Smart Money Leaving American Real Estate?

I've been a subscriber to Gary North's Reality Check since my senior year in college (via email). He is a prolific writer, multimillionaire, direct-response marketer, and staunchly conservative when it comes to finances. I have learned enormously by reading his advice and commentary.

In my opinion, Gary's newsletter is—by far—the best free financial newsletter of its kind. He publishes twice a week, and on the days when he doesn't publish, I receive The Daily Reckoning, which I've nicknamed, "The Gloom & Doom Report." (Kidding, although they do tend to focus more on pessimistic economic indicators.) The Daily Reckoning serves as a good counter-indicator to all the positive "rah-rah" economic news that is distributed by the mainstream media (CNN, Wall Street Week, etc.).

The article below was published in October 2005, and describes Tom Barrack and his views on the American real estate market. It also describes the overheated real-estate market in certain parts of the country. Last year, Fortune magazine wrote a piece on Tom Barrack, and the so-called "bubble" real estate areas. If I remember correctly, it was published in October or November, around the same time as the CNN article below.

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Gary North's REALITY CHECK
October 29, 2005

SMART MONEY BEGINS LEAVING AMERICAN REAL ESTATE

At the end of this report, I will include a link to a web form, "Is Your Home Overpriced?" As a prelude to this form, consider the following.

CNN/MONEY (Oct. 24) ran a story on Tom Barrack. I had never heard of Mr. Barrack, but according to CNN/MONEY, he is "The world's best real estate investor." He has made billion-dollar deals in the United States. Now he is selling. He is moving his investment portfolio off-shore. He is 58 years old. He is 6 feet 3. He is worth a billion dollars.

Arguably the best real estate investor on the planet today, he runs a $25 billion portfolio of trophy assets, from the Raffles hotel chain in Asia to the Aga Khan's former resort in Sardinia to Resorts International, the largest private gaming company in the U.S. Barrack's Colony Capital of Los Angeles, one of the largest private-equity firms devoted solely to real estate, has racked up returns of 21% annually since 1990, handing investors, chiefly pension funds and college endowments, 17% after all fees. Barrack has done deals with Saudi princes, Texas oilmen, a Caribbean dictator — even with Donald Trump.

If I were an envious man, he would make me sick. I'll settle on a little grumbling. He is a high flyer. He doesn't compete directly with his billionaire peers. He looks for the special situation, the property that is undervalued. He is the Warren Buffett of real estate.

To get his gaudy numbers, he'll go to the far corners of the globe, looking for under-appreciated assets he can buy cheap, fix up, and resell, usually within about five years. If a potential deal is complicated or politically sensitive, so much the better. Barrack cherishes thorny situations because they scare off most other bidders. Auctions aren't for him. "How do you congratulate yourself when you've outbid eight of the smartest people in the world?" he marvels…

There is much method to his madness. By focusing on distressed properties with lower pricetags, he limits his risk and maximizes his potential gains. He has 182 employees around the world who monitor local markets, looking for opportunities he can exploit. At the same time, he buys primarily high-quality properties — those that, if skillfully resurrected, can command a premium.

This is Buffett's stock-buying strategy. It is not his selling strategy. Buffett never sells, or never mentions it when he does. If Barrack's life story offers a lesson for ordinary investors, it's that you should always operate in areas where you have an edge. It's a theme that comes up again and again over the course of Barrack's career.

On the scale where you and I operate, John Schaub recommends this same strategy. Buy where you have an edge. If you don't have an edge, get one. He teaches how to get one. John Schaub's real estate investing strategies.

The article goes on to describe Barrick's background and successes. If you're interested in a rags-to-riches story, read it: Tom Barrack, Billionaire Real Estate Investor.

With respect to what he is doing today, the article gets very interesting.

Today Barrack sees signs of the tech bubble mentality in the U.S. real estate market. Too much capital is chasing real estate, he complains, with hedge funds, private-equity groups, and rich investors all bidding up the same properties. "They've driven prices to the point where the yields on high-quality properties are like the returns on bonds, around 5% or 6%," says Barrack. "That's too low." And he sees the bubble deflating soon. Barrack thinks the catalyst will be a trend that few others are talking about, a steep rise in the price of building
materials and labor.

"Construction costs have spiked 30% in the past nine months," he says. The reasons: shortages of labor and materials like lumber because of the building boom, and increases in the price of oil, needed to produce everything from plastic piping to insulation to shingles.

The slump will show up first in speculative hot spots like Miami and Las Vegas, he says, where condo developers are preselling their projects for what look like big profits. When they actually build the units over the next year or two, he predicts, they will end up spending more than the units are now selling for. At that point, says Barrack, the developers will try to raise prices. "But most of these buyers are speculators," he says. "They will either sue the developers to get the original prices or get their deposits back and walk away." The developers will then put the units back on the market, and the glut of vacant condos will drive prices down. "It's the busted deals caused by construction costs that will cause a turn in the market," he predicts…

He is not working where Schaub recommends: single-family dwellings, which means unique properties. Barrack is talking about commercial real estate. Barrack has just bought the Raffles hotel chain in Asia. He has also bought 26 Swiss hotels.

If he is worried about American real estate, so am I. But yuppies aren't.

THE MANIA IN WASHINGTON, D.C.

In "The Washington Post" (Oct. 26), an article appeared, "Only the Good Buy Young." It was a lousy title and a fascinating article. It surveys the real estate market in the D.C. area. I once lived in a rented 2500 square foot house in the D.C. area of Northern Virginia, near Falls Church. I could have bought it for $75,000 in 1977. It would probably go for $400,000 today.

You can buy a townhouse in Germantown for $280,000. The article described a potential buyer. He is age 30. Nationally, this age group is buying a lot of housing.

Home buyers between the ages of 18 and 34 made up 39 percent of the market last year, according to the most recent data from the National Association of Realtors. And 12 percent of first-time home buyers were younger than 25. Similar statistics from the Washington area are not available, but anecdotal evidence suggests that real estate fever — even at a time when the local market seems to be softening — is not just something for baby boomers and Generation X.

The article goes on to describe one of these buyers. As you read this, old as you are, think of two things: (1) the deal you missed; (2) the risk you would not want to bear.

Everyone, it seems, has a friend like Elizabeth Goldman, who works in marketing and public relations, and at age 26 is on her second home. Goldman bought her first condo in 2003, when she was 24, with money saved up from lifeguarding in high school and savings bonds from her grandparents because she couldn't shake the feeling that she was wasting money paying rent for an apartment in Centreville.

"I figured, hey, I could probably afford to buy something."

After boning up on real estate jargon and ditching a lender who refused to use e-mail, Goldman clinched a contract on a 625-square-foot, one-bedroom condo in McLean for $157,000. She put down 5 percent, mortgaged 80 percent and took out a line of credit for the remaining 15 percent. She sold it last summer for $300,000. Now she is living in a $425,000 three-bedroom, two-level condo in Falls Church. To keep her monthly payments low, Goldman financed it all with an interest-only mortgage that will balloon in seven years.

[My comments: This is insane. Goldman would have been wiser to take the $300K, buy a small home, and put the remaining money into investment real estate in a non-bubble area, or start a small business with the money.]

A balloon payment means that the lender will require her to pay off the loan, presumably by getting another loan for $425,000. She is, in fact, a renter who gets to deduct her rent from her gross income figure when it comes time to pay Federal and state income taxes.

What if interest rates go up?

Here is another story of a pair of guys…

Mazza and Cook bought a two-bedroom condo together in Old Town Alexandria in 2002 for $149,000. Cook's grandparents lent them the money to pay for it for only 5 percent down. But it wasn't long before that place seemed cramped, and they eventually sold it for nearly $230,000.

It's so easy to make money in real estate. I mean, why is Tom Barrack worried? [This is Gary North, being sarcastic.]

Now they're moving again. "When your house sale's return is comparable to your day job's salary every one to two years, moving is no big deal," Mazza said in an e-mail.

Buy and sell; buy and sell. Why, this can go on forever. All it takes is a buyer, who is also buying and selling, buying and selling. It sure beats working for a living.

In Maryland, for example, the median starter home price in 2001 was $117,801, according to the Maryland Association of Realtors. By June 2004, that figure had rocketed to $214,446 — an increase of 82 percent. As for the 30-year-old who wanted to buy the $280,000 condo, he missed it. "I know I can't really afford a mortgage," Newland said. "But I also know I have to buy a house."

More about the Washington, DC Real Estate Mania.

CONCLUSION

There comes a time when the game of musical chairs ends. The music stops. But in this game, the people still seated in the chairs when the music stops own them and the mortgages that go with them. Are you sitting in the chair that you want to own when the music stops?

Is your home overpriced? This form may help you. If [your home is overpriced], you face a painful decision: to sell or not to sell. Your wife must make that decision with you. Most people will not sell . . . today. They will eventually sell.

My parents once owned a lot in what is now Marina del Ray, California. They sold it decades ago. Here is what Barrack did with a nearby property…

In January he plunked down $305 million to buy a rental-apartment tower on the ocean in Marina del Rey, near Los Angeles, from Zell's Equity Residential. Why? Barrack calculated that a quick conversion to condos would give him a windfall. The property had a dowdy image as a haven for middle-aged divorcees. In classic Barrack style, he found a way to turn that into an advantage. Giving the divorcee rap a sexy, glamorous twist, he commissioned ads featuring a 6-foot model from Brazil, who posed for a shoot on the tower's roof with a helicopter and fancy luggage. In the copy, which Barrack wrote himself, she declares, "You keep the house. I'll take the condo." The gambit has helped Colony sell 130 of the 420 units in just 60 days — a 1,500-square-foot two-bedroom with ocean views sells for $1 million.

There is a time to buy and a time to sell. There is also a time to write hot advertising copy (any time, in my view). If you wait too long to sell your house, you had better be able to write hot advertising copy.