The Art of Extreme Value Investing in Real Estate

San Francisco Office Values


Real estate can be a very volatile asset with extreme highs and extreme lows, especially in certain urban areas. This leads many to question how or when to invest; the key to Extreme Value Investing in real estate is patience.  In the right location and with the right product type, real property will rise over the long run at a pace beating inflation, potentially significantly. An example of this may be found in the realm of commercial office properties, which have the most extreme volatility of all the real estate asset classes.  Los Angeles office values have dropped from 40 to 70% during market lows, offering a great opportunity for extreme value investing.  Apartment building rents and values are much less volatile, as apartment values have dropped from 5% to 40% during the last five recessions in Los Angeles. Though investors may become impatient as the amount of time between cycles can vary greatly (recessions since the 1970’s have arisen in as short as five years and as long as ten years), the key is to wait patiently for these periods to occur and then strike aggressively.  As Warren Buffet says, “The trick in investing is just to sit there and watch pitch after pitch go by and wait for the one right in your sweet spot.”

Supercharge with Trend Spotting

You can supercharge your extreme value investing by acquiring properties in areas most favorable to long term appreciation: gentrifying locations, emerging property types, and areas oversupplied but with a great future otherwise.  In the 70’s, Century City was a new office market that was horribly oversupplied.  The oversupply gave rise to extremely low rents that encouraged many firms to move to the Westside to take advantage of a reduced commute.  The concentration of similar firms produced agglomeration economies that made Century City even more popular.  In the early 90’s, Santa Monica was rich in amenities and a new growing market but was oversupplied with distressed office buildings.  Santa Monica, with all of its amenities, was destined to take advantage of the growing movement of entertainment firms off the studio lot and to the Westside near their talents’ homes.  In the 2000’s, SOMA in San Francisco was over supplied with creative offices due to the dot com bust but had a growing concentration of young software engineers. More recently in the last recession, Playa Vista represented an area of over supplied office space and cheap warehouse conversions. Again the large concentration of affordable creative offices attracted large tech companies that made Playa Vista even more popular during the recovery and sharply drove up rents. Despite the many examples of similar investment opportunities, you must be careful to distinguish between cyclical oversupply and long terms changes in socioeconomic circumstances.  High-rise offices in Downtown Los Angeles never came back as large corporations left Los Angeles and others moved to the Westside. Retail malls will probably never come back.   You must spot the right trends which  despite the oversupply or over-pricing in the expansion, will give birth to great opportunities during the contraction.

Recognizing a Cycle Bottom

Extreme Value Investing requires one to wait for recessions and then attempt to recognize the bottom for commercial real estate.  The anatomy of the bottom looks as follows: during the fall, you will not be able to rent much of anything and each deal will be at lower and lower rents. Values will fall significantly below their former peak and even below the long run trend line. Even values of high future growth properties will fall significantly below trend line.   Eventually, however, rents and occupancy stabilize; some landlords will be able to start leasing space painfully slowly at lower rents.  But for each successive lease deal, the rents, although low, will be at the same rate or higher. With these trends in mind, you will know when you are in a period of extremely good values.  Each period of such opportunity will seem like the best of your career.  The great extreme value investor Sam Zell wrote the following in 1976 in his article “The Grave Dancer”:  “The opportunity of acquiring real estate in its current distress offers the greatest single economic opportunity for investors in our time, one that is not likely to occur again.”  I am sure Sam would disagree with himself today.

Extreme Value Investing Can Be Long Term Investing

Though we have discussed how to spot the valleys in a cycle, we have found it very difficult to spot a peak.  Well located properties will eventually rise significantly above their long run trend line.  If we have to sell to balance our portfolio, replenish cash positions, lower risk exposure or satisfy investor demands, we will wait for this period to do it.  However, there is no predicting the peak, as prices can and often will continue to rise even more. Warning signs can abound of lower credit spreads, cheap aggressive debt, low cap rates, tailwinds, and values priced to perfection and extraordinarily over the long term trend line.  Politician will turn away from creating jobs and instead focus on the ills of prosperity: congestion, traffic, and inequality.  But value will still go up until it blows, and the higher it goes the more it blows.  A savvy Extreme Value Investor will still utilize  this period to monetize and aggressively create create value in his existing portfolio.  The Extreme Value Investor may continue to hold properties to take advantage of long run upward trends and tax advantages of holding real estate properties in California.  But during the downturn, this legacy portfolio may become a liability as you battle falling rents and occupancy.

Build Strong Value Add Capabilities

You will be dealing with your own properties under stress (vacancies, tenant and investor defaults, evictions, collapsing credit lines, falling rent, credit freeze, and uncooperative lenders), and new properties that you acquire may initially be in distress.  You must be a skillful value add operator and have people who know how to solve problems to steer your existing portfolio and your new acquisitions during this time period.

Pitfalls of Extreme Value Investing

There are several problems with Extreme Value Investing.

Your Existing Portfolio Will be Under Stress. If you have an existing portfolio – especially of offices – you will be in survival mode.  It is important to prepare your portfolio for this period of stress and operate accordingly.  To prepare, you will need to sell, carry significant cash reserves, try to have good credit long term leases, staggered expiration schedules, and extended debt maturities.  No matter what type of investor you are, you must be prepared to survive the carnage and economic violence of the downturn.

Leasing New Deals Will Be Difficult. You will be buying when leasing will be very difficult, and you may need to endure negative cash flow on the new acquisitions (or hopefully just low returns) for an uncertain time period.  You must have the skill and ability to manage through this period, as all new properties will be value add.  You must be a problem solver because you will be buying properties in some stage of distress. You will need to find creative ways to lease, cut costs, and manage cash flow.  As Sam Zell wrote:  “Grave dancing is a art that has many potential benefits.  But one must be careful while prancing around not to fall into the open pit and join the cadaver.  There is a thin line between the dancer and danced upon.” However, I would suggest that you try to stretch your criteria. During these periods, I have always bought too little and later regretted it.

Extreme Value Investing is Hard to Scale.  During the 90’s, we bought distressed offices and warehouse and used creative office conversions to fill them.  We were one of the pioneer creative office renovators at the cusp of the great trend.  But when the opportunity of extreme value investing ceased, we left the market and failed to scale the business.  If you also leave the market once opportunities cease, you will not be able to build an ongoing development and renovation business.  When you leave the market, you will lose sources, contacts, vendors, talent, technique, and employees.  You must scale quickly because the opportunities will be short lived.

You Will Pass Up Many Opportunities: Many real estate investors get rich hitting singles, doubles, triples and having occasional strike outs and home runs.  They build large organizations and large portfolios and take their lumps.  When Buffet was asked on Bloomberg (August 30, 2018) whether he was followed his own adage today to “be greedy when others are fearful and fearful when others are greedy,” Buffet responded, “I love it when there is fear – I don’t love it for the country as a whole – but that creates prices that make me want to shovel the money out as fast as we can – but we have been shoveling the money out anyway. That (extremely good value) will happen from time to time but you cannot sit around and wait for it.  You are never going to catch the bottom and everyone will be terrified at that time.  We just keep buying as long as we find something attractive.”  In contrast, the Extreme Value Investor will wait for each cycle and pass on many good opportunities waiting for a fresh crop of extremely good values.

Rip Van Winkle.

As Sam Zell wrote in his 1984 sequel:  Return of the Grave Dancer:  “Like Rip van Winkle, the Grave Dancer hibernates from one real estate cycle to the next.  He emerges from his long sleep when the real estate community violates George Santyana’s 1906 admonitions, ‘Those who do not learn from the past are condemned to relive it.’”


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