Imagining a cashflow monster

Regular readers know I’m an avid follower of Berkshire Hathaway, Warren Buffett’s company.

One interesting thing about BH is that Buffett never issues dividends. His argument is that he can find better uses for cash the company generates than the investors could on their own (particularly given that dividends are subject to taxes at the individual level).

By constantly re-investing the cash thrown off by BH’s vast holdings, Buffett is able to compound the value of its holdings perpetually.

Public real estate companies are organized differently – as Real Estate Investment Trusts (REITs). This structure acts as a pass-through entity (like an S-Corp or LLC) so that the distributions investors receive (effectively, dividends) are not subject to double taxation.

In exchange for this special treatment, REITs are required to distribute the vast majority of their earnings to investors. In other words, they are unable to re-invest their earnings. To grow, they need to sell more shares to the public, effectively diluting the ownership stakes of their present investors.

Why am I thinking about this stuff now?

The (ever-shifting) Republican tax bill winding its way through Congress right now is designed to cut corporate taxes (on C corps, like BH, Apple, Google, etc.) from 35% to 20%… a level which is well below the individual rate.

What if, in response, you organized a real estate holding company C-corp.?

Investors would be given the following rules of the road:

  1. The company will buy income producing real estate;
  2. The company will utilize sophisticated tax structuring to absolutely minimize taxable income, and any such income would be minimally taxed;
  3. There will be no dividends – so no double taxation;
  4. There will be no new shares issued – so no dilution;
  5. Instead, the company will reinvest all cashflow from operations, refinances and (eventually, asset sales) back into more income producing real estate, which will in turn generate more cash for reinvestment.

At some point, the company would need to provide a market for its shares… probably via being publicly traded. This would allow investors who wanted out to get liquidity.

But, so long as management is smart and frugal with overhead, I think most investors would be happy to leave their money in, effectively permanently, and have it perpetually compounded in a tax-efficient manner.

It would be the ultimate, diversified, tax-efficient, long-term real estate play.

An effective tactic we just can’t use

Yesterday, I noted that pricing for apartment buildings in LA has become detached from the underlying cashflows the buildings can generate.

But some deals are still getting done at (semi-)reasonable prices and I want to discuss how, and why it’s a problem for me.

Right now, listing brokers and sellers are pricing properties very aggressively. But that doesn’t mean that everything is selling at list price.

Often, we see transactions closing at meaningful discounts to list. By meaningful, I don’t mean $10-20k off. I mean off by hundreds of thousands of dollars, enough to materially improve the deal for the buyer.

In general, the way this happens is that someone jumps on the initial listing, offering to pay full price. Then, he gets into contract, inspects, and tries to renegotiate the deal. Often, the seller tells the buyer to take a hike. But, sometimes, the seller is so worn down by the process that he agrees to accept a huge price chip.

So, this tactic definitely works. But I can’t use it.

Why?

We participate in auctions all the time. We want the brokers who run those auctions to know, with 100% certainty, that the price we offer is the price at which we’ll close. That way, when they’re looking at a bunch of offers in the same range, they can in good conscience push their clients to accept ours.

So, we can’t chip price, ever.

This strategy definitely hurts us in this part of the market cycle. But (i) I prefer to conduct my business in an honorable way; and (ii) even if I didn’t care about honor, I’d still be 100% confident that, over an entire career, behaving honorably will mean we’ll get to do more and better deals than if we acted like jerks.

What is the difference between “price” and “value”?

Answered this question on Quora yesterday and thought it would be interesting to re-post here:

The key to understanding “value” is to separate it from “price”.

“Price” is the amount of a given currency at which a buyer is willing to buy or a seller is willing to sell (sometimes, those numbers overlap, in which case a deal is made).

A lot of people assume that the value of an asset is equal to its price, but that is not true.

Consider the example of a crazy person who walks up to you and offers to sell you his brand new, mint condition Porsche 911 for $500.

You would jump on that deal, right? Why?

Because you know that the Porsche is worth way, way more than $500. Another way to say this would be: “The value of the Porsche is higher than its price”.

How does this relate to stocks or real estate?

Well, a knowledgable investor is constantly reviewing information about asset classes (stocks, real estate, whatever) in which he is interested. He forms opinions about the assets involved – how much cash they are likely to generate, whether they are likely to appreciate or depreciate in value over the coming years, what other investors are paying for similar assets, etc.

Over time, this knowledgable investor gets a feel for the “value” he puts on these assets – eg what he thinks they are worth to him.

Over time, the prices offered by the market for those assets will fluctuate (based on investor sentiment, interest rates, economic growth rates, etc.), as will his estimates of the values of the assets.

Occasionally, the market will offer to sell the investor assets at prices which are materially below his estimates of their value, at which point he will buy.

And, on other occasions, the market will offer to buy assets from the investor at prices which materially exceed his estimates of their value, at which point he will sell.

Whether the investor is successful over the long term will depend to a large extent on whether the judgements he makes about value prove to be correct.

(For more on this, google “Allegory of Mr. Market” – it’s amazing.)

The forecast on our latest deal

As the economy has continued to improve, both nationally and here in LA, it has become harder and harder to find deals worth doing.

That said, it’s definitely not impossible.

Today, we are closing on a deal with the following characteristics:

  • Currently a vacant triplex
  • Paying $220 / sq ft
  • Suitable for conversion into a 5 unit building

By the time we’re done, in around a year, inclusive of a fee to us for managing the project, am expecting the building will yield approximately 7.5% / year unlevered.

Assuming that rates for apartment loans are at 5% by then (they’re currently around 4.5%), I think we’ll be able to refinance out ~$1.6MM of the ~$1.7MM investment.

The cash-on-cash yield on the $100k remaining in the deal ought to be ~25% / year.

Depending on rent growth, etc., the investor should have 100% of his money back within 2-4 years of stabilization. Then there will be 2-3 years where he gets all of cashflow from the building to pay down the preferred return accrued during the construction process.

Thereafter, the investor and Adaptive will share in a (hopefully growing) cashflow forever.

Who says you can’t find good deals anymore?

Regulatory insanity

Sometimes people wonder why rent is so high in Los Angeles.

Here’s a perfect example. We’re adding four units to a duplex we bought in Highland Park.

Because LA has decided to go down the path of “low impact development”, this is what we’re confronted with (again, on a six unit project!):

“First they have to come back with corrections.  They will probably request a modification from the grading department for the use of pumps.  Grading department mechanical plan check.  Assuming there’s no delay there, once we do the corrections we have to go back to Sanitation at which point they’ll generate a covenant.  Once the covenant is created we have to get with you to sign and notarize the covenant.  Once it’s notarized we have to take it to the county recorder’s office.  After they give us the purple copy of the receipt we take the whole thing back to sanitation.  After sanitation clears it, we have to go to the bureau of engineering to clear the tie in to the public street ( they won’t look at until sanitation clears).”

This is insanity… there’s no way on earth adding four units to an existing building in a densely populated area should require this level of insanity.

And, because it does, fewer units are built than would otherwise be the case. Less supply at a given demand level equals higher prices.