Chapter 20 | Investment Return Profiles

BRUCE KIRSCH: One of the old cliches of real estate is that you make money on the buy, and throughout the rest of the lifetime of that investment you’re really just trying your best to not lose that value that you captured at the point of acquisition. One of the advantages of being a really long-term investor is that you don’t have to be 100% right at the point of purchase. Versus if you’re looking at a much shorter timeline, if you’re off by 10% on the purchase you could end up walking away flat or at a loss.

DR. PETER LINNEMAN: This was something that I learned, really over the last 20 years of my career, that in an asset that does not have a lot of operating leverage, it has some operating leverage, you could be better at it than I am. But in a business, compared to Amazon, where there’s not a lot of operating leverage in real estate, if I buy badly, and I hold it for a year or two, there’s no way I can pump the profits enough to offset that I bought it 15% too high. There’s just not enough operating leverage to do that. When you throw in the fact that when values drop, also it tends to be when cash flows are dropping on top of that from a cyclical point of view. There’s not enough operating leverage for me to go steal all your customers. It’s just not enough operating leverage. So the short-term part is very difficult if you don’t buy well.

The long-term changes that dramatically, which is, if I look back on an investment that you held for 30 years whether you bought it 10% too high 30 years ago is not going to determine your return over the 30 years. What’s going to determine it is did you pick a good property, in a good market, were you able to manage it well. And, just quick, you bought it for 15% too high, over 30 years that’s a half a percent a year. And as you know that’s a rounding error into what can go right or wrong. You buy it 15% high, and you sell it a year later, that’s huge because you cannot make up 15%. And so by having a long holding horizon it eliminates having the timing part. Focus on you’ve got to have good assets in good markets, you got to run them well. And it is the lesson of good real estate, the lesson of good real estate is, if you buy good real estate you hold it over cycles, yes there’ll be downs, and yes there’ll be ups, but it will perform- because it’s a good location, a good building, well managed. Even a good building in a good location well managed, If you buy too high and hold for a year or two you may not be able to offset that.

BRUCE KIRSCH: We open the chapter by referencing one of these very common interview questions, which is if you had $100 million right now, where and how would you invest, it, and why. Well if we limit that to the asset class of real estate, generally speaking, how has your, if I had $100 million opinions, changed over the course of your career?

DR. PETER LINNEMAN: It’s changed in two ways. One is that when I was young, I would have answered it almost on an absolute basis. I think the absolute return is higher in that sector than in another sector. And as I’ve aged, now the first question I ask is, well, what’s your tolerance for risk, not what return is great, but what’s your tolerance for risk. And that’s one of the things I understand better now than 40 years ago, quite honestly, which is, I used to see investors do low leverage, low return, and I’d say they’re stupid they should go do these high energies, do a development, do whatever. I now look at it, and I better understand some people are just trying to maintain wealth, they’re not trying to create wealth. There’s get rich money, a friend of mine has the phrase, Darla Moore, get rich versus stay rich. What I better understand than I used to is not everybody is looking to get rich. Life insurance companies are not looking to get rich, pension funds are not looking to get rich. They’re looking to stay rich, and to send out retirement checks, and insurance checks, and they’re not stupid. They just have that mission. That’s the one thing is you cannot answer that $100 million question without the person asking, and saying, and here’s my risk tolerance or here’s my risk objective. OK. And I wouldn’t have said that 40 years ago.

And the second thing is that cash flow is wonderful. And when I was younger I understood this, but I didn’t have it deep in my soul, which is, you can show me a return profile of a 10% IRR for example- and you can show me another return profile at a 7% IRR, and I might much prefer the 7%. Why? Because it cash flows, and cash flow if you think about it is in many ways the ultimate risk mitigant. And so oftentimes you do a highly leveraged real estate investment, that after you do your TIs, and leasing commissions, and so forth, there’s no cash flow. Now by the way, It’s a great residual bet, but residuals sometimes work out, sometimes don’t, they’re more of a coin flip. Cash flow tends to mitigate the counting on the coin flip to come out right at the end, and again I knew that intellectually 40 years, ago 20 years ago. I appreciate the beauty of cash flow, and it’s probably because I’ve invested in land which is residual, I’ve invested in buildings that leverage themselves to a residual, and you go, huh, sometimes the coin flip doesn’t come out right, and you’ve got nothing to offset it in cash flow.