Buy with Conviction!
After graduation from the University of Michigan with a J.D., Sam Zell worked as a lawyer for one week before realizing that being a lawyer was not for him. Would you believe that before his graduation in 1966, he was managing over 4,000 doors (with fraternity brother Robert Laurie) and outright owned 150 units? When I learned Zell had quit after just one week as a lawyer, I thought it odd that someone would go through all the work to obtain the J.D., only to walk away so quickly. Why? He saw something and he knew something!
If Sam Zell is a new name to you, take the time to enjoy learning about this colorful and creative entrepreneur. Zell built a veritable real-estate empire with a watchful eye on the legal and compliance departments of companies he visits. After an interview with “LA Observed” in 2008 where he used some “salty language” an internal company memo commented, “Sam is a force of nature; the rest of us are bound by the normal conventions of society.” The point being salty language by guests is tolerated, for employees – it’s out of bounds. Zell is an astounding entrepreneur and is as colorful as he is creative.
For “the rest of us” who may never attain the stature of Sam Zell, we may never see the opportunities he saw in the 70s, 80s, and beyond. However, we are still faced with similar decisions. Decisions such as which of the core four do we like most? Where are interest rates headed, and with what impact? What about the economy, the new administration, oh, and what about that tech stock your friend told you to buy?
Let me remind you of a few tidbits you likely once knew, but like many of us, may have forgotten. Alan Greenspan was coined “Maestro” in Bob Woodward’s book Maestro published in the Fall of 2001. Why? After the tech bubble burst, he reignited the economy by lowering interest rates in a dramatic fashion. Greenspan manufactured an artificial yet undeniable force of liquidity and recreated the “Risk On” trade. Team Bernacke and Yellen (our two Federal Reserve board chairs who served the Fed from 2006 – 2018 collectively after Greenspan) continued with this theme and continued large asset purchases at the Fed’s discount window and QE everything.
This does have unintended consequences, however. Does anyone recall a brief moment in time in 2019 when the Fed took its foot off the gas pedal and slowed their purchase of asset-backed securities and the overnight repo rates jumped to 10%? The Fed subsequently responded and ramped up their asset-backed security purchases to bring the repo rate back down.
After an extended period (going on 20 years plus) of on-again off-again quantitative easing by the Fed, many of us are tempted to look in the mirror and pontificate about the shoulda, woulda, couldas in life that might have been. “I should have put more money into real-estate. But now it’s too late because interest rates are going to go up and the run has happened.” Right? Not so fast.
Last summer the Department of Labor (DOL) made a change to how retirement plan administrators (think 401(k) and 403(b) plans) are allowed to invest the assets they manage in their target-date retirement funds. To affirm this, take a moment to do an internet search for “US Department of Labor Information Letter On Private Equity Investments”. Retirement plan administrators are now permitted to invest a reasonable amount of the assets in their target-date funds in private investments.
Typically, before interest rates went to zero, an age-old rule of thumb for investors was to take the investor’s age, put a percent sign behind it, and that’s the percent of the investor’s portfolio that should be allocated to bonds. Do you think the typical 55-year-old has 55% of their 401k in bonds? My guess is no. The stock market has been good, and bonds have such low yields, there’s no sizzle. And, when interest rates go up, bond values go down. It’s difficult for an investor to get excited about bonds.
A compelling argument can be made for syndicated real-estate private investments. Syndicated self-storage assets, for example, are definitely on the come-up. In a deep value-add storage deal, the annual increase in Net Operating Income (NOI) divided by the cap rate is the increase to the property’s value. (Deep value-add meaning increasing the rentable square foot by a large percentage.) In other words, an 80,000 square foot expansion may add $5-6 million to the property valuation. These types of private investments may have a five-year cumulative preferred return of 7%, a 50 – 50, GP – LP waterfall split, and an IRR of 14-15% with an Equity Multiple of 1.8 – 1.95. This is much more compelling than buying treasury bonds or corporate bonds with Yield to Maturities in the low single-digit range.
Here are some questions and I challenge you to think and write down your answer before looking below. In 1982, when Paul Volker broke the back of inflation by hiking interest rates, what was the P/E ratio of the stock market then, how high did the Federal Funds rate go, and what is the stock market P/E ratio today? With the increase in M2 liquidity in our economy, and the recent jump in yield for the 10-year government bond (Feb – March 2021) – what does that tell you about the potential for inflation going forward?
In 1982, the stock market had been in a 14-year sideways moving bear market. The P/E ratio of the market was 7, the Fed Funds rate got to 18 and the P/E ratio of the market today is in the mid to upper 30’s. The point – stocks may easily fall in an inflationary environment.
If stocks are richly priced and can repeat the ~50% loss they had in the last two cycles (2000-2002, 2008-2011) would the retirement plan administrator be wrong to replace part of the bond allocation AND part of the stock allocation with private investments like syndicated value add storage assets? If the P/E ratio got to 7 in the last interest rate hike cycle, where do you think it’s going to go this cycle? I’m not saying the 401(k) administrators will do this, but I am saying they may.
I recently picked up the March 2021 copy of Investment Advisor magazine and read an article about the current allocation of the Target Date fund allocations to private investments. Of 138 Defined Contribution plans they asked, each of which has at least $100 million in assets, 9% have already incorporated Private Investments in their funds. Real estate private equity is the highest allocation with real-estate private debt, with hedge funds, private equity, and liquid alternatives following behind. That strikes me as quite a move since last summer.
So, Sam Zell is a real estate baron and a brilliant one at that. You and I may never have the swagger of Zell, but we can still buy with conviction in the face of likely higher interest rates. Why? That’s for you to say. Just know that there is at least one fellow real estate investor out there who predicts defined contribution institutional money is coming to syndicated real estate, and a lot of it!
About Ted Greene:
Ted Greene is part of the Investor Relations team at Spartan Investment Group. Spartan syndicates self-storage assets for investment. Ted has 24 years of experience in the financial services industry as an investment advisor and Chief Compliance Officer. Ted can be found on LinkedIn at www.linkedin.com/in/ted-greene-dontbeafraid or firstname.lastname@example.org.
Disclaimer: The views and opinions expressed in this blog post are provided for informational purposes only, and should not be construed as an offer to buy or sell any securities or to make or consider any investment or course of action.