Case Study: Debt Free Real Estate for Pennies on the Dollar

Warren Buffett, Ben Stein, Sexy Real Estate and a 19% IRR for 50 Years

Play a game with me.

You have to make a list of stocks to invest from for the next 20 years. You can’t invest outside the list. And the stocks on the list won’t change.

Here’s the catch - each stock must have some common characteristic. Could be a financial statement metric. Could be valuation related. Could be management quality.

What one defining characteristic do you choose?

• Sales growth?

• Consistent profitability?

• High ROIC?

• Capital return?

• Low EV/FCF?

You probably don’t want a valuation-based metric, as valuation will change daily. A bunch of sub-5x EV/FCF stocks will graduate from cheap to fairly valued. Then you’ll be out of cheap stocks to buy. You need a continual list.

Qualitative characteristics are hard. Management will probably turn over at 90% of the companies in the next 20 years.

Consistent profitability or high ROIC is good. Except you’re likely to get a long list of large, high-quality businesses that are more prone to overpricing than underpricing.

I’d choose something different.

My defining factor would be:

Liquidity.

Or rather, illiquidity.

I’d want a list of every stock in the world that trades below a certain level of dollar volume each day. The less liquid, the better.

I’m not the first person to make this observation.

There’s that famous Ibottson study. Where he found that small, illiquid stocks outperform:

It always made me laugh that illiquid microcaps outperformed anything else. While liquid microcaps underperformed everything else.

Anyone spending time in the microcap universe should understand this intuitively.

It’s no surprise that smaller, less liquid businesses outperform.

There are fewer eyeballs, less research, and less hype. These things aren’t prone to overpricing. Share count is low, and generally tightly held because they are profitable businesses that don’t need to raise capital.

Then there’s that age old “illiquidity discount”. The harder it is to unload a security fast, the cheaper that security should be. I’m damn happy this phenomenon exists.

If I run my affairs in a conservative manner - employ low/no debt and have a nice cash cushion to get you through a rainy day, I shouldn’t give a rat’s ass about liquidity. I can sidestep the illiquidity risk and get all the benefits of buying a cheap stock.

When studying illiquid securities, I’ve always found myself fascinated by the subset of securities that trade at a material discount to their private market value.

This phenomenon is best illustrated in real estate based enterprises. It’s not difficult to figure what RE is worth. There is generally a large basket of comps for just about any RE asset class.

But in public markets, we consistently encounter businesses where the private market value to an arm’s length buyer is 2x, 3x, or even 5x the current share price.

People know these businesses. They know the assets. They know there is a big gap between share price and intrinsic value. But on a handful of securities, that gap seems to never close.

And still, these things can compound at high rates.

I want to walk through a sleepy OTC security from recent history. I grabbed the data all the way back to 1970. And I’ll show you how the stock was cheap throughout most of its history as a public company.

This one’s got Buffett. It’s got sexy Los Angeles real estate.

And it’s got a 19% IRR over a 50 year period.

I hope you enjoy.

Los Angeles Athletic Club

The Los Angeles Athletic Club was founded in 1880. It was the city’s first private club.

Back then the initiation fee was $5, and monthly dues were $1. At this time there were only 11,000 residents living in Los Angeles.

The club location moved a handful of times throughout its first couple decades, before settling into its permanent location at 431 W. 7th St.

As Los Angeles grew, the club grew with it. It was a staple of early Hollywood culture.

In 1922, LAACO formed the California Yacht Club, which it owns to this day.

In 1926, LAACO established the Riviera Country Club.

LAACO members were instrumental in securing Los Angeles as the host city for the 1932 Olympics. LAAC athletes have earned a total of 47 Olympic gold medals.

Valuation

Here’s how the stock looked to a buyer in 1971. I’m not intentionally cherry-picking a date by choosing 1971. It’s just the earliest point from which I have financial data:

• Shares sold for between $38 - $44 in 1971. I’m using $40 as our cost basis.

• There was a little bit of net debt and preferred stock sitting in front of common shares.

• LAACO sold at 97% of GAAP book value and 5.5x EV/EBITDA.

If book value was an accurate proxy for intrinsic value, you may believe shares were fairly priced in 1971.

But keep in mind, LAACO had many decades of property appreciation at this point. This property appreciation is not reflected in book value, as real estate is recorded at cost and depreciated.

LAACO was paying a modest dividend in 1971.

The dividend yield was 4%.

The Silent Snowball

The 1970’s were good to LAACO. Sales grew nicely. Book value grew to ~$22MM by 1980, and the annual dividend had more than doubled over what was paid in 1971.

Still, the stock wasn’t a homerun up to this point.

The share price rose as high as $75. An investor could have earned a ~12% CAGR with dividends from 1971 - 1980.

But intrinsic value was still far, far greater than where shares were trading.

In 1988, LAACO sold the Riviera Country Club for $108MM.

LAACO decided to send some of its windfall back to shareholders.

In 1988, LAACO paid a $224 dividend. Then it paid another $305 dividend in 1989.

LAACO’s IRR from 1971 to 1989 was ~20%.

Here’s the mind-blowing part: LAACO sold off one segment for $108MM in 1988. But immediately prior to this transaction, LAACO’s book value was $20MM.

It sold a single segment for 5x the entire business’s book value…

Evolution

In the 1980’s LAACO began to diversify its real estate holdings. By 1989 it owned 5 self-storage facilities and two shopping centers.

By 1999 LAACO had 25 storage facilities. In the late 90’s the business was doing $7-8MM of EBITDA.

Throughout the 90’s the annual dividend was generally north of $20/share.

The 1971 investor, who had already recouped his basis several times over in dividends, was receiving a 50%+ yield on his original investment.

It’s important to note - the business never used excess leverage. In 1999 LAACO had ~$10MM of debt on the balance sheet and $58MM of book value. And book value understated market value by many 10’s of millions of dollars at that time.

In 2010 the business did $53MM of revenue and $20MM of EBITDA. Again, debt-to-equity was 0.2x. Shareholders received a $46 dividend.

Basically, the business just slowly plodded along.

Sales grew at a 5% CAGR from 1997 to 2021.

The Payoff

In late 2021, LAACO was acquired by Cubesmart.

At this point the self-storage empire had grown to 59 units. This is in addition to the Los Angeles Athletic Club and the California Yacht Club.

Cubesmart acquired the business for $9,838 per share.

LAACO’s $7MM valuation in 1971 had grown to $1.6 billion.

In total, shareholders walked away with $11,952 (including dividends) for every $40 invested in 1971.

As many of these dividends were earned in early years, the IRR works out to 19%.

I’ve ignored the income tax aspect in my calculations. LAACO converted to a limited partnership in 1986, which would result in individual owners paying income tax instead of the partnership. I believe a large portion of the income tax could’ve been avoided through IRA ownership, but there likely would’ve been some unrelated business tax that IRA holders would’ve had to pay.

Maybe you knock a couple points off the IRR if you want to be conservative. Either way, it’s a great outcome.

Book value was $209MM immediately prior to LAACO’s sale. In the year leading up to the sale, LAACO shares traded between 85-200% of book.

The acquisition was done at 800% of book.

So much for GAAP accounting.

Final Thoughts

Aside from the nature of the assets, there was nothing sexy about LAACO.

It grew slowly. It didn’t have any brain bending financial engineering.

But shareholders made ~300x if they held for 50 years. You wouldn’t got to bed at night worrying about LAACO. You knew they had a nice little business and weren’t going to take much risk with debt.

If anything, it would’ve been boring to own the stock.

In microcap value investing circles, LAACO was well known.

A young Warren Buffett said he and Munger bonded over the stock when they first met in the 1950’s. Here is Buffett’s quote from the 2024 Berkshire Hathaway shareholders’ meeting:

Ben Stein (the actor), said he made a 17% compounded return over nearly three decades from owning LAACO:

Stein says LAACO was the second best investment he ever made.

The first… Berkshire Hathaway.

So what’s the moral of the story?

Anyone with eyes could see that LAACO was worth more than where it traded in public markets. A shareholder in 1971 wouldn’t have had the temptation to sell, as shares basically never reached intrinsic value until the business was sold.

LAACO was cheap because it was boring.

Public market investors have remarkably short time horizons. Watching a stock go nowhere for 5 years makes their brain melt. They can’t handle it.

Of course, if LAACO was a private investment where you owned a stake, investors wouldn’t be prone to acting so irrationally. You’d know the business was spitting off cash flow that was being returned to you.

You’d know your investment was growing and you’d reap many multiples of your basis in a sale.

But watching the index go up and to the right while your security doesn’t move is too much for some folks to handle.

There are other securities similar to LAACO today. They trade at massive discounts to their private market value. They return FCF to shareholders… And people hate them.

There’s a reasonable argument against the point I’m making. If LAACO never sold, you wouldn’t have made nearly as much money. Funny enough, your IRR would still be quite high because of the power of those early special dividends.

But you wouldn’t have gotten that juice at the end.

I agree. There is a world where LAACO never sells, and you compound your money at 7% a year.

But if you owned 10 different LAACO’s, you would do very well. On average, one would sell out or rerate every few years.

That strategy would very likely outperform the S&P.

I guess it’s not rocket science. If you own a basket of stable businesses at 50 cents on the dollar, you will do well.

DISCLAIMER: THIS IS NOT INVESTMENT ADVICE. I MAY OWN SECURITIES MENTIONED IN THIS ARTICLE. THIS IS NOT A RECOMENDATION TO BUY THESE STOCKS OR ANY OTHER STOCK. I MAY BUY OR SELL ANY SECURITY AT ANY TIME. I MAY NOT TELL YOU IF AND WHEN I BUY OR SELL. THESE STOCKS MAY BE ILLIQUID AND YOU SHOULD UNDERSTAND THE IMPLICATIONS OF THAT IF YOU BUY THEM. THIS IS NOT TAX, LEGAL OR FINANCIAL ADVICE. I AM NOT YOUR FIDUCIARY. THIS IS THE INTERNET AND YOU’RE LISTENING TO A GUY NAMED DIRT.