“Those deals don’t exist anymore,” was my biggest takeaway from three days at Re-Convene. Shout out to Moses Kagan and his wife Simran for organizing an amazing, informative, and fun event focused on real estate syndication. I have been to the future and in person networking is not dead in our Covid addled world.
But back to the quote. It and versions of it were uttered repeatedly by Eliot Bencuya, CEO of Streitwise on stage at Re-Convene. It’s a dagger in the heart of any investor. Asset prices are high and rising and as a result returns are down. My conclusion is that it still makes sense to be a sponsor or general partner in real estate but the case for investing as a limited partner is questionable at the very least. Here’s what I heard:
Capitalization rates are falling and won’t get better anytime soon
The market doesn’t distinguish between buildings that are 40 years old and ones that are 15 years old
The whole, “I’m going to go to a second or third tier markets to get better returns,” thing is gone. There are only so many tiers and once you’ve bought up all the multi-family in Columbus, Ohio, there’s nowhere else to go.1
There are armies of capital massing like orcs outside the gates of Gondor looking to buy assets-any assets.
The big guys don’t care about returns. They make their money on the 2% management fee. The 20% is just gravy but the allocators have nowhere else to go so they keep giving them money.
A World Awash in Capital
The same situation exists for any kind of business: real estate, software, services, etc. There’s just too much cash floating around and almost no good returns to be had. I did some poking around on Google after hearing Eliot and found a Harvard Business Review article that makes the point nicely. Bain’s Macro Trends Group has estimated that global financial capital tripled in the last three decades and this article was written in 2017 before the Covid bailout. In this world, efficiently managing and allocating capital is a much less valuable skill. The article reads: “The skillful allocation of financial capital is no longer a source of sustained competitive advantage.” So it doesn’t pay to be Warren Buffett anymore.
I’m not sure I’d go as far as the authors but they have a point. Tiger Global is a perfect example of the new paradigm. Tiger has been a hedge fund trading public equities for years but recently got into venture capital. Traditional VCs hear lots of pitches and tout their ability to choose the most promising ones and then once chosen, help companies with advice and connections. Andreeson Horowitz has a phalanx of marketing, recruiting, coding, and other services it provides to companies. It’s really a VC company and not a fund. They spend a lot of time on value add.
Tiger does none of this. They just fund everything they can find with lower due diligence requirements and at higher valuations and with bigger checks. In their view there is a return to get from VC so just index the whole asset class and get that return. There isn’t really a need to distinguish good from bad. The market will do that and you just keep investing in the ones that survive. The rising valuations and increasing need to add even more value is striking fear into the hearts of the denizens of Sand Hill Road.
I think we’ll see this type of model also grow in the buy out side of private equity. Someone is going to do a version of Zillow’s home buying strategy for retiring baby boomer businesses.
Are We Only in the Third Inning?
Investors like to talk about the business cycle like a baseball game. After a crash you have an initial recovery. That’s the first inning. Everything hums along, getting better and better and finally it goes nutty with crazy valuations and people bidding up assets. That’s the ninth inning. Then there’s another crash and you start over.
Lots of things look like the ninth inning now. NFTs going for millions, meme stocks, crypto, etc. But I’m not so sure. As the authors of the HBR piece point out, the capital glut is only getting worse. Even if Washington stops spending, there is a global class of people in their prime saving years 45-59. They will add massive new waves of capital to the economy. All of it desperately looking for a return. At the same time, Baby Boomers will begin spending less while Millenials will be the only people actually spending. That will mean more growth in the US because we are one of the only rich countries in the world with a significant Millennial population. Everywhere else though is in chronic population decline. The rest of the world lacks Millenials.
So the waves of cash from that bigger 45-59 generation globally will overwhelm the consumption of US Millennials here at home. Global savings will continue to increase until at least 2040 so inflated asset values look like they are here to stay. In fact, the authors predicted that global financial assets would outstrip global GDP by 10 times in 2020 up from 6.5 times in the 1990s. I’d be curious to see the post Covid figure. It can only be higher.
What to Do?
I touched on some of these themes in my post on whether it still makes sense to buy a business even with inflated values. In a time when asset prices are increasing, it makes sense to supply assets rather than to buy them. This might sound like a reversal of my message from that previous post but I see this more as a further development of it. I do think it makes sense to buy smaller businesses using SBA guaranteed debt and bank involvement that can keep some limit on multiple escalation. Starting something from scratch is just so hard but once you have a base I think there’s a lot you can do to create more assets.
Once you have that business what do you do? You first focus on organic growth. Growth you can get by putting in a better marketing plan or a better offering or running a referral program. Traditionally you would also focus on fixing up the company. Are there gains to be had from operational improvements? Another part of the HBR article points out that in a world where returns are so low, the return to optimizing financial metrics and operations in a business are much lower. When capital was expensive all the way back in the aughts, it made sense to optimize for profitability but now that capital is cheap, it makes sense to prioritize growth. The authors estimate that when a firm’s cost of capital falls to 6% or below (some must be far below that now), a 1% of additional profitability will add only 6% to firm value whereas your return on 1% of additional growth is 27%. They are talking about big businesses but I think the same is true for small businesses as well.
My approach is to maximize all the organic growth I can in my current business and focus less on profit maximization. And after Re-Convene, I’m increasingly thinking about creating and growing new assets inside or adjacent to my current company. This is fraught with all sorts of dangers. If I do it internally, I risk distracting the team with my shiny objects. If I do it external to my company I can’t leverage the operational base I’ve created. In either scenario the risk of just wasting money on flights of fancy is high.
Despite these risks, I think it still makes sense to try. The market beast wants food and it pays to make it for him. My approach will be to make several small bets. I’ll do one or two internally and one or two externally. I’m also contemplating creating a holding company where I might position administrative staff so I can leverage them across all my projects. My thinking is that the key to success is keeping these bets small and being willing to kill them quickly. Easier said than done.
I want to start with a clear timeframe for each project and a predetermined check in point for when I take stock and decide whether to continue on. Additionally I’m contemplating asking my Entrepreneurs Organization forum mates to help keep me accountable. I can use them as a stand in for a Board. I’m also stealing a page out of Jeff Bezo’s Amazon playbook and creating investment memos on each project to force more clear and thorough thinking up front.
Again, this will not be easy but I see it as the best way to supply assets in a world hungry for them. If one or two of the bets show promise I’ll continue to invest and I hope to sell them eventually into that hungry market. It’s better than private real estate syndications I think or continuously putting money into an overvalued public market.
The Easy Stuff is Gone
The great tidal wave of cash has made the market efficient. All the easy stuff is gone. Those deals don’t exist anymore. The wave of cash finally breaks, though, when it comes to the hardest thing: creating assets. The market is still not efficient in the creation of assets. Even with Tiger’s blanket investing strategy, there is still an insatiable need for more assets. Everyone wants them but very few people want to do or are capable of doing the hard work to make them. As the champion bodybuilder Ronnie Coleman said: “Everybody wants to be a bodybuilder but nobody wants to lift no heavy-ass weights.” Get your weight belt out of the closet and get some chalk on your hands because we are going to go deadlift 500lbs.
That’s it for this week,
Alan
I just put that in there to see if Peter Lohmann was still reading my stuff. Nothing against Columbus.
Those Deals Don’t Exist Anymore
Great article. You mentioned using investment memos to help structure your ideas. Can you share an example of what that looks like in practice?
Good read