Don’t Lose Your Good Name

Last week on Methods of Prosperity

In 1969, Sam Zell enjoyed a lucrative deal in Reno with 100% occupancy, yielding a 19% cash-on-cash return. His broker friend approached him about working for Jay Pritzker, a prominent entrepreneur. Sam opted to propose a partnership instead. This led to a pivotal relationship, where Pritzker became Sam’s mentor. They tackled ambitious projects, including a problematic development in Lake Tahoe. This revealed the complexities and risks of such ventures. Sam had considered developing properties, but encountered debacles which changed his mind. He retreated to acquiring properties. He and Pritzker trusted each other. They conducted deals without formal agreements, including their Broadway Plaza acquisition. Bob Lurie liquidated his management company to partner with Sam. Bob managed their Reno assets. He later joined Sam in Chicago to grow Equity Growth Investments (EGI). In the 1970s, they acquired distressed properties from Arthur G. Cohen. He co-founded Arlen Realty & Development Corporation. Sam got involved in a messy deal which he took to his brother-in-law's law firm. The IRS was about to get suspicious. 

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Part 79. Sam Zell (continued).

You can find this week’s TL;DR here.

Key Lessons:

• Guard your reputation.

• Be worthy of loyalty.

• Have a good name.

• Realize incentives.

• Understand risk.

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During late 1968 and 1969, Samuel Zell entered into negotiations. It was for the purchase of the Arlington Towers. Which was a twenty-two story office-apartment complex. And the adjacent Arlington Plaza, an eleven-story hotel built on top of a six-story garage. The location of Arlington Towers and Arlington Plaza is Reno, Nevada. While these negotiations were taking place, Zell was in contact with Roger Baskes. Roger Baskes was a Chicago attorney specializing in federal tax law. He was also Sam’s brother-in-law. Baskes’ law firm put together a convoluted tax structure for the sale of this property.

A few years later, the IRS went after Baskes’ law firm. This transaction was central to the tax fraud case against Roger Baskes and others. Baskes attributed $700,000 of the sale price to a near-worthless gold mining claim. This manipulation concealed the true value of the properties. It thereby reduced taxable gains and avoided gift taxes. The scheme also used complex structures. Which involved trusts, corporate entities, and backdated documents. It was a scheme to reduce taxable gains. Attributing part of the purchase price to a worthless gold mining claim.

In February of 1970, Zell deposited the $700,000 in a foreign trust. The mining claim was then transferred to a foreign affiliate of a shelf corporation. A shelf corporation is a company created and left inactive to “age” with no assets. It has no assets, liabilities, or operations. It’s later sold to buyers seeking corporate longevity. Baskes’ law firm had already formed this corporation in Nevada. The claim was then transferred to another corporate entity in exchange for its stock. That stock was then sold to a partnership. Which involved Fantasy-Galaxy Inc, a key entity in the Arlington Towers transaction. Fantasy-Galaxy, Inc had a 99% stock interest and Buckeye Oil Co had a 1% stock interest. Defendant Baskes’ law firm was tax counsel to Fantasy-Galaxy. Baskes himself was a trustee and partner in Buckeye Oil.

The inquiry lasted a year and a half and turned into an investigation. In 1976, the IRS “invited” Sam Zell to Reno. The case went to court in 1978. The court decided September 18, 1980. The U.S. Court of Appeals for the Seventh Circuit indicted Sam and 3 lawyers from the firm, including Roger.

Zell avoided prosecution by testifying for the government. The court convicted his brother-in-law, Roger Baskes, and sentenced him to prison. The court acquitted the attorney who was the architect of the scheme.

Being indicted for tax fraud would impede future financing transactions. Northwestern Mutual Life Insurance Company had concerns. This was Sam’s first institutional investor in the 1960s. Now, with this indictment on his record, they needed Sam’s lawyer to explain it. His lawyer gave them this analogy. “Sam was standing in the railroad station, waiting for the train. The train came in and never stopped, and sucked everybody along underneath the tracks.” Northwestern Mutual went ahead with the deal.

The next time the indictment became an issue, Sam was attempting to buy a distressed asset from a bank. The bank was hesitant to fund and sell to him due to the indictment. One of Sam’s early investors, Irving Harris, stepped up and backstopped the deal. It was the kind of loyalty and trust that demonstrates who is with you when you’re down. It’s easy to attract fair weather friends. It’s hard to put your reputation at risk and support someone associated with tax fraud.

Sam’s father taught him to be a man of shem tov, a man of good name. You must guard your reputation above everything else, and prove you are worthy of loyalty. That’s the first lesson of this week’s newsletter.

Sam’s commitment to supply and demand led to his nickname, the Grave Dancer. By the early 1970s, his investment thesis focusing on high growth, small cities, had run its course. Competition was infiltrating. The influx of new capital was lowering cap rates. This lowered the rate of return based upon expected income. Which made real estate in these markets more expensive.

Sam shifted from buying existing assets to financing new property development. He didn’t assume all the risk. He provided equity, partnering with developers, and taking control of the property. Once construction was complete, Sam paid a determined amount over the mortgage. He paid one-third at the beginning, and one-third upon completion. The remaining one-third he would pay the developer at eighty percent occupancy. Sam structured the deals for maximum tax considerations. This allowed him to subsidize his ownership of the residual. They achieved solid returns.

In 1971, the US dollar de-pegged from gold. Nixon ended the direct international convertibility of the US dollar to gold. USA abandoned the gold standard system that had been in place. That’s when the US financial system shifted towards fiat currency. The money supply increased by about ten percent.

In the early 1970s, there was a notable increase in capital allocated to real estate. Investor’s portfolios shifted from equities to real estate. House prices rose while equity prices fell. Inflation and high mortgage rates made homeownership less affordable. This increased demand for rental properties, boosting the multifamily housing market. Inflation reduced the real cost of repaying fixed-rate mortgages. This made real estate an attractive investment.

By 1973, supply and demand was out of balance. He owned an apartment building in Orlando, Florida. He had it built in 1971. It was at full occupancy in one year. Now, in 1973, six other apartment buildings were under construction. There was too much supply in the area. The same scenario was playing out in the rest of the country. The real estate industry was in a building frenzy. The sky was the limit. It wasn’t going to end well.

New capital had flooded Multifamily real estate that decade. Lenders had billions of dollars to invest. Banks allocated a certain amount to bonds, equities, and real estate. The rules incentivized these institutions to allocate all of it. At the end of the year, if any capital wasn’t invested, they had to return it to their parent company. Departments of the lenders never gave anything back. This resulted in loans at rates lower than inflation.

There was another source of easy money. It was a financial structure invented in 1969. Real Estate Investment Trusts (REITs) provided financing for short-term construction loans. As a result, this new industry went from $1 billion to $21 billion within 3 years. It fueled massive real estate development. Institutions were creating REITs with no regard for risk.

To be continued…

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– Sean Allen Fenn

Methods of Prosperity newsletter is intended to share ideas and build relationships. To become a billionaire, one must first be conditioned to think like a billionaire. To that agenda, this newsletter studies remarkable people in history who demonstrated what to do (and what not to do). Your feedback is welcome. For more information about the author, please visit seanallenfenn.com/faq.