Junk Bond King Predicted This About Real Estate

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The rise and fall of junk bond king Michael Milken was well documented in the book, Den of Thieves. Years later, I remember him saying in an interview that the next “big thing” would be the securitization of residential real estate. In other words, you could look up the price of your neighbor’s house and trade it much like a stock. Today, that’s pretty close to reality. You can buy stocks that own thousands of single-family homes or visit Zillow to see your neighbor’s “Zestimate.”

As I wrote to you here, when we were in Key West in March, we took a random house tour simply out of curiosity. After the tour, sitting poolside with my iPhone, I looked up the house on Zillow and what caught my eye was that it had been viewed over 3,000 times only days after listing—the horse had left the barn.

When we were walking to dinner that night, a family was standing in front of the house we had toured earlier. I overheard the dad saying, “Kids, this is the one I was telling you about back home that I really like.” These days, word spreads fast. And homes are absolutely trading with the liquidity of stocks, especially with rates at a Blutarsky-ish “zero point zero.”

I don’t love single-family or vacation homes as an investment. But I want you to use these online tools if you’re downsizing or searching out a retirement destination. You can have an edge if you know a specific area that is off Zillow’s radar. Take for example our log cabin in the White Mountains. For years, it never came up on Zillow. I’d look it up and just see green trees, even though I knew that our cabin was “right there.”

Today on Zillow the cabin is there for all to see, but the value (in my opinion) isn’t reflected in the Zestimate. When I toggle above the area like an F-22, I see nice swaths of land and homes for sale that may have only a handful of Zillow views. These are the uncovered areas I think deserve your attention, not the areas swarmed by real estate speculators jetting around the world from their armchairs.

Action Line: Finding your oasis takes work. If everyone knows about a property you’re interested in, where’s the value? Remember, when you feel “pressure” to act, that may be a sign you’re letting emotions run the show. Emotions and investing don’t belong under the same roof.

P.S. Here’s an excerpt from the September 30, 1996 interview of Michael Milken by Fortune Magazine’s Joseph Nocera and reporter associates Erin M. Davies and Anne Faircloth.

“When I saw the problems of the Soviet Union…in the latter part of the 1980s, and realized that I had been trained my whole life for the solutions to this problem but could not help, it was stressful.”

Let it never be said that Michael Milken thinks small. Who else would call Lee Iacocca–collect, from prison–to offer the unsolicited advice that the Chrysler chairman needed to pump more equity into the company, which was then in one of its periodic downturns? Who else would look out at Latin and South America, as Milken did in the mid-1980s, and conclude that the whole region needed to change its capital structure–and he could show it how? And who else would claim that he could have rescued the Soviet Union–if only those problems hadn’t cropped up at the same time he was dealing with certain unmentionable legal problems of his own?

No question about it: Michael Milken has an appreciation of his own abilities that can fairly be called grandiose. In a series of interviews he held with FORTUNE over the past few months, nothing came through clearer than that. Again and again Milken told anecdotes that hinged on his capacity to see things before others did–and to act on them. But while one’s natural tendency is to roll one’s eyes at such egregious narcissism, in Milken’s case it is a tendency that ought to be resisted. After all, if he proved anything in the 1980s, it was that he really could figure things out before others did–huge, important things–and act on them profitably.

The fact is, while you can disagree on whether Milken was a saint or a sinner during his 1980s heyday (see next story), you simply can’t argue anymore about the singular importance of the junk-bond market he created. “We securitized business loans,” Milken says, and he’s right. And look, too, at the businesses he backed with his junk bonds! He was present at the creation of the cable industry and the cellular industry. Milken’s junk bonds made it possible for MCI to compete with AT&T. He backed companies like Turner Broadcasting and McCaw Cellular because he saw something others didn’t. Yes, this is the party line we’ve been hearing from Milken apologists for years, but that doesn’t make it any less true.

What is also true is that a number of the people Milken originally backed–including Rupert Murdoch and Ted Turner–still talk with him on a regular basis; some have even made joint investments with him. It is possible, of course, that they do so because they still feel indebted to him. But the Rupert Murdochs of the world tend not to spend much time wallowing in gratitude, and it seems far more likely that they talk with him because they think that what he has to tell them will be valuable to them in the future.

Which got us to thinking: Wouldn’t it be intriguing to find out what Milken’s saying these days–to eavesdrop, if you will, on those conversations he has with Rupert Murdoch and the like? So we put it to him directly: Where does he see the next cable industry, the next cellular? If he were betting on the future, where would he place his bets? Here is what he told us.

REAL ESTATE. “If I were 25 years old today and had no restrictions,” says Milken, “one of the areas I would move into is real estate.” Real estate? Yes, real estate.

In fact, when you listen to what he has to say about real estate, it’s not hard to understand his enthusiasm. He’s got an idea that is big and powerful and radical all at once–an idea not unlike his original insight about junk bonds. Then, the idea (or at least an important part of the idea) was to create a true market–a liquid market–out of something that had been fundamentally illiquid, namely, business loans that were made to companies that didn’t have good credit ratings. Now, Milken believes that the same can be done with real estate. He is convinced that real estate–whether it be residential housing, apartment buildings, or giant commercial buildings–can become as easily tradable, and as liquid, as a stock or bond. And he is equally convinced that the effect of such a thing on the investment world would be nothing short of revolutionary. As he puts it, “There’s a clear need for financial technology in this area.”

Milken begins with the rather unsurprising premise that real estate, having fallen out of favor for most of the 1990s, is about to become attractive again to the American investing public. But for most people, investing in real estate means buying something tangible, like a plot of land or a building, and then holding on to it in the hope that it will eventually appreciate in value. Other investors have begun to gravitate toward real estate investment trusts, which now have, in total, some $68 billion in market capitalization. REITs obviously constitute a market, and the larger ones offer a decent amount of liquidity. In fact, Milken points to the apartment REIT set up by Chicago real estate mogul Sam Zell as a model. Zell’s REIT now has $1.8 billion in market capitalization, which means that getting in and out of it is not particularly difficult.

But REITs are structured in a way that Milken feels is both awkward and overly complicated. For instance, REITs can sometimes have such complex capital structures that the securities don’t always reflect the true value of the assets. Further, a person who puts money in a REIT may actually be investing in the general partner of a larger partnership–which, in turn, owns the underlying properties. Milken’s real estate securities would allow the investor to own a piece of the underlying properties directly, without the partnership baggage. Indeed, a developer who wanted to build a series of apartment buildings, say, could issue securities directly to investors–just as companies issue stock in IPOs. And the owners of these securities could trade them whenever they wanted.

Milken has two other problems with REITs in their current form. First, their liquidity is largely dependent on their sheer size: The smaller they are, the harder it is to get out of them when you want to. That can be a problem, especially for institutional players with large sums to invest. Second, he simply doesn’t think they are specialized enough. Even REITs that have gone public in recent years have tended to be broadly diversified. Milken’s idea is that his real estate securities would be far more narrowly constructed. In the marketplace he envisions, an investor who wanted a piece of the condo market in Louisiana would be able to find a product that specialized in that niche, while someone else who wanted to invest in apartment buildings on the West Coast would also find a product that suited his desire.

And this marketplace, as Milken sees it, would operate very much the way the mutual fund industry operates today. Indeed, the mutual fund companies would be likely candidates to create these real estate securities. “How about if Fidelity tomorrow had 200 funds”–each of which concentrated on some slice of the world’s real estate market, Milken muses. “If they got to critical size, say, $50 billion to $100 billion, you’d have created real liquidity in the real estate market.” But how would you place a value on these securities? he was asked. “The marketplace will value them,” he replied. “If you were a fund company, you’d need an entire research effort, which would say that these are the pieces that make up this security and they are worth this amount. And then some other company might have a different assessment, but that’s what makes a market.”

And how big is this potential marketplace? Huge, in Milken’s opinion. “The debt market today is between $400 billion and $500 billion in the public market and another $400 billion to $500 billion in the private markets,” he says. “So that’s $1 trillion. Real estate in the U.S. alone is between $6 trillion and $8 trillion.” Ultimately, he believes, a securitized real estate market could be every bit as big as the entire debt market is today.

“The need,” he concludes, “is there. And whoever addresses this issue will wind up creating a whole new industry. It will be just like the enormous growth of the mutual fund industry.”