I am a full time real estate investor and developer with over 30 years experience. Early last year, I was approached by a representative of a very wealthy southern family, and asked to write them a letter about their portfolio of properties. I decided to write the letter in the form of an article, perhaps later to be expanded to book length. As it happened,, events took over, and I was asked to be President of their investment company before I could finish the article. Here is the fragment.
SURFING THE CYCLE
GET RICH AS A ROCK STAR IN REAL ESTATE
By cache22
April 2004
INTRODUCTION
In spite of the somewhat frivolous title, Iâm entirely serious in saying that there is a proven method of real state investing which not only yields extraordinary returns, but also guides the investor into purchasing the right property, in the right location, at a bargain price, with relatively low risk by timing purchases and sales according to the real estate cycle. I have used this understanding to make over xxxxxx for myself, and therefore this letter is the product of a practitioner, rather than a theorist. Nevertheless, Iâm small potatoes compared to Sam Zell, who used these same methods to become Americaâs largest property owner, and one of its wealthiest citizens. Additionally, this approach has a strong resemblance to Warren Buffetâs approach to stock investing: buy below intrinsic value and draw very strong cash flow for a long period of time while waiting for great capital appreciation. Iâm sure you were expecting me to recommend selling property A, exchanging property B, and refinancing property C, etc. These tactical decisions will be much easier to make, and much more timely, if first you have an understanding of how a particular decision fits into broad strategic goals. Then the tactical decisions become a lot more obvious, and relatively easy to make. In the remainder of this letter, I will state the â strategic ruleâ, explain in detail the components of the rule along with some real life examples, and then modify the rule somewhat to magnify the returns. Iâm confident that a person can multiply his wealth by a factor of at least ten over a period of twenty-five years by following this method. Finally, as you requested, I will analyze your real estate portfolio, and make specific recommendations for each property.
THE REAL ESTATE CYCLE
1). EXPANSION
Strong levels of new construction, rising occupancies, sales above reproduction costs.
2). OVERSUPPLY
Construction continues, rents level off. Occupancies begin to decrease, and rates of fill-up decline. Investors are plentiful.
3). RECESSION
No new construction, however completions keep coming on line, adding to the oversupply. Occupancy and rents fall as the market struggles to absorb the oversupply. Sales are at levels below reproduction costs.
No new construction, however completions keep coming on line, adding to the oversupply. Occupancy and rents fall as the market struggles to absorb the oversupply. Sales are at levels below reproduction costs.
4). RECOVERY
No new construction. Occupancies and rents rise. Investors scarce.
My impression is that we are at the tail end of stage 2, heading into stage 3. Any project started now would have to weather the storm, and just as it is ready for the permanent loan, interest rates could be significantly higher. For a developer, this is life threatening.
STRATEGIC RULE
1). Invest in a demographically long wave bidding for a restricted supply of real estate.
2). Within that long wave there is the âreal estate cycleâ (expansion, oversupply, recession, recovery). You should invest only during the recovery phase, when there is very little new construction, occupancies and rents are rising, investors and lenders are scarce, and bargains are plentiful.
The classic example of the long wave is the steady migration to Southern California beginning right after World War II. Trapped as it is between the mountains and the Pacific Ocean, the coastal area between Los Angeles and San Diego has experienced a tremendous increase in real estate values due to a) the long demographic wave, and b) ever increasing governmental zoning, planning, and environmental restrictions, which have had the effect of âshrinkingâ the amount of available real estate. The result of these two factors has pushed values to undreamed of levels. Nevertheless, California isnât immune to the real estate cycle. In 1974 California real estate was in a moderately serious recession, just starting to revive. There was a great deal of real estate available at bargain prices. Lenders had virtually abandoned lending on real estate. It was at this moment that I purchased 70 houses in Orange County, which I held for approximately 20 years. This was a wonderful investment, from which I made several million dollars, and the primary reason was that the long wave remained intact, and prices not only recovered, but also increased very significantly during the time I held them. An added bonus, analogous to the current economic situation is that within a year of purchase, the full effects of Lyndon Johnsonâs âguns and butterâ policy hit, and rents went up at 2.5% per month for over two years. The point Iâm making is that the purchase was significantly below reproduction costs. That is the key. I will more fully develop this thought later on.
In the early eighties, Houston real estate was in great distress, and values had dropped by about 25%. That is when I relocated my business from California to Houston. We spent over two years looking, and waiting for strong indications of a recovery. Since there was virtually no known methodology for determining for certain that a recovery had established itself, I devised my own. Part of it was to get information on commercial electrical connections from Houston Light & Power (HL&P). I put them on a graph. During this time, although my indicators showed no strong recovery, people from all over the world were descending on Houston, and buying properties at discounts from reproduction costs of about 25%. I didnât buy, which was a good thing, because just as all the new money was in place, and the escrows had all closed, the ârealâ decline set in, sweeping all of the new money back into foreclosure. Property values declined an additional 25%. It wasnât until April of 1988 that all of my indicators showed a strong, sustained recovery in the Houston market. That is when I started buying. One of the purchases was a large industrial park, which I bought for $2,200,000, with only $350,000 down. Since then the value of the property has increased to about $6,000,000, and rents have gone up by over $50,000 per month. Take a good look at that last number, because it illustrates the power of the concept. On an investment of $350,000, we have received several million dollars of cash flow, and the value of our equity has been multiplied by ten. The key to this investment, once again was buying below reproduction cost.
The reason buying below reproduction cost is so effective is that until the market recovers, and prices rise to reproduction costs, virtually nothing will be built; therefore markets over time regain their equilibrium. In Texas, we are rapidly approaching a situation where lots of property will be available at bargain prices. I anticipate the decline to start with housing, and then spread to all real estate asset classes which are overbuilt, which is to say, virtually all of them. In Austin, which was, and one day will return to being one of the best âgrowth citiesâ, there are over 9000 houses for sale, with prices starting to decline, and forclosures escalating. Dallas is much the same story. Other real estate types, such as multi-family, mini-storage, industrial, and retail, are similarly overbuilt. This is not caused by any unusual economic distress, but rather the opposite, âirrational exhuberenceâ. Texas is pro-growth, and tends to build far in excess of the demand. Thatâs just Texas, and that is our opportunity. Real estate cycles come about every seven to ten years. Some are big swings, and some are small, but the real estate cycle is operative everywhere, and at all times. When interest rates are low, occupancies high, and rents are increasing, the cycle begins. When interest rates increase, and occupancies and rents are falling, the cycle ends.
