If I were King (or Queen) of Exxon, I would….

 

INTRODUCTION

 

If you were King or Queen of Exxon, what would you do with the unprecedented gusher of profit accruing to that company?

 

Exxon profits hit fresh US record

http://news.bbc.co.uk/1/hi/business/4383296.stm

Petrol pump

Exxon Mobil is the world's largest listed oil  company

US oil giant Exxon Mobil has posted a quarterly profit of $9.9bn (£5.55bn), the largest in US corporate history, on the back of record oil and gas prices.

 

Profit was up 75% and revenue rose 32% to more than $100bn.

 

Thursday, 27 October 2005

Exxon Mobil Posts $10.36 Billion Profit

Company Faces New Round of Criticism

http://www.washingtonpost.com/wp-dyn/content/article/2006/07/27/AR2006072700383.html

By Tomoeh Murakami Tse

Washington Post Staff Writer
Friday, July 28, 2006

 

Exxon Mobil Corp. said yesterday that its second-quarter earnings jumped 36 percent, to $10.36 billion, boosted by climbing oil prices and larger profits at its refineries.

The quarterly profit -- the second-largest in U.S. history -- brought forth a fresh round of criticism from consumer and environmental groups. Critics accused the Irving, Tex.-based company of getting rich at the expense of motorists -- squeezed by $3-a-gallon gas prices -- while distributing billions to shareholders through dividends and by buying back shares. The largest quarterly profit by an American company, $10.71 billion, was also posted by Exxon, in the fourth quarter of 2005.

 

You would:

 

  1. re-invest it in more oil exploration;
  2. buy other oil companies;
  3. increase dividends for shareholders;
  4. buy my stock back from existing shareholders;
  5. raise wages and salaries for my employees;
  6. reduce prices for consumers;
  7. hire more Washington lobbyists to ward off a windfall profits tax;
  8. shop for my next Presidential candidate who would continue existing policies that have resulted in unprecedented gains for my company;
  9. buy real estate.

 

I would guess that the CEO of Exxon is thinking about all of the above except for i. Sheesh, why would the King or Queen of Exxon consider buying real estate?

 

Well, the real question I was asking myself the other day is what would a person do if he or she wanted to create a lasting enterprise—one that would be around for several centuries or millennia? This is a non trivial problem. Think how few corporations make the age of 50 years let alone 100, 200 or more. Actually, think of how many make the age of 5*!

 

(* The US Bureau of Labour Statistics, in a report in the May 2005 Monthly Labor Review, (http://www.bls.gov/opub/mlr/2005/05/ressum.pdf) showed that, across all sectors from March 1998 to March 2002, 66 percent of all establishments were still in existence after two years and 44 percent after four years.)

 

But before tuning our minds to the idea of making Exxon a long, long term play, let’s just put in perspective what $10 billion in PROFITS are each quarter. There are 52 weeks per year or 13 weeks per quarter on average. That means that Exxon made about $770,000,000.00 in profits each week. If you won $10 million in the mega bucks lottery, it would be like someone coming to your door 77 times a week with a cheque. That is, someone would ring your doorbell every two hours and 18 minutes, 24/7 holding a $10 million cheque. You would plead with them to stop coming after they had disturbed your sleep for a week or two!

 

Even baseball players don’t make that much.

 

So if you wanted to create a sustainable enterprise, say one that would last as long as the Holy Roman Catholic Church (a couple of millennia or so), what would you do?

 

For readers of the popular business press who are older than 35, you will have realized by now that firms that they were raving about a few quarters ago are now treated like neighborhood lepers. Remember the celebrity CEO? He is in jail.

 

Companies have a birth, life and a death. They are subject to cycles. Great names like DEC, Arthur Anderson, Systemhouse, TWA, Pan Am, Enron, Sperry and Burroughs can disappear (to be replaced with really yucky names like Unisys).

 

What do the House of Windsor, Emperor of Japan, Hudson’s Bay Company, Canadian Pacific and the Holy Roman Catholic Church have in common other than they are all extraordinarily long lived institutions? They all have significant ownership interests in real estate.

 

A DOZEN RULES FOR REAL ESTATE INVESTING

 

I think there is something fundamentally different about real estate from every other type of investment that humans might make. Here are a few things for the CEO of Exxon to consider if he or she wanted to make Exxon a long lived real estate vehicle:

 

  1. Ownership of real estate would become the chosen investment vehicle for their windfall profits (or your spare cash).
  2. There would be little trading in real estate—it would be a long term hold thereby minimizing capital gains taxation.
  3. Properties would be rented or leased including the leasing (but not sale) of land (the Catholic Church has entered into long term land leases for generations*).

 

(*A recent example in Ottawa, Canada might illuminate this a bit. The local Church (St. John’s Anglican) in Kanata could have sold their 4 acres of land on March Road for $500,000. Instead they entered into a 65 year land lease with a housing co-op for around $45 per unit per month with an inflation hedge built in. The land lease is worth more than $3 million and, at the end of the lease term, the Church still owns the land. They can do it again! For the Co-op, that’s 500 grand they don’t have to budget for—the renters pick up the land lease.)

 

  1. Investment would be in jurisdictions where there is respect for the rule of law, contracts, property and human rights*. There can be no value created where war and violence are prevalent; where natural disasters are common (see Florida and hurricanes or Santa Cruz, California and earthquakes or Darwin, Australia and cyclones); where pestilence or disease decimates the population** (e.g., Europe in the time of the Black Death or cities in Africa in the time of AIDS); your property can be taken arbitrarily without due process or compensation. 

 

(*Former Prime Minister Pierre Trudeau tried to get property rights entrenched in the Canadian Constitution along with his Charter of Rights and Freedoms for the individual but failed. The Provinces objected because of their fears that this would prevent them from managing and owing subterranean mineral rights.)

 

(** Cities do disappear. Where is Troy now (destroyed by ancient Greeks). Where is Babylon…)

 

  1. Significant investment would be in the residential sector—it is less volatile than commercial real estate—people always need a home.
  2. Investment would favour high growth, desirable cities over low growth, less attractive ones. No one knows what will happen in major western industrialized nations including Japan where birth rates are far below replacement rates and immigration is low but surely it won’t be good for real estate values.
  3. Careful consideration would be given to income tax and realty tax considerations. Once the Queen of England gave up her right to be income tax exempt in a colossal error in judgment, she unknowingly destroyed the family’s future guarantee of wealth.
  4. There would be no leveraging of the assets, no negative pledging or any other form of debt registered against the properties.
  5. The properties would be self insured against loss. Insurance is a way for large companies to appropriate part of the value of your property each year without compensating you. If you are the US Government, for example, you self insure. Large companies might do the same.
  6. Property management is a core competency and would never be contracted out.
  7. Investment would be in a maximum of two or three dozen cities in a small number of countries—enough to give geographic and political diversity but not so many as to be unmanageable.
  8. Management would be highly centralized, conservative and experienced in real estate. The portfolio would consist of existing income property, property to be developed (both greenfield and brownfield sites) and land with the bulk of the assets held in the income category.

 

Those are a dozen rules that can apply to any large investor in real estate. For smaller investors, they would inevitably change the set of rules. For example, real estate is an intensely local business so it would make no sense for them to be in more than one or at the most two or three markets.

 

Also, small players (who want to get bigger) must by necessity use leverage to increase their ROE. They are almost certainly better off with four properties with 25% equity in each than one property with 100% equity. This assumes that they are not upside down on equity (i.e., that their cost of borrowing is less than their ROE) and so leverage represents a positive gearing for their investments. Also, if they have four properties rented out and one becomes vacant, their vacancy rate is 25%. If they only have one and it becomes vacant, their vacancy rate is 100%. But we digress.

 

So if you were going to create a new state called Exxon Nation, you could do worse than follow the 12 rules above. But why is it that real estate appears to give enterprises such long life*?

 

(*The oldest company in North America and one of the oldest anywhere is the Hudson's Bay Company, which was incorporated on May 2nd, 1670. A Royal Charter from King Charles II granted the company a monopoly over the fur trade in the region where all rivers and streams flow into Hudson's Bay, an area of 3.9 million km² (Ref: Wikipedia). The Company has very significant real estate interests.)

 

WHY REAL ESTATE IS DIFFERENT

 

People, markets, weather, sun spots are all subject to cycles. Real estate is subject to cycles too. But one thing about real estate—it generally doesn’t go out of fashion. Since villages, towns and cities began to form about 10,000 years ago, real estate has generally tended to increase in value if we exclude factors such as war, famine, disease, pestilence, depopulation* and natural disasters.

 

(*Almost certainly, nations in Europe and Japan are going to face significant decreases in their populations. Russia’s population is already imploding due to emigration and death from alcoholism, drugs, poverty and crime. East Germany would have ended as a nation-state even without Glasnost—its population was dropping like a stone. Japan has very little immigration and Japanese women are having about the same number of babies as other women in developed nations—about half the replacement rate.

 

No one knows what will happen to real estate values in countries suffering from depopulation but overall, it can’t be a good thing for real estate owners. Thus far, depopulation impacts have been reduced by other factors:

 

a)      a long trend toward lower dwelling occupancy rates which means that average household size has decreased and this has caused an increase in demand for residential accommodation even where populations are decreasing;

b)      the amount of space per person in both residential and commercial settings has tended to increase, thereby offsetting some of the drop in demand;

c)      migration from rural areas to urban areas has also caused prices to be more robust in cities than they otherwise would have been but there are many rural areas, villages and towns where real estate is worth practically nothing.

 

It is strange that after the developed nations produced perhaps the greatest generation ever (one that faced two world wars, a great depression, a cold war and took the world from buggies to the Moon), the next generation appears so self interested and so without core beliefs that having children is seen as more of a nuisance than anything else by many of them. Go figure.)

 

It served the purposes of the Catholic Church to own well-situated pieces of real estate in 100s of towns and cities. It makes sense for most people and companies to own their own real estate. I tell my students, as soon as you can, buy your own home and pay off the mortgage as soon as possible. When you do that, you start to earn what the British term unearned rent—rent that you receive on your own home from yourself on which you are not taxed.

 

This sounds a bit far fetched but the effect is real enough. The way to understand it best is to imagine that you move out of your own home because someone has offered to rent it from you for $2,500 a month. But you still need a place to live so you go out and rent another home—guess what? You end up paying $2,500 a month but this is not a zero sum game. You are paying your rent with after tax dollars and receiving rent that is before tax. So if you are in the 50% tax bracket and ignoring your cost of doing business for the moment, you end up with $1,250 a month from the rent you are collecting on your own house after tax and you are spending $2,500 per month on the home you are occupying so you are $1,250 per month worse off in this scenario…

 

This is a very real effect—people who have paid off their mortgage can tell you that somehow, they quite understand how, they have way more spending money every month. It’s true, they do. (Note that this effect is diluted somewhat in the US because home mortgage interest is tax deductible there. However, the principal residence is also subject to capital gains tax when you sell it whereas in places like Canada, you can’t deduct your mortgage interest from your taxes but at least your home is not subject to capital gains taxes when you sell it. If you are a home builder starting out, it makes sense to build, live in and sell a few homes early in your career—it’s one of the few (legal) tax-free ways to make money.)

 

I also tell my tech clients to buy their own buildings. I realize that most tech companies are told to focus on their core businesses but surely it doesn’t hurt them to diversify their risks by owning their own premises. In many cases, it is also cheaper.

 

One of my Ottawa tech clients needed 15,000 s.f. of triple A office space. When he found out that it costs $18 to $22 per s.f. per annum (circa 1999) to rent this type of space plus more than $12 per s.f. for operating costs (or more than $450,000 per year), he wanted to look at the alternatives. We ended up selecting a 15,000 s.f. building in the south end of the City which he then bought for $1.5 million. He ended up paying $85,000 per annum on his first mortgage and a few years later he sold it when they moved to a bigger space. He got $2.1 million for it and bought a 33,000 s.f. building for just over $3 million.

 

He will pay off the mortgage on his newest acquisition within 5 years.

 

Below is a table that summarizes the attributes that four different asset classes exhibit—

 

  1. GOLD,
  2. FORTUNE 500 STOCK OWNERSHIP,
  3. OWNING YOUR OWN BUSINESS,
  4. HOLDING REAL ESTATE.

 

Asset

Gold

Fortune 500

Own Business

Real Estate

 

 

Stock

 

 

 

 

 

 

 

Interest

No*

No

Yes

Yes

Dividends

No

Yes

Yes

Yes

Capital Gain

Yes

Yes

Yes

Yes

Cost to Store

Yes

No

No

No

Rent

No*

No

No

Yes

Concession/Franchise/Location

No

No

Yes

Yes

Volatility

Yes

Yes

Yes

Yes

Inflation Hedge

Yes**

No

No

No

Portability/Negotiability

High**

Moderate

Low

Low

Unearned Rent

No

No

No

Yes

Capital Gains Tax Exempt

No

No

Possibly

Possibly

Capital Cost Allowance

No

No

No

Yes

Transaction Costs

High

Low

High

Moderate

Financing Available

No

Yes

Yes

Yes

Wealth Effect

No

No

No

Yes

Externalities

No

No

No

Yes

(*Note some central banks will enter into gold leases to top up their mix of assets and pay a small rent.)

(**Also note that gold is a unique asset in that it generally increases when interest rates increase where interest rates are tracking inflation. Higher interest rates generally mean lower values for most stocks, most SMEs and almost all real estate holdings, at least in the short run. Gold is also a holding against catastrophe; it is portable and easily negotiable in times of war.)

 

Notice that real estate has some unique attributes including:

 

a)     you can rent real estate to third parties;

b)     by renting to a third party you are benefiting from a ‘Wealth Effect’; every year a renter is paying off part of your mortgage for you—when you sell that property, that decrease in principal owing goes into your pocket (assuming that the price you sell for is more than what you paid for the property plus transaction costs);

c)     you receive unearned (and untaxed) rent on self-occupied property after your mortgage is retired;

d)     when the city builds infrastructure around you, when your neighbors improve their properties, when the density and area of the city increases, demand for your property increases without you having done a thing—as a result your property value benefits from positive externalities;

e)     in many countries, you are allowed to deduct a non-cash capital cost allowance against income—a significant tax advantage from holding real estate assets.

 

In addition, while real estate shares an advantage with other asset classes that is worth pointing out, it offers you a unique opportunity to develop a sustainable business model even if you aren’t a genius:

 

Real estate develops a concession or franchise for its owners because once you own a particular location, by definition, no one else can own at that location. Everyone knows that real estate is all about LOCATION, LOCATION, LOCATION but perhaps people don’t realize why that is so crucial. For you to have a business that will nurture you and your family for a long period of time, you need to have sustainable competitive advantage.

 

Imagine how difficult it is to run a company like Apple Computer or how difficult it is to paint like Rembrandt. Not everyone can be Steve Jobs or create artworks like Rembrandt Harmenszoon van Rijn. Real estate held in fee simple (the highest form of title ownership) gives you a franchise forever that tough competitors like Microsoft can’t take away from you—IT’S A BUSINESS MODEL FOR DUMMIES*!

 

(* A friend of mine owns a great site at the corner of Woodroffe and Carling Avenues in the City of Ottawa. He comes from a tech background but his chosen investment vehicle is real estate! They built a new, high concept strip mall (not intended as an oxymoron) on top of the old foundation of a previous building and, because of its high traffic location, great visibility and design features, they get rents that are 1/3 higher than other nearby properties. I mean how difficult can it be to own a great location and have people come up to you, one after the other, to offer you top dollar for your space?)

 

 

ADDENDUM—LEVERAGE AND REAL ESTATE BUYING

 

The messaging to my students is: buy your own home, buy your own business premises and buy some investment real estate and pay off your mortgages as quickly as possible.

 

This message is meant to convey the importance, in my view, of being debt free and being (relatively) creditor proof (http://www.dramatispersonae.org/CreditorProofing.htm). Having said this, most of us end up with significant mortgages and it usually takes a long time to pay these off. It turns out that more leverage can mean faster pay down of larger mortgages. Huh?

 

Take the example of an investor who wants to buy one townhouse or condo to rent out. Say it costs $200,000 and she has 25% down. So her 50 grand buys one townhouse that produces rent of $2,050 a month. After paying property taxes and other expenses, she is left with $1,450. If she has a 25 year mortgage at 6%, her NOI (Bet Operating Income) is $5,665.99 which gives her a ROE (Return on her Equity of $50,000) of 11.3% per annum. See table below.

 

Townhouse or Condo Purchase-- One Unit Using 25% Down

 

 

 

 

 

Purchase Price

 

$200,000

 

 

Down Payment

25%

$50,000

 

 

Mortgage

75%

$150,000

 

 

Interest Rate

 

6%

 

 

Amortization

 

25

years

 

Mortgage

 

($11,734.01)

per annum

 

Rent

 

$2,050

per month

 

Property Taxes and Other

($600)

per month

 

Net Rent

 

$1,450

per month

 

Net Rent

 

$17,400

per annum

 

NOI

 

$5,665.99

 

 

ROE

 

11.3%

per annum

 

Real Estate Inflation

1.25%

5.00%

per annum

 

Wealth Effect

$6,000

12.0%

per annum

 

Total ROE

 

28.3%

per annum

 

 

Now in addition to her cash on cash return of 11.3%, she is also benefiting from general real estate inflation. In the example shown here, I assumed an average 1.25% increase in real estate values per year; this implies a 5% ROE from general real estate inflation (1.25%/.25, where .25 is the equity she has in the deal).

 

But real estate gives you something else—a wealth effect. The tenants are paying off her mortgage for her. That means, over a period of 25 years, they are paying an average of $6,000 down on her principal ($150,000 mortgage amount divided by the amortization period of 25 years). This adds another 12% ROE so her total ROE is actually more than 28%. Now that is a pretty good investment and we have ignored any tax advantages from things like sheltering income from CCA (Capital Cost Allowance).

 

Now these calculations are approximate and practioners are advised to use IRR (Internal Rate of Return) analysis for more precise measurement of actual returns on investment in real estate (see: http://www.dramatispersonae.org/IRR/IRRPowerOfLeverageGoalSetting.htm). Nevertheless, it gives a first order of approximation which is all we require here to demonstrate the fundamentals of real estate investing.

 

Now imagine our investor deciding instead to buy three condos with her $50,000 instead of one; she puts down $16,667 on each one. What happens to her ROE?

 

Townhouse or Condo Purchase-- Three Units Using 8.333% Down

 

 

 

 

 

Purchase Price

 

$200,000

 

 

Down Payment

8.3%

$16,667

 

 

Mortgage

91.7%

$183,333

 

 

Interest Rate

 

6%

 

 

Amortization

 

25

years

 

Mortgage

 

($14,341.57)

per annum

 

Rent

 

$2,050

per month

 

Property Taxes and Other

 

($600)

per month

 

Net Rent

 

$1,450

per month

 

Net Rent

 

$17,400

per annum

 

NOI

 

$3,058.43

 

 

ROE

 

18.4%

per annum

 

Real Estate Inflation

1.25%

15.00%

per annum

 

Wealth Effect

$7,333

44.0%

per annum

 

Total ROE

 

77.4%

per annum

 

 

It goes up. She is now getting a 77.4% total ROE—all three types of returns have increased. Her cash on cash return has gone up because her equity investment went down faster than her NOI. Her mortgage has gone up which means her tenants are paying more of her principal down for her each year. And lastly, her property is going up at the same absolute rate each year but because she has less equity in each deal, she is getting relatively more benefit from real estate inflation. Also, if one of her units becomes vacant, she has an occupancy ratio of .667 rather than 0.000 which would be the case if she just invested in one unit.

 

But interestingly, the increase in leverage also means that she can pay off her mortgages faster is she so chooses. In the first case, she has $5,665.99 cash left over at the end of each year. In the second example, she has $3,058.43 left over from each unit or a total of $9,175.30. So if she chose to pay down her mortgage each year with her cash on cash return, she would pay them off a lot faster in the case where she bought three units instead of just one using more leverage.

 

HOW TO BUY REAL ESTATE WITH LITTLE MONEY DOWN

 

A student called me recently to advise him on how to buy a commercial property for $600,000. He has no money but he does have two important things:

 

a)      a tenant lined up;

b)     his own credibility.

 

Actually, he has a language training contract with the GOC (Government of Canada) worth about $20k a month. For his $600,000, he gets an existing building and a ton of beautiful property in a scenic setting less than 20 minutes from the Parliamentary Precinct.

 

So here is what I told him not to do:

 

a)      spend zero time raising money from VCs—they ain’t interested in real estate;

b)     spend zero time looking for angel investors—they ain’t interested in real estate;

c)      don’t take on a partner.

 

And here is what I told him to do:

 

a)      get a commercial appraisal that hopefully shows the property is worth at least $600,000;

b)     arrange a first mortgage for 65 to 75% of the appraised value with an interest rate of around 7%;

c)      arrange a second mortgage to bring you up to 85% of the appraised value of the property—this will cost him in the order of 10 to 12%;

d)     get a line of credit (LOC) based on your own credit rating and the property for the balance plus some transaction costs and some working capital.

 

Now this is expensive and risky. No one wants to pay 12% interest on a second mortgage but I told him—debt is way cheaper than equity. If he could get someone to co-invest with him, trust me, they will want returns on their equity of at least 20% and probably 30%. And I don’t like partners in most instances anyway.

 

 It’s risky because if he doesn’t make it work, he is on the hook for any shortfall in the equity financings part of the equation and maybe even for the first mortgage too. (Any secondary financing is considered a form of equity financing because they get paid out of the equity in the deal after the first mortgage is paid off.)

 

So I told him not to do it unless he was very confident that the GOC contract would get him past the first to years. The downside though isn’t really too bad. Most likely, I told him, if he fails he will end up selling the property for at least what he paid for it and maybe he is only on the hook personally for the LOC. Then I told him, he will have to get a JOB and pay it off. Entrepreneurs who are successful don’t let a little thing like failure get in their way. However, it is way better to make your first few deals successful.

 

After two years, he should be able to go get another appraisal and between the real estate and the now successful language training centre, he should be able to refinance the deal to:  i. take out the secondary financing and ii. renegotiate the LOC, maybe without his personal guarantee.

 

 

ADDENDUM—THERE’S ALSO NO BUSINESS LIKE THE OIL BUSINESS

 

Is there any business like the oil business? It’s unique too. Where else could so many large firms apparently collude on prices and get away with it?

 

Petrol station owners get up to ten phone calls a day—no email record or fax record—telling them what price to charge. It just coincidentally matches to the tenth of a cent what every other station at every other oil company is charging. Sheesh.

 

If you had left for Mars on the day Mr. Clinton left the Oval Office and returned six years later to find that prices at the pump had gone from 45 cents per litre to $1.05 per litre, you could probably conclude with some degree of confidence that the oil business had a friend in the White House.

 

How long does it take a barrel of oil to jump out of the ground, into a pipeline to get into a ship to get into a refinery to be refined into gasoline to get into a tanker to get driven to the local gas station to wait for you to come along and pump some of it into your tank? Apparently, it’s practically instantaneous. Another war in the Mid East can cause that barrel to traverse the distance from the desert to your fuel tank in the time it takes for a phone call from head office to the local gas station owner to raise prices by a dime.

 

I feel sorry for the poor saps in Canada and the US who get caught for price fixing—not that colluding on prices should ever be tolerated, mind you. But if a couple of slugs at a few construction companies decide to do a little bid rigging, it’s like they have committed a crime against humanity. They get their photos on the front page of the local newspaper and are totally disgraced.

 

There certainly appears to be different rules for the power elite than for the rest of us… (See: http://www.dramatispersonae.org/PoliticsMediaBusiness.htm).

 

http://www.ottawarealestatenews.ca/WhyInvestInRealEstate.html

 

http://www.eqjournalblog.com/

 

http://www.ottawarealestatenews.ca/

 

http://www.dramatispersonae.org/