4 Signs an Investment Won’t Survive the Next Black Swan Event | Ep. 15

0:00 – Welcome back to the Sage Investor. In the last episode we talked about something that most
0:04 – investors misunderstand risk. We discussed why the academic definition of risk, which is
0:10 – volatility, it often fails to capture what investors actually care about. Because real investors
0:17 – aren’t worried about volatility, they’re worried about losing their money. And we also talked
0:22 – about something deeper that risk is often invisible. It builds quietly inside the structure of investments
0:29 – during the good times. And it only becomes obvious when something unexpected happens, which leads
0:35 – to a natural question. If extreme events are inevitable, if markets will eventually surprise us,
0:43 – how do great investors prepare for that? And that’s what we’re going to talk about today.
0:47 – I’m Brian Spear and my mission is to help you generate cash flow and build legacy wealth in a
0:51 – tax-efficient manner because that’s what I’m trying to do for my family and I’m sharing all
0:55 – the secrets that I learn along the way. Today, we’re going to be preparing for Black swans.
1:01 – There is a simple truth in investing that often gets overlooked. It’s that survival precedes
1:08 – compounding. In other words, before you can ever compound capital, you must first avoid losing it.
1:15 – The idea shows up repeatedly in the thinking of many great investors, Warren Buffett.
1:21 – He once explained it in very, very simple terms. If you multiply a long string of positive numbers
1:27 – and somewhere in that sequence is a single zero, the entire result becomes zero. One catastrophic loss
1:35 – can wipe out decades of progress, which means the investor’s primary responsibility is not simply
1:43 – generating returns. It’s avoiding the one event that wipes them out. And that’s the context
1:50 – for understanding Black swans. The term Black swan comes from Nassim Taleb was very popularized
1:56 – by him in one of his books. It describes events that have three respective characteristics. First,
2:02 – is that they’re very rare. Second, is that they’ve got a massive impact. And then third,
2:08 – after they occur, people try to explain it as if they were very predictable all along the way.
2:12 – Examples include the 2008 financial crisis, the COVID debacle in 2020, the sudden credit
2:19 – market freezes, banking crisis, right? The important thing to understand is that these events
2:24 – are extremely difficult to predict. How could you have possibly predicted when September 11th
2:31 – occurred? It’s literally impossible. I often say my crystal ball is broken, your crystal balls
2:36 – broken. It’s impossible to predict some of these events. The truth is, however, they are extremely
2:42 – rare, but they are not extremely rare over long periods of time. They’re very difficult to
2:49 – predict, but they’re not extremely rare over long periods of time. Over the course of an entire
2:54 – investment career, it doesn’t happen in the course of normal day to day business, but it is an
2:58 – inevitability that you will likely encounter several of these Black swan events. And that leads to
3:04 – a very important insight. Black swans rarely destroy good assets. What they destroy are fragile
3:15 – capital structures. I was recently speaking on stage in Boston to a group of dentists, very
3:20 – successful folks that have allocated exorbitant amounts of capital over time. And one of the speakers
3:25 – up there went on to try to explain away some of the problems that sponsors are facing after
3:33 – the massive interest rate increase of the last handful of years. And he went on to say that a lot
3:38 – of these deals are going bad, right? A lot of these individual syndications, they’re going bad,
3:41 – not because the sponsors are bad, not because the deals are bad, but because they had bad
3:46 – capital stacks. I would make the point after going up and hearing that I spoke shortly thereafter.
3:52 – And my point was that I took a contrarian perspective. I would say that yes, it is true that the
3:58 – capital stack was the reason that those deals ultimately failed, the fragile capital structures.
4:04 – But if you take extreme ownership, it is ultimately the accountability of the sponsor
4:10 – to ensure that you put in place a prudent capital stack and have a capital structure that allows
4:17 – you to survive during the next inevitable downturn. Folks can’t simply explain away the fact that
4:23 – these deals have had paused distributions. Capital calls sometimes total loss of capital because
4:28 – some sort of random black swan event that nobody could have predicted would have occurred.
4:32 – It does not matter. Ultimately, that is the job of the sponsor to put in place a structure that is
4:40 – not fragile. Again, most investments, they do fail for structural reasons, not because the
4:46 – underlying asset was bad. A building can still be standing. Tennis can still want to lease space,
4:53 – demand for housing can still exist. But if the capital structure collapses, the investor loses
5:00 – the asset anyway. And that’s why understanding fragility is so important because fragility
5:07 – it tends to hide. It tends to hide in four places. There’s four structural weaknesses that
5:14 – repeatedly show up over and over again in the investments that ultimately fail. These are what I
5:19 – like to call the four fragility points. Fragility number one is excessive leverage. Most investors
5:26 – hear the phrase excessive leverage and they immediately think about the high loan to value ratio,
5:31 – right? They picture something like 85% or 90% LTV and that can certainly be dangerous undoubtedly.
5:37 – If you have 90% leverage and the value the property declines even modestly, right? Your equity
5:42 – can be wiped out very quickly. But leverage risk actually shows up in two different forms. The
5:48 – first is the balance sheet leverage that we just covered. That’s the loan to value ratio. But the
5:53 – second and the often overlooked version is the form of leverage that is free cash flow leverage.
5:59 – It’s cash flow leverage. That’s where the debt service consumes so much of the property’s
6:05 – income that there’s very little margin for error. In the last episode, I told the story of an
6:10 – office portfolio. That portfolio had about 50% LTV, 50% loan to value on paper that looked
6:17 – extremely conservative. But the loans were fully amortizing and the debt payments were very
6:24 – heavy, which meant that the portfolio operated with extremely thin debt service coverage ratio
6:30 – about 1.1%, maybe 1.2. And there was almost no breathing room at all. And when COVID hit and the
6:37 – tenants stopped paying rent, suddenly the portfolio, it couldn’t service the debt even though the
6:42 – properties themselves were still extremely valuable. The portfolio was worth $300 million.
6:48 – The bank had lent a mere $150 million on the portfolio. Yes, a black swan event occurred.
6:56 – The portfolio values did go down significantly, but imagine a scenario where the portfolio value
7:02 – went down 33%. A huge chunk removed. Let’s say that occurred. And the portfolio was now only worth
7:09 – $200 million. How is the bank feeling? All the bank is feeling good because you can’t make the
7:15 – debt payment. They only have $150 million out the door and they can foreclose on a portfolio
7:21 – worth at least $200 million. The bank feels very good in that situation. And that illustrates a
7:27 – very important lesson. Leverage is not simply about how much debt you have. It’s also about how much
7:34 – breathing room your cash flow has onto the second fragility point. The second fragility point
7:41 – is floating rate debt. Floating rate loans can appear attractive during periods of low interest rates.
7:47 – They often come with lower initial borrowing costs and more cash flow because they have lower
7:54 – debt payments, but they also introduce significant uncertainty. Because if interest rates rise,
8:01 – the cost of servicing the debt rises as well. And over the past several years,
8:05 – we’ve seen exactly how dangerous this can become. When interest rates increase rapidly,
8:11 – debt payments can double or even triple. Suddenly properties that had previously generated
8:15 – really healthy cash flow, they’re struggling, struggling to cover their debt service,
8:19 – struggling to cover their debt obligations. They have paused distributions, capital calls,
8:24 – and sometimes, unfortunately, total loss of capital. The third fragility point is short debt
8:31 – maturities. When alone matures, the borrower either refinances or sells the asset. They must
8:38 – at the end of that debt maturity. And during stable markets, refinancing is usually very straightforward.
8:43 – Let’s say you implement the business model. You buy the deal. You got a 70% LTV. You implement
8:47 – the business model property increases in value. Go back at the end of the term debt expiration.
8:52 – Easy. Cash out refinance. Easy. Potentially sell the asset in a decreasing interest rate
8:56 – environment. Life is good. But during credit contractions, lenders can disappear. Lone terms can
9:03 – tighten. And capital markets can become scarce. And borrowers who depended on refinancing,
9:10 – they suddenly faced very, very difficult choices. Even good assets can fail under those conditions.
9:18 – Even if you operated the business model the way that you would have otherwise anticipated,
9:22 – let’s say you’re a quote, good sponsor who implemented the business plan the way that you would
9:27 – have otherwise anticipated. You’ve gone in. You’ve increased the revenues. You’ve minimized expenses.
9:32 – You’ve increased the NOI in a material way. It does not matter. If you have a short term maturity,
9:38 – you could be an exceedingly precarious situation. Why? My crystal balls broken. Your crystal balls
9:44 – broken. That’s why the fixed and flipped model eventually fails because somebody somewhere is
9:50 – going to mistime the market and they’re going to hurt investors dearly, even if they’re a quote,
9:54 – good sponsor. When I say that, I use air quotes because they do a good job of implementing the
10:00 – business model if they’ve actually increased the NOI kudos, but they don’t have a holistic perspective
10:05 – of what is necessary to minimize downside risk. They did not ensure that the investment was solid
10:11 – on solid financial foundation. They put together a capital structure that was fragile. Again,
10:17 – even good assets can fail under those circumstances. Under the fourth fragility point,
10:22 – which is the lack of liquidity. Liquidity is what allows investors to survive temporary disruptions.
10:30 – Without reserves, investors become forced sellers. They may own good assets, great properties,
10:36 – main and main, but they cannot hold these assets long enough for the market to actually recover.
10:42 – And Sam Zell learned this the hard way. He’s one of the greatest investors of all time,
10:47 – readily viewed as the best real estate investor of all time. And he used to say something very simple.
10:52 – Liquidity equals value. Told the story before. He’s walking down the street. He sees his own
10:59 – individual face on a Forbes article where it says, Sam Zell billionaire, he’s doing exceptionally well.
11:06 – And as he’s walking down the street, he sees himself on this Forbes article. And what he’s,
11:11 – he’s, he’s stays to set to himself. He’s can’t even really believe that most folks don’t realize
11:16 – that that respective week where his, his face was plastered on that article. He couldn’t even make the
11:21 – payroll. He had to go borrow $50 million from the Pittsburgh family just to make payroll.
11:28 – Even though he had a wonderful billion dollar portfolio, why is that the case? Because he did not
11:34 – have enough cash on the balance sheet to be able to survive during the downturn after the savings
11:40 – in loan crisis. He was in a very precarious situation. And he didn’t have enough liquidity to survive.
11:45 – Liquidity provides you with time. And he meant he made sure from that moment on, onward,
11:51 – he put in place the philosophy that liquidity equals value. He would always have cash and liquidity
11:57 – available to survive during the next inevitable downturn. Again, liquidity provides you with time.
12:03 – And time is often the most valuable asset an investor can have during a crisis. You want to have
12:11 – liquidity events when market conditions warrant instead of having forced liquidity events.
12:17 – If those are the four fragility points, how do thoughtful investors protect themselves?
12:22 – That’s where we introduce what I like to call the Black Swan Survival Framework.
12:27 – These are four structural defenses that help investors survive uncertainty. And the first
12:33 – defense is a margin of safety. And this concept comes from the great Benjamin Graham
12:38 – in value investment in general. The idea is very, very simple. Buy assets below their intrinsic
12:44 – value. And that cushion protects investors if things don’t go out exactly as planned. Because
12:50 – mistakes are inevitable and markets, they’re unpredictable. So ensure that you have a margin of
12:57 – safety. The second defense is conservative leverage. And that means avoiding fragile capital structures.
13:05 – It means maintaining reasonable loan to value ratios. It means maintaining strong debt service
13:12 – coverage ratios. Ensuring that the property generates enough cash flow to comfortably
13:18 – service all of its obligations. It’s about building resilience into the investment.
13:23 – The third defense is durable debt structures. I’m going to prefer and always have long-term fixed
13:30 – rate debt when possible. I’m going to prefer long-term maturities to short-term maturities.
13:37 – I’m going to avoid dependence on short-term refinancing. And I’m further going to diversify
13:44 – inside of a fun structure. And I’m going to cross collateralize all these individual loans
13:48 – with staggered term debt explorations. Because my crystal ball is broken, your crystal ball is
13:53 – broken. And any given individual transaction has a higher likelihood of mistiming the market.
13:59 – And having that term debt expiration pop up in an opportune time. However, if you stagger your
14:05 – term debt explorations across 10, 15, 20 deals, even if you mistimed the market at one point in time
14:12 – because it is an inevitability that market timing risk cannot be solved for, you structure your
14:18 – portfolio in such a way that you can survive and ultimately have liquidity events when market
14:23 – conditions warrant. And all of these things reduce exposure to interest rate shocks and credit
14:29 – market disruptions. And the fourth defense is liquidity. It’s maintaining reserves that provide
14:37 – flexibility. Liquidity allows investors to survive downturns, to support properties during
14:43 – difficult periods. And perhaps most importantly, to take advantage of opportunities that arise
14:50 – when others are forced to sell. Because crisis, they often create the best buying opportunities
14:56 – around. But they are only opportunities for the investors who actually have the capital to act.
15:03 – And all these principles, they ultimately connect back to the one simple idea. It’s avoiding
15:08 – the single zero event. The investment outcome that wipes out all of the entirety of the portfolio.
15:13 – Charlie Munger once described a version of this using a Russian roulette example and analogy,
15:18 – right? Imagine someone offering you a massive, a very large amount of money to play Russian roulette.
15:25 – Even if the odds seem favorable, the downside is completely unacceptable. If one bad outcome occurs,
15:35 – the game is over. And in investing, there are certain risks that simply cannot be taken.
15:41 – Because the cost of failure is far too high. It’s important to acknowledge that being overly
15:46 – defensive can also create problems. Too much caution can lead to excess cash drag, missed opportunities,
15:54 – or excessive conservatism. You cannot remove risk entirely. You cannot eliminate risk.
16:01 – If you put your cash under a mattress, you still have inflation risk eating away at your
16:05 – purchasing power every single day. You cannot eliminate risk entirely. That would be impossible.
16:12 – The goal is not to eliminate risk. The goal is to eliminate ruin. And over the course of a
16:19 – long investment career, the markets they’re going to surprise you. Credit conditions are going to
16:24 – tighten. Liquidity is going to disappear. Unexpected events will inevitably happen. None of these
16:30 – things are predictable. You don’t know when it’s going to happen. My crystal ball is broken. Your
16:34 – crystal ball is broken. But one decision always remains within your control. How resilient your
16:41 – portfolio is before those events arrive. The most successful investors do not simply chase returns.
16:48 – They design investments that can survive uncertainty long enough, long enough for compounding to
16:55 – do its work. Because in the end, the first rule of compounding is simple. Stay in the game.
17:03 – Real estate is not a get rich quick style of business over a short period of time with a low
17:08 – probability of success. Real estate is a build massive amounts of wealth over a very long period
17:14 – of time with a very high probability of success. But you have to actually be an investor. You have
17:20 – to actually survive and be in the game. In the next episode, we’re going to unpack why I
17:25 – are our focused sponsors, why they got it all wrong. And what you should do, what you should look
17:30 – for when building long-term wealth. When 9 out of 10 deals work, that isn’t as good of an outcome
17:37 – as you might think for all the parties involved. Thank you for joining us guys. We look forward to
17:41 – seeing you on the next one. And until next time, you’d be great.