Robust Real Estate
5 Factors to Determine if a property is "anti-fragile"
An old investment adage says that there are “fish for trading and fish for holding”. I don’t know the origins, as most fish don’t seem great for holding. For real estate it is true that some properties are more suitable for long-term holds than others.
But what real estate fits this long-term profile? One question to help: “Is time a friend or an enemy to this property?” Close your eyes and imagine the building, neighborhood and market in 5, 10, 20 years. Is it better or worse?
I recently finished re-reading the book “Anti-Fragile” by Nassim Taleb. His central argument is that “fragile” things are susceptible to chaos, stressors and time. A teapot is fragile because a small stressor will cause damage. Over time, a teacup is less likely to survive than is a doormat or a wool hat.
Items that are “anti-fragile” are not only robust to chaos, stressors and time, but actually benefit from them. These are often organic items with a feedback loop. For instance, our immune systems are anti-fragile, as exposure to a stress like injury or germs makes us stronger through time.
Long-term real estate investors want to steer clear of teacups. Time itself is a cumulative scorecard of all the possible stressors a property could face. A longer time horizon makes it more likely something bad will happen. We want to identify properties for which time is a friend. To do that, let’s examine five factors to identify a property’s robustness.
Diversity
Diversity enhances system robustness and resilience. Monoculture farms grow a single crop every season and are used by large agriculture firms due to increased “efficiency” and larger scale. However, repeatedly planting the same crop year after year depletes the soil of essential nutrients, decreasing crop yields and requiring the use of fertilizers to maintain productivity. Polyculture farms are more balanced, with fewer pest outbreaks, less soil depletion and more future optionality.
Detroit was a very wealthy city in the 1950s, but heavily concentrated in the auto industry. San Francisco was concentrated in tech heading into the migration instigated by Covid. Both cities faced stresses and found themselves vulnerable. New York – more diverse and dynamic than San Fran – has performed better, as its diverse economic base allows it to response to various economic changes.
Organic
Top-down, centralized systems are fragile. The Soviet Union was fragile, and then it inevitably broke. Smaller units such as neighborhoods are more robust, as decision-makers have more at stake, information flows more freely, and there are fewer principal-agent problems.
Large, centrally planned cities are unsatisfying, because they lack the feedback loop to recognize changing human needs for real estate. Brasilia was planned in the 1950s and built in the 1960s to become the new Brazilian capital, instead of chaotic Rio de Janeiro. Do you ever hear people rave about Brasilia? It is far cleaner and safer than Rio, but which would you prefer to visit?
Like neighborhoods, properties themselves should evolve through time. Consider the contrast between Mall of America in Minnesota and The Grove in Los Angeles. Like most Malls, the MOA was built all at once, with little allowance for the future changes in retail. The Grove has gone through various iterations since its original construction in the 1920s. The Mall of America is far more fragile over the coming decades, as the monolithic construction allows less flexibility.
The image below shows two different areas of New York. On the left is public housing, built by the central planner and builder Robert Moses. On the right is SoHo, the favored neighborhood of Jane Jacobs, who argued that people themselves are the key to neighborhoods and that neighborhoods should organically evolve.
Leverage
Debt has a complicated relationship with fragility. On the one hand, lenders themselves are the most fragile players in the system, having sold an option to the borrower. Banks are currently finding themselves in this position, owning all the downside and none of the upside of the properties on which they have made loans
However, heavily levered borrowers are also fragile to volatility and uncertainty. An investor who consistently overleverages his positions is playing Russian roulette and will suffer when the inevitable volatility comes.
We can use Harry Macklowe and Jamie Dimon as examples. Macklowe’s aggressive debt made him fragile to the property declines of the GFC, while Jamie Dimon’s business is inherently short the debt option. On the other side is Warren Buffett who uses debt prudently and sits on billions in cash, waiting for the volatility that will harm the Dimons and the Macklowes.
Optionality
In nature, those organisms most adaptable to changing environments have thrived while animals with very specific skills were most at risk when the environments changed. The Wooly Mammoth dominated during the ice ages. However, when it got warmer, its thick fur become a disadvantage, and they were unable to compete. Honeybees, on the other hand, have honed their communication and social structures over millions of years, allowing continual adaptation.
The question to ask: if the world changes (the city, neighborhood, demographics, traffic patterns, etc.), is it likely that my building will become more or less valuable?
For examples of optionality, I walked 50 yards around my office in a neighborhood outside Boston. There are few large properties. The wooly mammoth is a 60,000 sf office building. The honeybee is a block of street level retail with some second story office space. In 20 years, which of these buildings will be here? Which will have the better opportunity to respond to a changing world?
Asymmetry
Similar to a property with potential optionality, robust long-term investments should be those where things are more likely to get better than to get worse. Some examples (italics indicate what I consider positive asymmetry):
- An empty building or a full building?
- A property with above or below market rents?
- A property that has had world class management or one with poor management?
- A property at a low use (industrial, self-storage) versus one at a “high” use (hospitality, life science)?
- A property with well-known, high credit publicly traded tenants or no credit?
- A property with a world class brand or no known brand?
Strangely, most of what I suggest makes properties fragile is precisely what many core funds and institutional investors want to invest in! They are in the business of buying fully priced downside asymmetry.
Just like the Wooly Mammoth, I believe that a building that is currently at its highest and best use is the most fragile. Today’s Wooly Mammoths are data centers. Institutional investors love them but they seem extremely fragile, hugely capital-intensive beasts susceptible to any number of outside forces.
There are two office buildings shown below. The Biolabs innovation lab building (on the left) is a beautiful, newly built building in an A+ location that hopefully will stimulate more innovation in the UNC ecosystem. The property on the right is an empty office building in a business park in Huntsville, Alabama. Exactly the type of property people hate right now.
For investors looking to acquire one of these properties, I would argue that the building on the right is safer and has more investment upside than the Life Sciences building. This of course, assumes a significant pricing difference. Life science buildings are an expensive bet so let’s assume the cost here is $500-600 per foot to build, requiring significant rents to earn adequate return. The property on the right is 120,000 SF and likely to sell at around $60/SF.
An empty building is often safer than a full building. But risk averse institutions and core funds would always prefer the pretty, full building.
So what would be the perfect real estate property that is close to Anti-Fragile? I would argue something like an older strip center or Class B multifamily in an emerging neighborhood. It will provide cash flow and maybe some near-term upside through minor enhancements. Over the long-term the land will appreciate due to the densification and the owner will have future options on redevelopment.
When the neighborhood gets better, the option value will be clear and developers will price it into the land. They will build a pretty life science or data center Wooly Mammoth and sell that to an institution.
