Avoid Being the Greater Fool

No one wants to be known as the Greater Fool.  A recent article by the San Francisco Business Times titled “Building buyers swoop on Lembi apartments”(http://portland.bizjournals.com/sanfrancisco/stories/2009/09/28/story4.html#) provides a focal point to write about avoiding this dubious distinction when it comes to investing in San Francisco apartment buildings.

The story reports on the sale of a few of the many buildings recently foreclosed upon by lenders from San Francisco’s crumbling Lembi real estate empire.  For the past few years, Lembi’s organization dominated San Francisco’s apartment investment market, driving building prices to unprecedented – and as it turns out, unsustainable – levels.  Now that Lembi has collapsed, Lightner Group, along with every other investor who Lembi crowded out of the market, is seeking to buy buildings that will eventually be sold by the foreclosing lenders. 

How can you take advantage of this rare opportunity to get a piece of the San Francisco apartment market while avoiding Lembi’s fate? 

Investing with a qualified Sponsor

As far as we can tell, the United Bank of Switzerland, Credit Suisse, and the other big banks that financed Lembi won’t deal with individuals. Even if they would, and presuming you are willing to put all of your money in San Francisco apartments, investing in partnership with a professional operator would still be the best strategy. 

• Real estate partnerships allow you to buy into a number of buildings and diversify your holdings.
• They lay the burden of management on experts freeing you to pursue your core competencies.  

So, let’s say a real estate investment sponsor like Lightner Property Group offers you a chance to buy-into one of these buildings. 

How should you analyze the opportunity? 

Obviously, you will want to invest with a qualified sponsor.   

• Does the sponsor present a well-articulated written plan for the property? 
• Are the building’s physical issues considered?
• Is the sponsor experienced with rent-controlled apartments?
• Do they know how to operate under complex landlord/tenant laws?
• Are their management skills proven? 
• Can the sponsor clearly explain its philosophy and practices or are they just speculating on inflation? 

Drill deeply.  Ask lots of questions, especially “dumb” questions.  Don’t accept one-line answers, demand explanations.  If the sponsor doesn’t provide complete answers or talks down to you, beware. Remember, that was Enron’s game, Bernie Madoff’s too.

How is the deal structured – financially speaking?

The financial architecture of an investment is as important as a building’s foundation. Make sure the investment entity is financially sound. Lembi didn’t just overpay for buildings, he borrowed way too much money to do so; and had inadequate reserves when his plan failed. 

Question the sponsor’s pro forma. If in doubt pass it by an expert, not just an accountant, an expert. I wouldn’t borrow more than a building’s current net income could support; and I would be sure to raise enough investor capital to set up a prudent reserve behind the loan.

Be sure the financial structure is designed with financial resiliency.

“Net” income isn’t always predictable. Things happen, like 9/11, dot.combustion, financial meltdowns. And they seem to happen more and more often. Read Joshua Ramo’s The Age of the Unthinkable,   (http://www.hachettebookgroup.com/features/unthinkable/index.html), and you’ll see my point.  Avoid business plans that deny this reality.

Are you being treated fairly? Avoid sponsors who take all their upside out of the investors’ initial investment. Real Estate investment sponsors need to cover their overhead and deserve to be paid well, yet they should also be incentivized to maintain their focus over time, a long time.  Talk to the sponsor’s long-term investors.

Does the investment make sense and match your objectives?

Avoid deals that are too complicated to be explained in plain language. While managing income property isn’t for amateurs, apartment economics  isn’t quantum mechanics either.

Beware of sponsors who promise quick profits from San Francisco apartments. Lembi proved they don’t work that way.  As I have written, real estate is part commodity, part operating business.  As a commodity, San Francisco apartments are a fairly predictable investment. There are so many investors perennially seeking them it is almost impossible to pick one up at bargain prices. And it follows that barring catastrophe, investors can expect both value preservation and steady appreciation from San Francisco apartments too. During our twenty-five years we have returned many times our investors’ capital, but it took time to ramp up cash flow to do that.

Watch out for the “promised” annual yield.

There’s a big difference between promised cash distributions and a “preferential” rate of return. No sponsor we know promises to pay investors 5% or 6% per annum, but they may agree to pay a “pref” equivalent to 5% or 6% per annum before they take a cut of the upside – but only after the cash becomes available. That could be a few years downstream. This is the reality of it; so be sure you understand the difference. Promised annual distributions might just be coming out of the money you invested in the first place. Again, think Bernie Madoff.

Make sure the profits promised by the investment are based on a reasonable purchase price and realistic assumptions regarding appreciation and resale values. The value of any income property – even a pristine specimen in precious San Francisco – is based on its income stream. With the exception of the Lembi years, the methods of valuing those income streams have been fairly consistent. Verify that the purchase price and resale assumption are in line with historical norms.

Whatever you do, don’t count on a future buyer paying Lembi prices. If you do, you just might be the greater fool.