2015-11-28 Turning $2,000,000 USD into $3,500,000 USD
In this weekend’s case study, we will walk through process we went through to when we our investment partnership started to increase its asset allocation in the U.S. by buying raw land.
From 2009 through 2013, our group was focusing on residential property throughout the southwest United States, principally in Phoenix and Las Vegas as these were in our view not only the most consistent markets, but also far simpler than some of the more well known cities. We won’t focus too much in this case study on how we shortlisted Phoenix and Las Vegas as our prime target areas out of more than 25 cities we researched and visited often multiple times. But given we can attribute at least half (50%) of our performance to choosing the right cities to allocate capital to, we can abbreviate our investment process regarding geographic markets into point form. In short, the criteria and factors we considered were as follows from top down:
- We had to decide whether the country itself was worth entering in comparison to other international opportunities. (In 2008, the biggest financial crisis since 1929 caused collapses in all asset categories in the U.S. )
- We had to decide what asset category we wanted to invest in: Actively run businesses? Real Estate? Financial instruments? All of the above at distressed prices? We chose real estate for collateral reasons and for speed of entry.
- We objectively searched all major real estate markets in the country to understand relative market pricing between regions, and pricing relative to geographic growth, personal income among many other factors. One often overlooked factor we consider carefully, was whether we could seriously compete against local incumbents in a given city. Or in another words, how transparent and accessible was a particular city for foreign or non-resident investor? We were not interested in committing years to a market where we would only end up with scraps that other well funded and well connected locals did not want.
- Legal protections for Property Owners played an important part in our decision making since the power to remove tenants quickly can solve problems efficiently. Both Phoenix and Las Vegas have laws that are friendly to landlords, and played a strong role in motivating us to test these markets sooner than more well known cities such as Miami, Los Angeles or New York.
- Tax on income and capital gains was also considered and both Phoenix and Las Vegas are located in states that have zero corporate tax rates. (though US Federal taxes still apply)
- Other factors and criteria include ….growth rate of the city, physical geographic constraints such as finding out Las Vegas is surrounded on 4 sides by mountains, limiting the amount of prime land available for future development.
Now to the real essence of this case study, we look at the decision and execution behind a transaction executed on January 2014, arguably more than halfway into the market recovery cycle if strictly looking at price graphs, but early enough in normal business cycle because we knew that major players had not yet started playing too seriously yet. By the end of 2013, our group had conducted dozens of residential property transactions, half of them held for rental income and appreciation, and half of them rehabilitated and flipped onto the open market for 25% or more profit right away. It should be noted that at this point we had built up effective local teams in each city and developed a good reputation among our networks so that good deals usually landed in our email boxes or mobile phones sooner than our competition. We were among the first foreign investors to enter these markets and together with a handful of other US investment funds, we collectively proved that it was possible to use a private equity fund structure to acquire many single family homes and manage them profitably. Prior to this, conventional thinking in professional real estate circles was that buying many houses was not a scaleable venture and certainly not as efficient as multi-family housing units. We leaned more on past trends and behavioral science to conclude that conventional wisdom during this crisis period was not the most profitable or least risky strategy.
As our early bets paid off, and knowing that we were “ahead of the pack”, we decided to press a bit more aggressively before the competing investors and the public had enough confidence and capital to crowd our market. We wanted to keep doing something similar to where we experienced success (residential property), but scale it up while minimizing risk. We started looking for land in prime locations that had space for many residential homes.
In a rising property market coming off of a crash, being able to secure land allowed us to buy the upside of many housing units, while allowing us to be exposed on the downside to manageable losses so long as we had the power to hold onto the parcels until prices were in our favour. In trading terms, we were buying a “call option” on the real estate market, allowing for lots of upside and limited downside. In actual terms, our first purchase was a parcel that could fit 35 large homes, each with 3 Chinese Mo of land. At that time, each home would have an average selling price of $650,000. If we owned 35 finished homes, this would cost us almost $23 million USD. We bought the nearly 20 acre parcel for just $2,000,000 USD and now had the flexibility to flip it as-is later on, develop the infrastructure and sell the finished lots, or build the complete houses ourselves. Having flexible exit options is critical for any professional investor. And so with just $2,000,000 USD we have claim to the upside of a $23,000,000 USD asset. On the downside if say the market fell 20%, we would lose far less than 20% of $23,000,000 USD. For simplicity sake, we will not go into detailed mathematics or financing scenarios. The summary up to this point is:
- When the market is moving in your direction for the ‘right’ reasons…meaning the reasons you anticipated, press your bets before the rest of the herd shows up to compete. At this stage, you can expect the mainstream investment community and public to be hesitant and skeptical, we call these ‘lonely’ trades.
- Look for ways to get more upside leverage with minimized or manageable risk. And risk can be broken down into pricing risk and liquidity risk.
- Coming off any serious crash, press your bets AFTER prices are moving in the right direction to prove your positioning is correct. This means you will never achieve the lowest theoretical price. Admittedly, there is quite a degree of “art” vs “science” in identifying when market capitulations are over, but we won’t go into detail here since that is a case study all to itself. But ascertaining a transaction’s downside risk is much easier when you have seen liquidity disappear and have observed how each category of asset or property has behaved when the market is frozen.
- Look for assets and strategies that allow for multiple exit options. This flexibility not only helps to lower your downside risk, but can often help enable the opportunity to earn much higher profits.
By early 2015, just one year later, local government auctions indicated that our first parcel of land had an approximate market value of $3,200,000. At the time of this writing (November 2015) the market value is in the range of $3,800,000 to $4,200,000. Local homebuilders have presented us with similar offers, anxious to secure land as they are all short on inventory since the crash. Such builders stand to make about $100,000 of profit on each house they build, thus for their efforts, they would earn approximately $3,000,000 or profit for the 35 homes they would build on our parcel. And they would only need about $3,000,000 USD of working capital to execute such a project thus they would be making a return of 100% on their working capital. Everybody wins.
Alternately, our own group could build the homes and earn that extra $3,000,000 USD (on top of the $1.5M~2M profit on the land price) to return to our investment partnership.
And so concludes our real life case study of how to turn $2,000,000 USD into $3,500,000 or more.
Oasis Global Partners continued to accumulate more parcels of land and now owns enough area to build more than 250 single family homes and a small shopping market. As always, we are driven to maximize shareholder value.