Investing with Conviction

Before graduating, Zell had managed over 4,000 doors alongside fraternity brother Robert Laurie. He also owned 150 units outright.

When I learned Zell had quit after just one week in law, I couldn’t believe that he would go to the trouble of obtaining a J.D. only to walk away. But Zell saw something — and he knew something!

Lessons From a Billionaire

If the name Sam Zell is new to you, take the time to enjoy learning about this brilliant real-estate baron.

Zell built a veritable empire with a watchful eye on the legal and compliance departments of companies he visited.

He quickly earned a reputation as an astounding entrepreneur who is as colorful as he is creative. After an interview with LA Observed in 2008, where he used some “salty language,” an internal company memo commented, “Sam is a force of nature; the rest of us are bound by the normal conventions of society.”

We may never attain the stature of Sam Zell — or see the opportunities he experienced in the 70s, 80s and beyond. However, we still face similar questions and decisions.

Which of the core four do we like most? Where are interest rates headed, and what will the result be? What about the economy, the administration — and that tech stock your friend told you to buy?

The Role of the Fed

Alan Greenspan, the 13th chair of the Federal Reserve, was coined “Maestro” in Bob Woodward’s book of the same name, published in the fall of 2001.

After the tech bubble burst, Greenspan reignited the economy by lowering interest rates dramatically. He manufactured an artificial yet undeniable force of liquidity and recreated a risk-on trade environment, where more money flows to riskier investments like stocks.

Ben S. Bernanke and Janet Yellen, who served as Federal Reserve board chairs from 2006–2014 and 2014–2018, respectively, continued this trend with large asset purchases at the Fed’s discount window and heavy quantitative easing.

This policy did have some unintended consequences, however. For instance, for a brief moment in 2019, the Fed took its foot off the gas pedal and slowed its purchase of asset-backed securities. In response, the overnight repo rates jumped to 10%. The Fed reacted by ramping up its asset-backed security purchases to bring the repo rate back down.

Operating With Hindsight

After an extended period (going on 20 years plus) of on-again-off-again quantitative easing, you may be tempted to look in the mirror and pontificate about the opportunities you wish you had taken. “I should have put more money into real estate. But now it’s too late because interest rates are up, and the run is over.”

Right? Not so fast.

During the summer of 2020, the U.S. Department of Labor (DOL) made a change to how administrators of retirement plans — like 401(k)s and 403(b)s — are allowed to invest the assets they manage in their target-date funds.

Per the DOL’s letter on private equity investments, retirement plan administrators are now permitted to invest a reasonable amount of the assets in their target-date funds in private investments.

The Case For Self Storage

Typically, before interest rates went to zero, an old rule of thumb was to take the investor’s age and put a percent sign behind it to find the percentage of the investor’s portfolio that should be allocated to bonds.

Does today’s typical 55-year-old have 55% of their 401(k) in bonds? My guess is no. The stock market has been healthy, while bonds have offered consistently low yields. And, with rates moving, bond values are going the wrong way — making them a hard sell for investors.

On the other hand, a compelling argument can be made for syndicated private real-estate investments. Syndicated self-storage assets, for example, are definitely on the come-up. In a deep value-add storage deal, where the rentable square foot is increased by a large percentage, the annual increase in net operating income (NOI) divided by the cap rate is the increase to the property’s value. In other words, an 80,000-square-foot expansion may add $5-6 million to the property valuation.

These types of private investments may have a five-year cumulative preferred return of 7%, a 50/50 GP-LP waterfall split and an internal rate of return of 15% – 20% with an equity multiple of 1.8–2.0. That combines to present a much more compelling offer than buying treasury bonds or corporate bonds with yield-to-maturity in the low single-digit range.

A Shifting Landscape

In 1982, when Paul Volker broke the back of inflation by hiking interest rates, what was the stock market’s price-earnings ratio? How high did the federal funds rate go, and what is the stock market price-earning ratio today?

Before reading on, I challenge you to think and write down your answers!

In 1982, the stock market had been in a 14-year sideways-moving bear market. The market’s price-earnings ratio was seven, and the federal funds rate rose to 18. Today, the market’s price-earnings ratio is in the mid to upper teens. The bottom line? Stocks may easily fall in an inflationary environment.

Suppose stocks are overpriced and risk repeating a ~50% peak-to-trough loss similar to the last two cycles (2000–2002 and 2008–2011). If the price-earnings ratio got to seven in the previous interest rate hike cycle, where do you think it will go this cycle? Would a retirement plan administrator be wrong to replace part of the bond allocation and part of the stock allocation with private investments like syndicated value-add storage assets?

There is no way for us to know if 401(k) administrators will diversify stock allocations. But they could.

Facing Down the Market

I recently picked up the March 2021 copy of Investment Advisor and read an article about the current allotment of the target date fund allocations to private investments.

Of 138 defined contribution plans they asked — each with at least $100 million in assets — 9% had already incorporated private investments in their funds. Real estate private equity is the highest allocation with private real-estate debt, with hedge funds, private equity and liquid alternatives following behind. That strikes me as quite a move in nine months since the summer of 2020.

You and I may never have the swagger of Zell, but we can still buy with conviction in the face of potentially higher interest rates. Why? That’s for you to say. But know that at least one fellow real estate investor predicts that defined contribution institutional money — and a lot of it — could be heading to syndicated real estate!

If you are interested in discussing how Spartan can help you meet your investment goals, schedule a call with me.

Spartan does not give tax, legal or investment advice. Please seek outside counsel from your CPA or attorney before making any tax, legal or investment decisions.

Published by Ted Greene