Thoughts to challenge how we think about our places, our neighbors, our work, and our future
The Real Estate Ponzi
Pop quiz: What do Evergrande, Trump, and WeWork have in common?
They all spent too much money, assuming the party would go on forever. They financed their purchases with debt - or in the case of WeWork, venture capital - and kept spending to build massive portfolios. The trouble with this strategy is that it works really well…until it doesn’t.
Let’s first look at Evergrande, a Chinese real estate developer with a portfolio of thousands of projects and over a million residential units across hundreds of cities, and has been in news quite a bit recently. A quick look at their balance sheet will show liabilities of more than $300 billion. (To put this in layman’s terms, this is roughly equivalent to me borrowing about $8 bazillion).
But who cares how much debt they have as long as they can make the payments, right? Now you’re thinking like an executive! “There is insatiable demand for housing! Go buy more land, build more, outbid if you have to!” And that’s exactly what they did. For years, Evergrande routinely bought land at a premium, passed on that risk to their debt partners, rinse, repeat. Pretty soon they’ve got a billionaire CEO, thousands of units under construction, and debt payments looming.
Being over-leveraged is a bit like going full-speed on a jet ski. On smooth, glassy water, there’s nothing quite like it. It’s exhilarating, seems easy, and you want to do it again. But when a rogue wave shows up, you’re going for a ride. Evergrande has now hit a few of these waves - COVID, change in demand, government regulation, and terrible corporate management - and are currently selling assets in an attempt to avoid default. It’s a bit of a unique case as their size creates a ripple effect in China, and therefore the rest of the world. Bailout coming? We shall soon see.
Trump is a wacky example of the same phenomenon. Trump borrows money to buy/build real estate, Trump refinances to buy more, payments come due, Trump declares bankruptcy / sues the bank / becomes President. No one can say he’s not a crafty ol’ son-of-a-gun. Quite a playbook if you ask me.
Lastly, the WeWork story is a fascinating rendition. The founder and former-CEO, Adam Neumann, was a brilliant storyteller and fundraiser. By positioning WeWork as a tech company capable of changing the course of history, he was able to raise a whopping $13.8 billion. Jet ski, full speed ahead.
The core business signed long-term leases with landlords across nearly 800 locations in 38 countries. While not quite as capital-intensive as building your own spaces, you can’t quite call it light either. Cashflow gets even tighter when you consider the millions of dollars spent along the way on corporate retreats, private jets, and additional startup costs for new business lines like WeLive (coliving) and WeGrow (education). And by tighter, I mean they lost $1.9 billion in 2018.
The rogue waves came in quick succession when WeWork filed for IPO in 2019, by then carrying $22 billion in debt in an attempt to keep the party going. You can watch the WeWork documentary
for a fun recap of that party. Long story short: the IPO failed, a $47 billion valuation is now $9 billion, and they are in the midst of an attempted turnaround of the business. Time will tell.
A Ponzi scheme uses new funds to pay off earlier funds, a way of manufacturing returns out of thin air. As opposed to creating real value along the way (i.e. profit, appreciation of assets, new technology), a Ponzi creates smoke and mirrors. The above examples are essentially legal versions of this scheme, where instead of going to jail like Bernie Madoff, the CEO’s walk away as billionaires as others clean up the mess.
But here’s the real punchline: most real estate investment, even on a small scale, works exactly the same way. After the housing crisis in 2008, we quickly hopped right up on our jet skis and it’s been nice glassy water for the last 13 years. Both amateur and professional investors alike are buying up houses as fast as they can, overpaying if they have to, doing a quick/crappy renovation to justify rent increases, refinancing based on higher rents to get their cash out, rinse, repeat.
I see a trend here: cheap debt, high leverage, and a reliance on strong demand + smooth water.
Real-World Real Estate
Here’s how this plays out in potential real estate projects. There are a few key ingredients that drive the process:
- Capital-intensive + long cash cycle
- Track record is king
- Yield is even more king
Capital Intensive + Long Cash Cycle
First, we must realize what kind of air real estate developers are breathing. From the moment a property is purchased, it can take years just to get permission to start building. Land costs are high, material costs are high, labor costs are high, permitting costs are high. It’s a looooong game to say the least, hence the desire to have a great bank as a partner and let them hold most of the costs while the developer starts new projects. The alternative is to raise more equity from investors (or invest more money themselves), which is a safer but much more expensive option.
Below is an example of how this can play out. Option one is using all cash, and returns 1.3x on that cash. Option 2 uses 80% debt and 20% cash, and returns 2.1x on that cash. There are certainly risks associated with Option 2, but the numbers paint a pretty clear picture of why everyone gravitates to this situation if at all possible.
Option 1: Pay all cash (100% Equity):