The Best Real Estate Investor of Our Time Is Cashed Up and Ready to Buy
A nude Marilyn Monroe taught Sam Zell his first big investing lesson.
Monroe was struggling to make it in 1949 when she was photographed au naturel for a payment of $50.
Four years later, the photos made their way into the first issue of Playboy magazine. And the magazine made its way into the opportunistic hands of an upper-class 12-year-old.
Walking through the city on his way home from school one day, Zell passed a newsstand, where he noticed Marilyn Monroe, splashed across the cover of the inaugural Playboy.
The scandalous magazine was not for sale in Zell's upscale neighborhood of Highland Park. So he bought the newsstand copy for $0.50, took it home, and sold it to a friend for $3.
Zell went back to the newsstand and bought more magazines. He sold them all for six times what he paid.
In his autobiography Am I Being Too Subtle? Straight Talk From a Business Rebel, Zell wrote that it was...
... a lasting business lesson: Where there is scarcity, price is no object. This basic tenet of supply and demand would later become a governing principle of my investment philosophy.
Zell went on to build a $5.5 billion personal fortune and create billions more in value for investors over a five-decade career – all based primarily on buying assets at low prices and selling them for many times what he paid.
For example, he earned his followers 1,237% in 10 years with what he termed a "fun" little investment...
In 1990, Zell's Equity Group Investments ("EGI") teamed up with corporate restructuring firm Chilmark Partners to form a $1 billion distressed-opportunity fund. The partners targeted good assets with too much debt.
One such target was Cincinnati-based radio station owner Jacor Communications. From 1992 to 1996, EGI and Chilmark invested $79 million for a 90% stake in the company. They cut Jacor's debt in half and grew the company from 17 radio stations to 243 in just three years.
The partners sold Jacor in 1999 for $4.4 billion... a 5,500% gain. They sold out at the top of the cycle, one year before the tech bubble – the then-most expensive equity bubble in history – burst. Owning radio stations has been a tough business ever since. Great timing.
From its 1990 inception to its 2000 unwinding, the fund earned investors 19% a year after fees.
Zell had even more "fun" in early 2007. That's when he sold his office building real estate investment trust ("REIT"), Equity Office Properties, in (at the time) the biggest leveraged buyout in history.
He founded Equity Office Properties, or "EOP," in 1976. It went public in 1997 at $21 a share. It paid $16.48 per share in dividends as a public company. By 2006, it was the largest REIT in the U.S. Zell called it "an irreplaceable collection of over 500 of the best buildings in every major market in the U.S. It was my baby."
In 2007, private-equity giant Blackstone bought EOP for $39 billion (including debt) at $55.50 per share. Investors more than tripled their money. And Zell managed to avoid the 2008 financial crisis and ensuing Great Recession. Great timing.
I was in the room with Sam Zell when he spoke at a conference in New York several years ago. He wore his usual uniform: jeans, sport coat, no tie. I found him an irrepressible ball of energy. He speaks his mind plainly, often bluntly. And he has a similar reputation to fellow billionaire investor Warren Buffett... Both men are known to make quick decisions involving huge commitments of capital.
Zell is at his best when the market is at its worst. Time and again, he has followed his Monroe mantra – buy cheap, and know when to sell. Knowing when to be cautious, avoid risk, and sell when markets are at their most euphoric is a skill set that has made him rich. And he's getting ready to do it again.
The Grave Dancer
In 1976, Zell wrote an article in Real Estate Review about buying distressed assets called "The Grave Dancer." In it, he described his philosophy of buying assets for cheap (typically real estate), turning them around, and then selling them at new highs. He likened his success in this industry to "dancing on the skeletons of other people's mistakes." The name stuck.
Buying distressed, of course, is just the flip side of spotting risk. Zell can usually tell an industry is set to generate distressed opportunities when other people can't...
In a March 1988 piece in Real Estate Issues called "From Cassandra, With Love," Zell said the real estate downturn then occurring "was being grossly understated. People were asking when it would end, but that was the wrong question."
The real estate market didn't recover until the mid-1990s. Zell called it "the worst real estate crisis since the Great Depression," with $80 billion in industry losses and commercial real estate prices down 50% in some markets.
Investors kept buying into real estate, thinking prices couldn't get any lower. Meanwhile, Zell went into hibernation...
In an article titled "Return of the Grave Dancer," he wrote, "The Grave Dancer hibernates from one real estate cycle to the next." When real estate gets expensive, Zell sells out, refuses to buy overvalued assets, and goes into hibernation until prices get cheap again.
That's exactly what he is doing right now.
As we'll show, real estate valuations are rich today. And like us, Zell believes in the power of cash. So he is selling property and hoarding the cash until prices are once again cheap enough to deploy it.
Bloomberg reported in November that Zell has sold stakes in four companies since October 2017. Since 2015, his Equity Residential (EQR) – the largest apartment REIT in the country – sold $8.5 billion worth of property.
And office REIT Equity Commonwealth (NYSE: EQC) has sold more than $6 billion in property since Zell's team took over management in May 2014.
Back then, it was called CommonWealth REIT and headquartered in Newton, Massachusetts. It had more than 150 properties, $3 billion in debt, and $634 million in outstanding preferred stock.
Boston-based real estate investor Barry Portnoy and his son Adam managed CommonWealth at the time... much to the chagrin of shareholders. Starting in 2013, activist investors Keith Meister of Corvex Management and Jeff Blau of Related Companies began pushing for a management change and a turnover of the entire board of trustees (a REIT's board of directors). They said the Portnoys were more concerned with earning exorbitant fees for their management company than good returns for CommonWealth shareholders.
Shareholders voted with the activists, removing the entire board in March 2014. The Portnoys were fired. The activists recruited Zell for chairman. The headquarters moved to Zell's home base in Chicago, and three of his top lieutenants became chief executive officer, chief operating officer, and executive vice president/general counsel.
The Grave Dancer began putting EQC into hibernation right away...
EQC has sold more than 140 properties since Zell's team took over. It has paid down debt and preferred stock, bought back shares, and even paid a special $2.50-per-share cash dividend this past October (roughly an 8% yield at the time).
Here's a look at what Zell's team has accomplished at EQC...
- The implied value of the real estate portfolio has nearly doubled, from $143 per square foot to $276 per square foot.
- The cap rate implied by current financials and market cap has declined from 8.1% to 6.5%. (That's a good thing. Like a bond's interest rate, the cap rate falls as property value rises.)
- Sold about 140 properties for more than $6 billion.
- Increased net operating income ("NOI") per square foot from $11.60 to $18.32.
- Leases expiring within three years have declined roughly 50%, giving management plenty of time to replace tenants.
Today, EQC has $2.6 billion in cash, 11 properties, $280 million in debt, and $123 million in preferred stock outstanding. Four of the 11 remaining properties are in various stages of the sale process.
Management has publicly discussed liquidating the entire company. We suspect EQC won't liquidate in the next 12 months. The market for commercial real estate has slowed down, and EQC will wait as long as it needs to fetch a good price. If it has to, it'll cease marketing the properties to wait for better pricing.
But assuming EQC does sell the properties currently up for sale – and that it needs to keep some cash on hand for day-to-day operations – it'll wind up with about $3 billion in cash available to buy new property and generate substantially more than that in shareholder value.
That likely won't happen immediately. Zell knows you need to avoid making mistakes with your capital so it's available to deploy once you find a good asset at a bargain price.
This month, we'll show you why deploying capital right now would be a mistake for EQC... why simply holding cash is such a brilliant move... and how sending this company into hibernation has created one of the best low-downside risk/high-upside potential setups we've found in the stock market all year.
How to Destroy $300 Million
Equity Commonwealth currently owns office buildings in some of the highest-demand markets in the country... like Washington, D.C., Bellevue, Washington, and Austin, Texas. These properties are trading at rich valuations today.
We can get a good idea of this by looking at the prices paid by knowledgeable buyers in four of EQC's most recent property sales. These transactions were similar in size, pricing, and income generation. Notice that on a square-foot basis, the typical deal is priced above replacement cost...
Let's also assume that EQC uses debt and equity financing similar to that represented by its current balance sheet, roughly 35% debt (includes preferred stock) and 65% equity. That means EQC's $3 billion in cash would buy $4.6 billion worth of property ($3 billion + $1.6 billion debt).
With an average sales price of $121 million, EQC could buy about 38 typical properties. On average, those properties would generate roughly $285 million of NOI (38 x $7.5 million = $285 million).
REITs are valued in the stock market at multiples of funds from operations ("FFO"). That's the real estate version of free cash flow. EQC's peers trade around 19 times FFO. Based on recent results, EQC generates about $0.80 of FFO for every $1 of NOI.
So... $285 million of NOI generates $228 million of FFO. At 19 times FFO, that'd be worth about $4.3 billion. In other words, under current market conditions, we estimate EQC would spend $4.6 billion of total capital to end up with a portfolio of properties worth just $4.3 billion – $300 million less than the capital deployed!
Now you understand why management is selling property, not buying it. And why we don't recommend stocks or any other investments at rich valuations. The most wonderful asset in the world will destroy your capital if you pay too much for it.
Fortunately for shareholders, EQC management isn't interested in buying properties under current market conditions.
Instead of losing $300 million, EQC has set itself up to earn $3.8 billion...
How to Turn $3 Billion in Cash Into $6.8 Billion in Real Estate
What's $3 billion in cash in Team Zell's hands ultimately worth?
To answer that, we'll have to speculate on what might happen in the future. We don't pretend to know the future any better than anyone else. But we'll have to make some assumptions and imagine how Zell's management team might behave under difficult market conditions. That'll involve guessing about prices and market outcomes, both of which are impossible to know with any certainty in advance.
But we've studied up on Sam Zell and EQC, and we have a reasonable view of the opportunity the stock represents at current prices. EQC won't buy property at current prices. So let's start by imagining the kind of prices it'll need to start buying...
During the Great Recession of 2008-2009, economic conditions were poor, and many properties sold for 20%-40% less than replacement cost. In other words, a building that cost $100 per square foot to build was selling for $60-$80 per square foot.
Just like in the early 1990s, Zell says a decade of free money has once again set the stage for suddenly over-supplied office markets, ultimately leading to lower office building valuations.
Let's say properties start selling at 30% discounts. Using the earlier table, the typical office property selling today for $121 million would trade for just $76 million (30% discount to estimated replacement cost of $198/square foot = $139/square foot x average building size of 550,000 square feet = $76 million).
At an average purchase price of $76 million, EQC could buy roughly 60 properties. That's 22 more than it could buy at today's prices, resulting in potential NOI of about $450 million and a real estate portfolio worth $6.8 billion ($450 million of NOI x $0.80 = $360 million of FFO x 19 FFO multiple = $6.8 billion).
Now you can see why the Grave Dancer waits for distressed market conditions and why EQC is building cash. EQC's patience is worth a lot...
If EQC were buying today, we'd never recommend the stock. It would literally be destroying capital.
But by waiting until properties are once again priced well below replacement cost, Zell could potentially turn $3 billion in cash into $6.8 billion in real estate.
That's the value of $3 billion in cash in Team Zell's hands. That's why you should buy this stock today.
We're being conservative. I would bet Team Zell would use more leverage than we've assumed. I would also bet Zell could get even better deals than we've assumed.
There are so many parts to a piece of commercial real estate, so many ways into the deal: the building title, the land, the lease, the mortgage... In his autobiography, Zell tells the story of a Manhattan building worth $10 million in the market, which was ultimately worth $15 million in the hands of real estate wiz William Zeckendorf. That's when Zell learned how the sum of the parts can be greater than the whole.
Given Zell's past successes in real estate, we could see a 15%-20% annualized return over seven to 10 years – as long as the market turns down soon enough and far enough for EQC to put lots of money to work at bargain prices.
If EQC uses more leverage or gets better pricing than we assume, it will buy even more properties, generating even more FFO growth, and perhaps leading to a higher market valuation than the 19 times FFO we've used in our example.
The steeper the downturn, the better the pricing, and the higher the expected long-term return from EQC. Buy this stock and pray for real estate markets to crash.
Yet Another Source of Upside
There's another source of upside potential here, one you won't find on the balance sheet, though it's likely the primary factor behind Zell's ability to create value for investors: culture.
I can't describe Zell's culture better than he can, so here are some quotes from his autobiography:
- "Culture is king."
- "Culture can inspire ideas or stifle them."
- "A meritocracy gives you the freedom to be yourself by eliminating superficial markers, so you are measured only by what you produce."
- "Our culture is driven, creative, playful, effective, and smart."
- "We have an 'open kimono' policy. No secrets, no whispers, no closed doors. Everything is on full display. That's one of the ways we manage risk."
- "If the number one guy is totally accessible, then anyone else who isn't looks like a schmuck... Secrets are what bury you."
- "I run an entrepreneurial organization... I want people taking the initiative, pushing the edge, questioning, challenging."
- "What best predicts your success in my world is drive, energy, attitude, judgment, conviction, and passion... I'd trade another 20 IQ points for those qualities any day."
- "I constantly challenge my people to 'take me on.' I want them to challenge me just like I challenge them."
Clearly, this is not the usual corporate environment. As Howard Marks – another great distressed asset investor – has often said, you have to do something different if you want to earn superior returns. From the radical transparency and "open kimono" to the playful yet driven attitudes, Zell's culture is certainly different. And it works.
Best Downside Protection in the World: Cash
EQC's cash hoard comes with huge optionality, meaning low downside risk and huge upside potential. (Optionality is another favorite Zell concept. He learned it early in his career when he and his partner were flush with cash and able to buy property from an investor who was overleveraged.)
We've considered the upside. Now let's look at the downside...
EQC's downside is limited to the current value of its cash plus the downside in its current real estate portfolio.
EQC's current market cap implies a value of $1.5 billion for its real estate portfolio, roughly $12 per share. The decline in current market values to 30% below replacement cost would equate to a total decline of about 40%. And a 40% drop in commercial real estate values would take EQC's portfolio down to about $7 per share in value. If you take $7 off yesterday's close price of $31.23, you're looking at a maximum drawdown of about 23%.
The upside is 100% of the recent share price. The downside is about 23%. That's an enticing risk/reward scenario of four times as much upside as downside.
Since 2015, EQC has spent $245 million buying back roughly 9 million shares at about $27 per share on average. A share price decline could prompt management to buy back more stock, which could help support the price, limiting downside. EQC has $130 million of share buyback authorization in place.
Maybe you're thinking you'd rather wait until the market drops, then buy the stock. I understand that viewpoint, but you should remember that EQC can buy back shares and pay dividends. Buybacks could help push the share price up. Dividends could provide a cash return while EQC and its shareholders wait for management to start buying property.
If investors who seek safe havens choose EQC, it's possible the stock won't fall much at all from current levels.
I've often said holding plenty of cash is the best way to reduce risk in an equity portfolio. Well, it's the best way to reduce risk in any portfolio, including a real estate portfolio.
Other, more leveraged REITs could find their share prices dropping 50% or more in a market downturn. We doubt that will happen to EQC. EQC's cash hoard will maintain 100% of its value in a market downturn. ($1 is worth $1 all day long.) That will put strong support under the share price. It has a ton of cash, and its real estate won't go to zero.
With four times as much upside as downside, there's no reason not to buy the stock today.
What Are the Risks?
Zell's sell discipline is a facet of his well-known aversion to risk, which has helped him literally avoid disaster...
The Port Authority of New York City invited Zell to bid on the World Trade Center's ("WTC") lease in 2000, but he passed on the opportunity for two reasons.
First, it was what he calls a "hometown deal," meaning the idea of a Chicago investor owning an iconic New York asset could make it harder for him to buy the building than someone from New York.
Second, Zell didn't want to own a "target" (referencing the 1993 terrorist attacks). After 9/11, his partner Bob Lurie asked, "How did you know?" He said he didn't know, but the WTC "was a symbol."
Under Team Zell's risk-averse management, we know EQC doesn't have many points of worry. The only source of risk that needs mention is its 510,000 square feet of office space coming up for lease renewal in 2019.
That's spread over multiple properties. The largest one is a 128,000-square-foot building in Washington, D.C. It's currently leased to Georgetown University. Government is the all-time growth business of the ages. And D.C. is government central.
Still, if EQC can't find new tenants next year, it will lower the portfolio's NOI. The reduction is likely temporary, but we can't say how long it would last. The market could take a failure to roll a new tenant into the space as a sign of weakness, pushing EQC's share price down. Most investors would understand that not finding a new tenant doesn't permanently impair the real estate value. Even so, a permanent impairment of 10% of the portfolio would only reduce EQC's total per-share value by about $1.20 from current levels.
Overall, EQC management admits that it has heard "anecdotal evidence" in office building markets across the country that pricing is down 0%-0.5%, likely excluding higher-quality assets. But it says...
The rest of the market, which is substantially all of the market, probably is facing downward pressure. How sustained that will be and what that means longer term, it's hard to say, but there is definitely some pushback from buyers.
The ability to say "I don't know what will happen" is a sign of a healthy mind. Neither we nor EQC management can predict the future. We can find low-risk ways to set you up for excellent long-term compounding. And that's how EQC looks today.
This Is Exactly What You Want to Own Right Now
EQC might just sound like a lot of "maybes" strung together. Well, yes there are lots of maybes... just like every great opportunity looks without the benefit of hindsight. But tell me...
What if you could go back in time to 1990 and put your money in the Zell/Chilmark distress fund so you could make 19% a year over a 10-year period? Would you do it? Of course you would.
And wouldn't you love the opportunity to go back and buy EOP shares for $21 at the IPO, knowing you'd earn $16.48 in dividends and sell out to Blackstone for $55.50 per share 10 years later? Of course you would.
EQC is as close as you'll ever get to owning your own personal stock market time machine. There was some downside risk with the 1990 and 1997 opportunities, but they worked out great because Zell and his people are driven and competitive. They're among the best capital allocators on the planet.
This is one of the best low-downside risk/high-upside potential setups we've found in the stock market all year.
BUY Equity Commonwealth (NYSE: EQC) up to $32.50 per share. As of yesterday's close, shares trade at $31.23. We're keeping the maximum buy price tight because the stock is trading right around liquidation value, which provides a margin of safety.
Dan Ferris and Mike Barrett
December 14, 2018