Gorging on Leverage Always A Dumb Idea?

Heresy – according to a dictionary I found on-line, is a word that means

Any belief or theory that is strongly at variance with established beliefs, customs, etc.

I think it has become heresy to advocate a lot of leverage – at least for “conservative investors” in investment funds. But I am going to do exactly that, at least in part.

Hopefully you will at least hear me out before you stop reading. By the way, many years ago, I was a math major although I admit I can’t remember anything about it.

This article has two parts. First, there is the kind-of obvious part of my analysis, for which I suspect most people will agree with me. And second there is the more subtle thinking, which I suspect is more thought-provoking and subject to more disagreement.

First – the obvious thought process:

Let’s say you bought a property about three years ago for $50,000,000 and it is now worth $75,000,000.

Let’s say that when you bought it you took out “conservative” 60% leverage of $30,000,000. This means you wrote a check for $20,000,000.

Let’s say the property is in a stable type of asset – e.g. multifamily – where the cash flow is unlikely to be lumpy over a long period of time.

Let’s say that you intend to hold the property for a total of roughly 5 to 7 years and you are hoping for future additional appreciation.

Let’s say that there is long-term debt (e.g. 10 years or even 30 years) available at historically low fixed interest rates – and in some instances 85% (and maybe even 90%) leverage is also available.

Let’s say you are a conservative investor type who generally believes leverage over 60% is “too much”.

In this instance, I think the conclusion that leverage should be limited to 60% should be challenged. Please consider the risk/reward of taking the following action:

Right now, leverage up the investment to 85%.

This returns to you $63,750,000 (less the $30,000,000 you borrowed) = $33,750,000.

You invested $20,000,000 at the beginning so you now have all your capital back plus $13,750,000.

You now still own the asset – albeit with high leverage on it – but at a low interest rate – and your debt doesn’t come due for a long time. My belief (explained below) is that, for an asset without lumpy cash flow, lower leverage with a shorter maturity is actually more risky than higher leverage with a longer maturity – so you have actually lowered your risk by the foregoing actions. But either way this is relatively moot since you just took out all the money you invested anyway.

You might be concerned about prepayment penalties for long-term debt; however, if interest rates rise prepayment penalty risk is not really that big a concern – and if interest rates fall then you will probably obtain more upside from property appreciation than you will lose from a prepayment penalty. Also, you can – and should – mitigate the prepayment risk by negotiating assumability for the loan and the ability for the buyer to put on mezz debt or preferred equity (admittedly difficult to negotiate at times), so hopefully there will not be a need to prepay in the first place.

If all this can be done, then isn’t this too good to be true? Shouldn’t you in fact take the long-term cheap money and the highest leverage possible as long as this market anomaly (i.e. interest rates below long-term norms) exists?

Of course I made up these numbers, but even if the numbers are a lot worse, it would seem that if your asset is of the type that permits long-term leverage on these terms you might consider the above proposition and run the numbers. I already admitted (above) that I can’t do the math myself anymore; however, my former-math-major brain believes that this will enhance your IRR’s quite a bit in some situations.

Second – the more subtle thinking:

Now let’s continue to assume you are a “conservative” investor, i.e. someone who wants to be “conservative” in the use of leverage. Let’s play around with what this means.

Generally, this means that you don’t use a lot of leverage right? But why not? In the not-sorecent-any-more Global Financial Crisis, what happened? My general view is the following:

Those who were conservative in the years leading up to the Financial Crisis did worse than those who were aggressive. This is because those who were aggressive (obtaining, say, 90% leverage), by definition, made more upside as the market rose than those who were conservative (obtaining say 65% leverage).

Then when the Financial Crisis hit property values generally dropping – in the short run – anecdotally about 35% or even more. And even math-challenged people know what this means – it means, alas, that both the conservative guy and risk-prone gunslinger were wiped out. Sadly, in the end there was no reward given to those who were more conservative. Each ended up with nothing.

But look at my preceding paragraph – there are two words there that I deliberately didn’t emphasize but I think tell the real story. Those are the words “short run”! What happened after the “short run” ended? After the short run ended prices bounced back up and in only a few years for many asset classes prices had risen to the same, or even a higher level, than before the Financial Crisis.

What does this tell us? I will tell you what it tells me. It is that (for non-lumpy cash flow assets) there is a lot more “risk” in short-term debt than there is in high loan to value ratios. Those who had long-term debt in place before the Financial Crisis had only “paper losses” and if they waited a year or two or three were just fine. Those who had short term debt, and unforgiving lenders, faced disaster.

So if I am not crazy – which of course I myself cannot be sure about – it looks to me that investors looking to manage their risk in the context of leverage should be looking at maturity at least as much, and maybe more, than loan to value.

To conclude:

I am probably overstating my points here a bit to make a point, but my points are as follows:

If you own significantly appreciated property — with non-lumpy cash flow – with high leverage available – that can be long-term in nature, then take out as much as you can, and negotiate to preserve your ability to (i) transfer the property subject to the debt and (ii) put mezzanine debt or preferred equity in place.

If you are buying new property, don’t limit yourself to a “rule” that you “always” have to limit leverage to, say, 65% of loan to cost; instead, for property that does not have lumpy cash flow, consider raising the percentage of leverage and lengthening the maturity and, again, negotiate to preserve your ability to (i) transfer the property subject to the debt and (ii) put mezzanine debt or preferred equity in place.

None of us has an actual crystal ball of course; however, my sense is that the above courses of action are destined to increase your likelihood of obtaining higher IRR’s in markets that go up and down with frequency.

Finally, if you think I am missing something in this analysis I would certainly like to hear about it.

Porter’s Five Forces in the Real Estate World

Michael Porter is a professor at Harvard Business School. He has spent his long career analyzing strategy and competition. His analysis is exceptional and probably just about everyone in the business world knows all about him; however, I have never seen his theories applied to the real estate world.

The most interesting thing about Porter’s work, at least to me, was his admonition that the goal should “not” be to “compete” with one’s competitors, as all this really does is give away your upside to your customers, employees, suppliers and other parties (e.g., competing on price just helps the customer). Instead, the smartest thing is to do something “different” from your competitors. Indeed, asked what the biggest mistake companies (and those leading them) make, Porter’s response is exactly that: Companies trying to beat their competition when the goal should instead be to extract as much “value” as they can out of their industry.

Porter, after many years of thought and analysis, concluded that there are five forces that dictate the competitive situation in an industry. In a nutshell, and generally speaking, when these forces are strong, it is kind of rough to be a player in the industry, and when these forces are weak, it is great times.

As the managing partner of a New York real estate law firm, I have performed this analysis for my firm and have found it to be quite helpful. Indeed, the sine qua non of my law firm is to try to be different from other law firms by becoming a top player in the real estate niche, rather than trying to be all things to all people. Instead, my firm focuses “only” on real estate; hence, our brand as The Pure Play in Real Estate Law.

I am now going to do my best to illustrate how one might do this for an “industry” that is part of the real estate world.

Also, I would like to emphasize that this is not pointless philosophizing, as I would think that anyone considering entering an area within the real estate industry, or considering a project in an area of the real estate industry, should logically do exactly this analysis.

Before one can get to an analysis of the five forces within an “industry”, one has to define what “industry” it is that one is analyzing, and that is not as easy as it might seem. I mean, is the industry to be analyzed:

All real estate in the world?

Of course not. Is it then:

All real estate in, say, New York City?

Still kind of too broad, so maybe:

Building housing in New York City?

I think still too broad, so how about

Building condominiums in New York City?

Even that may be too broad as most people think there are three submarkets consisting of relatively affordable, medium range, and super high-end luxury, so how about:

Building super high-end luxury condominiums in New York City?

That sounds kind of reasonable to me as an industry for analysis, so let’s go with that for purposes of this article; however, as I hope is relatively obvious, an “industry” could consist of innumerable concepts including those based on geography, product type, way of doing business (locally, nationally or internationally), deal structure, new economy, etc. There are always innumerable ways to define the industry one is analyzing and it is easy to get bollixed up and diverted or to fool yourself in this analysis; however, for the conclusions to have any use this is critical to do. I deliberately picked a relatively easy industry concept for purposes of this article.

So now let us embark on our analysis of the Five Forces as applied to the industry that is the building and selling of super high-end luxury condominiums in New York City.

If you have been wondering, here are the Five Forces, which I will go through one by one to reach a conclusion as to whether the competitive forces are low, medium or high:

  • Competitive Rivalry

  • Threat of New Entrants

  • Threat of Substitutes

  • Bargaining Power of Buyers

  • Bargaining Power of Suppliers

Competitive Rivalry: This one seems to be quite high. There is a ton of competitive rivalry right now. There are quite a few players building and selling super high-end luxury condominiums in New York City.

Threat of New Entrants: This one seems to be relatively low or at best medium. It is not so easy for someone to just go out and build a super high-end luxury condominium in New York City. There are innumerable regulations and other obligations to be dealt with. Plus the reputation of the party building the condominiums has a great deal to do with a project’s success, which is a further barrier to a new entrant. Accordingly, a new player will have a great deal of trouble just moving into this industry.

Threat of Substitutes: This one seems to be quite low. It is difficult to come up with a substitute to this product as there is only one New York City. One could argue that living in Brooklyn is a “substitute”, and there is a slight element of that; however, overall I would say this threat is a low one in view of how we have defined the industry. Another possible “substitute” could be renting instead of buying; however, that also doesn’t seem quite applicable at the top end of the luxury market.

Bargaining Power of Buyers: Of course this fluctuates, but right now the bargaining power of buyers seems pretty high as there seems to be more super high-end luxury condominiums than buyers. The obvious difficulty in analyzing an industry such as building and selling super highend luxury condominiums, that makes the risk/reward perspective so much worse, is that you are not selling your product right now but in the future when you don’t know what the bargaining power of buyers will be. To be safe, even in a time of a shortage of luxury high-end apartments, you would have to assume the bargaining power of buyers is high even at times when it isn’t.

Bargaining Power of Suppliers: This one seems to be very high as well since one of the problems in making a profit in this market is it is taking longer to obtain the necessary supplies, plus the pricing has risen for these supplies. Indeed, workers, to my mind, are also technically suppliers too; and, due to the construction boom, the cost of workers is much higher.

So to sum up:

Competitive Rivalry: High
Threat of New Entrants: Low/Medium
Threat of Substitutes: Low
Bargaining Power of Buyers: High
Bargaining Power of Suppliers: High

Looking at the above it seems that overall the Five Forces are pretty strong in the super high-end luxury condominium industry in New York City. This would mean that it is (probably?) not the best industry to go into right now because it will be more difficult to make a profit

So this is a very quick and dirty analysis of how one might apply Porter’s Five Forces to the real estate world. I did it very fast here and without a ton of depth as my goal was to illustrate rather than dive into a deep analysis.

To sum up, and hopefully make this article useful to you in your real estate business, the way to apply Porter’s Five Forces is as follows:

First – figure out what “industry” you are in or are you would like to move into. This should not be quick and dirty. You really want to spend a lot of time on this as there are many subtleties and you can end up with the right or wrong results just by how you define the industry. It is actually the most difficult part of the analysis. For example, is Ford Motor Company in the “car business” or is it in the business of “transporting people.” And are you in the business of building buildings for people in a certain market or in the business of providing a lifestyle for people. You could see a lot of difference in analysis and results depending on this.

Second – go through the five forces and analyze each one as it applies to your industry.

Third – be honest with yourself about the application of these Five Forces to your plans and take these Five Forces into account in planning your actions. Of course, this is not the whole story, and a possible problem for Porter’s analysis is likely the cyclical nature of the real estate markets that you have to adjust for (i.e. the Five Forces may change a great deal from the day you start a project until the day it is ready to be sold). However, overall the goal with the Five Forces is to permit you to make a more informed decision whether to go into a market deeper or possibly to get out.

In my next article, I am going to work further with Professor Porter’s works and apply his definition of competitive advantage to the real estate world. To get you excited about my next article, I will give you his definition, which I find incredibly insightful:

Competitive advantage depends on offering a unique value proposition delivered by a tailored value chain, involving trade-offs different from those of rivals, and where there is a fit among numerous activities that become mutually reinforcing.