We are now officially six years beyond the unforgettable (and not for good reasons) year of 2008. While 2008 was more painful than I care to relive, I feel fortunate that Altus has been able to bounce back so successfully. In the last six years none of our investors have taken a loss on any of our projects, which number in the hundreds. That isn’t to say that we have always produced our proforma numbers, which if true would be something to brag about for years to come, but we can say our performance and investment structure has shielded our investors from loss. As we move into a new year, and with several large purchases being negotiated, we hope to be able to say the same thing at the end of next December, one year from today.
With one year ending and another just beginning I will try to keep this month’s article shorter and more to the point than I often tend to do with a quick jaunt through the news, starting with some local news that is a good reminder for all of us.
An Unfortunate Wakeup Call: On Christmas Eve our local newspaper provided the shocking headline that the CEO of Warren Capital, who had passed away suddenly in November, had apparently been running a large Ponzi scheme. I never met the man but knew of the company and to my knowledge he ran a respected company. For selfish reasons I hate to see stories like this since it sheds such a negative light on all alternative asset companies, including Altus. There are thousands and thousands of alternative asset companies across the country run by individuals or teams with impeccable ethics and morals, yet when something like Warren Capital occurs these companies are then viewed in a skeptical light. But skepticism is actually something all investors should feel prior to making any investment. Even without taking dishonesty into account there are millions of bad ways to invest money and without a healthy dose of skepticism it is far too easy to invest in any one (or dozens) of these bad investments. Shoot, even a cynical yet successful investor will still suffer the occasional bad investment. A couple particular items from the Warren Capital article stood out to me as clear indications that the investors investing in/through Warren Capital had lost their skepticism:
- Warren Capital had $23 Million of investment on its books but only $300,000 in security.
- Warren Capital promised its investors returns of between 8.5 – 10.25% per quarter.
- Warren Capital had 6 employees.
It should be pointed out that Warren Capital was effectively a hard money lender. As a hard money lender, $23 Million in investments should have been secured by $23 Million in loans. As a hard money lender there should have been recorded documents verifying the full investment amount. That only $300,000 in security existed against that $23 Million tells me that the investors of the company had stopped doing any sort of verification of what their money was being used for. Several of the investors of the company had more than $300,000 in their individual accounts. There may have been historical performance that justified some amount of trust in the investment professional but that such a huge discrepancy could exist between investment and equity means that no one was requesting proof of collateral.
Bullet point number two may not need an explanation. These hard money investors were making between 34% and 41% per year. It seems that Warren Capital was provided operating loans for companies, but companies can’t afford that kind of debt burden. And there is no reason why they would have to. Especially in current economic times where there is far less expensive money available. Any investor seeing these kinds of returns should have been skeptical enough to do research into the documentation of the investments of the company, where they would have discovered the missing collateral.
Were six people in on this scheme? Were six people this dishonest? Or was the scheme so sophisticated that not only were the investors snowed but the employees, including one with the title Chief Operating Officer, were also in the dark?
As someone who both runs funds and has invested in other sponsors’ funds I take away a couple simple lessons:
- Be skeptical and do your research.
- As relationships are built and results obtained trust will grow. It is natural that it should do so. Trust, but verify. Always require the appropriate documentation. Not only will this reduce the chances of fraud, but it will also diminish the chances for future misunderstanding.
- With online banking now being what it is it should be possible for fund managers to provide review access to investors. This won’t allow you as an investor to move money or pull out your investment, but it will allow you to see the flow of money in and out of the account(s).
- If the fund is investing in real assets then an audit of public records should be relatively easy to do. If the fund is buying real estate there will be a grant deed, and likely an accompanying deed of trust showing the fund as the borrower. If the fund is providing debt for real estate then there should be deeds of trust showing the fund as the lender. If the fund is providing working capital debt there should be UCC filings against the assets of the business favoring the fund as the lender. As the investment strategies become more complicated doing a public record audit may become more difficult, but documentation will still be available.
- When things look too good to be true they probably are. It doesn’t mean for sure it is too good to be true but it should at least warrant additional and more thorough due diligence.
I hope everyone that reads this article takes these items to heart, including in your dealings with Altus. We want intelligent investors that hold their principals to a higher standard.
Greenback Up, Green Crops Down: Over the past couple years the team at Altus has often discussed agricultural land for investment. Purely from a fundamental standpoint there are a lot of positive aspects to such an investment (scarcity of supply, low maintenance, etc) but over and over we came back to how high commodity prices were from a historical standpoint, and understood that the rapid appreciation of land prices were directly connected to those commodity prices. We found only one project during that time that interested us due to it producing a specialty product with high barriers to entry and being structured in such a way that our downside risk was mitigated outside of calamitous event. Unfortunately we weren’t able to put together the investment fast enough and the price of that opportunity increased to the point where the returns were no longer attractive. Otherwise we have done nothing, watching the land prices continue to increase and wondering if there will be a market adjustment that might create buying opportunities.
Earlier this month I spent some time talking with a farmer/rancher from Western Alberta. He told me of a rule of thumb (and I am paraphrasing) that a strong dollar leads to lower grain/vegetable based commodity prices and higher meat based commodity prices. This is because North America’s diet is far heavier on protein than most other parts of the world. As we have discussed in previous month’s articles, the US dollar is strengthening at a pretty remarkable rate. If the trend continues, especially in light of the signs of economic weakness coming out Europe, Japan, and China, we could experience a correction in the price of agricultural commodities. If that occurs land prices may not be far behind, and with it, buying opportunities.
Those Who Cannot Remember the Past Are Doomed to Repeat It (George Santayana): Only a few years removed from one of the greatest real estate collapses in our country’s history the largest secondary market buyers of residential mortgages have relaxed their requirements so that they will now purchase loans with only 3% down. Fannie Mae and Freddie Mac, those government sponsored entities, are of course the two largest buyers. We all know that buyers not having enough skin in the game is one of the reasons for so many people walking out on mortgages they could afford after the underlying values dropped. The first question is why is this necessary? After all, the Federal Housing Authority already insures mortgages with 3% down and there seems to be no shortage of money available to fund those loans. It is almost shocking how short our collective memories can be that such a move would be considered. Reading between the lines I think this tells us the government is concerned with the stall in the appreciation of home prices. Without home price increases, especially in many large markets in California and other highly regulated states, builders can’t afford to profitably build entry level homes. There is demand for low priced housing but there is no supply (as an aside, this is why we believe in the long term viability of multifamily properties). The government must be thinking that reduced down payment is what is holding back more buyers coming into the market. Maybe they are correct, but it is my belief that the down payment isn’t the problem (remember, FHA already offers these sort of loans) but rather how large a loan a family can qualify for based on their income. Average real incomes across the country haven’t gone up in over twenty years. Interest rates are historically low. The only way people are going to be able to afford more is for lending standards to loosen (neg. am. loans anybody?), interest rates to go down (even though we are now to a point of diminishing returns on lower rates since most of the payment is amortized principle), or an increase in income. Based on a 4.25% rate standard 30 year amortized home loan, for every $1000 increase in annual income the maximum loan amount obtainable goes up roughly $8000. Said another way, a 45 cent per hour raise supports a 4% increase to the Phoenix median home price. This equates to roughly a 20 – 25% increase in the gross margin percentage for builders. There are few businesses that wouldn’t be ecstatic about those kind of increases in their margins.
Maybe I am wrong and these new reduced down payment lending standards are just what the residential market needed to reignite its recovery. Only time will tell. And only time will also tell if we are destined to repeat a collapse in prices that led to the Great Recession.
From all of us at Altus, we thank you for reading our thoughts on investing and economics. For those of you who already invest with us an even larger thank you. The success of our business not only benefits you, it also depends on you. If you are reading this and haven’t yet had the opportunity to invest or partner with us we look forward to making that happen in 2015.
Here is to a prosperous and healthy 2015,
