My father was a custom peddler in New York City, and he had a saying: "There's a million dollars under your shoe," he would tell me. "You just have to find it." I always assumed he meant that opportunities are all around us. In recent years, however, I've discovered that the saying can be literally true.
I'm referring to the opportunities that exist in real estate -- specifically the real estate that I own as part of my business. For the better part of my career, I took that real estate for granted. Like most entrepreneurs I know, I saw space as a necessity, not an opportunity. I had to have it to operate my companies, but I didn't even think about trying to make money on it. I was a business guy, not a real estate guy.
So how has it turned out that my newest business is a real estate venture? Well, it didn't happen overnight. The journey began in the early 1990s, when I leased a warehouse on the East River in Brooklyn for the records storage business I was starting. As the warehouse began to fill with storage boxes, it dawned on me that I could be in trouble when the lease expired in six or seven years. Moving several hundred thousand boxes to a new facility would be expensive and disruptive -- and put me in a tough negotiating position with the landlord. Fortunately, I was able to buy the property from him, but it was a purely defensive move.
Like most entrepreneurs, I saw space as a necessity, not an opportunity.
So was my next acquisition, in 1999. By then we were running out of space, and I knew we'd have to build more warehouses. We were negotiating to buy property a couple of miles away when four blocks of vacant land became available across the street from my other buildings. It turned out that a bank owned the land as the result of a foreclosure in the late 1980s. Sensing that the bankers wanted to get rid of it as soon as possible, my partners and I put together a deal that gave them what they wanted -- a quick exit -- while allowing us to buy the property at a price below that offered by other bidders. (See "The Art of the Deal," April 2000.) But I was still thinking of the land as a necessity. All I wanted was the one block I needed for my business. I'd already found a buyer for another block, and after completing the purchase, I put the other two on the market.
And that's when my attitude toward real estate began to change. I was actually a little nervous about the deal we'd just done. We'd had to get outside financing, and we were paying a lot of interest. We also faced penalties if we didn't sell the remaining two blocks within a certain time frame. I was worried that we might have trouble finding buyers, but almost at once, we were swamped with offers. And that got my juices flowing. It was fun. It was exciting.
The next step in the evolution of my thinking came two years later as a result of conversations my partners and I had with some big companies interested in acquiring our records storage business. The would-be buyers made it clear that they wanted only our boxes, not our land and buildings. If they had to buy the real estate to get the boxes, they would, but they'd immediately sell it to another company that would lease the space back to them. Rather than give someone else the opportunity to earn the rental income, they said, we should think about spinning off the real estate into a separate business. In early 2002, we did just that.
Of course, as soon as we had a real estate business, we decided we should learn to think like real estate people, so we began to educate ourselves. Among other things, we realized we had a tax shelter. The records storage company was paying rent to the real estate company, which in turn was allowed to depreciate the value of the buildings it owned over a period of 39 years. If someone is paying you $100,000 a year in rent, and your building's value depreciates by the same amount each year, you can take the cash out of the business tax free if you want.
As long as the value of your real estate is rising, moreover, you have access to additional funds on a tax-deferred basis. Let's say you buy a building for $2 million, putting up 20% (or $400,000) and borrowing the other 80% from a bank. Over the next three years, you pay down the principal by $200,000, so your debt is now $1.4 million instead of $1.6 million. Meanwhile, the value of your property has increased to, say, $3 million. A bank will lend you 80% of that amount, or $2.4 million. After paying off the $1.4 million you owe on the previous mortgage, you have $1 million left that you can take out, tax deferred. Granted, you'll have to pay those taxes when you sell the building, but that could be many years in the future, if ever. In the interim, you have the cash you need to diversify your portfolio -- always a good idea for those of us whose eggs are in one basket.
There are certainly pitfalls associated with this approach to diversification, the main one being the danger of getting over-leveraged. If something unforeseen happens -- and something unforeseen always happens -- you could find yourself unable to keep up the payments on your debt. So it's important to proceed cautiously.
It also helps to be lucky. It's been said that if you want to get rich, you need only buy real estate and hold on to it for a hundred years. In fact, the value of real estate tends to rise in spurts. It might be flat for 20 or 30 years, then double or triple almost overnight. The problem is, it's hard to predict the spurts. That's where luck comes in. I just happened to buy my land at the beginning of an extraordinary boom in my section of Brooklyn. Not long after we'd spun off the real estate into a separate entity, we began getting amazing offers. All of a sudden, I realized that my land might be worth as much as my business. Maybe more.
That got me thinking even more about diversification. It seemed foolish to have so much of my net worth tied up in illiquid assets, particularly at my age. I told my partners that I wanted to look into selling either the land or the business. We started investigating the possibilities and soon wound up in the world of REITs.
A REIT, or a real estate investment trust, is essentially a mutual fund that owns real estate rather than stock. Investors buy stock in the REIT, which acquires the properties and -- by law -- pays out in dividends most of the rental income they produce. Initially, we thought we might sell our real estate to an established REIT, taking so-called partnership units in payment rather than cash. Because we'd be swapping the REIT's partnership units for our own, we could continue to defer the taxes we owed on the money we'd taken out when we'd refinanced our property. We wouldn't have to pay them until we decided to cash out, at which point we'd turn our REIT units into REIT stock and sell it like any other security. Meanwhile, we'd be earning those dividends.
Beyond such considerations, REIT stock has one big advantage over actual real estate -- it's extremely liquid. It's also true that property generally sells for a higher multiple of cash flow than a business does. By spinning off the property and selling it to a REIT, you can take advantage of that higher multiple.
To the REIT, the value of property depends on the rental income it generates. Suppose a REIT was buying property at 10 times the annual rental income. If your business was paying a low market rent of $2 million a year, you could trade the real estate for $20 million in REIT partnership units, readily convertible to stock. Or you could agree to pay a higher market rent of, say, $3 million a year, in which case you could get partnership units (and hence stock) worth $30 million. To be sure, the increase in the rent would diminish the value of the business by reducing its earnings, but you'd be getting the cash out at a higher multiple and diversifying your holdings. On top of all that, selling to a REIT lets you dispose of the personal guarantees that banks insist you sign when you take out a mortgage or a building loan.
The deal sounded perfect for someone like me. It sounded so good, in fact, that I couldn't help thinking there must be other people in my situation -- owners of records storage companies who weren't yet ready to sell their businesses but who were seeking diversification. And so my partner Sam and I began exploring the possibility of setting up our own REIT. If all goes well, Archive Storage Realty Trust Inc. will be my next business.
Meanwhile, I've already experienced a change in the way I view my business. As regular readers may recall, I've long believed that I was in the real estate business metaphorically, in that I rent space in my warehouses to boxes. But now I realize that I've also been in the real estate business quite literally. I buy land, build warehouses, and generate income by renting space for boxes. Eventually I can sell the real estate at a profit, which I can then invest elsewhere while continuing to operate the box business. It's a way of creating value out of vacant, depressed property -- literally the ground beneath my feet. That has been a revelation to me, although I doubt it would have surprised my father.
Norm Brodsky is a veteran entrepreneur whose six businesses include a three-time Inc. 500 company. His co-author is editor-at-large Bo Burlingham.
NORM BRODSKY | Columnist
Street Smarts columnist and senior contributing editor Norm Brodsky is a veteran entrepreneur who has founded and expanded six businesses.