The Derivative - Really? Real Estate? Right Now? with Matt Lasky and Darren Kottle

Episode Date: December 3, 2020

Many investors look at commercial real estate as a high-risk, confusing, and sometimes scary way to invest. Our guests today show us why this isn’t the case. From commercial real estate, to mortgage-backed securities, pandemic affects, and hedging risk, Matt Lasky of Equity LLC and Darren Kottle of Caddo Capital Management are on today to go through it all. Take a listen to learn more about private investments, hedging real estate with trading models, mortgage-backed securities, favorite investing books, levels of leverage, basic income effects on real estate, real estate debt, yield solo, deflationary periods, Maple & Ash, hedging fixed income, negative rates but not negative mortgages?, the future of large retail real estate, eating in the East Bay, and pandemic effects on future of real estate & mortgages. Bookmarks: 00:00-02:37 = Intro 02:31-27:23 = The current state of Real Estate and Lasting Effects of the Pandemic 27:24-40:40 = Is Another Stimulus underway? Inflation vs Deflation 40:41-48:23 = Malls: Quality of the Dirt 48:24-01:02:04 = The Ultimate Real Estate Hedge = Having Volatility Model 01:02:05-01:08:04 = Favorites Follow along with Matt on LinkedIn, Twitter, and the Equity LLC website. Follow along with Darren on LinkedIn or click here to learn more about Caddo Capital Management’s ACXIX fund. And last but not least, don't forget to subscribe to The Derivative, and follow us on Twitter, or LinkedIn, and Facebook, and sign-up for our blog digest. Disclaimer: This podcast is provided for informational purposes only and should not be relied upon as legal, business, or tax advice. All opinions expressed by podcast participants are solely their own opinions and do not necessarily reflect the opinions of RCM Alternatives, their affiliates, or companies featured. Due to industry regulations, participants on this podcast are instructed not to make specific trade recommendations, nor reference past or potential profits. And listeners are reminded that managed futures, commodity trading, and other alternative investments are complex and carry a risk of substantial losses. As such, they are not suitable for all investors. For more information, visit www.rcmalternatives.com/disclaimer

Thanks for listening to The Derivative. This podcast is provided for informational purposes only and should not be relied upon as legal, business, investment, or tax advice. All opinions expressed by podcast participants are solely their own opinions and do not necessarily reflect the opinions of RCM Alternatives, their affiliates, or companies featured. Due to industry regulations, participants on this podcast are instructed not to make specific trade recommendations nor reference past or potential profits, and listeners are reminded that managed futures, commodity trading, and other alternative investments are complex and carry a risk

of substantial losses. As such, they are not suitable for all investors. Welcome to The Derivative by RCM Alternatives, where we dive into what makes alternative investments go, analyze the strategies of unique hedge fund managers, and chat with interesting guests from across the investment world. You could argue at some point, you know, there's been many cases of assets in financial markets recently that have a significant amount of government interference. Those assets can be very difficult to trade. When the government decides to turn off the spigot, you don't know when they're going

to do that. And then there can be a lot of things backfire. What I mean by this is, you know, this is assets that are not trading at artificial levels, I would argue, relative to like credit. So that zero to five year credit that everyone was trying to front run, you don't have that as much or at all in a lot of the non-agency space. And so these are really attractive yields is one of the only asset classes out there, maybe some of the international markets as well, that are still attractive and haven't nearly come close to their pre-March of this year plateau. All right. Hello, everybody. We're back for the second, hopefully last COVID Corner podcast. I've been down here in the basement quarantined for 11 days now and hoping to be

let upstairs tonight. And so what am I going to get myself for quarantine exit present? I'm going to get to talk real estate, private transactions and real estate debt with these two guys. So welcome. We got Matt Lasky and Darren Cottle. Thanks. How are you? So I've been a very poor real estate investor over the years. Absent my house, I guess, but that's probably not going to work out either here in debt-laden Chicago. So I want to get into you guys convincing me real estate's an okay thing and an okay thing to throw off enough

income to pay some debt. But let's start a little with your background. Matt, you want to start? Give us a little background on how you got into real estate and your firm. Sure. So the quick story, born and raised in Chicago, my mom held onto her condo that she owned in the Gold Coast before moving out to the suburbs. And as a kid, I thought it was cool that a rent check showed up every month and she didn't have to do anything. So very naive view, knowing what I know now on real estate, but I went to school for finance and was always interested in the kind of tangible

nature and being able to have an asset that you can touch and feel and see. So fast forward to today, managing partner at Equity Velocity Funds. We have roughly 500 million of assets that we control and manage, primarily focused on medical office buildings and neighborhood retail in the Midwest, Southeast, and Texas. So primary markets of focus are secondary and tertiary markets east of the Rockies and call it off the eastern seaboard in the south. And you're in Columbus, Ohio? Correct. Love it. All right, darren give us the backstory yeah i am from originally from louisiana so my firm caddo is is uh caddo parish uh where i where i grew up um what happened to the accent i want some like uh

you know shreveport is a little bit of an interesting town. It's not such a strong Louisiana accent. There are some pockets, but I would say that that's really more South Louisiana. Yeah, I want some James Carville. Well, of course, yeah. Yeah. You know, I don't know if you've seen that Disney show where he the the there's the Disney movie where they're where they're down in South Louisiana and the lightning bug asked him if they're from around here. He said, no, I'm from somewhere far away. And he said, you know, he's like, oh, are you from Shreveport? That's an inside joke? The Frog and the Prince?

The Frog and the Princess? What's the name of that one? Princess and the Frog. That's right. Princess and the Frog. All right. Disney hits. So I went to college for math and economics.

And I got my start at Salomon Brothers right out of college on both mortgage. I spent time on the mortgage desk, you know, really the famous Salomon Brothers mortgage desk, as well as the fixed income derivatives desk. And that's where I got started in learning about non-trading mortgages, non-agency mortgages, hedging, both credit risk and interest rate risk. And so what I do in my fund is a hedged vehicle for accessing mortgage credit. And we're doing that through fixed income, investing in mortgages.

And we have a tactical future strategy that performs better in higher volatility. So that acts as a hedge. Let's go into that a little bit right off the bat here. So mortgage-backed securities, famous or infamous, depending on your view in 08, 09, right? But they were screaming buy after that, right? That's right. Backstop. So take us through the whole evolution of the mortgage-backed security and kind of where it exists today. Well, so it was one of the buys of the century post-08. You know, really attractive returns. These were beaten down, severely beaten down, because that was the epicenter of the crisis.

Starting in 2007, the couple of Lehman funds that blew up. In 2009, when the economy rebounded, the stock market rebounded, these were incredible investments. At least at a minimum, digit returns. You know, fast forward today, there's still, we're still not back to the issuance that we saw pre-08. So where you look at other asset classes that have really regained their highs, their frothiness and so forth, the non-agency mortgages, the private label mortgages, commercial mortgages, there are still a lot of fines out there that are good attractive returns. But wasn't some of that issuance was fraudulent and right? Like some of it was so frothy and so there was so much issuance because they were giving it to anyone who would sign their name, right? This is true. And we actually swung back in the opposite direction where it was very difficult to get a loan.

So people that were actually worthy credits were being denied the loans. So in the loan market, you're seeing a very attractive credit profile. And you also have a situation where you've got these legacy parts, some part of our portfolio is legacy mortgages, pre-08 mortgages. And one of the interesting things about these is if they haven't paid off now, by now, then- It doesn't make sense to refinance or anything. It doesn't make sense to refi. And they're, you know, so they have neither the convexity of risk or much credit risk. So those are very attractive. But in general, you know, we're seeing much better credit worthiness.

Specifically right now, what you saw is the Fed decided to back pretty much everything in the market, except non-agency mortgages. So while you've had the stock market rebound strongly, you've had corporate credit become extremely frothy in my mind, mortgages weren't backed. So if you're someone that likes an asset class that's free from government interference, this is one of them. So that's good and bad. Well, free from government interference because there's so from government interference. This is one of them. So that's good and bad. Well, free from government interference because there's so much government interference. I'll put it this way. You could argue at some point, there's been many cases of assets in financial markets recently that have a significant amount of government interference. Those assets can be

very difficult to trade. When the government decides to turn off the spigot, you don't know when they're going to do that. And then there can be a lot of things backfire. What I mean by this is this is assets that are not trading at artificial levels, I would argue, relative to like credit. So that zero to five-year credit that everyone was trying to front run, you don't have that as much or at all in a lot of the non-agency space. And so these are really attractive yields. This is one of the only asset classes out there, maybe some of the international markets as well, that are still attractive and haven't nearly come close to their pre-March of this year,

you know, kind of, you know, plateau. Yeah. And that makes it a really good attractive profile. So that's mostly on the residential mortgage side? Are you talking commercial mortgages as well? It's across the board, residential and commercial. So just the asset class that is non-agency, not backed by Fannie, Freddie, any of the government agencies, they were willing to, it seems like the Fed, the Treasury, maybe if we would have seen

something worse than what we saw, but it seemed like they were willing to let the situation unfold in March. And that's why we saw the price really escalate and such volatility in March. Whereas corporate just know, corporate just, you know, all of a sudden just had a very sharp V-shaped recovery. Well, Fed started buying outright. Well, there was front running ahead of the Fed in those asset classes. They knew which ETFs they were going to be buying. So Matt, let's flip it back over to you and come at it from the commercial side.

And just what you've seen historically as the opportunity and kind of what it looks like now. Sure. So I think, you know, a lot of going back to March, you know, a lot of the people who were around in 08, 09 thought, you know, they might have another buying opportunity kind of, you know, just assets thrown to the wayside without really much thought and for sellers. That definitely wasn't the case, mainly because of some of the stimulus maybe that would have been parallel in the public markets kind of helped its way into the private markets. I don't think we're through the woods yet, but if you look at like a lot of the industrial REITs, storage REITs, apartment REITs, basically everything but call it mall REITs and some of the neighborhood retail REITs, their collection took a dip for maybe March and April and a lot are as strong as they've been.

So didn't really get hammered. There's still been a wall. You were seeing those articles like Gap wasn't paying 80% of their rent and big headline things like that, but you're saying it wasn't that bad? So I think we could probably go for an hour and a half on the nuance of retail. My thoughts are, in summary, malls are highly nuanced and we're over-malled, and that's going to be a mall-by-mall conversation on what shakes out. But there's been a number of examples of Sears goes out, JCPenney goes out, they were paying a handful of dollars of rent because of legacy rent issues. And then, you know, someone in San Francisco redevelops that and they're getting 25, 35 a foot and real accretive kind of profit growth through the redevelopment. But, you know, so there was, I think, retails got murkier waters ahead.

I also don't think we're through the woods because of the amount of stimulus that was thrown at this. I don't know if a lot of the, call it non-public private operators who are tenants, have really kind of stabilized and set their, you know, their path forward. You know, you think like restaurants, gyms, things that weren't publicly traded, some of the service oriented things. They've got stimulus money, but we've got maybe a wavering second lockdown, depending on what state you're in. There are second lockdowns. I just, I don't think, worst on the early innings of the long-term

kind of rent reset and asset price reset. There also haven't been a ton of transactions, but the ones that are are really quality, call it asset trades fueled by cheap debt. So kind of the saving grace here is the spread between, you know, where you can finance a commercial real estate asset and you're going in cap rate, which is basically, you know, your net operating income divided by purchase price. So you're going in unlevered yield based on where you can, you can borrow those spreads are, are still huge. So people are getting two, three, 400 basis point spreads with rated credit. You know. People whose credit worthiness in the bond proxy is investment grade quality. And they're financing that at three to three and a

half percent debt, or some of the multi-family guys are borrowing sub-free. And these are like the big operators or big real estate developers can borrow for next to nothing. And then they're still going to get a cap rate that's above that. So they're still okay. Yep. And I mean, there's real positive carry. And then the flip side of that is if you think there's inflation on the horizon, those are all inputs that have to go back into real estate to build them. So there is a little bit of a peg to inflation, the underlying asset value. And so people like to go in and yield in a relatively low yield world, and it's got positive carry if you can buy right. But to me, that doesn't mesh with what you see

and hear on the news, right? Of like, hey, there's 30 million unemployed, there's people aren't going to go back to the office in the same way, right? So you might not be talking about office space, but what are your thoughts on the lasting effects of the pandemic? Like, even if we come back, there's not lockdowns, is there going to be lasting effects on where we'd come from? Yeah, I think absolutely. And, you know, the Chicago's of the world, the New York's of the world, right? Call it 40 story office towers where people don't want to be in crowded elevators. And now, if you're going to socially distance appropriately and try to go into the office, it's a commute once you there, but we don't do a ton of gen office, but there was a trend over the last 20 or 25 years where the square foot per employee shrunk way down and, you know, it was near record lows. So that contracted, if that expands back again, there might not be this horrible dearth of, you know, empty office space. It seems like we're having nuanced conversations where remote works great, except the people in leadership don't always feel that way. And it's tough to build culture. You know, no one has really gone through a recruiting cycle yet

in the COVID world. So people have onboarded new employees in this digital world, but we still haven't seen results. It happened in March. And so we're eight months past, but no one has a full year of fiscal performance to see how their company operates in a kind of remote and distributed world. And the most famous maybe anti-example to work from home was when Yahoo went fully remote and then called everybody back in, you know, 12 to 18 months. And I think the answer is going to be in between. I mean, they also had a dying product at the time, right? They did. That doesn't help. I think the answer is in between. But where I think we see a lot of this shakeout is in the non, you know, kind of core markets, people are realizing that you can get a really good

cost of living in the Georgias, Atlantos, Nashvilles, Austins, Columbuses of the world, where there's educated workforce. We can work remote. The internet's everywhere. And that million-to-million-five starter home in the Bay Area, you can live a really great life most other places. So I think we're going to start to see some acceleration into these migration patterns into warmer and more tax friendly, probably environments from call it some of the major cities. kind of will self-correct, but it might be a 50-year self-correction, right? But if like Nashville traffic gets so bad that it can't support itself anymore, they've got to do something. They've got to raise taxes to build new roads or whatever. So it seems to me that long-term that self-corrects. But who knows? You have Rust Belt towns that have never come back, right?

Yep. No, that's true. And I also think that we as Americans aren't really good at looking five to 10 years in front of us. So it's like Nashville's great today or Austin's great today. Not thinking that, you know, hundreds of thousands of other people think that too. And that the traffic five years from now won't be what it is today. I don't, I don't. It's bad. I have friends there. They're like, get these Chicago. And there are a lot of Chicago people. They're like, tell your people to stop moving here. I can't, it takes me 40 minutes to get down the street now. Yeah. And so Darren, how do you view the mortgage side of it? Like you're making an implicit bet, right? That you think these people are going to be able to continue to pay off their mortgage in mass, or what does that look like? There has to be at some percentage, does the whole mortgage back separate into tranches still and all that? That's right. Well, but so I think what the conversation that you and Matt were just having really does, it really does show the bifurcated outcomes, if you will. And,

and really why I think that you need a prudent approach, because I think that there's the base case here where I think that the real estate is probably one of the best rebound plays. We have a vaccine that's widely adopted and accepted by, you know, call it June, July, August, some timeframe. It was certainly by fall of next year. The market is not going to, it shouldn't be something that discounts only one, two months in advance. It's going to be looking a year out. In that particular case, you've got, you know, you have prognosticators that said, you know, the whole industry is going to, everybody's going to be working from home. No companies are going to be going back to the office. And so if you have that case, that base case that we're talking about, where folks are

going back into the office, maybe it's still part-time, but there's still a need for physical office, then that means, yes, that means that there's some resumption in the economy and there's probably going to be some built up, a pinned up demand, which is very good for this asset class. On the other hand, what you're seeing is you've got a number of different points where you can see some stumble and some obstacles. And that's where I think either, you know, to, to, to use the, the real estate example of, of, of margin, margin of safety through that cap rate and through the coverage ratios of the properties and so forth. In the fixed income space, you've got to make sure you're in the right, you know, tranche, as you mentioned at first. And I also see the potential for higher volatility, because right now you've got stock market at hitting all time highs. And you could argue that's because the maybe the maybe you could somehow justify it by saying that the economy's

super great. I don't necessarily buy that. I think we've had a liquidity-driven increase in stock market. But to the extent that the economy is not going off a cliff, that's where you've got the real estate plays, fixed income, non-agency, some of the lower tiered credit as very attractive plays because you're not seeing the economy go up to cliff. But that's not to say that there's not going to be some bumps along the road. We've got a new administration and so forth. And that non-agency and lower tier, that's you're saying that's going to be the first one that gets hit if the economy does massively slow down? It would, but it also offers an incredible risk reward. And so right now, volatility is higher than where, say, look at the VIX proxy.

It's higher than it was the average over the last three, four, five years. But it's still an attractive type of hedge against a catastrophe again. That was a hedge we had, and I still think that that's a hedge that's going to potentially play out if we see some stumbling in that particular asset class. And Mary, you two together. I don't know what I meant there, but right. So if you're, Matt, you're doing private investment into these properties, you're taking on the debt. Yep. You're receiving the payments and you're earning that spread, simplistically.

So how do you go from there to a mortgage-backed security that Darren can buy in his mutual fund? So is someone packaging that up? Talk me through that. Yeah. So we do a lot with banks who might resell the loans, but aren't going to repackage them. But I'd say probably the best connection point is much like Darren was saying on the risk reward spectrum, three or four years ago, we were taking on less leased property with less lease term and higher leverage and aiming for higher risk adjusted returns. Whereas today we're buying more stable things with higher lease term in place and lower leverage levels to try to have that margin of safety that Darren talked about.

And we're going to have wider cash reserves, wider debt service coverage ratios to hopefully not have a situation where Darren is trying to foreclose on us if he owns our loan and get back to collateral. And so I think... Sorry, real quick. I think leverage was the piece I'm missing. So you can take your 500 million and go invest it and buy these properties, but then you don't have the leverage. So better to take your capital to the bank, get leverage, then buy the properties. And then that leverage they're providing you as a loan that it's getting packaged. Yeah. So historically when we were buying assets, call it five to 10 years ago, it certainly come out at 08, 09, to the extent we could get it, we're going 75%

leverage. So for every dollar of equity we put to work, we take on $3 a debt. Today, that's more like one to two. And so we've taken down that leverage based on where we think we may be headed in the economic cycle. And is that self-imposed or is that bank-imposed or a little bit of both? Mostly self-imposed, a little bit of bank-imposed or is that bank imposed or a little bit of both? Mostly self-imposed, a little bit of bank imposed, but it's, it's really that we're trying to lock in that yield for as long as we can. So it's, um, you know, because of what the 10 year treasury has done and, and LIBOR. And so real estate is this weird industry where we're still pegging

things to LIBOR, even though we know it's going away. And because that is in the tubes, we're trying to lock in fixed rate debt for as long as we can. And sometimes a trade-off there is more conservative leverage levels to the bank, but it also makes us feel good too. And we've managed kind of our equity return side with, we'd rather tamper back the returns and not try to take that extra, you know, 2% annualized return for debt maturity or debt service coverage risk. So, and Jeff, I mean, from my perspective, this is music in my ears because, you know, it makes, you know, so I'm, if you will, I'm not taking specific credit to, to Matt, but we could set that up. We could do a little side pod,

but see that makes it that that's better for me. And that's better for this industry to hear that people are approaching it that way. You know, whereas, I mean, I would rather bet on Matt than I would the spec investors who are propping up Nasdaq stocks on Robinhood. I mean, and that's really the choice that you've got and why this space looks so attractive. Right. But to me, that's an interesting point, because it's like you're betting on real economy versus like what we see on CNBC economy, right? Of Tesla and everyone going to the moon. Like this is actual real businesses renting real properties and paying real money, right? I mean, to some extent, it's justified that this market still hasn't reached new highs. And it's still below the February. because, you know, I mean,

there's no two ways about it. We've seen some creative, maybe not even creative destruction in this economy, just destruction in this economy because of the, you know, because of the virus and pandemic and the steps we needed to take. But to the extent that there's a vaccine and this ripples through the economy, you're going to see improvement in the real economy, which is going to pay dividends to, you know, hopefully my investments and Matt's investments. what where are you guys both stand on if they're going to be more stimulus you think we need more stimulus you think that's coming down the pipe and does that help you i'd say we're not necessarily making investment decisions on it, but as you can imagine, we get asked that all the time. And we think some is coming, especially Chicago, California, locking back down, same with New York.

So that's a lot of the U.S. clout, at least in the financial industry. We think there's a good chance. And then, you know, without getting political with, you know, the new president coming in, you know, probably more apt historically to give some sort of stimulus or spend. Maybe the last four years probably weren't very analogous to typical Republican, you know, politics. But, you know. When we've had other guests on here saying it doesn't even matter your politics, the Fed is out of bullets. They're pushing on a string. So even if they want to do something, it needs to be fiscal instead of monetary policy. Yep.

That's right. I mean, look, to answer your question, we have to know what's going to go on in Georgia. That's where that's where it all the crux of this. That's the inflection point right there, because the Democrats can pass stimulus in the House and it can come to a standstill in the Senate. And I would say that in a divided government, Senate versus presidency or versus the executive branch, neither side wants to give so i don't think that that looks very like a situation where we're going to see a ton of fiscal stimulus um i'm just going to get real political now what do you guys think i'm like basic income what does that do for the whole real estate model right if there's if people just get checks and they can spend those checks on their rent or whatever, would everything just reset higher that by that amount?

Or you think that would be a good thing? It would take away a lot of risk on your side, right? So we only dabble in like multifamily and I have some like personal allocations there to people who do it far better than I do. I think it could be good, but if you look at areas where there's rent control or severe restrictions, and so kind of taking the opposite end of a bunch of stimulus, but suppressing demand artificially based on zoning laws and stuff, prices have gone through the roof. So maybe that's great in the short term for investors. I don't know if as a country, that'll be great long-term because the private side is going to find a way to profit off it and win more and enough won't be enough because if I buy something and for every dollar that flows to the bottom line, I get call it 15 to 20 times that value in balance sheet wealth.

When I go to sell it, it's just going to continue to kind of magnify wealth gaps. Yeah. What's interesting to me on it is if you just think of like Apple and Amazon, for their stocks to keep going up at some point, everyone's got to keep buying the stuff. If they don't have enough money to buy the stuff, give them more money to buy the stuff so your stock can go higher. So you feel like everyone could get on board with it at some point just to make stocks go higher. I think you're talking about something, so universal basic income. In my mind, you're talking about- Really jump the shark. We'll pull it back after this.

You could, that could potentially be inflationary. I mean, there's not much out there that looks inflationary. I mean, even if the Fed is going to run hot, which, which they've basically telegraphed that they're going to, and you've got Yellen in the treasury who is also very dovish. And, and it looks like Brainerd is going to be the next Fed chairman, you know, but all of those things, none of those things auger for we haven't had inflation. Now, you introduce what you're talking about, and I think you could start seeing cracks estate because inflation, you've got the real asset that's going to do much better in that type of environment. This could be one of the safer places in an inflationary world. Right, which Matt, you mentioned you kind of view it as a bit of an inflationary hedge.

You didn't say hedge. I can't remember what you said. Yeah. I just said, you know, there's, there's tailwinds to real estate because you own a real asset when, when it's inflationary and mainly from the equity side, we like it because it increases our margin of safety because if all the input costs go off, you can't go build down the street for the same basis I own my asset. And that's a good thing. From a competition standpoint, you're saying? Correct. So let's talk the flip side of that of yield so low. And if we go in a deflationary environment, what does that do for both the income stream and the investment as a whole?

So one of the questions we always wrestle is what the reversion and sale of your asset looks like. And so if it's deflationary and yields go lower or we pull Germany or Europe and we go negative type of situation, cap rates are slightly, they're highly correlated to the fixed income proxy and bonds, but they're also reflective of kind of demand and investor sentiment for commercial real estate. It might hurt near-term yields, but I think real estate is, in our world, seemingly getting more and more attention from registered investment advisors, family offices, some foundations and endowments as just a better place to look for fixed income relative to corporate bonds. And in a lot of cases, you can get the same underlying corporate credit, not in a bond, but through their real estate secured by their lease. So you're just behind the bondholders, but you have an asset if something goes wrong and similar credit worthiness. What does that look like? Aren't those firms big publicly traded that would lease to like

Boeing or something in Chicago? Is that what you're saying? Yeah. So if you just take like, everyone seems to know retail well, and regardless of the outlook, right, if we own McDonald's on a long-term single tenant net lease, now that might be tougher to do something with than like an office building. Let's say it's not, you know, there's times where you can buy that real estate for a substantially higher yield with call it 15 or 20 years of lease term than their corporate bonds trade at. I'm not sure where that's at today, but those conversations used to not be a conversation of, hey, where do we go search for yield? But because yields have gone to zero, people are starting to get creative. I'm talking to guys like Darren or looking at things like that of, all right, this used to just be 20-year treasuries because they were safe and they yield a decent amount. Now I can't do that.

Where do I go? But that to the point of a lot of those people are, you know, the danger there is they're stretching for you and they're getting into more riskier stuff. So Darren, talk to me about your, you're not only doing, uh, the real estate income stream, you're hedging that with systematic trading models. So talk to us a minute about that. So I would say you could see some pretty decent trends develop on... Yields are so low that it's really hard to make money on a trending fixed income asset right now. There's way more room at this point to see a trending asset as interest rates go up. So to the extent we can get short on the fixed income side, that's where probably

more money can be made going forward. Germany and Japan beg to differ because the Bund and Japanese 10-year went negative, further negative, more negative even so. So I mean, there was trends there, but I still think at this point, there's a lot of money being made on the short side to see rates go up. On our fixed income assets, we could get hit, I would say, one or two months. I look at it based on the 2013 taper tantrum and what happened to this space. Yeah, it got hit, but it was one or two months. And then the market repriced and it rebounded and it actually ended up being a very good environment. So I think we're not insulated from a very, very short-term perspective, but I think that higher inflation could be good for us because both on the trend side, making money on that side, on that way, because I think there's going to be more

opportunities, as well as our fixed income assets are pretty short duration. So it's not a problem for us buying a 30-year corporate bond or a 30-year treasury. That you could be underwater for a long time. But the whole concept of your model is not to just own the income, right? It's also to be- That's right. So just talk to us for a, what the other sides of the old model are. Well, so, you know, we've done a lot of research in terms of, of trend models that work on interest rates on the upside. And so we've really pinpointed different models to make sure they could capture moves that we saw in, for example, 1994, you know, big upward moving rates.

The 2006, 2005, 2006 environment. And then also looking at more recently, 2013 paper. So we want to backtest our models and make sure that they're robust to be able to make money in higher rates. So we can get, we quite simply, we can just get short, you know, five-year, 10-year treasuries on a systematic basis. And that's how we make money in that, on that. And we're talking some sort of trend following model. Yeah, we have, I'd say about 25% of those models are trend following. When're trying to capture early stage kind of momentum moves um trend trends tend to capture the later stage moves if they happen they haven't really there haven't been any later stage well there have but then they've reversed before you know trend following could lock in those lock in those gains so um you know we do we've got a number of different models that try to look at um try to our shorter term than than the longer term trend models of the

70s and 80s but that way got it um and i was just thinking we were talking negative rates like germany or no one no one's had negative mortgages, have they? It's not a thing. They don't pay you to buy a house. I think there might have been some shenanigans in like the Netherlands where they but they didn't technically pay you, but they like abated you. Not an expert, but somewhere in my knowledge bank, I think they were getting credited to buy things roughly. There were some interesting things going on in the Nordic countries and have seen some kind of weird. Right. So that blows up the whole model, right? Like if

you have to pay people instead of them paying you the income stream. How does that work? You know, I don't think we, just given the, the, where we are, so we're not in the, so where it's gone negative has been in that, that would be the equivalent to our U S agency space. So, you know, that would be government, you know, so situations where there was very little credit risk our our our sectors have enough credit risk where rates would have to go severely negative for our rates to see for for the the assets that we're investing to see negative i i want i don't ever want to say never never but I don't see it at all feasible. And it's not

something I think about because I just don't, I don't, I don't see it in the cards. Matt, how about you? Any pretzel brain there? You can unwrap that. No, I don't, I don't like, I don't have a strong opinion. I don't think that'll change kind of our normal course of business. I mean, if we're getting paid to borrow, I think we try to borrow more. I don't foresee that being the case. But that's usually tied to residential housing and, as Darren said, the agency side. So with us being primarily commercially focused, that would be even more mind-blowing if that pops up than a German boon going negative to me. Right. You mentioned before the malls.

I just want to touch on that a little bit. And retail, it seems nobody wants to touch that with a 10-foot pole. I haven't seen what those REITs are trading at, but are they at 10-year lows, 5-year lows? What does that look like? Not exactly sure where they are relative to history. A couple of the mall guys had to restructure. A couple are getting bought out. A lot of the mall, pure play mall operators, their stocks have been in a precipitous decline. And that, but that started, you know,

a handful of years ago, kind of as you had your Sears and JCPenney start to, and Macy's, you know, were struggling type of thing. And so that's, you know, I think in the real estate space, COVID has really been an accelerant. I don't know how much, you know, other than the work from home abilities and kind of distributed workforce. And I think, you know, we'll forever change the way we work. I still think it's going to be a blend of in-office and teleconferencing, but instead of like being on the plane all the time, I think, think you know zoom calls will be more uh more appropriate yeah but you know i was short macy's four years ago i didn't have enough uh staying power in the trade but i was looking at him like this is the same thing as blockbuster right they spend all this money on expensive real estate they pay someone to pick

out things they think you'll like yep and and And I think the real estate space in retail is extremely nuanced. So there's a bunch of data that shows omni-channel retail does better, meaning both online and store. And there's been a number of online brands that launch. You look at a Warby Parker who launched online, went gangbusters and now is building out their physical store footprint. And the data supports that being more profitable from call it a net margin standpoint. And whether it's brand awareness, or, you know, easier returns where people feel more comfortable buying something online, because then they can go return

it in the store, or swap it in the store. The data seems to support that but if you look at a macro level you know all the all the big smart wall street money always compares call it us retail per square foot to the global set and we're just we're infinitely over retailed um even if you factor in the, you know, the fact that we like to spend up to our gills and America has typically had more of a consumption problem than the rest of the world. What do you have those numbers top of mind? What do they look like? Like, I don't. Yeah, their magnitudes different. It's not like we have 10% more retail, we have more like multiples more retail per square foot. And so I think that's where e-commerce and Amazon being able to deliver to rural towns within a day

or two, that's a risk. Whereas that mall used to be the center of a county and draw from an hour in each direction, e-commerce is really putting a dent in that type of stuff. But some of the mall operators are pivoting well and building, the buzzword is experiential real estate or experiential retail, where they're converting part of their old dead big boxes to live workplace stuff, where they know, residential component and an office component. So you really don't have to, it doesn't feel as much like a mall, but leave kind of your area. And we're seeing creative things like field houses being brought in.

If you think about, you know, taking your kids to, you know, like sporting event, you know, if you can have all the amenities of a mall or go do something else rather than being a, you know if you can have the all the amenities of a mall or go do something else rather than being a you know a field in the middle of nowhere and stuck with like concession stand food um you're seeing creative things like that in vero beach where i'm from i was down visiting my mom before covid hit and she walks in the mall in the morning so we're doing the walk it's like a church like this years is now a church the uh a kung fu studio the sheriff like a satellite sheriff's office and i was i was telling uh her husband i'm like this is smart they're like

pivoting they're doing stuff and he's like nobody ever made a career selling to a church it's like they're not known for paying high real estate costs no that's uh that we we call that that's kind of like the death now once there's a church in the retail there you know, that's, uh, that we, we call that, that's kind of like the death. Now, once there's a church in the retail there, you know, that's, that's a bad sign. They don't pay. Um, yeah, but that's gotta be, there's gotta be specialists or other specialists who come in and like, Hey, we'll, we'll, we'll try and turn this thing around. Yeah, there are. Um, a lot of it really gets back to kind of blocking and tackling of the quality of the dirt. If it's in a really good location with great surrounding, call it real estate demographic

trends, if you can buy it at the right basis, then you'll be okay. I mean, we kind of flippantly say it, but we frequently all say there's no bad assets, only bad prices. And if you give me a well-located mall for free, we'll figure out what to do with it. I might not pay a bunch, but it's's like it's the margin of safety concept and now i see these malls it's just the like carrabbas and like the restaurants on the in the parking lot on the outside like they're busy and there's nothing going on at the center of the mall people are just coming to go to the things in the parking lot. Yep.

And then, so malls dead. I don't want to invest them. But how about more like strip Molly type retail stuff? Or is that one in the same? No. So that, I mean, we own a lot of that.

I would say, you know, probably call it a hundred to $150 dollars of kind of gross asset value there um and you know for for 10 years we've had this term called the amazon test which was our way of saying you know if you could do it online or it had big e-commerce exposure we weren't as interested looked like geniuses up until march and then you know when you have a heavy exposure to restaurants and fitness, um, you know, we're working through some things, but our, our collections in that in April dropped to 70%. We're back in May and now they're back in the nineties. So I still think we're in the early

innings and, you know, worried about restaurants, but what's, what's normal? You're never at 100%? Yeah, we're usually in the mid 90s in collection. And a lot of that is just, there's things you're not going to be able to do online. And we're trying to buy where rents are replaceable and getting in and building a new building at the same cost for relatively similar rents is mathematically impossible. And so that gives us a decent staying power. We might not be rapidly increasing rents, like kind of call it like Bay Area multifamily guys or office guys were able to do over the last 10 years, but it hasn't been super painful. But a lot of it comes down to supply and demand. If you're in a strong suburb in most parts of the country at a reasonable basis without too much leverage, you'll have staying power and probably get through it. But if you're over levered and there's cornfields next to you and prices drop, then someone might build next door and take your tenants. that's my brother's a realtor in uh boulder denver area and he said they just keep building east they just keep going further further almost out to the airport he's like no one wants to buy

a used house when they can go three more minutes down the road and get a brand new um it's a similar thing if there's i like that if there's a cornfield next to you be wary. Darren, you got any other words of wisdom? Tell us quickly about your... So there's the model to protect on the rates going up, but you also have a volatility piece, right? Right, right. Tell us quickly about that. And then, Matt, I want to ask you on your a volatility piece, right? Right. Right. Tell us about that.

And then Matt, I want to ask you on your, you do some investment stuff on the side. Sure. Well, that was really our saving grace in March is, is, so we have a, so part of my background is I was a volatility trader, started off in fixed income and then, then led to equity volatility trading. So we have a model that is dictating our positioning in VIX futures.

And that's been a painful long, even tactically a painful long. We've lost money in and out of that. We expect it costs us about 85 bps a year. This year, it made us 17%. And so it really saved us. That's a lot of 85 bps a year you can make up for with that. Well, yeah. I mean, and we wouldn't do it if we didn't expect or hope for that kind of return on these particular occasions.

But keep in mind, it's been since really 2011, I would say, since there was a really large, significant vol blow up. But we expect that to be a hedge to us because we think that, well, for the longest time, vol was so attractively priced. And if we could tactically get in there, which our model was dictating, then we'd be able to make money. And then we actually had gone flat in our fixed income portfolio toward the end of March, stepped back in in April. But in the meantime, what we had done was gone to just agency mortgage credit, agency mortgages. And we started to, you know, this was really in the beginning stages of where we saw some sort of rebound, we had put off spread on in VIX. So we were short the front and long the second and third VIX contracts.

And that gave us a bit of a roll down return. So if vol stabilized, if vol were, so what's going on is the vol curve, the front end was way higher than the back end. And so we were playing that. That was the first thing that was going to stabilize before assets started to really rock it up. And so at the end of the day, that was the play we made at that point because we felt that was the most conservative.

It was also dictated by our systematic model. Right. It seems like most retail or most normal investors don't consider that they need to hedge their fixed income component. Right. Like you get institutional investors are buying credit default swaps and doing all sorts of fancy stuff. But a normal investor doesn't really think of that. I guess, you know, what I would think of what I would say is in this world, you can either just go buy something to yield. I would rather buy something that's yielding 15%, 16%, 17% and hedge it than to buy something in the fixed income space that's yielding 3%, 4%, 5%. Which seems like it's even hard to get three four or five percent these days right

or sometimes two and so so so we do we do want to go down and spec in the down the credit spectrum and hedge that's where i believe the risk reward is but it's necessary to put those those hedges on now we at part of our model what our model is saying is vol got so high in March that vol no longer was a hedge. It was approaching 70, which was where it was in 2008. And so what our model tells us to do is to flatten both. Because we need to feel comfortable that we can go buy an asset and hedge an asset. And with vol at 70, there's no hedge. Right. It could go to 120, but how much lower are the bonds going to go?

Yeah. And so it actually, I mean, we felt really good about that tactical move dictated by our model again, because what happened was for a bit, vol was coming down and asset prices were declining. And that's really what we, that's kind of what we expect, what we had built into our model to do that. But back right now, again, I think, we're starting to see assets that look good and vol is attractively priced.

And so we would go back, right now we're flat hedges on vol. But, you know, I, we're very close to going back into our vol hedges. And Matt, how do you guys view that from a corporate standpoint of hedging the risk, or it's just lowering the risk going in is how you hedge? Yeah, we're, you know, different on the personal level, but on the professional level, it's, you know, we play the role of commercial real estate. You know, a lot of our clients who are family offices or RIAs, it's up to them to, you know, have a global view of the portfolio and hedge accordingly or, you know, construct the portfolio

in a way that we're delivering what we said, which is pure play, private equity, commercial real estate. And then that's the bucket that's in and any hedges, part of their tactical asset allocation. Do you feel they make the mistake sometimes you don't have to name names of like thinking that this is a diversifier, the real estate? I think, yeah, a lot of times correlations go to one and people tend to forget that very quickly. And, you know, we benefit from it, but it's nice not, you know, in March, it was great not looking at a personal P&L and seeing assets mark to market daily, but that doesn't mean there's not volatility. And I would say that's the more common mistake in either, you know, what call it middle market company,

private equity or commercial real estate, private equity is that we're updating assets, you know, valuations annually. That doesn't mean they don't change every day. It just means you don't have to forget them every day. So when you're saying that benefits you, just the fact that you don't have to update it every day. Yeah. And I think behaviorally it's nice, right? It's like intuitively, you know, that they're changing, but I don't get to refresh my trading screen and see a live look at my pnl yeah i've joked around on twitter i should have gone into private equity you get to market market to what you want um manage futures world we're marking the market every day

getting calls um so then on a personal level how how do you do that? So I built and it sounds similar to Darren. I wouldn't quite call it trend following because it's a little quicker. And I'd rather get chopped out for a small loss than give back huge gains or miss the first call it 12 or 15 percent of a move. So I was year, traded everything from long and short VIX futures to gold futures, treasury futures, and more recently, Bitcoin. So don't want to sound the internet alarm on it, but I like assets with volatility because my whole, you know, I'm trying to quantify human emotion and trade it systematically. And so I think, you know, Bitcoin, no matter what side you're on, there's a lot of emotion there. And I feel like you can see it in a trading model. And so I'm interested in that. But the Chicago prop firms, right, that trade their own money,

I feel like they just created Bitcoin in a lab, right? They're like, what can we do? We need something that's digital that we can trade back and forth with one another and basically have a contest of who's smarter, who can make more money. All right. It's a trader's dream. And right now you got right the one institutional custodian really in GBTC trading at like a 25% premium to net asset value. And you're able to like buy in a pipe and have your money locked up at net asset value. I mean, it's an ARB trader's dream. It's kind of like, yeah, I wasn't around then, but it feels like the wild, wild west

of like futures trading, you know, 30 years ago. Oh, it's crazy. We get into some of those conversations here in Chicago and then a lot of them are mining it also. So that kind of like they're on all sides of it um and so you're you're saying personally I realize I'm kind of short volatility in this career wise and so I want to hedge it with some access to volatile moves on the personal account side yeah basically build a way to have something with a convex payoff that you know doesn't just you don't just watch tail

risk whether you're seeing it mark to market or not but watch it implode right it's kind of like you uh you look at some of these strategies then you see what happened in 08 um you know i real estate you didn't know what the daily value was but you know it was plummeting. And so to try to hedge that out and really it was to have, if I can allot and keep liquidity with a relatively positive carry, it's kind of like the Dow Capital, Mark Spitznagel thing of, I want to have a lot of liquidity in an 08 or an 09. So building something that's liquid and inversely correlated and suited my worldview for, you know, cheap assets. Now I also thought real estate was going to crack for the last two or three

years and have been woefully wrong. So that's why it's systematic and not what Matt thinks is going to happen. But, but that's the theory behind it. And why not just like buy puts on REITs or something? Good. I mean, that's one way to do it. You know, I do a little bit of option work, but I don't want to, you know, in high volatility environments where I have to be worried about my balls and my overpaying for volatility. I just think there's morepping their margin on VIX futures, but there's other ways through futures to have more efficient uses of capital than options and higher ball regimes. All right. I'm going to write a paper on how even when the futures are more volatile, that's an implied price. That's the same as the higher option price. But that's a topic for another day.

Yeah, I'll read it. Then we can talk about it. And when I say I'm going to write that paper, it's never going to happen, but it's in the for another day. Yeah, I'll read it. Then we can talk about it. And when I say I'm going to write that paper, it's never going to happen, but it's in the back of my brain somewhere. I'll just add, the thing about hedges is you want to have a diversity of hedges. You know, like for example, what was going on in March is gold was plummeting.

Yeah. So, you know, that's one of the, when you look at traditional hedges, they don't always work. And so I think the key is to have, you know, these different hedges. I mean, to give, you know, just to answer that question you posed about the puts on the REITs, for example, in this particular case, it would have been really good because REITs was an epicenter of the destruction in March. But what if REITs was a relatively unscathed asset class in that period, then you would have bought PITs at a relatively high implied vol and it didn't pay off. Right. What if it was like, there was something with the sun rays and you could only shop inside malls they broke the internet you had to go to the malls to shop the mall rates

exactly i mean like trend following should be the uh the strategy that that that is so complimentary right the problem is is that it's what what's your time frame right especially if it's an extended big blowout move that's going to be like bankrupt you as a real estate investor right like if it's a month of pain or even three six months so be it but if it's that's why you want to have the vix two three year blowout can can really pop a lot quicker that's why we do the VIX plus trend following because each has its own purpose. But in this particular case, the trend following, it made some money, but not that much, certainly not enough to compensate. That's why the VIX was there. Yeah, I would do an echoing on that, like looking throughout long term history, right?

If you look at like gold or 20 year treasuries as a hedge or diversifier, those correlations have changed dramatically over the last hundred years and don't always hold up to Darren's point as a hedge, depending on the environment. So, you know, I think the only way to not get your face ripped off is some sort of trend following type mentality on maybe multiple diversified and uncorrelated asset classes. Right. A systematic approach, to be sure. Yep.

So if you're just throwing dice out there right off like, oh my God, March, I'm going to hedge now, you're going to be too late. It's been fun. I'm going to move on to some of your favorites. We'll do quick fire here. So, Matt, you used to live in Chicago. You have a favorite Chicago restaurant? So, probably current favorite restaurant there, and ash pretty yeah that's fantastic the

candelabras and all the uh except we took some uh business people from spain there and it was a bad move because the it was so loud and there was having trouble translating um darren how about you any san fran spots we need to check out next time you know i gotta i have to give a nod to the east bay and i would say comice i mean if you're if you're a real foodie this guy uh is comice comice it's uh it's worth a trek out to the east bay if you're staying in san fran all right i'll do it. I don't think I've ever been to the East Bay, so I have to fix that up. The, and Matt, you're a bit of a golfer. Aspiring.

Favorite golf course. Oh, I got, I mean, haven't played there, but just watching on TV, nothing gets me excited like the Masters. I mean, the atmosphere there is phenomenal. That was. Darren, what's his name? Dustin Johnson just kind of cruised through that, though.

I was hoping it would be a little more exciting. I had COVID. I'm locked in my basement. I'm like, all right, here we go. Darren, how about you? A golfer? I don't have the patience. I've tried. I'm a member of a golf club, but I don't. And I actually would have played if my younger daughter would have kind of continued. You know, just my kids

were young and I just didn't have time to play, know and also you know i used the weekends to hang out with them but you know now that they're older i'm i am actually starting to think about getting getting back and giving it another fair shake make some friends get out to pebble beach and you'll be all good um the uh any favorite books on real estate investing? Not really. Or I'll take favorite famous real estate investor. Sam Zell, I think would be my go-to, not just being from Chicago,

but has done a great job of earning the title of the great title of the grave dancer and, and has done well. I don't know that title. What, what was he grave dancing? Yeah. But buying distressed assets or distressed debt, you know, when everybody else thinks he's nuts and, and riding the reversion. Was that his monster truck or no, wasn't that a monster truck? Grave dancer, grave digger. I think it was grave digger i think it was grave digger but affiliated uh darren how about your favorite uh investing book real estate or

otherwise yeah i'm gonna throw out one you know he actually deserves to be read um uh vick niederhofer education of a speculator it's book, but I love, that was the book that really turned me on to investing because he was so smart and he talked about history and politics and philosophy and how it all worked into his own trading scheme. Now, even though he was, you know, spectacularly blew up, the guy was so, he is still, he is so smart. And I think it's a worthwhile book to read just from understanding someone's philosophy. And then you can actually take some lessons from his, you know, his mistakes. Yeah. And so I think about him all the time in terms of being able to build in that margin of safety, build in that risk

reward and so forth because he didn't. That one instance he didn't and it really cost him. I know his brother is also a famous CTA. Last one. Favorite Star Wars character. Can I say Baby Yoda or do i have to pick a current no you can go baby yoda we've had a couple of those i had a i've got somewhere over here a little baby yoda thing i can't find it darren got one yoda yoda or senior yoda Baby versus senior. I love it. We'll see.

Next Friday, there might be some reveals when they take baby Yoda to see Ashana Toka. But we'll leave the nerddom there. All right, guys. It's been fun. Thank you. We'll put some links to all your different stuff in the show notes, and we'll talk to you soon. Thank you, Jeff. Great. Thank you.

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