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The first question Sam Zell asks when someone offers up an investment opportunity is “Where’s the demand?” he explained at the 62nd CFA Institute Annual Financial Analysts Seminar.
“Opportunities are completely connected to demand,” he told moderator Sameer S. Somal, CFA. “I’m a student of demand and when demand is there, I look at the cost of fulfillment.”
The fundamental law of supply and demand is one of Zell’s governing principles in his investment decisions, whether he’s looking at commercial real estate, asset-intensive industries like oil and gas, or manufacturing in developed or emerging markets.
He keeps an eye out for supply-and-demand imbalances and likes situations where supply is shrinking or nonexistent. In his recent book, Am I Being Too Subtle? he says that “much of my career has been about understanding and acting on this basic tenet.”
A voracious reader, Zell studies the macroeconomy as well as individual businesses. Today his biggest worry about where global economic growth is headed is the overall lack of demand. “If there is a worldwide shortage or crisis, it is a shortage of demand,” he said.
Excess Supply: US Commercial Real Estate Markets
Well known for his successful commercial real estate (CRE) ventures, Zell told the audience that after the financial crisis, real estate markets seized up and despite low interest rates, industry participants stayed on the sidelines. Then, two or three years into the recovery, everyone started building at the same time, leading to the excess supply scenario we have across nearly all CRE sectors in the United States today.
“Last year, I was saying that the CRE industry was relatively benign and supply and demand was in balance,” he said. “In the last 18 months, however, there has been an enormous increase in supply.”
Zell is concerned about oversupply in nearly every segment of the real estate market.
Growth in multifamily residential units is at an all-time high, he observed, with 380,000 being added in 2017 — a pace not seen since 1972, a time when the sector was the only game in town.
Office space supply is rising when occupancy rates are on the decline. Due to secular shifts in the way we work — towards higher density workspaces and more efficient use of space — occupancy has fallen from 240 square feet per employee to 180 square feet, maybe less.
“We are behind the rest of the world in terms of adapting to shrinking office space,” he said.
Zell says retail space has a difficult road ahead given excessive supply, though he believes there will always be room for brick and mortar. “Only the very top-end malls and the very bottom ones are doing okay,” he said. “Anything in between is obsolete.”
Hotels in major cities like New York and Chicago are overbuilt by about 20%, he said. The only segment that has an appeal from a supply-and-demand perspective is mobile homes because of how difficult it is to obtain park permits and because of the “not in my backyard” (NIMBY) stigma associated with them.
On housing, Zell noted that the delay of marriage is the single largest demographic trend that is transforming the market. “Just like Levittown and suburbia grew up after World War II, now we’re replacing suburbia with 24/7 cities,” he said.
This has had a negative effect on bedroom communities, starting with the upper end. “Just look at places like Greenwich where mansions are just sitting without buyers,” he said.
Opportunity for Growth and Scale in Emerging Markets
In the 1990s, Zell and his team were intrigued by the opportunities in emerging market real estate platforms and other types of emerging market companies and started investing. Even though the potential for strong returns was much higher, Zell’s team wasn’t deluded about the trade-offs. “Investing in emerging markets is a bet on growth,” he said. “But what’s being given up is the rule of law.” That compromise is one he never takes lightly.
One of the ways Zell manages risks in emerging markets is by finding the right local partners. “Many times the quality of the investment is based on the quality of your partner who can give you a much better chance of success,” he said.
He also feels it’s critical to visit companies on their own turf. “I’m making decisions about people every day,” he said. “I must see them in their own environment, see how they operate, and how they treat their own.”
The ability to scale is another key driver in Zell’s emerging market investment decisions. He likes Mexico and Brazil in particular because of their potential for growth, scale, and important geographical locations. In addition, Zell understands that investing in emerging markets requires more agility than in the United States. Over the years Zell has been in and out of Brazil. Now with signs that the Brazilian economy is turning, he’s back in.
What’s the Difference Between Quantitative Easing (QE) and Printing Money?
Zell believes we don’t yet know the unintended consequences of monetary policies in the United States, the eurozone, and Japan since the financial crisis. “When I was coming along, ‘printing money’ was called inflationary. Now it’s QE. I’m not sure I know the difference,” he said.
After eight years, Zell believes the economic recovery is long in the tooth and that some kind of recession is likely.
As to whether health care, tax, and infrastructure reforms will be passed by the US Congress, Zell is skeptical. “Sometimes the stars come together and they’re able to get consensus behind something,” he said. “President Trump will go down in history as having had an extraordinary opportunity. Whether or not he’s able to take advantage of the opportunity remains to be seen.”
Zell has never seen a period in his lifetime with more headwinds or more questions without answers than today. He believes conventional wisdom is mistaken by looking at geopolitical risks one at a time. He tries to view each as part of a whole. “We have a different world today and there are lots of players with different values. There is enormous unsettledness,” he said, noting that this manifests itself in a lower global growth rate.
As for his views on interest rates, Zell said that rates are a function of demand. The risk-free rate averaged 5.6% over the last 25 years, not counting the last seven. Will it return to that level? Unless there’s a change in demand, Zell said the answer is no.
“But I’m not ready to X demand just yet,” he added.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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