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Lessons from Howard Marks on real estate cycles

Howard Marks writes extensively about cycles in his book “Mastering the Market Cycle”, and I particularly enjoyed the chapter where he discusses real estate cycles, given I now work in the real estate business. I haven’t come across someone who understands and writes about economic and business cycles better than Marks. And fortuitously he shares his thoughts in books he has written, podcasts and newsletters.

Marks is the founder of Oaktree Capital Management, an investment firm which focuses on distressed securities. They try to buy distressed securities at significant discounts to par value with the idea of selling then in the future at a higher price. His superior understanding of how cycles work and getting the odds of success on his side has given Marks a significant edge over other investors.

He firm took some large positions in distressed securities in the years following the 2008/09 global financial crisis, which later turned out to be correct. The positions were taken in American non-performing home mortgages and bank loans. After the 2008/09, global financial crisis, additions to the housing supply had mostly stopped, and the conventional thinking was that the American home ownership dream had stopped, with most young people now preferring to rent rather than own. Marks realised this was a cyclical phenomenon and predicted that demand for housing would continue in the future. Which it did of course.

As Buffett says, “be greedy when others are fearful, and fearful when others are greedy”. This principle is easier said than done because during the bad times, it seems that things are bad and won’t recover and during greedy times, it seems optimism will continue forever. Furthermore, when things are really bad, assets don’t look cheap and when things are good, prices don’t look over priced. Historic bias has a lot to do with it.

In Zimbabwe one of the biggest companies on the stock exchange is Delta Beverages, which is the country’s main producer of beer and soft drinks. The share price has fallen recently, and a friend who invests in Delta shares says it is so cheap now, because it’s on a nearly double-digit dividend yield. But this is a historic dividend yield, based on dividends paid from operating performance last year. The stock market can be thought of as a foreword indicator of investor sentiment. If the market psychology is negative, share prices will drop and historic dividend yields will rise because of the inverse relationship between prices and dividend yields.

Marks describes the general upward and downward stages of credit cycles as follows below. 

The Credit Cycle

The upward cycle

  1. Positive events and increased profitability lead to greater enthusiasm and optimism generally.
  2. Improved psychology encourages increased activity which includes doing more of something based on current assumptions (building, manufacturing, lending etc.), paying higher prices to do it (e.g. paying more for property or a share); and/or lowering the standards that have to be met if one is to do it (e.g. a company offering credit to lower quality customers or a bank offering mortgages to sub-prime borrowers).
  3. The combination of positive psychology and the increase in activity causes asset prices to rise, which encourages still more activity, further price increases, and greater risk-bearing.
  4. Inevitably this cycle takes on the appearance of being unstoppable, and this appearance causes asset prices, and the level of activity to go too far to be sustained.

The downward cycle

Eventually, the downward cycle begins with:

  1. news turns less positive,
  2. the environment becomes less hospitable,
  3. levels of psychology, activity and risk bearing prove to have been excessive, and the same goes for asset prices.
  4. Price corrections causes psychology to become less positive,
  5. This causes disinvestment, which leads to
  6. Further downward pressure on prices.

Difference between the real estate cycle and credit cycle

Marks points out that real estate cycles are a bit different to the normal credit cycle because of the long lead time from conception to completion of a real estate development. Unlike banks which can turn on or off credit lending very quickly, or manufacturing companies which can increase or decrease production quickly, real estate projects often take several years to complete, and business/economic cycles can change drastically during this period.

A typical real estate project will go through the following stages:

  1. Carry out economic feasibility study
  2. Locate a site and purchase land
  3. Design the proposed building and estimate building cost
  4. Complete an environmental impact assessment
  5. Get permission to build from local authorities
  6. Apply for zoning modifications if necessary
  7. Obtain financing
  8. Complete construction

The above steps can take several years to complete, and during this period economic and business conditions can change considerably, which may affect the viability of the proposed project.

Understanding at which stage of the cycle a sector or country is in is critical for giving the most chance of success. The real estate cycle according to Marks is described as follows:

The Real Estate Cycle

  • Bad times cause both the level of building activity to be low and availability of capital for building to be constrained. In the years following the global financial crisis in 2008/09 this was the case.
  • Over time, things become less bad, and eventually turn less bad;
  • Better economic times cause the demand for premises to rise;
  • With lower building stock having been developed during the formerly hard times, additional demand for space causes the supply/demand picture to tighten and rents/sale prices to rise;
  • This improves the economics of real estate ownership, reawakening developers eagerness to build
  • Better times and improved economics make providers of capital more optimistic, causing more finance to become readily available;
  • Cheaper, easier financing raises the forecast returns on potential projects, adding to their attractiveness and increasing developers’ desires to pursue them;
  • Higher projected returns, more-optimistic developers and more-generous providers of capital combine for a ramp-up in building starts. At the same time one could add that more marginal products get funding approved as lending standards loosen;
  • The first completed projects encounter strong pent-up demand. They lease up or sell out quickly, giving their developers good returns.
  • Those good returns – plus each day’s increasingly positive headlines – cause still more buildings to be planned, financed and approved
  • Cranes begin to fill the sky, and concrete mixing trucks are all over the roads;
  • It takes years for the developments to reach completion, but eventually the first ones to open eat into unmet demand.
  • As demand starts to be satisfied, economic and business conditions can change so that more buildings come onto the market in less good times, causing an over-supply of space, leading to vacancies, downward pressure on rents and sale prices.
  • This causes the level of building activity to be low and capital to be constrained (the end of the cycle and the beginning of the next cycle).

The same real estate cycle principles can be applied to agriculture and farmland investing. My first job as an investment analyst was with a farmlands investment fund focusing on southern and eastern Africa. The fund was raised during the period 2010-2012, when there was a strong case for investing in farmland. By the time the fund was ready to be deployed, the commodity prices were high and farmland prices were strong, leading to high asking prices for land. Then 10 years later, when the fund is trying to exit its investments, commodity and farmland prices are low, which makes it harder to get good prices for assets. This is one of the drawbacks to private equity funds, and one of the advantages of permanent equity investing, which I write about in a separate blog post.

The Johannesburg residential real estate market appears to be at the bottom of a cycle. I visited there in September last year, and looked around at a few apartments with the view to buying. There has been a proliferation of apartments buildings going up over the past few years, and this combined with poor economic and business fundamentals has led to high rates of vacancies, and downward pressure on rents and sale prices. In addition, the Rand has depreciated by about 30% in recent years which has caused real returns in USD to fall even further.

The Zimbabwe property development industry has been booming over the past 2 or 3 years, and seems to be quite far along in this cycle. I remember in 2019/early 2020, the Zimbabwe economy was in a nadir. Economic activity was low, the stock market was depressed, there were fuel and electricity shortages, there was very little money around and trading in USD was banned. Since mid-2020 when the government legalized USD trading, banks have begun to extend USD credit, the economy has opened up and the construction industry has boomed. Since the late 1990s, I would say the construction industry has not been this vibrant.

Third owner usually benefits

It is often said that the third owner usually gets the highest returns from a big project. The initial developer who conceives a new real estate venture usually only puts down 5% or 10% equity, with the bank funding the balance. In Zimbabwe, because bank credit is tight and interest rates are high, a higher percentage tends to be equity funded.

Because of all the moving parts and cycles mentioned above, the developer can run into difficulty, in which case they lose their equity, and the bank repossesses the land. An investor comes along and offers to buy the land from the bank, often at an attractive discount from what the development has cost to date, and when a lot of time and cost has already been sunk into the project.

Marks writes that investors who bought the halted projects often benefit from:

  • The ability to buy the development for less than the developers had invested in land, planning, and construction of the structure;
  • The reduced cost to complete the development at lower prices for labor and materials in a non-boom environment
  • The shorter period remaining between the onset of their involvement and the completion of the building;
  • The possibility that stalled projects purchased in bad times might come onto the market in good times.

In short, the investor is buying the asset when the upside potential far outweighs the downside potential, something Marks talks about as key to investment success generally.

A similar analogy can be applied to gold mining, given the long lead times in development, but different supply/demand dynamics. Our group purchased some Zimbabwean gold mining assets in 2016. The previous owners, being international firms with deep pockets, had sunk millions of dollars into exploration and development of the mine but were unable to make the mine viable. The group bought another mine too which had been developed in the late 90s, then went into care and maintenance for many years, and was acquired at a sizeable discount to cost.

The price of gold was around $1,200 per ounce at the time. In hindsight, the mine was purchased at a good time, when a lot of cost had been sunk and “school fees” had been paid. In short, we were in some senses, that “third owner”, who came in at the right time, and put ourselves in a position where the upside potential outweighed the downside risk and the odds of success were on our side. The mine is now listed on the VFEX and trades at a market value significantly higher than the value at which the mines were initially acquired.

Consider the actions of other players

Marks points out that when economic players make decisions they often fail to take into account the actions of others. Say for example a developer sees demand for 200 homes to be built in a town. He may decide to build 40 homes, being 20% of the demand. However, what if ten other housebuilders have the same plans. This means that 400 homes will be built, which is double the number of demanded homes, therefore leading to vacancies, lower prices or rents, and poor returns for the investors. In addition, if these homes come onto market at a time when the economy has slowed, then these issues are amplified.

Application to Zimbabwe fuel retail sector

I see this happening in fuel retailing in Zimbabwe. Over the past two or three years there has been a proliferation of fuel stations across Harare and the country. Operating a fuel station is a profitable business in Zimbabwe now with a strong return on investment. It costs about $400,000 to build a fuel station, and retailers make about 10c per litre of gross profit. A well-located station will turnover about 300,000 litres per month, which equates to $30,000 gross profit per month, and say $25,000 operating profit after overhead costs, indicating a payback period of one and a half years.

In our shopping centre development alone, we have a fuel station ready to open. A fuel station has recently opened across the road and I believe there are two more planned in the same vicinity. This means that the four fuel stations will now battle for a share of the profits. Ultimately the most profitable one will be the one that offers the customer the most value (cheapest fuel (or best value per type of fuel e.g. unleaded versus blend), ease of access from the main road, and other amenities such as windscreen cleaning/car wash/drive thru restaurant etc.).

Key Lessons from Marks

  1. The real estate cycle is distinguished from the normal credit cycle due to the long lead times from conception to completion of real estate projects;
  2. Projects that begin in good times have a chance of being completed in less good times;
  3. Developers should constantly be on the lookout for additional supply of similar property which is being developed concurrently that may come onto the market at the same time, increasing supply, and potentially leading to vacancies. There is an element of game theory to apply here;
  4. The best returns often accrue to investor who buys the property in distress and rode the up-cycle, rather than the developer who first conceived the idea, or the banker who funded the project.