The Grave Dancer

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This week’s newsletter is about how Sam Zell transformed an industry.

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Sam Zell transformed the Real Estate Investment Trust (REIT) sector. A REIT is a company that does three things. Owns, operates, or finances income-producing real estate. It allows investors to buy shares and invest in real estate. And they don’t purchase properties. The REIT must distribute most of its income to shareholders.

He pioneered the public listing of REITs. So investors could access capital markets instead of relying on mortgage financing alone. He founded Equity Office Properties Trust. This was the first REIT in the S&P 500 and the largest office building owner in the U.S. at its peak.

Zell invested in distressed properties with high appreciation potential. Which helped democratize real estate investment, and it benefited millions of Americans. He was a key figure in modern REIT development.

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In late 1968 and 1969, Sam Zell negotiated a deal he’d never forget. The purchase of Arlington Towers and Arlington Plaza in Reno, Nevada. He collaborated with his brother-in-law, Roger Baskes, a tax attorney. It was a complex tax scheme to manipulate the transaction’s value. This involved attributing $700,000 to a near-worthless gold mining claim. This reduced taxable gains.

The IRS later targeted Baskes’ law firm. This led to a 1980 court case. Zell testified against his brother-in-law to avoid prosecution. Baskes went to prison. The court indicted Zell. He continued successful real estate ventures, backed by loyal investors.

Zell’s business strategy emphasized balancing risk with reward. He found opportunities in supply-demand imbalances. By the early 1970s, macro shifts and deregulation led to a surge in supply. Easy money fueled a building boom. Real Estate Investment Trusts (REITs) for short-term loans resulted in risk-laden growth. Everything was about to change.

Part 80. Sam Zell (continued).

You can find this week’s TL;DR here.

Key Lessons:

• Cash flow needs to cover your debt.

• Be prepared for a market downturn.

• Inflation is good for real estate.

• Avoid inductive reasoning.

• Location

• Location

• Location

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There’s a flaw with the real estate business. Not only could it be the most capital intensive industry known, it’s built with a cognitive bias. I’m not sure if any experts have identified this cognitive bias. There’s no name for it. The volume of real estate development correlates with availability to funds. Not to demand.

A financial structure invented in 1969 was another source of easy money. 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.

By the early 1970s, Sam Zell was certain that a crash was coming. It was then that he stopped buying assets and started accumulating capital. It would be the greatest buying opportunity of his entire career. His thesis was that over the next 5 years, he would have the opportunity to make a fortune. That’s when he started acquiring distressed assets. He established a property management firm, First Property Management Company.

Understand that this was a contrarian position at the time. His contemporaries thought he was crazy. They thought the market was strong and would continue in the same direction. This is inductive reasoning, AKA gambler’s fallacy. It’s the incorrect belief that past random events influence future outcomes. But these are independent situations. When something happens more often during a given period, it fools most people. They assume it will continue. They also could assume that because something happened, the opposite will happen. But independent situations don’t cause other independent situations.

Sam knew that the market shifted by understanding risk. He followed the logic of supply and demand. And he was right. It became obvious to him that supply was overtaking demand. On top of that, USA was heading into a recession and inflation was increasing. The market crashed in 1974. Overnight, real estate went on sale. He was buying assets at 50 ¢ on the dollar.

He figured out how much debt service the assets could handle, based on their existing cash flow. He restructured the debt at a lower interest rate. All he needed was a dollar down on the property, along with a limited cash flow guarantee. The institution had to avoid going into default while waiting for the market to recover.

For example, an apartment building with a 7 percent loan for 10 years. This asset could only service debt at 4 percent. His guarantee assured the lender that the restructured loan would avoid default. This way, Sam had to put up zero capital. The lender’s only alternative was to take back the assets. Which they weren’t prepared to do. Sam’s First Property Management Company was ready. They branched out from apartment buildings to retail and office buildings. Between 1974 – 1977 they bought roughly $4 billion in assets.

The important thing about these assets is that they were below replacement cost. That means it was less expensive to buy them than it would be to build replacements. They had to be in a good location. More upscale areas provided better downside protection than not-so-upscale areas. When the economy goes down, upscale tenants tend to upgrade to better locations. These were value-add deals. That means there’s room for improvement. Deferred maintenance, for example. Sam could improve the properties and justify raising the rents. Which improves the net operating income (NOI). That improves the value of the asset.

While the economy of the 1970s was a disaster for many people, for Sam Zell, it was perfect. All he did was create a massive arbitrage. He created a fixed-rate instrument in an inflationary economy. He took on $4 billion of non-recourse debt at an average interest rate of 6 percent. Inflation was up to 9 percent. That gave him an immediate 3 percent return on the buy.

He knew this plan would work. What he didn’t know is that the economy would get worse. USA elected President Jimmy Carter. Everything he did raised inflation. That allowed Sam to make a lot more money than he expected. During this time, Sam wrote an article for Real Estate Review titled, The Grave Dancer. It was about the opportunity to resurrect those assets deserving of a fresh start.

To be continued…

I like you,

– 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.