I recently came across the excerpt from Seth Klarman’s annual letter to his investors. Seth Klarman is one of my favorite investors who unfortunately does not write much – the only book on value investing he has ever written, “Margin of Safety”, is out of print and its used version is available for purchase on Amazon for only $14,950 – which is a great value. NOT!
(But don’t worry…you can find a free PDF version online these days).
Anyway. When Seth speaks, the whole investment community listens – the Baupost Group which Klarman founded in 1982, is one of the most successful hedge funds and has generated an average annual return of 19% since inception (phenomenal).
When I was reading the excerpt from his letter, naturally I was thinking of how it applies to real estate in general and multifamily investing in particular and I wanted to share my thoughts with you. Below is my comments on some of the lessons, but I of course highly recommend you read the original for yourself – it’s only two pages. https://www.slideshare.net/vlad0/seth-klarman-the-forgotten-lessons-of-2008
7. The latest trade of a security creates a dangerous illusion that its market price approximates its true value. This mirage is especially dangerous during periods of market exuberance. The concept of “private market value” as an anchor to the proper valuation of a business can also be greatly skewed during ebullient times and should always be considered with a healthy degree of skepticism.
Same applies to the latest sales of houses OR apartment complexes in the particular area – so called “sales comps” which are traditionally stated in multifamily investing using a “price per unit” metric. Often, commercial real estate brokers would insist that the recent per unit comps are a true of reflection of a property value when in fact it only shows how exuberant other investors have become. A conservative investor would look to the cash flow the property generates first and derive the value range based on that cash flow. Yes, valuation is always a range and not a single number. As Warren Buffet likes to say “It is better to be approximately right than precisely wrong”.
9. You must buy on the way down. There is far more volume on the way down than on the way back up, and far less competition among buyers. It is almost always better to be too early than too late, but you must be prepared for price markdowns on what you buy.
I want to buy on the way down! But then – who doesn’t. In my frequent conversations with other real estate investors this topic comes up often – how we all need to be prepared when eventual downturn comes. The question here is – are we going to be mentally and emotionally prepared to pull the trigger when everyone around us thinks we are crazy, the mood is gloomy, the headlines are depressing and everyone around us is telling us that we are about to catch a falling knife? Only time will tell. Also, in order to buy, guess what, you need to have cash. Will you have a pile of cash sitting in your bank account at the right moment? Or will you be resourceful and persuasive enough to find someone else willing to provide financing? I remember how investors (including myself) were complaining in 2006/2007 how expensive everything was and how hard it was to put money to work. However when the downturn actually came, most people either were paralyzed by fear – even if they knew the price was “cheap” they were afraid of further mark downs – or didn’t have enough cash on the books to actually take advantage of the right opportunities, either because of the wave of redemptions or otherwise.
13. At equal returns, public investments are generally superior to private investments not only because they are more liquid but also because amidst distress, public markets are more likely than private ones to offer attractive opportunities to average down.
The key words here are “equal returns”. But they are not always equal – for example, multifamily value-add deals have often delivered much stronger returns than stocks (we guide our prospective investors to 17%+ IRR). And even more so if we take into account the enormous tax advantages available to real estate investors.
14. Beware leverage in all its forms. Borrowers – individual, corporate, or government – should always match fund their liabilities against the duration of their assets. Borrowers must always remember that capital markets can be extremely fickle, and that it is never safe to assume a maturing loan can be rolled over. Even if you are unleveraged, the leverage employed by others can drive dramatic price and valuation swings; sudden unavailability of leverage in the economy may trigger an economic downturn.
While leverage is one of the very reasons I love real estate, it has to be “smart” leverage – meaning conservative, especially considering where we are in the cycle. What do I mean by conservative? 1) Lower leverage (for multifamily it means 80% and lower) – so that when the downturn comes you still have margin of safety and a cash flow cushion and 2) Longer maturity. We underwrite our deals with 10 year debt. I see a lot of syndicators getting fascinated by the bridge loans. They are easier to get, a lot of them are non-recourse and the providers are willing to finance sketchier deals with lower occupancy (which Fannie and Freddie won’t touch) and also finance renovation costs. I am not blind to the benefits…and I agree it’s tempting. But the bridge loans are usually short(er) term (2-5 years), and the questions that need to be asked are (A) what happens if you have to refinance when the capital markets are frozen? Hint – nothing good happens; (B) what happens if the paper valuations go lower by the time you have to refi and you are “under water” – meaning you have to put in more equity into a deal if you want to get a refi done? and (C) what if the interest rates jump and even if you can get someone to refi, the interest rates are materially higher and your deal numbers don’t work anymore? Just sayin’. I think some people underappreciate the risk involved in the bridge loans.
17. Having clients with a long-term orientation is crucial. Nothing else is as important to the success of an investment firm.
Another thing that I love about real estate – investors who put money in real estate deals generally realize that it is illiquid and are prepared to hold for the long term; they don’t ask for their money back at the slightest sign of a slowdown. It is a different mindset. Real estate investors (both passive and active) know that there are market cycles, they don’t want to sell at the bottom (and you generally should not have to be forced to sell unless you have an upcoming maturity – see above on the bridge loans) and they are comfortable to be invested until the economy turns again and the asset is sold. Compare this to most of the hedge funds where investors can redeem (usually a certain % of their money per quarter) on a 90 days notice – while you, as a hedge fund, are trying to invest long term. I have a lot of stories about how this model “works” – happy to share over a glass of beer ?