Making money in real estate- dissecting two investment verticals

Either 1.) have the relationships or 2.) start combing through balance sheets

Above image is excerpted from Frederik Gieschen’s thread on WEB’s investment in Delta Duck Club (summarized here)

The intuitive idea for the layman generalist investor has simply been to buy the best, easiest business possible. A business perceived to be eternal, permanent, impervious. In the public markets, this idea has historically worked out to average success: market multiples for well known quality companies (“easy businesses”) will provide competitive returns with broader market indexes. The pari-mutuel system correctly bids up the market prices for these “easy” businesses, but usually not to excess. Some obvious periods of exception provide instruction: the nifty fifty, tech bubble, Japan in the 80s, ARKK et al. There are also instructive examples of “easy” businesses falling apart, Kodak being the posterchild of a golden monopoly brought to ruin.

The second order idea for the layman generalist is to find the business that is temporarily misperceived as a difficult business, buy from a disgruntled shareholder at a depressed multiple, wait for the winds to change and sell to a more excited prospective shareholder (this is what I am trying to do currently with EQH, see previous newsletter). The degree of difficulty here has been belabored by too many investment writers for it to be worth repeating, but it is hard.

System 1 & System 2

Real estate in the private market exists in between the two preceding applicable stock market concepts: you want to buy quality, and you want to buy it at the price you’d buy distressed assets at. But you’re okay just buying quality- after all the private market real estate investor needs to find an asset to 1031 exchange within 45 days of a sale. Readily available dirt-cheap bankruptcy-remote leverage from commercial lending operations provides the private real estate investor with a nearly-government-guaranteed reasonable return. Buy quality and stay rich (never pay taxes).

Because private market commercial real estate is private, rarely do these quality assets sell at generous prices to counterparties outside of the “boys’ club” or in-network, off-market participants for whom favors have already been traded, country club memberships have been synched, and alumni events have been planned. This is what I would call the System 1A of real estate investing. This is where common misconceptions occur with real estate: generalist laymen see these slam-dunk transactions and the seemingly risk-free returns generated from them. They observe “dumb people” getting rich not knowing these people are actually repeat-players in a multi-generational game. They play nice with each other to stay in the club and stay rich.

A good rule of thumb for making money in real estate is that it is never as easy as it looks. There’s always uncertainty, it’s never a cinch, you’re dealing with large amounts of leverage and potential catastrophic risk. In particular, this is where you hear about the development disasters: developers and home-flippers that bought from a land bank or a broker listing and tried to put in the sweat equity and a little bit of capital and ended up taking a bath. Call this the System 1B of real estate investing. Development is a dangerous game and the dispersion of outcomes is enormous.

System 2 is simply buying discounted real estate off the balance sheets of private companies. One could start with REITs, call this System 2A but these names simply never become that mispriced: management teams, analysts and investors rarely let the market price and the private market asset value deviate too widely. Arguably this is the best hunting ground for short sellers: management teams have a bad habit of overestimating the values of their portfolio and the price impact of bringing large quantities of real estate to market. Washington Prime Group and CBL trumpeted the private market value of their assets all the way into bankruptcy, and Seritage might soon follow.

System 2B ideas are simply non-REIT real estate plays in the public markets. This is where current opportunity exists for public market investors to make the same kind of money in real estate navigating areas where system 1 and 2A investors can’t or won’t go. Opportunities exist right now where real estate value on balance sheets exceeds total enterprise value. These opportunities are typically produced by corporate actions or mismanaged companies that eventually are liquidated for asset value. This is the optimal path for non-private market players to make money in real estate. It invokes most of my previous letters on asset valuation and the process that goes into unlocking it: how is management incentivized, what concrete steps can be taken to unlock that land or asset value, what’s the likelihood that price given can be achieved and what frictional costs will have to be removed. Some symbols I am following in this vein:

Maui Land & Pineapple (symbol: MLP) - mentioned in my previous letter, others have written better work on this, but a de-levered Hawaiian land bank with lots of optionality.

Howard Hughes Corp (symbol: HHC) - perpetually traded at a NAV discount with 150 page investor presentations, HHC is an amalgam of assets held for sale, assets being developed, and assets currently cash flowing. Invincibly complicated investor presentations mask thoroughly valuable land and commercial real estate.

Copper Property Trust (symbol: CPPTL) - a JCPenney landlord REIT that was spun out of the JCPenney bankruptcy and owned by former creditors, the trust has already cashflowed out 1x its market cap to investors as asset sales and dividends.

Seritage (symbol: SRG) - the Sears REIT that failed to launch and diversify its tenant base into the COVID pandemic is teetering on bankruptcy. Asset sales will need to be completed but with new management and deep capital pockets (Berkshire Hathaway lent to the firm years back) the stock could work on the other side of a quasi-liquidation.

Geo Group & CoreCivic (symbols: GEO, CXW) - two private prison operators that trade at substantial discounts to where assets in the private prison market have traded. Fraught with political discord over their use, private prisons have destroyed billions of enterprise value after re-rating substantially. Both names de-converted from REIT status to sell off assets and mend their balance sheets. Buybacks and capital return programs have been announced.

Happy to chat names any time here.