Protect the Downside: How to Profit Even When Everything Falls Apart | Ep. 6

0:00 – There’s a quote from the Indianapolis 500 that perfectly captures everything that we’re
0:04 – going to cover today.
0:05 – One of the winners was once asked what it takes to actually succeed in racing and his
0:08 – answer was unbelievably simple.
0:10 – To finish first, you must first finish.
0:13 – And that’s not just a racing principle.
0:15 – That is also a life principle and it is definitely a business and investing principle.
0:21 – And investing the only unforgivable sin is complete and utter ruin, losing all of your
0:26 – money.
0:27 – You don’t need to be the smartest person in the room.
0:29 – You don’t need to capture every single bit of upside and every investment and you don’t
0:32 – even need to be right all the time.
0:34 – But you cannot afford a single mistake that permanently impairs your capital where you
0:39 – lose money.
0:40 – Warren Buffet said it best.
0:42 – Rule number one, never lose money.
0:44 – Rule number two, don’t forget rule number one.
0:46 – And that’s not just a clever line.
0:47 – That is the foundation of compounding.
0:49 – Real estate works extraordinarily well over very long periods of time but only if you stay
0:53 – in the game long enough to actually allow time to do the work.
0:58 – Most businesses and investors, they don’t fail because they lacked intelligence or they
1:01 – lacked ambition.
1:03 – They fail because at some point somewhere along the journey, one week link just failed.
1:09 – It snapped.
1:10 – Liquidity dried up.
1:11 – Leverage terms came due.
1:13 – Capital market is closed or an unforeseen shock hit the market, right?
1:17 – A black swan of it and they had no margin for it.
1:19 – So today we’re talking about the principle that makes compounding possible, which is
1:24 – P.
1:25 – Protect the downside.
1:26 – I’m Brian Spear and this is the sage investor.
1:28 – Our mission is to help as many people as possible generate cash flow and build legacy wealth
1:31 – in the tax efficient manner because that’s what I’m trying to do for my family and we’re
1:34 – going to help as many people as possible do that as we can along the way.
1:38 – Right now you’re catching us midstream on a seven part series where we’re walking through
1:41 – each individual letter of the acronym capital, which is a portion of our sunrise capital
1:46 – strategy where we’re digging really, really deep into the foundational principles that
1:51 – help our organization manage capital to the greatest effect possible.
1:55 – We’re taking histories, you know, greatest entrepreneurs, businessmen, investors, we’re
2:00 – taking all their golden nuggets and wisdom and we’ve wrapped it up into the sunrise capital
2:04 – strategy to generate cash flow and build legacy wealth in a tax efficient manner and
2:08 – today we’re covering part three, which is P. Protect the downside.
2:13 – Protecting the downside means designing your business and your investments so that no
2:19 – single individual event can destroy you.
2:22 – You have no single point of failure.
2:25 – It means survival comes first always because the math is unforgiving.
2:31 – If you lose 50% of your capital, you don’t need a 50% gain to recover.
2:36 – You need a 100% gain just to get back to even.
2:40 – If you have any single number, right, regardless of how well you’ve been investing historically,
2:44 – the number continues to get bigger and bigger and bigger.
2:47 – Any number no matter how impressive if you multiply it by zero is zero.
2:51 – So compounding only really works if you avoid that single zero event and that’s why
2:56 – protecting the downside is not conservative thinking.
2:59 – It’s actually strategic thinking because the investor who survives will always outlast
3:05 – the speculator who chases the upside and eventually mis-times the market and parishes along
3:11 – the way.
3:12 – Warren Buffett is quoted as saying, the three most important words of investing are margin
3:16 – of safety and we couldn’t agree more.
3:18 – And that’s really what we mean over at Sunrise when we talk about protecting the downside
3:23 – risk.
3:24 – It means when we go and do an investment, we want to make sure that we have a cushion
3:27 – at closing and every step thereafter.
3:31 – We’re going to expound upon that throughout the entirety of the episode here, but that’s
3:33 – what it really means.
3:34 – It means having a margin of safety immediately at closing and then maintaining that margin
3:39 – of safety throughout the entirety of your journey on that individual investment and throughout
3:44 – the entirety of the portfolio.
3:46 – So let’s go ahead and dig into how some folks have had shortcomings in this philosophy
3:50 – historically.
3:51 – You heard the phrase that those who don’t study the past are doomed to repeat it and I
3:55 – couldn’t agree more.
3:56 – Charlie Munger’s got a really great fascinating quote on this as well.
3:59 – He’s an individual that always has this philosophy of invert, always invert.
4:03 – So when he’s thinking about how can I create the best life possible for myself?
4:07 – As opposed to trying to craft what that looks like, he thinks, well, what would I need
4:11 – to do if I wanted to fail miserably at life?
4:14 – And he inverts that thought process and some of the things that he’s come up with really
4:18 – are striking and phenomenal, do not be reliable.
4:22 – So if you’re unreliable, you’re definitely doomed to fail.
4:25 – But another one that I thought was absolutely exceptional, only learn from your lived experience.
4:31 – If all you’re ever going to do is learn from your lived experience, then you’re doomed
4:37 – to fail because there are so many individuals that have already walked the path that you
4:43 – have walked that have already seen the same exact problems because history repeats itself
4:48 – over and over and over.
4:49 – If we can avoid those same potholes and mistakes that history’s greatest entrepreneurs
4:54 – and founders have inevitably overcome those those difficulties, then we’re going to be
4:58 – much, much more well served as human beings, as investors, as business people, as fathers,
5:03 – husbands, brothers, etc.
5:05 – So we’re trying to learn from all of the wisdom that’s been shared throughout history to
5:10 – improve as human beings.
5:12 – But in this example, we’ll share some of the mistakes that folks have encountered in
5:17 – their invest in journeys and how we have modified our strategy to ensure that we can protect
5:23 – the downside risk and avoid some of the mistakes that they ran into along the way.
5:28 – One of the most cautionary tales in financial history is long-term capital management.
5:33 – This was a hedge fund that was run by Nobel Prize-winning economists and the best bond
5:39 – traders in the entire world, 16 different individuals, hundreds of years of combined experience,
5:48 – extraordinary intellect.
5:50 – Warren Buffett once said, this group of 16 individuals likely had a higher cumulative
5:54 – average IQ than any management company in the entire world.
5:59 – Microsoft included in a million other things and he’s such a huge fan of Bill Gates.
6:04 – So I mean, he claiming that these individuals are literally have higher horsepower and
6:08 – intellect than anyone else in the world and with hundreds of years of combined experience.
6:14 – By the 1990s, mid-90s, they had about $5 billion in capital that they were managing.
6:22 – But here’s the problem.
6:23 – They borrowed over $125 billion.
6:28 – So they’re at about 25 to 1 leverage and their strategy was arbitrage.
6:32 – They were using modest price discrepancies in bond markets that were theoretically low
6:38 – risk, but they used massive leverage to juice the returns.
6:41 – Unfortunately, then Russia defaulted on its debt, global markets panicked, and suddenly
6:46 – positions that were once uncorrelated all moved against them all at the same time.
6:51 – So long-term capital management ended up losing $4.6 billion in four months.
6:56 – The Federal Reserve had to step in and organize a bailout to prevent systemic collapse.
7:02 – And Buffett was offered the opportunity to go ahead and buy the portfolio to discount,
7:07 – but he decided to pass.
7:08 – And later he said, it is insane to risk what you have and what you need for something
7:14 – that you don’t have and you don’t need.
7:18 – Intelligence does not protect you from leverage.
7:20 – Models fail at exactly the wrong time.
7:23 – And leverage doesn’t kill you in the good times.
7:25 – It kills you when liquidity disappears.
7:28 – Clearly long-term capital management didn’t do a comprehensive job of providing the best
7:34 – risk-adjusted returns in their strategy.
7:37 – The amount of risk that we’re taking obviously was far too much for the incremental rewards
7:42 – that they were ultimately receiving.
7:43 – It’s foolish to risk something that you have and need for something that you don’t have
7:47 – and don’t need.
7:48 – All the individuals that were running long-term capital management were successful individuals,
7:53 – but they were heavily invested in this venture.
7:55 – The vast majority of their individual networks were all rolled up into this and they ended
7:59 – up losing the vast majority of not only the reputation but all their personal net worth
8:04 – for something that they really didn’t need to risk.
8:07 – So again, the risk-adjusted return analysis was poor from their perspective.
8:12 – By way of example, Buffett chose this phenomenal analogy to explain this exact situation, right?
8:17 – So let’s say you hand him a revolver.
8:20 – There’s a hundred different chambers in the revolver and you ask him to put the gun to
8:24 – his head.
8:25 – There’s only one bullet in there so the odds are obviously heavily in his favor that
8:27 – nothing is going to go wrong as it were.
8:30 – But there’s not a single dollar amount that Warren Buffett will be willing to accept
8:34 – for the risk to pull that trigger.
8:36 – I don’t care if the odds are a hundred to one, a thousand to one, a million to one.
8:39 – There’s no time ever, it doesn’t matter what the sum is that you would ask him to bet
8:43 – that it would be a successful investment because the risk-adjusted returns are never going
8:47 – to be in your favor.
8:48 – Obviously, there’s no dollar amount that would be worthwhile if he doesn’t actually need
8:52 – the additional incremental increase in value there.
8:56 – And obviously the downside is pretty self-explanatory.
8:59 – From the risk-adjusted return perspective, a flawed logic from long-term capital management
9:04 – in this regard.
9:05 – And that’s how you should be thinking about your investments as well, making sure that
9:08 – you’re protecting the downside risk, never risk something that your family has and needs
9:13 – for something that your family does not have and does not need.
9:16 – Leverage is a chainsaw.
9:18 – You could obviously build something unbelievably beautiful with it, right?
9:21 – Chopped down a tree and just build an unbelievably phenomenal mansion with it.
9:25 – Or you can cut off your leg.
9:27 – Long-term capital management didn’t slip.
9:30 – They were running with a chainsaw down the highway at full speed and they fell and chopped
9:34 – off their own legs.
9:35 – So leverage is brutal.
9:36 – It’s a double-edged sword.
9:38 – And Buffett and Munger, they’ve been crystal clear about this for many, many, many decades.
9:42 – Of course, leverage can magnify your gains.
9:45 – But it also creates the one thing that you cannot recover from, which is forced liquidation.
9:52 – Buffett put it this way, like we talked about before.
9:54 – Any series of positive numbers, however impressive, evaporates when multiplied by a single zero.
10:02 – And he also warned repeatedly about refinancing assumptions.
10:05 – Because refinancing is not a plan.
10:07 – It can’t be the material plan.
10:09 – When maturities come to you, your loan maturity comes to you.
10:12 – The only thing that actually works is cash.
10:17 – Buffett said that borrowers learn that credit is like oxygen.
10:21 – When it’s abundant, it goes unnoticed.
10:23 – But when it’s gone, that’s all that is noticed.
10:27 – It’s very much reminiscent of what’s happened in the last handful of years here in the real
10:30 – state industry.
10:31 – Where obviously during the run-up, after COVID, interest rates unbelievably low, the lowest
10:36 – interest rate in 5,000 years, so inflated prices in an exorbitant manner, folks continue
10:42 – to buy deals with higher and higher prices, lower cap rates at ridiculous debt.
10:48 – The terms became more egregious.
10:50 – Folks started using floating rate debt with short-term balloons over the course of two or
10:53 – three years.
10:54 – And all of a sudden, what happened was, when the debt markets shifted materially in that
10:59 – window during the holding period, folks came to realize that whatever they assumed was
11:04 – going to be their exit and their refinance at year three, when that debt came due, their
11:09 – refinance was no longer an option that whatever diminimous margin of safety that they thought
11:14 – they had had completely gotten wiped out and they had no other options.
11:19 – And it is for this reason that so many folks have unfortunately had paused distributions,
11:24 – capital calls, and sometimes total loss of capital because they have not thought through
11:28 – in advance the fact that markets change and they’ve not protected the downside prior
11:34 – to actually making the investment years prior.
11:37 – And I guess a part that people often miss is that Buffett doesn’t avoid leverage because
11:40 – he’s afraid or scared of leverage.
11:43 – He avoids leverage because he wants freedom.
11:46 – He wants freedom to sleep at night.
11:48 – He wants freedom to act when nobody else can.
11:51 – He wants freedom to play offense when everybody else is struggling to survive when chaos ensues.
11:56 – If you’re really being cautious throughout the entirety of your journey with respect to
12:00 – leverage, you penalize the returns ever so subtly by a minor amount.
12:04 – Which your grant to the ability both financially and emotionally to play offense when everybody
12:10 – else is just struggling for survival, scrambling around just trying to survive, then you can
12:14 – go on offense with significantly better terms, significantly more liquidity and actually
12:19 – really generate much better outsized yields than what all of your competitors can at that
12:23 – respective time.
12:24 – So we just heard the best investor of all times perspective on leverage.
12:27 – What about the best real estate investor’s perspective on leverage and liquidity?
12:31 – How does Sam Zell feel about the same exact topic?
12:34 – Sam Zell, back in the heyday, learned the lesson the hard way.
12:38 – During one of the most brutal recessions, Sam Zell found himself massively constrained.
12:44 – At the time, his business was over a billion dollars and if you were to, you know, use inflation
12:48 – to kind of make that into today’s numbers to be somewhere around five, 10 billion dollars.
12:52 – Okay.
12:53 – So it was a real successful company, solid size and scale at that time.
12:57 – It was worth a billion dollars.
12:59 – But at that time, recession hit, capital markets shut down, refinancing disappeared and
13:04 – highly leveraged asset owners became trapped.
13:08 – Zell has told stories over and over again about scraping together quarters and dimes just
13:12 – to make payment.
13:13 – We’re talking about a guy that’s got a billion dollar business and he couldn’t even make
13:16 – payroll.
13:17 – He was struggling just to survive.
13:19 – He had to go to Pritzker and borrow 50 million dollars just to try to make it through.
13:24 – He was in a precarious situation.
13:26 – And from that experience, he instituted a maximum that never went away.
13:32 – Liquidity equals value, not net operating income, not in turn or return, not EBITDA, not hypothetical
13:39 – appreciation, cash, cold hard cash, cash flow to write out the next inevitable recession
13:46 – and liquidity on the balance sheet to ensure your own survival because cash is oxygen.
13:53 – It allows you to survive when the world is just struggling to breathe and it allows you
13:59 – to act when everyone else is cornered and harkening back to Charlie Munger’s philosophy.
14:05 – If all we’re ever going to do is benefit from our own individual lived experience, we’re
14:10 – going to be a far cry beyond all of our competitors.
14:14 – It is from these bits of wisdom and these golden nuggets from the world’s greatest entrepreneurs,
14:18 – the world’s greatest businessmen, the world’s greatest investors that we’ve rolled together
14:22 – are Sunrise Capital Strategy to avoid the same mistakes that the world’s greatest investors
14:26 – have already made.
14:28 – The principle of protecting the downside is not theoretical for us.
14:31 – It’s operational.
14:32 – It’s something that’s built into who we are and what we do.
14:34 – That margin of safety is a massive piece of how we operate over here at Sunrise.
14:39 – It’s not all sunshine and rainbows.
14:40 – We’re going to walk through some case study examples of how things have gone awry historically,
14:44 – but ensuring that you’re protecting the downside risk can kind of get you through these situations.
14:49 – So we’ll cover some of that in a little bit.
14:50 – But here’s what protecting the downside means for us here at Sunrise.
14:55 – First and foremost, it means having a cushion at closing and then every step throughout
15:01 – the rest of the holding period.
15:03 – But one is buy with a margin of safety, right?
15:05 – Where the purchase price of your acquisition is lower than the current market value of
15:11 – that acquisition.
15:13 – That is the definition of buying with a margin of safety, not hope, not optimism, a real
15:18 – gap between price and value.
15:20 – So we’ve got many.
15:21 – I can give you a 40, 50 different examples and the praises of deals where we’ve done this
15:24 – over time.
15:25 – But I’ll give you a couple of different examples.
15:27 – One is a parking facility out in Charlotte, North Carolina.
15:30 – We did this deal a couple of years ago.
15:32 – It’s called the spectrum garage in downtown Charlotte, absolutely phenomenal location, location,
15:37 – location.
15:38 – Literally been in high demand for multiple hundreds of years.
15:42 – It is catty corner to the spectrum center where the Charlotte Hornets play.
15:46 – And this was a very complicated transaction.
15:48 – In order to make this deal work, we ended up getting the entire city block under contract.
15:53 – It was a $250 million total capitalized cost of the transaction.
15:58 – It came to us because we’ve become more well known in parking.
16:01 – There’s not a lot of guys out there doing what we do.
16:03 – It’s pretty niche real estate sector.
16:05 – And somebody ended up having a deal that was a mixed use transaction.
16:10 – This entire city block had a hotel, multiple office buildings, as well as a parking facility.
16:17 – And so he was trying to find somebody that knew parking very well because a large chunk
16:21 – of income derived from parking.
16:22 – And so this deal hit our desk right after kind of the downturn in COVID.
16:26 – So office values plummeted, office income dropped significantly.
16:30 – Folks weren’t staying in hotels near as much.
16:32 – So the values of those assets dropped precipitously, but the parking was doing exceptionally well.
16:36 – People were still out there based on the multiple demand generators in the phenomenal location,
16:41 – location, location.
16:42 – The parking asset was still doing very well.
16:44 – But we don’t consider ourselves specialists in all respective real estate sectors.
16:48 – We definitely don’t fancy ourselves specialists in hotels, nor do we fancy ourselves specialists
16:54 – in office, most assuredly not office to residential conversions.
16:58 – But what we ended up deciding to do was going and getting a third party appraisal,
17:03 – looking at the parking exclusively as parking in and of itself.
17:08 – If we remove that parcel of land and we only bought the parking,
17:12 – that’s all we cared about, how much would that be worth?
17:14 – And the appraisal came back that it would be worth $35 million.
17:18 – We said great, we’ll pay 31.
17:21 – And then we went and found others that specialized in the other areas of business that we didn’t want.
17:26 – We didn’t want a hotel, so we found a hotel operator.
17:29 – We didn’t want the office building.
17:31 – So we found somebody who was exceptional at doing office to residential conversions.
17:34 – And they took those assets off our plate.
17:37 – We went and bought a parking asset that was valued at $35 million immediately out of the gate.
17:42 – And we purchased it for $31 million.
17:45 – That’s a $4 million margin of safety, beautiful right out of the gate.
17:48 – And that’s what we mean when we say we buy with a cushion at closing.
17:52 – Another deal where we can exemplify the idea and the concept of P,
17:55 – protect the downside is a small little mobile home park we ended up buying.
17:58 – This is literally the very first mobile home park that we ever did.
18:01 – It’s in Georgia.
18:02 – It was a 29 space mobile home park literally bought from the bank for a mere $200,000.
18:08 – At the time, literally had no income.
18:10 – In that mobile home park, 29 spaces were 29 individual empty shells.
18:16 – And what we knew going into that respective transaction was what is the worst case scenario?
18:22 – Very much like the old Benjamin Graham philosophy of cigar, but investing.
18:26 – The individual assets that we were buying, the tangible assets were worth more than the cumulative purchase price.
18:35 – Even if we didn’t do any sort of high quality value ad strategy to get residents in,
18:40 – to get tenants paying on a monthly basis, if all we ever were able to do was to take the individual mobile homes
18:46 – and literally sell them off, that would have been worth $290,000.
18:49 – You literally couldn’t go wrong in that respective deal.
18:53 – You could not lose money.
18:54 – This is the definition of Benjamin Graham’s cigar, but investing.
18:58 – And that was how we got started in this respective business.
19:01 – That’s the definition of buying with the margin of safety, right?
19:03 – That is an example of it, but it’s a short term version.
19:06 – And that worked for Warren Buffett in his earliest ventures.
19:11 – He was able to start buying some cigar, but businesses,
19:13 – but then eventually began to realize that it’s more prudence to buy wonderful businesses at a fair price
19:21 – than simply buying mediocre businesses at a deeply discounted price.
19:26 – And over time, we’ve evolved away from trying to just buy everything ridiculously phenomenal off-market direct to owner at a discounted price,
19:33 – but rather pay wonderful for wonderful businesses,
19:36 – deals that literally have exceptionally profound, long-term macroeconomic tailwinds,
19:41 – truly phenomenal assets that we know are going to be in high demand for literally generations to come.
19:46 – As opposed to some assets that may not have that sustainable cash flow over time.
19:50 – There’s a distinct difference there, but this was a perfect example of literally protecting the downside risk.
19:54 – If we’re literally buying it, and there’s no way we could lose money.
19:58 – Worst case scenario is we just got to sell the individual shelves and to be worth more than the cumulative purchase price,
20:03 – the entire mobile home park.
20:04 – That’s a perfect example of protecting the downside.
20:07 – We can give you numerous examples of this.
20:08 – We’ve got another mobile home park that we bought in Ohio that was not too dissimilar.
20:12 – We ended up buying it for $13.5 million appraised just north of $15.2 million, something like that.
20:19 – But the point is, a little bit more than a $1.5 million margin of safety immediately at acquisition,
20:24 – when you take into account the additional leverage that we used at closing,
20:27 – we ended up having roughly a 28% return on equity immediately at closing on that respective investment.
20:35 – That’s what we mean when we say buy with a margin of safety, right at acquisition, right out of the gate.
20:41 – You’re not buying at hope, you’re not buying on optimism,
20:45 – you’re buying with a real gap between price and value.
20:48 – Across our most recent fund fund for, we just closed it out.
20:50 – We ended up buying $197 million real estate,
20:53 – but the cumulative appraised value immediately at closing all those assets was $222 million.
20:59 – Again, a $25 million margin of safety between the purchase price and the appraised value immediately at acquisition.
21:05 – That’s downside protection before we ever think about the upside.
21:10 – That’s what we mean, invert, always invert.
21:12 – When folks go into investments, they’re always thinking about how much money can I make this that and the other.
21:17 – Charlie Munger would say invert, always invert.
21:19 – What we’re thinking about is not how much money can I make,
21:22 – but rather how can I lose all of my money?
21:25 – And we squash every single one of the ways that we could lose all of our money to the best of our degree.
21:31 – And assuming we’ve squashed all those,
21:33 – then we’ll contemplate going ahead and acquiring that deal and implementing the business model
21:37 – and generating the best return on investment that we can.
21:40 – But we’re first focused on return of investment before we ever even contemplate return on investment.
21:46 – But protecting the downside does not only mean buying with the margin of safety.
21:51 – There’s several different additional things that we’ll layer in.
21:53 – I got to handful more that we’re going to walk through here in terms of what we mean when we say protecting the downside risk over at sunrise.
22:00 – Before we dig into some actual case studies and examples of how this has played out in real time.
22:05 – But the second piece of the puzzle in terms of protecting the downside risk is applying modest leverage, conservative debt.
22:13 – And for us, this means on any given individual deal,
22:17 – we might have an LTV that goes up to 60, 65, maybe on the high side, 70% LTV.
22:24 – But then the fund is an entirety, right?
22:27 – Across the numerous different assets inside of the fund,
22:29 – we like to maximize our LTV at 60%.
22:32 – We feel like that’s very conservative.
22:34 – And it allows us to absorb any of the shocks that would inevitably occur.
22:40 – You never know when the next Black Swan event’s going to occur,
22:42 – but we want to make sure that we’ve got a nice margin of safety and we’re not over leveraged to the gills.
22:47 – What about on the low end?
22:49 – We like to have our LTV’s range in the fund somewhere between 40% on the low end and 60% on the high end.
22:55 – When the loan to value drops down to 55 to 50 to 45, down to 40%, right?
23:01 – Because when we buy assets with a 60% LTV, over time, assuming we’re implementing the business plan well,
23:06 – revenues are increasing, expenses are decreasing, our NOIs are going up over time.
23:11 – The value of the property increases are LTV drops from 60 to 55 to 40 over time.
23:17 – The LTV is so low that it is adversely affecting your return on equity.
23:24 – And whatever modest, incremental, additional leverage we would use would be a creative.
23:30 – And it wouldn’t add that much risk to the table.
23:33 – Again, if we’re only going to max it out at about 60%, we’re then comfortable bringing the LTV up from 40% on the floor
23:40 – to about 60% on the high side.
23:42 – And this is the comfort zone from our perspective where we know we’re not getting out in front of our skis from a debt perspective.
23:48 – Another way that we like to share that we’ve got conservative debt is we like to use fixed rate debt period end of story
23:54 – because we know what we’re signing on the dotted line because we never know what the future holds.
24:00 – My crystal balls broken, your crystal balls broken, the Fed doesn’t even know what they’re doing.
24:04 – Our willingness to sign on floating rate debt is negligible.
24:08 – We don’t do that because we know that the next black swan event could be tomorrow.
24:12 – I mean, today could be a version of September 10th 2001.
24:16 – You never know when that next inevitable crazy black swan event is going to occur that just completely shocks
24:23 – the interest rates and could lead you to ruin.
24:26 – So we’re just unwilling to do that.
24:28 – We also never want to be in a situation where we’re praying at refinance that we can just maintain
24:33 – and hold the asset.
24:34 – We don’t have to liquidate.
24:35 – So you want to have long term fixed rate debt to the best of your ability.
24:38 – And the shorter the term debt expiration, the more equity you need to have in that respective investment.
24:45 – Because if you’re over leveraged and you have very short term remaining a tenure on that respective debt,
24:51 – that’s when you can get into an exceptionally precarious situation.
24:55 – Which leads me into the next step in the process in terms of staggering term debt expiration.
25:01 – We obviously prefer to use fund structures as opposed to individual deal specific syndications
25:05 – because we feel like it minimizes risk from the perspective of everybody involved.
25:08 – I’ve already made the point that nobody knows when the next inevitable black swan event will occur.
25:13 – So it is for this reason that it’s much better to stagger your term debt
25:19 – expirations across many different dates, many different periods of time, many different years
25:24 – as opposed to having all of those term debt expirations come due in one moment.
25:28 – Because if all of your debt comes due in one moment in time,
25:31 – and it just happens to be the next version of the savings and loan crisis or the great recession
25:37 – or COVID debacle or the interest rate increases, you could be in an exceptionally precarious situation.
25:43 – And we don’t want to find ourselves in a spot where we don’t control our own destiny.
25:48 – So we stagger those term debt expirations to minimize the risk on the portfolio as a whole.
25:53 – It’s why, yet another reason, a fund structure is much superior in our humble opinion
25:57 – to deal specific syndications.
25:59 – Because you can never remove that timing of term debt expiration as a risk from an individual
26:04 – deal specific syndication.
26:06 – It’s why, again, we’ve been fortunate to have no capital calls, no pause distributions,
26:11 – no loss of capital over time when we’ve seen so many different sponsors, unfortunately,
26:14 – have those events occur.
26:15 – Another thing that we loved to really ensure that we have is sufficient cash,
26:20 – speaking about cash in general, not only cash flow to write out the next inevitable recession,
26:25 – but also liquidity and the balance sheet.
26:28 – We can obviously go learn the hard way or we can just read the biographies of Warren Buffett
26:33 – and Charlie Munger and Sam Zell and learn that Sam Zell, the best real estate investor of all time,
26:38 – learned this 30 years ago when he almost went bankrupt because he couldn’t make payroll
26:42 – because he didn’t have enough liquidity in the balance sheet.
26:44 – Now that we know that, I’d rather just go ahead and learn from his mistakes over time
26:48 – as opposed to us having to feel them personally.
26:51 – So we’ll make sure that we have sufficient amount of cash on the balance sheet so that if and when,
26:57 – that next inevitable Black Swan event occurs, we’ll be able to write it out and be able to survive
27:02 – until greener pastures arise.
27:04 – And the last topic we’ll discuss in terms of mitigating the downside risk and protecting the
27:08 – downside in terms of our strategy is having multiple exit strategies.
27:13 – You never want to be in a situation where you’ve underwritten the deal and you have to have
27:19 – one specific outcome occur or else your deal goes to zero and you lose all of your money.
27:25 – Because then you’re in a hostage situation.
27:28 – That’s not a strategy, right?
27:29 – That’s a hostage situation where you’re too heavily dependent on something outside of your control.
27:35 – Because your crystal ball is broken, my crystal ball is broken,
27:38 – you can’t predict the future so you have to have optionality.
27:40 – And what that means is you need to be able to should you choose to do so
27:44 – and market conditions warrant holds for cash flow.
27:48 – One option, hold on to it forever, just hold for cash flow.
27:51 – Another option, sell it, sell it to a different buyer.
27:54 – Somebody’s won to pay a premium over and above the intrinsic value of the asset.
27:58 – In the third one, refinance without crazy heroics refinance because market conditions warrant.
28:04 – Maybe the interest rate environment went down suddenly.
28:06 – You’ve got great cap rates.
28:07 – You can extract the vast majority of the equity that you invested.
28:11 – Life is good, but maintain a solid margin of safety.
28:14 – Maintain sufficient DSCR.
28:16 – Maintain sufficient cash flow.
28:17 – So you don’t put yourself in a precarious situation again, right?
28:20 – So it’s not only having a appropriate amount of debt immediately at acquisition,
28:24 – but throughout the entirety of the holding period.
28:26 – But you have to have that optionality when you’re going into a respective
28:29 – real estate investment.
28:30 – You can’t just say I’m going to buy, fix, and sell it in two years,
28:33 – or buy, fix, and sell it in three years.
28:34 – Because if you do, you could end up holding the bag
28:39 – if the market shifts underneath your feet in a very short period of time.
28:43 – That’s how you have capital calls and ultimately total loss of capital
28:47 – inside of transactions.
28:48 – You need to have optionality so that you could ride out the next inevitable recession
28:54 – and make it to the other side so that you can have material liquidity events
29:00 – when market conditions warrant as opposed to having forced liquidity events.
29:05 – Because that’s when imprudent decisions are made and people lose money.
29:08 – As I promised earlier, guys, I wanted to talk about our failure case, right?
29:12 – Like a case story where it’s not all sunshine and rainbows, right?
29:15 – Not every single deal we do is a single double triple home run grand slam.
29:19 – It’s also important to learn.
29:20 – You learn way more from the deals that didn’t work out than the deals that actually do, right?
29:24 – So let’s dig into one of those respective transactions here today.
29:28 – I would say here’s a truth that most sponsors won’t admit.
29:32 – The only thing that I can guarantee when I send you a pro forma
29:36 – is I guarantee you it’s going to be wrong.
29:39 – It’s either going to be better or it’s going to be worse,
29:41 – but I can promise you it is not going to be accurate.
29:44 – It’s just because there’s so many different assumptions that have to be made
29:47 – on an Excel spreadsheet over the course of the next 10 years
29:49 – when nobody knows what’s actually going to occur.
29:52 – It’s impossible.
29:52 – So you try to mitigate downside risk to the best of your ability.
29:55 – But we had a mobile home park in Oklahoma that’s still water
29:59 – that did not perform anywhere near the way that we would have otherwise expected.
30:03 – We did everything that we possibly could in advance to mitigate the downside risk,
30:06 – but it didn’t go as planned.
30:08 – Cash flow was much weaker than we anticipated.
30:12 – The deal was a headache, and I guess that’s putting it nicely.
30:16 – You know, there’s an 80-20 rule where typically 20% of the deals take up 80% of your time,
30:21 – and this was a perfect example.
30:23 – It probably took up 90-95% of our time, given the amount of angst
30:27 – that it was placing inside of the organization.
30:29 – And the business plan just didn’t play out the way that we would
30:33 – have otherwise anticipated.
30:34 – But because we spent so much time in advance protecting the downside risk,
30:39 – we used conservative leverage, we bought with the margin of safety,
30:42 – we had significant liquidity, we didn’t lose capital.
30:45 – And at the end of the rainbow, we ultimately sold the asset for slightly more
30:49 – than we paid.
30:50 – It’s not a home run, but it was survival.
30:52 – And we were able to move on to the next deal,
30:54 – and survival preserves capital, and preserves the compounding.
31:00 – So we could ride off into the next deal and continue that compounding
31:03 – in another asset that has a much better long-term macroeconomic outlook
31:07 – than that individual transaction did.
31:09 – So again, tying it back to the pro forma.
31:12 – You know, the only thing that I can guarantee is the pro forma is going to be wrong.
31:15 – And in this case, obviously, it was once again.
31:18 – I think Charlie Munger, you know, explains this pretty well.
31:20 – The way that he thinks about businesses is he thinks about it like a bridge.
31:24 – He thinks about businesses like bridges, engineered systems,
31:28 – redundancies, stress tested for extreme conditions.
31:33 – He’s literally said before it is illegal to imprudently engineer bridges in this country.
31:40 – And he feels like it should be illegal to imprudently engineer businesses
31:44 – in the same thing. So Sam Zell said it perfectly.
31:47 – Redundancies are much more predictable
31:50 – than theoretical opportunities to add value.
31:53 – So for us, when we’re looking at the pro forma,
31:55 – you’ve got to find there’s a million assumptions that go into it.
31:58 – But you’ve got to ensure that you build numerous redundancies
32:02 – into the pro forma to mitigate the downside risk
32:05 – to the best of your ability.
32:06 – Protecting the downside, it’s not pessimism.
32:08 – It’s architecture.
32:10 – You’re engineering the deal.
32:12 – It’s building something that can withstand all the storms that you can’t predict.
32:17 – So what went wrong in this deal?
32:18 – One of the giant crazy misnomers in the mobile home park sector,
32:22 – just the name, mobile home is known as a misnomer.
32:25 – Mobile homes typically only move twice.
32:27 – First, they move from the manufacturer to the mobile home park
32:30 – and then they move from the mobile home park to the dump
32:33 – after the end of the home’s useful life expectancy.
32:36 – They usually stay in the community for literally decades and decades
32:40 – sometimes multiple generations because it’s cost prohibitive
32:44 – to move a mobile home.
32:46 – Why is this the case?
32:47 – Well, it takes maybe $8,000 to move a single wide.
32:51 – It’s going to take five figures, $12,000 to move a double wide.
32:55 – And every time that you put it on a new chassis and move it down
32:59 – the highway, it’s going to adversely affect the interior.
33:02 – There’s going to be more costs associated with it.
33:04 – The only logical reason folks would move one mobile home park
33:08 – to another is oftentimes because they’re going to end up
33:11 – having a lower monthly cost at the other respective community.
33:15 – Well, let’s say your community rents for $300 a month
33:19 – and the community down the road is renting for $275.
33:24 – Okay, some version they’re in.
33:25 – Well, that’s $25 a month that they’re ultimately saving.
33:28 – Think about the break even in the payback period necessary
33:30 – to ultimately justify spending $10,000 in an outbound expense
33:34 – when you’re only saving $25 per month in rent,
33:37 – recapturing that on a monthly basis.
33:40 – And there’s no guarantee that the guy down the street
33:43 – is not going to increase his rents to $325 the minute that you get there.
33:48 – It’s for this reason that mobile homes typically never leave
33:51 – the community once they ultimately arrive inside of that respective
33:55 – mobile home park.
33:56 – That had been our experience historically and it has been our experience
34:00 – in every single mobile home park that we’ve owned except for this one.
34:03 – It was a very unique and out scenario.
34:04 – We had numerous homes that were ultimately leaving the community.
34:07 – There was a situation where a mobile home park
34:12 – in the vicinity ended up having lost that we ended up getting sold individually.
34:17 – It meant that the individual residents inside of our community
34:20 – for just a few thousand dollars were able to kind of
34:24 – buy their own individual parcel of land and move their home out there.
34:28 – So the break even period was close enough to where they knew that eventually
34:33 – the lot run was going to go away in its entirety.
34:35 – And they could see the writing on the wall that if I stayed here
34:37 – for a long enough period of time on that small parcel of land
34:40 – that it would end up being a reasonable break even from their perspective.
34:44 – It was just this ongoing churn.
34:47 – We were working our fingers to the bone just to stay above water.
34:52 – And what I would use is the analogy of a tub.
34:54 – Inside of a tub, if the real estate investment is a tub
34:57 – and my goal is to try to increase NOI,
35:00 – i.e. increase the volume of water inside of the tub.
35:04 – There’s two things that I really need to do.
35:05 – First thing is, I need to make sure that the faucet is on.
35:07 – I’ve got a lot of water coming into the tub.
35:09 – And the second thing that I need to do is make sure that the drain is clogged.
35:13 – That we’ve actually capped the drain and you’re not losing money out of the bottom.
35:17 – And in this example, we were bringing in homes left and right,
35:21 – selling a lot of homes, bringing in new residents,
35:23 – doing an exceptionally high quality job.
35:25 – There’s a massive demand for affordable housing, massive demand for our product.
35:28 – We’re moving a lot of units, et cetera.
35:30 – But unfortunately, on the back end,
35:32 – we’re seeing homes get pulled out, left and right,
35:34 – and we’re losing a lot of revenue and a lot of residents along the way.
35:37 – So we were constantly churning cash, constantly churning capital,
35:42 – and we were not able to make any material ground in terms of
35:45 – formally adding value in the material sense.
35:49 – Certainly, the way that we would have otherwise anticipated,
35:50 – and the way that we had underwritten inside of the pro forma.
35:53 – If we had not protected the downside risk in advance,
35:57 – if we had not bought with the margin of safety,
36:00 – if we had not intentionally had massive amounts of sufficient reserves on the
36:05 – sideline in advance of closing that property,
36:07 – if we hadn’t done those things,
36:09 – we would have likely run out of money and had to do a capital call.
36:14 – Or we would have likely ended up having a DSCR issue
36:18 – where the bank would have come calling to take that asset back
36:21 – because the revenue getting generated wasn’t high enough.
36:23 – We could have had an occupancy issue where the bank could have called the note due.
36:27 – If we had overlavered the asset too much,
36:30 – all of these, what seemed to be modest,
36:34 – inconsequential decisions on the front end,
36:36 – any individual one of them could end up having the deal blow up.
36:40 – But if you squash all of those individual problems in advance of closing that
36:44 – transaction, we were able to at least salvage the deal
36:48 – all be it have a very modest cash on cash return and a very modest
36:52 – outcome, I’ll call it a single as opposed to a double a triple home run
36:56 – a grand slam.
36:57 – We were able to maintain all of the original base of capital
37:01 – and keep the capital compounding over long periods of time.
37:04 – And that is better than a sharp stick in the eye in my humble opinion.
37:08 – Protecting the downside risk is paramount
37:11 – to ensure that you never stop the compounding.
37:14 – How we manage capital over here at Sunrise is how we try to manage
37:18 – our own families capital for the betterment of everybody involved.
37:21 – Here’s the big idea to take with you.
37:23 – Survival proceeds success.
37:26 – Protecting the downside is what allows compounding to actually work.
37:31 – It’s what gives you the right,
37:32 – not the obligation to play offense when everybody else can’t.
37:36 – You don’t need to get rich twice.
37:38 – Most investors, they don’t need more upside.
37:41 – They need fewer mistakes.
37:42 – You just need to avoid complete and utter ruin
37:46 – where you lose all your money.
37:48 – So protect the downside and let time do the rest.
37:52 – Next week, we’re going to flow into the fourth part of our seven part series
37:56 – where we’re going to go into letter i, which is invest.
37:58 – Don’t speculate.
37:59 – We’re going to talk about how compound interest over long period of time
38:02 – is truly the eighth wonder of the world.
38:05 – And why so many folks believe that they’re investing
38:08 – when they’re actually speculating.
38:10 – So until next time, you’d be great.