolios unlevered value. It is first and foremost about price and not about the popularity of an asset class, its location, etc. As a side note, eighteen months after we made that purchase, another division of GE moved in leasing over 30,000 SF for seven years, effectively doubling our portfolio’s unlevered value. It gets better – about a year later, GE decided to move its operations to Mexico so they had to pay a substantial penalty and left all their brand new furniture behind. Shortly thereafter we backfilled the space and for good measure used some of the furniture for our New York office. Then we refinanced for the third time.

In the interim we closed on over  9,000,000 SF of Office in the Midwest and Southeast making us the largest landlord in Kansas City with over 3,000,000 SF, Indianapolis’ largest suburban landlord with close to 1,700,000 SF and its second largest landlord over all. In Columbus with nearly 1,400,000 SF we are also the largest suburban landlord and have more than 1,000,000 SF in the Cleveland/Akron area making us one of the largest owners in that market. We also have assets in Montgomery, AL., in Memphis, TN, and  several other markets  Such scale carries many advantages, not least is the ability to attract the best talent, an attribute too often underrated.

A deeper analysis shows that beyond the reasons cited above, there are more subtle causes for the availability of such low prices in markets such as the Midwest and other “unloved” smaller localities in the U.S. We observed a phenomenon applicable to secondary and tertiary markets when we bought almost all our earliest assets in Quebec; when the mood is bad, assets tend to be discounted far further than similar properties in larger markets. Parenthetically, many U.S. secondary markets have larger GDP’s than most major cities around the globe, and some have an even larger GDP than many nations.

But the real question is this: what in fact is our risk? A lease from a credit tenant in NYC or Kansas City or Columbus is equally binding and equally safe. Therefore any risk there is illusory, but nevertheless offers a further discount.

The knee jerk response then is “liquidity risk”. The answer to that is that liquidity is a risk only if there is a promise to sell the asset by a specific date. If such a date did exist, it might wind up being a horrible time as it was for those who had to sell in NYC in the mid-seventies or early nineties.

Therefore the only real and legitimate risk comes from overpaying. Consequently, if we buy at a price where the margin for error is wide as defined against replacement cost and the ability to undercut the competition, then others’ “catastrophizing” based on macro scenarios serves only to drive down prices irrationally. We all know that five or ten years after some opportunity, people comment longingly with the cold comfort of retrospective analysis, “boy, I wish I bought then, it was obvious that prices would not remain low.” But the interesting part of this sort of cycle is that when the mood is high, these small markets benefit and the properties can be sold to a REIT as part of a larger portfolio. As John F. Kennedy once said, “The rising tide lifts all the boats”. It is worth remembering that as long as twenty years ago, somebody felt that it was worth spending four times the price we paid for properties in the Fort Wayne portfolio. Those enthusiastic and hopeful investors will come back, they always do. The key is to be sure that they are never us.

There is still a further and complementary reason why discounts can be so high in these smaller markets. It has to do with the somewhat uniform investing behavior exhibited by REIT’s, pension funds, private equity groups, and institutional investors in general. This is what Warren Buffet referred to as “the institutional imperative” in his 25th letter to the shareholders of BKH. Even he was surprised at its stubborn persistence. It is not in the inherent advantage of an asset manager to risk career and reputation by doing something out of the norm.

For quite some time now, large institutional investors have been focusing their attention on certain big and “safe” markets. No manager will be fired for buying a 4 cap in NYC with little upside simply because all the others are doing it and therefore the strategy has consensus. However, ironically, institutional managers can get in trouble for buying into a small market at a 10 cap with upside only because no other manager is doing it and it is therefore not considered a “consensus” approach. That is why sellers tend to write off (or let go an asset at a huge discount) in secondary and tertiary markets, not because it is a wise economic move on their part, but rather because it takes an “embarrassment” off their portfolio. It is better for the portfolio manager when he can say at his next conference call that he “got rid” of the Fort Wayne asset which for them was a rounding error in any event. These managers are far from being silly or ignorant. It is simply that their motivation set is different from ours. In fact, some of our LP’s work at hedge funds, investment banks, and so on. When it comes to their own money, their motivations revert out of the institutional imperative.

Concerning the U.S. and its opportunities, Warren Buffet is generally recognized as a wise and credible source for astute, prudent, and intelligent perspective. He continually warns us that the naysayers who discount the U.S. are making a serious mistake. They have made that mistake over and over in the past, crisis after crisis, only to be proven wrong every time. The U.S., Mr. Buffet reminds us, remains the world’s leading nation with great minds and with a diverse and growing population benefitting from a constant inflow of people striving to make their dreams come true. According to Mr. Buffet, as well as many other reflective minds, there is no other place on earth or in history where human potential and utility can be so unleashed.

Right now specialized pockets of the U.S. are still on sale, though this situation is rapidly changing as economic circumstances improve with optimism flowing right behind. Nevertheless, occasionally opportunities do still arise. For those who understand the fundamental economics of real estate and are clear-headed in their mathematics, the next little while offers an opportunity that does not come around very often – particularly in the world’s greatest economy. This does not mean that it is easy to find the jewels. In fact these now seem to be restricted to very large Office portfolios sold by institutions for reasons unrelated to the economics of the disposed assets. Even at the best of times for bottom feeders (that is during the most pessimistic times for most others), much dirt needs to be sifted through and then examined by experienced and cautious eyes before nuggets of opportunity are found. Pickings are getting slimmer by the year as optimism returns and time is running out.

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