One of the advantages of going to a top-tier MBA program is that you get to meet a lot of succesful, well-known people. Last week, billionaire real estate investor Sam Zell was on campus and gave an hour long speech about his views on the economy.
He made an analogy that the economy was like a bus being run by a monkey who let everyone drink, smoke weed and fornicate like crazy and then crashed it! There’s no free lunch. We’re going to have to pay for the past excesses.
Over the past 40 years, there’s only one true metric for real estate – and that’s the replacement cost of a building. Costs cannot stay much higher than that for extended periods of time. During the past few years, real estate was selling at astronomical levels. People were buying long-term with short-term financing, which has always ended in disaster. The value was not based on its intrinsic value, but on how much they could borrow against it. And the people making the loans just sold them off to unsuspecting pension funds and sovereign wealth funds. There was a huge disconnect between the borrower and the actual lender. There was also a disconnect between risk, reward and responsibility.
A lot of the current mess was caused by long held beliefs just being plain wrong. People believed that real estate always goes up, that companies like GM and Merill Lynch were too big too fail. They also came up with a new belief system that didn’t include paying back loans – instead they just refinanced them! A rolling loan, carries no loss.
Instead of throwing people with bad credit out of homes they couldn’t afford in the first place, the government lamented on the victimization of the borrowers. Zell isn’t impressed with the government’s handling of this situation. In an effort to get the bail-out bill passed, there was a lot of fear-mongering and even a bait-and-switch to get the bill passed. Apparently a $700 billion bailout got passed with a 3 page memo which no mention of how to spend the money.
He also commented on the recession. He sees consumer consumption going down, but the government will step in replace it. He thinks that government spending will increase from the current 18% of GDP to being more like France, where it is around 50%. This is a structural change caused by the deleveraging effects of and this recession is going to felt around the world.
But this doesn’t mean there won’t be opportunities to make money! Opportunities exist, but for those with access to capital. Capital is as scare as ever and you need to recognizing that capital will be the key to make money in this environment. Asset pricing has started to become out of whack with reality. We are starting to see deep discount below the intrinsic value. We can buy assets below their replacement cost. This will essentially create a floor at some point, since buyers will step in below the replacement cost.
But right now he see the best opportunities in debt. Right now we can get unlevered returns of 15-20% on performing loans, which is unheard of. This is a function of liquidity risk, not of default risk!
In the 80s and 90s, Zell was a buyer of the last resort. He’s proud of the fact that everyone calls him the grave dancer, since he buys properties at fire-sale prices and resells them for a profit.He recommends waiting until the equity holders have no equity left in the assets before buying them. He mentioned the story about a bank who came to him with a property they said was worth $32 million. He offered $16 million. The bank said they’d do the deal at $18 million or else they’d take it to the market. Zell called their bluff and eventually bought it for $9.5 million! Patience is a good thing to have in this market! (Check out this link to see cheap commercial real estate).
Zell thinks there will be a demand recession. You never want to invest where there is no demand for your product. He recommends buying where demand is still strong. He’s currently building low-income housing in places like Mexico, where there is a strong pent-up demand for that product.
He also spoke about investing in BRIC (thats Brazil, Russia, India and China). He strongly cautions against Russia because there is no law. However, he thinks positively of the other countries since they have embedded demand. If you can service that demand, you will do well. But doing business with honest and ethical people is very important. He recently passed on a proposal to do business with an Indian company because he didn’t think they were ethical. As it turns out, they weren’t and they’re now facing bankrupcy. That company was Satyam, India’s Enron!
He isn’t a fan of investing in Europe. With it’s shrinking population, he sees no demand.
However, if you can find demand in the US, you will do well here too. The US will somehow spend its way to recovery, although he later mentions that this will come at a cost of a severe inflation. But he still likes the US. We’re special. The US is the only place on the planet where you’re allowed a do-over if you mess up. It’s called Chapter 11!
Housing in the US is getting better. While there is a standing inventory of 1 million households, the creation of new households keeps on increasing. Housing will come back, but slowly.
He thinks there will be no instant gratification this time around. The medicine being put into the system will slowly impact the economy. He thinks the economy will start to turn around by the beginning of 2010 but the risk of inflation is very high. He didn’t really elaborate on the inflation or economy part but the only thing I know is that you should buy gold ;-).
The US is a unique society with a lot of opportunity. However, he sees the current government interference hindering the growth that has made us the greatest country on earth. This sounds a bit contradictory to me. First he says the government spending will pull us out of recession but it will also hinder our growth? Again, he didn’t really explain this.
After this he took a few questions:
He doesn’t think the US will lose it’s place as the world’s reserve currency. There isn’t really any other replacement. In the very long term maybe it might happen, but right now he doesn’t see any alternative. Currently no central bank wants to bet against the dollar. He also mentioned that the “beggar thy neighbor” mentality of European countries would disappear and interest rates would drop all across the developed rates to match the pathetically low rates of the US.
He also explained how he managed to sell Equity Properties at the very peak of the real estate cycle to Blackstone group. (Speaking of Blackstone, check out this post on How Capitalism Really Works). He does a quarterly valuation of all his holdings. Blackstone made him a $39 Billion offer that was 20% higher than what he thought it was worth, so he sold it.
He also mentioned that he didn’t think the government programs would stem foreclosures. There has been massive fraud going on. He gave the example of an entire subdivision of homes in Stockton being sold to migrant Mexican workers. People who made $8/hour were somehow approved for $350,000 loans! Only people who can really afford them to get to keep them. He cites the example of Japan. The government/lenders allowed people to stay in the homes rent and mortgage free. Since there was no incentive for people to pay, property prices stayed depressed a lot longer than they should have. So the biggest risk right now is lenders not cleaning up and making poeple pay for there mistakes.
Zell also spoke about his Tribune purchase. He says the newspaper model is broken. It costs more money to have papers home-delivered but you pay less for that service. He explained he would change that model and that would increase the revenues. Let’s see if that’s true.
In all, it was very interesting. But it was over quickly and the $5 billion man literally ran out the door before anyone could stop him for photographs or autographs.
