Variant Perceptions

Category: Zell

Commercial Real Estate

Here is some recent information on commercial real estate transaction prices as background information to the Sam Zell interview,. The market is behaving much better than residential real estate and it looks like the next shoe will not drop. Housing remains a concern.


Sam Zell speaks

… and we ponder his thoughts on commercial real estate.

Sam Zell at the 2010 BMO’s Real Estate Market Conference

  • Investors waiting for waves of distressed real estate assets to hit the market may be waiting forever
  • Low interest rates encourages banks to hold onto assets since the cost to carry is very low
  • The incentive to foreclose has also been reduced for properties that still pay some interest
  • New construction is historically low and keeps supply in check
  • In Chicago for example, it would take $45 per square foot in rent to justify a new building, while most buildings are around $28 per square foot right now (replacement cost)
  • Large amount of capital is targeting a small amount of quality assets so as long as supply remains low high quality assets will continue upward
  • Investment in core CBD property in the US might be good investment for pension funds, but for many investors the returns will not be as good as they could be in other parts of the world

Maguire Properties, a tale of two cities (Part I)

Even during TCI’s most heavily leveraged days, Malone was always careful to use as much non-recourse debt as possible, so if water flooded one “compartment” (i.e. an individual cable system could not service its debt) it would not threaten the entire ship (TCI and its shareholders as a whole) – Investor’s Consigliere Blog

At MidAmerican, we have substantial debt, but it is that company’s obligation only. Though it will appear on our consolidated balance sheet, Berkshire does not guarantee it. Even so, this debt is unquestionably secure because it is serviced by MidAmerican’s diversified stream of highly-stable utility earning – Warren Buffett

“In my 40 years in real estate, I’ve found there is only one metric that matters replacement cost– Sam Zell

If you want to invest in hard assets (real estate, utilities, gas pipelines, oil fields, shipping, etc), you need to know how to analyze debt quality. I am not fan of debt, but most of the companies in this arena use easy credit in boom times taking advantage of their tangible and tradable assets, or collateral as bankers call it. Collateral makes it so much easy. So if you want to profit from busts in these cyclical industries it is important to separate those that were prepared for the bust from those that were just trading stinky sardines.

To make things as easy and illustrative as possible, I am going to use as an example Maguire Properties (MPG). What I like about this example is that it is a pure equity REIT buying and developing properties with debt. No investment in CDOs, CMBSs or RMBSs like a mortgage or hybrid REIT. In summary, no weird instruments that could obscure the lessons of non-recourse debt, stable earnings and buying below replacement costs.

So we are clear, I own MPG stock but it is a small position. There are still some necessary steps in the turnaround and it is just beginning to solve its issues. MPG is unusual both because of the quality of its assets and scale of its debt. The company has assets of $4.2 billion and liabilities of $4.7 billion. So $500 million of negative equity? Yes, but please bear with me.

Robert Maguire is the 74 years old founder and former CEO, fitting so well the part of gutsy developer that it is almost tragic. He built several of the most prominent skyscrapers in downtown Los Angeles. The Downtown skyline is dominated by Maguire properties: Gas Company Tower, One California Plaza, US Bank Tower, Two California Plaza, and the Wells Fargo Tower.

MPG problems can be traced back to the $3 billion purchase in 2007 of a section of Equity Office Properties from Blackstone Group that they had just recently bought from Sam Zell in a legendary deal. These deals were made at the market’s top and included office buildings leased to brokers and financial institutions in Orange County that were at the epicenter of the mortgage bust (i.e. New Century).

Facing a stock price tailspin and concerns about MPG’s financial strength Robert Maguire tried to raise money to take it private. Having failed, he stepped down as chief executive in May 2008. Those of you that have followed the Premier Exhibitions posts know how I consider waiting for change of management a critical first step before investing in a potential turnaround. And that is even truer when the CEO is a brilliant, gutsy and stubborn founder.

Well, it is more than a  year since Robert Maguire’s departure and only recently good news are starting to surface.

  1. MPG announced in August that it was handing over the keys to seven of its office buildings in Orange County and Los Angeles to lenders.
  2. On December, MPG announced they sold one of its prized properties: the Lantana Media Entertainment Campus, home to several entertainment firms (i.e.: Larry David Productions of Seinfeld and Curb your Enthusiasm fame). The deal was valued at more than $200 million. Minus $175 million of debt it should report a profit

How is it that abdicating properties or selling prized ones for a small profit improves the prospects of a company? That is the power of non recourse debt. But to understand what is going on, it is important to lay down the investment thesis that is the subject of part 2.

Long MPG