Standing out in the sun, in my bare feet and shorts I thought enviously about how an investment banker acquiring a ten-million-dollar industrial corporation has a much easier time of it than a real-estate man buying a ten-million-dollar building. The investment banker can divide and sell the ownership and rights in a corporation in a great many ways, a piece at a time. For instance, he can sell first-mortgage bonds to an insurance company, at the prime rate of interest. He could also offer debentures, which, though they take a second position to the bonds, offer a higher rate of interest in compensation. For investors interested in a speculative fillip (in case the company does very well), there are convertible debentures that can be turned into common stock. He can issue preferred shares (convertible or straight), which tend to be especially attractive to corporate investors, because preferred dividends passing from one corporation to another are taxed only seven percent. Finally, there is the common stock, the basic equity of a corporation, but the availability of capital does not stop there; there are also bank loans, accounts receivable (which may be financed with a factor), warrants to buy stock, and various other ways to draw investment capital into a corporation. In fact, investment bankers have over the generations invented as many ways of catering to investors as there are investors with particular personal needs, whims, or tax requirements.
While hauling in an empty line from the Hawaiian seaside, it occurred to me that if an investment banker did not have all these ways to reach various kinds of investors, he would be in just as difficult a position as I was with 1 Park Avenue. If he had to sell a corporation in toto, to one buyer, an investment banker would not get nearly as much money as he did by dividing it up for special customers . . . the lucky devil.
This kind of thinking was not really getting me anywhere; I pulled back with my rod and cast way out into the water again. Then an idea came to me: "Why can't we break the property up, just the way an investment banker does?"
With a corporate financial structure as my model, I began mentally to divide up 1 Park Avenue to see how and at what price the building might appeal to various kinds of investors. As the pieces and the arithmetic began to dovetail, I forgot my fishing or even where I was until I suddenly realized I was standing on a Hawaiian beach, in water up to my ankles, with a useless rod and reel in my hands. I went into the house, and in the course of two hours on the telephone I began to make the first application of what was to become known in the trade as the Hawaiian Technique.
In practice, because it involves a long chain of interconnected events and multiple side branches, the Hawaiian Technique can become as complex as some of the long molecule chains chemists work with and link together to concoct new products. In essence, however, like most good ideas, it is simple. I determined how it could work, in the case of 1 Park Avenue, which earned one million dollars in rentals a year and had a ten-million-dollar price tag on it.
Though most homeowners don't think of it this way, a major urban property breaks naturally into two parts—the land, and a lease which gives you a right to the use of the land. A building usually comes with this lease, but as the basic leaseholder and building owner you can alter, tear down, or rebuild on your site in any way you want—as long as you pay your ground rent for the land.
Now, considering only the land, I determined that $250,000 of the total million-dollar income of the property should go to the ground rent. This ground rent, since it must be paid before any other expenses, is the safest of all possible incomes to the property. Capitalized at the rate of five percent, therefore, the ground should be worth five million dollars. I could try to find a buyer directly at this price, or I might do something else: since ground income is so sure, a mortgage on the ground (which would have first call on the already ultrasafe ground rent) would be even more secure. I should have little trouble finding an insurance company or pension fund willing to take a four-percent return for such a safe risk and could therefore sell them a mortgage on the ground for three million dollars which would eat up $120,000 of the land's total income. The remaining $130,000 of income capitalized at the rate of 6½ percent would be worth two million, and for this sum I would sell the land to an institutional or individual investor.
The land mortgagor and land owner would be our equivalent of a corporation's bond and debenture holders, and at this point, having first mortgaged and then sold off our land, we would have five million dollars, plus a building and, of course, a basic lease giving us undisturbed use of the property.
The earnings on this property, after payment of ground rent, would be one million dollars, minus $250,000, or $750,000. The job now was to properly fraction and sell this leasehold and its income so as to attract particular buyers. What I did, basically, was to create two leases, an inner (or sandwich) lease, and outer (or operating) lease. Whoever purchased the operating lease would, in effect, be the manager of the building. He would solicit tenants and collect rents. He would get one million dollars in income, pay $750,000 in rent, and keep $250,000 for himself. The holder of the inner lease would, in effect, be the owner of the building. He would get $750,000 in rent, pay $250,000 to the owner of the land, and keep $500,000 for himself.
Before selling the inner lease and its $500,000 income, however, I could readily mortgage it with a leasehold first mortgage of 6½ percent for four million dollars. The mortgage payments on this would come to $270,000 per year plus two percent or $80,000 per year for amortization. This would leave $500,000 minus $350,000, or $150,000, to the building owner. Capitalizing this $150,000 at an attractive six percent, I would readily find a buyer for 2.5 million dollars. Thus the inner lease would bring me four million dollars when mortgaged, plus 2.5 million when sold.
As for the operating lease, with its $250,000 income, we could, at a seven-percent return to investors, get a price of almost 3.6 million dollars. If we provided the financing, by taking back a mortgage, it might be even higher, but holding things as is (in this simplified case), it turns out we have arranged to: (1) sell and mortgage the land (for five million dollars), (2) sell and mortgage the inner lease (for 6.5 million dollars), and (3) sell an operating lease (for 3.6 million dollars). All for a grand total of 15.1 million dollars on a purchase price to us of ten million.
In this profitably fractioned property, the holder of the operating (or outer) lease, who acted as manager of the building, in that his costs were fixed (at $750,000), was in a position not unlike that of a common stockholder. He was relatively secure against inflation, and if he could increase sales or rentals, his income would rise phenomenally; a ten-percent rise in rentals, for instance, would give him a forty-percent rise in income.
The building owner, or innerlease holder, would be in a cash position much like that of a preferred stockholder, with fixed income but with tax advantages even better than those available to corporations that pay only seven percent of their preferred dividends. This, because the building owner can write off the annual depreciation of the building against his cash income from the structure. What with the accelerated depreciation, such investors would be able to pocket their $230,000 income with no tax—and to garner extra tax credits against other income—until such time, of course, as yearly depreciation on the building began to equal amortization payments. At this point the individual owner would likely want to sell his interest in the building (paying only twenty-five percent in capital gains if he sold at a profit), to wind up with an excellent net return.
These, as with a great many other tax possibilities that we realized for investors, were perfectly legal and well within the concepts and spirit of the law as it existed then. They also led to much new legislation, however, because the Internal Revenue Service, upset about the amount of money they were not getting, instituted new rulings to plug the new holes we had discovered.
The example of property-fractioning I have given above is a simplified one. In an actual case there might be quite a number of individual variations and many more investors. For instance, in an inner (or
sandwich) lease, aside from the first mortgage we might create a two-million-dollar second mortgage, this second mortgage to pay interest but no amortization, till the first mortgage had been paid off. Or we might create a dormant mortgage which did not pay anything for twenty-five years. Only after the first mortgage was paid would this dormant mortgage take over, but then, as a first mortgage, it would acquire full value. One might be able to sell such a mortgage for, say, $750,000 to a man who wants to give it to his children twenty-five years hence.
Similarly, the operating (or outer) lease, instead of being sold outright, might be mortgaged, broken into subleases or subsubleases, hedged against various possibilities, and sold to as many as ten or twelve different investors.
The Hawaiian Technique was so flexible that it became a very powerful tool which often could make two plus two equal to four plus one plus two plus more. I was not the first one to package real-estate deals for particular customers or to use a sale-and-leaseback technique (I, for one, had been doing just such things since the 1930's), but this was the first time anyone consciously and deliberately fractioned a great property off beforehand in order to tap many markets at once. We used the technique with 1407 Broadway, with West Thirty-fourth Street, with the Graybar Building, and with just about every other one of our major properties. The Hawaiian Technique, because it permitted us to anticipate and make early use of the future earnings of our properties, became the principal tool of Webb & Knapp expansion. And, as the technique spread and was adapted by others, it brought a new liquidity and flexibility to real-estate financing in general.
An interesting little transaction which took place a little before the time of my Hawaiian interlude, but which is important because it had roots even further back, and flowerings far forward, was my purchase of McCreery's Department Store on Thirty-fourth Street. This deal came to us on a Friday afternoon in 1951, when I got a call from Robert McKim, chairman of the board of the Associated Dry Goods Company, the owners of McCreery's Department Store.
"I'd like to see you tomorrow, Bill," he said.
At that time we had not yet moved to Beekman Place, nor had we acquired our place in Greenwich. I said, "Sure, Bob, I'll be working tomorrow . . . but I'll be at my apartment at 30 East Seventy-second Street."
"I'll be there at ten-thirty."
McKim showed up as promised. It was a sunny day, I was out on the terrace picking up a little tan, and he joined me. I knew that McCreery's was not going well, but this was quickly verified when McKim explained his visit by asking me if I wanted to buy McCreery's.
"Sure."
"What will you pay for it?"
"I'll pay five and a quarter million dollars."
Looking a little flabbergasted, McKim said, "Do you know anything about it?"
"I've never been in the store."
"How did you come to that price?" he asked.
"Well, that's my business. . . ."
I might have gone on to say I was offering five and a quarter million because that is what I thought the land was worth, but, shaking his head wonderingly, McKim said, "Bill, our book value is five million four hundred and fifty thousand dollars. If you pay that, you can own it."
"We'll buy it, if you will take a million dollars down and the balance in a year or two at two-percent interest, so we can turn around and lease the property to someone else."
"You've got a deal," said McKim.
Part of the deal was that he and his people had to get out of the store by title date. We did not want the heartache and problems of discharging hundreds of employees; that was his job. He agreed to make his severance arrangements, and tucked away at the corner of my mind I had a pretty good idea of who I would be able to get in as a new tenant for the place. The tenant I had in mind was Ohrbach's. I knew they were getting restless down on Fourteenth Street because of a deal that had come up eight or ten years previously when I was acting for the Astor estate. Astor owned the middle one of a three-building property occupied by Ohrbach's. In the process of generating cash for Astor so he could buy properties elsewhere, I had gone to Nathan Ohrbach with a very attractive proposition. Ohrbach's rent to Astor was seventy-two thousand dollars per year. I told Ohrbach that if he would give us a first mortgage of $900,000 and one dollar in cash we would give him the property. The mortgage would be at two-percent interest (in the early 1940's, interest was very low, but this was phenomenally so). I had so designed the package that this two-percent interest plus amortization of the mortgage would be covered by the rent Ohrbach was already paying. In other words, Ohrbach without having to go into his pocket for a single extra penny, would wind up owning his store. For our part, we would hock that mortgage, take the cash, and invest it in profitable out-of-town properties I had been scouting. It was an attractive deal all around, especially for Ohrbach, but he could not see it; he was afraid he was being cheated and so turned me down. I gave Ohrbach thirty days to think it over, but he again turned me down, and I put the parcel on the market. Quite soon a man named Weinstein from Brooklyn bought the property for $1,150,000 (the $72,000 rental represented a nice return on this investment). That might have been the last you would hear of the deal—except for one thing: Mr. Weinstein was the owner of Brooklyn's Mays Department Store, which is not to be confused with the national department store chain mentioned in my Denver chapter. What Weinstein wanted was a merger with Ohrbach. Over the years since that purchase, Ohrbach had held Weinstein off, but that lease was going to run out someday, and Ohrbach was understandably nervous about having a landlord who, if the occasion arose, could apply excruciating pressure. As a result, in 1951 I did not have too much trouble making a deal to move Ohrbach's to Thirty-fourth Street at a yearly rental of $435,000 against a percentage of sales and with a negative covenant against their establishing another store within a specific mileage of the Thirty-fourth Street site.
On the strength of this lease I was able to borrow enough money from the Central Savings Bank to pay McKim his 5.45 million dollars.
As my friend Jim Lee at the Central Bank put it, "I don't care what you paid for it, what matters is the value of the building now. If you created a new value by getting a good lease, we will lend on that value." He gave us the money at four-percent interest, and we were able to acquire a most profitable property with no actual equity investment of our own.
About a year later, however, a broker representing James Butler (a scion of the family that owned the Yonkers Race Track) came in looking for another kind of deal. Some years ago the Butlers had bought property on the edge of New York, in a place called Baychester for a new race track which they had never been able to build. They owned four hundred acres; the family wanted to swap that land for some income-producing property.
I said, "I have just the thing you want. . . . I'll give you Ohrbach's on Thirty-fourth Street. It'll give you $150,000 a year income after paying the charges on a 5.4-million-dollar mortgage."
The Butlers liked that, and we made a deal. They felt safe about their income, and I felt safe because it occurred to me that it is pretty hard to go wrong when you trade one acre in New York City (with a 5.4-million-dollar plaster on it) for four hundred acres in New York City free and clear. It was in Baychester that we later built the Freedomland Amusement Park, which is another, later, and different kind of story. It is in Baychester that the United Housing Foundation, a labor-financed group, is building Co-Op City. Co-Op City, the largest housing project in the world, will, at a cost of over 350 million dollars, house 16,500 families (75,000 people). It is the last great work of an amazing man, a Russian immigrant named Abraham Kazan, now eighty-one years old.
I have always been rather fond of Baychester; its acreage and potential for development pleased me. It was the similar lure of an enormous acreage near an urban area that attracted me to the Great Southwest project which was organized between Dallas and Fort Worth in Texas, but this later venture also illustrates another point.
Sometime early in 1955, Bob Anderson, for
merly the Secretary of the Air Force and subsequently the Secretary of the Treasury, stopped by my office for lunch. Anderson, a Texan, was a trustee and executive officer of the Waggoner estate, which, with its million-acre ranch, is one of the greatest land holdings in the world. But Anderson wanted to talk about a much smaller Waggoner ranch, the family's 2,500-acre quarter-horse breeding-and-racing ranch along Route 80 between Dallas and Fort Worth.
Dallas and Fort Worth are rival and quite different cities. Dallas is a relatively sophisticated city of great wealth which thinks of itself as a Southern city. Fort Worth, on the other hand, is where the West begins. The competitive fires between these two cities were fanned by Amon Carter, publisher of Fort Worth's main newspaper, a banker, and wealthy civic booster who, if he went to Dallas, conspicuously brought his own lunch in a paper bag. I am told he was responsible for a sign in the Fort Worth airport men's room saying, "Please flush the toilet, Dallas needs the water." Carter affected Western attire, even in his evening clothes, and wore six-shooters on his side on visits to New York.
In spite of the carefully nurtured rivalry between the two cities, it was obvious that a megalopolis would grow up between them. There were excellent rail connections between the two cities. With Route 80 getting crowded, one knew a new turnpike would eventually be constructed. A new airport somewhere between the two cities was also in order, and at two thousand dollars an acre, or five million for the whole, the Waggoner ranch was a good buy. We would acquire it— plus more land—create an industrial and distribution center, and by planning and accelerating that which was inevitable, we would create new values and profits.
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