When Investments Don’t Work Out as Planned
What would you do if you made an investment that lost $11,000,000,000? Yes—not a typo. BILLION. Or how would you respond after pursuing a new tenant only to learn they decided to lease from your competitor? Or how would you determine why your offer to purchase an investment property wasn’t accepted by the seller? Blowing an investment, being outbid, or losing an opportunity to your competitor isn’t easy or fun. However, losing provides every investor the opportunity to step back, reflect, be humble, analyze and assess. And to ask the hard questions: What led to this outcome? What could have been done differently? And, what improvements can be implemented to ensure success next time?
In early 2021, at Berkshire Hathaway’s annual meeting, CEO Warren Buffett announced that the company earned $42.5 billion in 2020. Nearly 100% of all investors would love to earn that much in one year. However, Buffett also acknowledged that the results included an $11 billion write-down of its investment in Precision Castparts Company (PCC), an aerospace parts supplier that Berkshire purchased in 2016 for $32 billion. Buffett said, “I paid too much for the company. No one misled me in any way. I was simply too optimistic about PCC’s normalized profit potential.” He added, “I was wrong… in judging the average amount of future earnings and, consequently, wrong in my calculation of the proper price to pay for the business. PCC is far from my first error of that sort. But it’s a big one.”
The Investment Autopsy
So, what was Buffett actually doing here? He acknowledged the outcome, took responsibility, was humble, reflected on what led to the loss, and recognized how to prevent repeating the mistake.
Determining the causes of a loss should be a process, much like a medical examiner performing an autopsy on a cadaver. It should be without emotion, non-accusatory, clinical, harsh, but also honest, and eye-opening; it can provide an investor with valuable insights to help ensure future successes and long-term portfolio profits.
No need to wear latex gloves, but let’s examine the process of performing an autopsy on a blown investment as well as methods of prevention.
Blown Investment Dissection Points
1. What was the basis of your investment thesis?
When investing in a publicly traded stock, your decision is generally based on a belief that either the stock price is undervalued, or that a catalyst will occur to increase the company’s earnings. Occasionally a good company’s stock price can be depressed due to overall negative investor sentiment in the sector (i.e., industry) or overall economic issues, such as a forecasted recession. Alternatively, you may believe that a company’s earnings will increase due to an innovation, adding a new market (such as international) or buying a competitor. These types of catalysts typically increase stock prices. But what if that catalyst doesn’t occur as expected? Investors should regularly review their investment hypothesis, consider more recent events and market conditions, as well as reevaluate if their beliefs are still valid.
Investor sentiment in various real estate property types can shift, as it does with the stock market. Between 2000 and 2010, investor interest was much stronger for office buildings than it was for warehouses. As a result, Kenwood focused on acquiring warehouses during this time. After 2010, investor sentiment flipped from office buildings in favor of warehouses, leading to warehouse pricing reaching historic high levels. Kenwood’s investment focus has tended to be contrarian, but also founded on specific criteria and metrics. Historically, this has produced high returns for our investors.
2. Reconsider your underlying assumptions.
Every investment decision is based on certain underlying assumptions, such as corporate sales growth for stocks or improving occupancy or Net Operating Income in real estate. Many publicly traded companies inform investors of forecasted sales projections during their quarterly conference calls.
At Kenwood, we regularly compare current lease assumptions and operating costs against our original underwriting model to ensure that we remain on plan.
3. Did you have realistic expectations on timing and returns?
Although investors hear stories of explosive returns over a very short time period, this rarely occurs. Recognize that your investment return goals may take longer to realize than initially thought. It doesn’t mean your investment thesis is wrong, but it may take longer to fully materialize.
Kenwood’s real estate investments are generally long-term focused. By not selling into an unfavorable market, we have been able to enhance investors’ returns, especially when compared to the S&P 500.
4. Did external circumstances change?
An investment theory is always based on certain external assumptions, such as interest rates and GDP growth. As external circumstances change, they will impact your investment. All investments carry some level of risk that is outside an investor’s control. The overall economy being the prime example.
In our real estate business, Kenwood has developed many investment criteria metrics. Being disciplined and focusing on market fundamentals reduces the likelihood of investment mistakes, even as interest rates increase.
Lost Real Estate Acquisitions
When commercial real estate properties are being sold in a widely marketed format, brokers utilize a “blind bid” as opposed to an open auction where every bidder knows the highest bid. Since blind bids are made without knowing the high bid, it can result in an investor’s offer being significantly higher than other offers. To avoid this, be conservative but realistic, in addition to being prepared to lose often. At Kenwood, our experience has been that we are outbid at a 10:1 ratio. Certainly not “hall of fame” statistics, but winning blind bids too often means continually overpaying and that is not a long-term successful strategy.
Inflated offers can result from many factors, including utilizing overly optimistic underwriting assumptions, such as higher market rent, or larger rental rate growth. This was Buffett’s error with Precision Castparts Company.
Some real estate investment companies partner with foreign investors who frequently have lower cost of capital and are willing to accept lower returns. Section 1031 exchange buyers can also be more aggressive because the tax consequences related to not reinvesting their funds can outweigh the need for a normally desired return level.
When Kenwood is not the high bidder, we look to perform an investment autopsy by contacting various sources. Investment sales brokers will generally share some information with us, but we often seek out information from multiple sources to develop a full understanding where our analysis fell short.
Missed Leasing Opportunity
When we lose a prospective tenant to a competing property, understanding what led to that decision is similarly valuable. Rent can be the prime differentiator, but more often, other factors impact the tenant’s decision. Sometimes it is simply which property is the shortest distance from the owner’s home. Sometimes it’s a prospective tenant’s ability to visualize themselves in the space. This highlights our strategy to create spec suites with staged furniture, which we have found to be very effective.
Sometimes, business owners want to know their Landlord and value the ability to easily contact them. Local ownership benefits from this because institutional owners are frequently in other cities making the landlord-tenant relationship more difficult to establish. At Kenwood, we promote the value of local ownership, meet frequently face-to-face with every tenant, and provide them with our principals’ cell phone numbers to facilitate a readily accessible relationship and a better collaboration between landlord and tenant.
Kenwood Management is always looking for new investors to join the Kenwood Community. Learn more about our investment services and how you can generate steady and secure commercial real estate gains with our team of experts.