Quarterly Reports: Real Deals

Real Deals

Here's $25,000; I'm giving you a choice. You may invest it in a musical comedy about four dead nuns, in Iowa farmland described as consisting of "poorly and very poorly drained soils" or in a real-estate partnership consisting of three apartment complexes and two motels.

Take your time. Twenty-five thousand dollars is a lot of money. Which do you go for--the dead nuns, the poor soil or the motels?

Ah. I knew you'd say that.

Well, the answer is no. You can't just take the cash. I know you. It would be gone before you could say 380SL. I want you to invest this money. And, no, you can't just spread it over all three choices. Great fortunes are not built by hedging bets. They are built by the bold stroke--that special insight that allows one to distinguish the nuns from the mud from the motels.

Being a bit of a wuss myself and possessed of no such special insight, I put a little something into each. But I'm giving you the $25,000, so I get to set the rules. Choose, Charley: dead nuns, poor soil or the partnership.

I guess you need a little more information.

The play about the nuns is called Nunsense. The music is terrific, the lyrics are tasteless and sophomoric but ultimately pro-nun, and the plot--well, briefly, this is the story of the Little Sisters of Hoboken, 19 of whom were out playing Bingo when Sister Julia, child of God, served tainted vichyssoise to the rest. The 19 return to find their 52 sisters face down in the soup (let me say again: The show is, at heart, pro-nun), whereupon they bury 48 of them (all of this off stage, to keep the cast down to five sisters and a band), and the remaining four--well, there was much sentiment for burying them, too, but funds were scarce and Mother Superior decided to put them in the freezer and buy a Betamax for the convent instead.

As the play opens, the New Jersey Board of Health has threatened to shut down the convent if the sisters don't get those four blue nuns out of the freezer and into the ground by tomorrow morning. So the sisters have, in desperation, thrown together a little talent show to raise the needed funds.

In short, your basic nun-poisons-nun, nun-buries-nun musical comedy.

The farmland is in western Iowa. It's flat--no problem with its washing down the hill onto someone else's farm--but its soil is not like that rich brown earth on sale in sacks at Sears. It's more like the surface of a clay tennis court. Of course, as any tennis buff knows, vegetation can grow through clay if not properly discouraged. Encouraged, it can grow as high as an elephant's eye.

This particular land can produce 100 bushels of corn per acre (not 100 bushels of ears, I was amazed to learn--100 bushels of just the little yellow kernels themselves) unless, because of its very poor drainage, showers have turned it into a lake during what would otherwise be the relatively brief opportunities for planting and harvesting or drought has turned it into a desert during the growing months in between.

The real-estate partnership includes five separate, existing, attractive operating properties in Virginia Beach, Sacramento, Fort Lauderdale, Indianapolis and Tomball, Texas. Unlike the nuns and the farm--tiny, private offerings--this is a multimillion-dollar partnership put together by a large real-estate syndicator.

(A real-estate syndicator arranges to buy property jointly with a bunch of dentists and airline pilots. The syndicator, or general partner, puts together the deal; the dentists and the airline pilots [limited partners] put up the money. Whatever profit or loss the property generates, after certain fees to the general partner, gets passed through to the limited partners. If it appreciates, the partnership may either sell it, with the investors taxed on the gain, or take out a bigger mortgage, with the investors sharing, tax-free, the extra $5,000,000, say, borrowed against it.)

In this deal, the syndicator guarantees distributions to the limited partners of at least six percent (shielded from tax by depreciation) in the second through the fourth years of the deal, even if the revenues from the three apartment complexes and the two motels lag behind their projections. Projections call for considerably higher returns thereafter.

So now are you ready to choose? Yes, you are. You have long since figured out that this must be a trick question, so the solution is simply to pick the worst possible investment. A lot of us--perhaps feeling that life itself is something of a trick question--seem to choose our investments in very much the same way. (Surely you know someone who has proclaimed that from now on he'll beat the market simply by deciding whether a stock should be bought or sold and then, because he's invariably wrong, doing the opposite.)

But in order to beat this trick question competently--if it is a trick question, and I didn't say that it was, just that you'd concluded it must be--you have to decide which of the three is the worst investment, and for that you need more information.

Did I mention, for example, that the "large real-estate syndicator" guaranteeing six percent minimum distributions (and whose name I'm sure you noticed I did not reveal, to make you smell a rat) is actually a well-regarded, highly profitable New York Stock Exchange--listed firm? The guaranteed distribution checks have been arriving quarterly, like clockwork.

Did I mention that the bricklike Iowa soil comes with a water well and a gigantic pivot sprinkler, unlike anything you have ever seen on your lawn or any other? (It looks like the world's tallest crane, keeled over on its side, with a well at its base and big rubber wheels at intervals for support as it imperceptibly describes a lush, wet circle around the parched farm, except for the corners, on which you could bake bread.) This enormous piece of machinery (if it works) helps ensure that, drought or no, in most years we'll get our 90 or 100 bushels per acre. Eighty, anyway.

Did I mention that this land sells for just $500 an acre, compared with the $1200 to $1500 it fetched just a few years ago, when inflation raged and farmland was hot?

You should also know that the U.S. is swimming in corn; that this land is not suitable for raising aspartame, aloe or artichokes; that corn prices fell to less than one dollar last year for the first time since 1953 (so at 100 bushels an acre, you're talking $100 an acre in revenue, less maybe $75 an acre in seed and fertilizer, for a net profit--before the cost of labor or of equipment or of the land itself--of $25 an acre); and that your tax dollars effectively kick in another dollar or more per bushel in Government subsidies, bringing the true revenue per bushel up closer to $2.50 (and the "profit" per $500 acre to more like $175 in a good year), except that there's no telling how long Uncle Sam can continue these mind-boggling subsidies.

Oh, yes. Will Rogers said, "Buy land; they're not making any more of it." And we've all seen Gone with the Wind.

As for the nuns, did I mention that, as investors in the original off-Broadway play, we would be entitled to a small piece of all ancillary rights, such as movie rights, sitcom rights(The Flying Nun's been done, but never a sitcom about dead nuns), recording rights and royalties on out-of-town productions? Did I mention that virtually all New York theatricals, whether on Broadway or off, lose their backers' money? I've invested in several--a Mike Nichols--directed award winner, a show by the author of A Chorus Line, a musical about the first woman ever to run for President, to name three--and to date have gotten back, in total, $146. Even the big hits that run a year or more often fail to return their backers' money, let alone a profit.

Now are you ready to choose?

I grant you there's a lot more you need to know, but that's always true. And even if you knew it--if you read the 200-page real-estate prospectus, with descriptions of and computerized projections for the three apartment complexes and two motels; if you went out to Iowa and kicked the tires of the pivot irrigator and boned up on U.S. farm policy; if you read the Nunsense script and saw the sisters sing and dance--there would still be more you had to know. Are the people you're relying on honest? Have they been realistic in their projections? Will we have inflation or deflation? Will the demand for corn sweeteners surge? Do Catholics have a sense of humor? (Is the Pope Catholic?) And, as always, if this deal is so good, how come they're offering it to us?

So this is it. Seriously. Write your choice here, in ink,------and then read on to find out how, as of this writing, these deals are working out.

I bought the farm last year, because it was about as bad a time to own farmland as anyone could remember. This doesn't mean that by the time you read this, things won't be worse (buy more!); but when loads of people want to sell and almost nobody wants to buy, that's sometimes a sign of a bottom. After all, food is always likely to be worth something, and without farmland, it's hard to grow.

I was struck by the fact that for the same money, one could buy either a single condo parking space in Boston's Beacon Hill garage or a 120-acre farm. Somehow, I felt that the farm might be more productive in the long run--never mind the fact that within two miles of Beacon Hill it is truly impossible to find a place to park.

When the massive Government farm subsidies erode, as it seems inevitable and not unreasonable that they will, only the more economical farms will survive. The marginal land, presumably, will go out of production. Prime farmland in the Midwest these days runs more to $1200 (down (continued on page 148) Real Deals (continued from page 121) from $2750) than to the $500 I paid. Whether or not it will remain economical to farm my vast clay tennis court remains to be seen. In the meantime, it's rented to a farmer who owns land nearby, and it throws off eight or ten percent a year in rent after expenses (principally, property tax and a management fee).

Those of you who chose to sink your 25 Gs into the farmland: Smart move, guys! (I hope, I hope, I hope.)

(If you have just inherited half a million and want to risk a fifth of it on 80 acres of prime ground in the nation's heartland, or 160 not-so-prime acres near me, two of the hundreds of farm managers who may be eager to help are Murray Wise of the Westchester Group in Champaign, Illinois, and Richard Thoreson of Security National Bank in Sioux City, Iowa.)

I went into the real-estate deal because it was geographically diverse, because its attractive projections were based on existing, operating properties and because I wasn't keen on paying 59 percent of my income in Federal, state and city taxes. (This was in late 1984, before Congress killed, retroactively, much of the tax advantage of investing in real estate.)

Even so, I have always had a problem with real-estate syndications. Most of them eat up about 15 percent of your investment in syndication fees and sales commissions, leaving only 85 percent or so actually to be invested in real estate. Lots of investors accept this haircut who would never consider, by way of contrast, paying $205,000, say, for a house they know is really worth only $174,000. Yet that's the difference 15 percent makes.

Not only that, real-estate syndicators, in their hurry to get something to syndicate, haven't always the same incentive as you or I. Where you or I might hold out for something really irresistible, the syndicator may very reasonably pay fair market value--which is to say full market value--or perhaps even a little more. After all, it's not his money. And how many dentists and airline pilots know whether a shopping center is worth $4,900,000 or merely $4,300,000, anyway? What's more, if inflation comes roaring back and this shopping center is sold for $20,000,000, who cares? so what if the investors put up $5,750,000 to buy for $4,900,000 (what's left after 15 percent in fees) a property that a really tough, patient negotiator might have snagged for $4,300,000?

The syndicator would certainly like to see you do well--he likes to do a good job, just as you do, and the better you do, the better he'll do, both in future business from you and because he shares in the ultimate profits on the property. But most of that incentive is years off. The incentive now is to put tens or hundreds of millions of dollars' worth of deals through the pipeline, getting an immediate cut thereof. That's what stocks the refrigerator and fuels the private jet.

Anyway, for those of you who placed your $25,000 on the three apartment complexes and the two motels, I have bad news. It turns out that things have not been going so well. The memos you've gotten from the general partner are cheerful, to be sure, and your quarterly checks come just as promised; but the 1985 financial statement, issued in the summer of 1986, tells a worrisome story. Revenues from all five properties have been lower than projected. They're not just generating tax losses (what with the depreciation), they're generating huge real losses.

So what else is new, right? But there's a distinction here. It's one thing if you go into a chancy gold-mining deal and--guess what--it doesn't pan out or if you buy into an office building in Houston and then, months or years later, the price of oil collapses.

You pays your money, you takes your chances. Nobody likes a sore loser.

But in this case, you bought into five operating properties in late 1984. Isn't it odd that all five, in different parts of the country, should turn in results sharply below projection for 1985? Was there a recession in 1985? I missed it. Were there unexpected economic shocks or a sudden steep decline in motel occupancy? No, 1985 bumbled along much as 1984 had.

Yet here were the property-by-property projections for 1985 used to sell the deal in late 1984, and now here were the actual 1985 results. Rent had come in eight percent under projection from the Fort Lauderdale apartments, 21 percent under projection from the Virginia Beach apartments and 26 percent under projection from the Tomball, Texas, apartments. (Did your rent go down 20 percent in 1985?) Gross revenues from the Sacramento and Indianapolis motels had come in 26 percent and 27 percent under projection, respectively, while their "cost of sales" had unfortunately come in 43 percent higher than projected.

Bad results or no, the mortgages still had to be paid, along with some other expenses, leaving a nearly $2,000,000 cash shortfall on an over-all investment by the partners of just under $8,000,000.

That's not much of a shortfall for a Third World nation (let alone our own), but it's a lot for three small apartment complexes and two motels. Is it conceivable that the projections were based more on what it would take to make the deal look good than on the professional judgment of a New York Stock Exchange company? (Is that the way the world works?) Yes, the general partner is making cash distributions of six percent per annum anyway--those checks just roll in--but they take the form of loans to the partnership and, in any event, cease after three years.

Now, you say, calm down. They got off to a rocky start. Given two or three years, those 26 percent shortfalls in revenue will gradually disappear and everything will be fine.

But it's not enough that the projects eventually start bringing in what they were projected to bring in for 1985, because even had the partnership performed as projected in 1985, it would have lost real cash money. Fundamental to the eventual success of the deal were substantial annual improvements in net operating income--higher sales and/or lower expenses--so that there would be enough left over to pay the mortgage. (Not pay it off; just pay the interest.)

The general partner projected that for 1986, "net income before other expenses" (such as $3,468,510 in mortgage interest) would outstrip the 1985 target by 15 percent. And perhaps it did; the numbers are not yet in. To have done so, however--to have gotten back on track (even without recouping the 1985 shortfall)--would have required a jump in such net income of 160 percent. And then, to stay on track, another 12 percent gain in 1987, ten percent in 1988, ten percent in 1989 and--well, there's not a lot of time in these projections to stop and catch your breath.

Anyhow, having studied the projected and actual numbers, which neither I nor most investors, I think, generally do, and having noted that all five geographically diverse projects were performing under projection, I placed a call to the general partner to comment on the coincidence.

"You sons of bitches robbed us blind!" I said--though not quite that way.

"What's the problem?" the investor-relations department said. "The program's going to work out great!" (Again, I am paraphrasing liberally.) "It's just that the economy was terrible in 1985."

"It was?" I said.

"Well, and we're not sure the sellers of the motels were entirely candid in their representations to us."

Now we were getting somewhere.

I muttered something sweetly about "due diligence" and a couple of other legal phrases I don't really understand but that I thought might conceivably apply, and within minutes--in the scale of time at which things like this move--the general partnership had agreed to buy back my interest. (Not for as much as I had paid, to be sure, but for enough, after taking into consideration the tax benefits I had received less the taxes I'd now have to pay, for me to come out whole.) "We think it would be unwise for any investor to sell out," read the gracious letter. "Nevertheless, if you are dissatisfied and wish to sell at this time...."

Whether or not any other limited partners took the time to compare the annual statement with first-year projections and whether or not, if so, any of them squawked, I cannot say.

But if you chose this deal for your $25,000, it would not have paid you to do so.

And now for the nuns. I know that's what you chose, hard as I tried to deflect you. You're not stupid. If you had just three choices--farmland, apartment buildings or a musical comedy about dead nuns--your money was on the nuns.

I went into Nunsense myself for several reasons. First--with all due respect--I thought it was hysterical. Second, it was capitalized at a mere $150,000--versus, perhaps, $500,000 these days to put on your average off-Broadway number (and $4,000,000 to mount a full-fledged Broadway musical). Third, unlike most shows, where for each one percent of the capital investors put up, they are entitled to half a percent of the profits (with the general partner set to reap the other half, should there be any), this one offered a full point for each point invested. Presto: The odds, though very long, doubled.

Fourth, this was a show I actually got to see before investing. With most, you're asked to attend a backers' audition in the producer's living room to hear a description of the plot and eight of the show's 14 songs. In this case, a shoestring production of the actual show, with the actual cast, was playing on a high school stage in my neighborhood. And, fifth, they needed the money.

The Devil made me do it.

And although not a penny has yet to flood my coffers ("You're so rich, the banks are charging you storage," my broker likes to tell me, as accurate in this appraisal as in most others), things are looking good on the nun front. The sisters in Life, the sisters on Today, separate productions in Boston, Philadelphia, San Francisco, Toronto, Amsterdam and Australia, a fat amateur-and-stock-rights sale, a cast album, Peggy Cass in a Michigan production, Kaye Ballard and Jaye P. Morgan slated for another, awards--it looks as if you grabbed that $25,000 by the dollar sign and slammed it down on the right choice.

Nice job.

"Great fortunes are not built by hedging bets. They are built by the bold stroke--that special insight that allows one to distinguish the nuns from the mud from the motels."

"Real-estate syndicators haven't always the same incentive as you or I. It's not their money."