We Study Billionaires - The Investor’s Podcast Network - TIP337: How to Identify Value in Commercial Real Estate w/ Ian Formigle

Starting point is 00:00:00 You're listening to TIP. On today's show, we bring back a guest by public demand, Mr. Ian Famigli. Ian has over 24 years of experience in real estate, private equity, startups and options trading. As the CEO of Crowdstreet, Ian has over 400 offerings with over $13 billion in commercial real estate. Today we talk about how to value commercial real estate, how to take advantage of trends not fully priced into the market, and the five best cities to invest in right now. So without further delay, here's our interview with Ian Formigli. You are listening to The Investors Podcast, where we study the financial markets and read the books that influence self-made billionaires the most. We keep you informed and prepared for the unexpected.

Starting point is 00:00:56 Welcome to today's show. I'm your host, Dick Broderson. And by popular demand, you have one of our favorite guests with us here today. And that is Ian Famigli, Chief Investment Officer at Crowder. Street, and he's with us for the sixth time. So, first of all, thank you, Ian for joining me today here in The Investors podcast. Stig, it's a pleasure to be back on this show. As you know, I'm a big fan of what you do, and I love coming on this show. So I'm eager for today's conversation. That sounds fantastic. And Ian, as we kick off this interview, talking about the outlook for

Starting point is 00:01:28 commercial real estate in 2021. Let's first take a look at 2020, because it's not possible to say 2020 without talking about the coronavirus. So let's get right to it. How did commercial real estate perform in 2020? So to begin with, the key theme for commercial real estate performance in 2020 was just simply unprecedented price dispersions that was driven by the effects of the pandemic. The results were either good or very bad depending upon varying circumstances. So to begin, Let's provide some context as we get into the numbers, and I think we can look to some benchmarks for a little bit of help. I think the first is the S&P, right? That finished 2020 at up 16.26%. I think we can all agree to take that that that's a fairly amazing annual performance number, given where the index sat mid-year.

Starting point is 00:02:21 Second is public reads. The MSCI U.S. Index captures 99% of all U.S. reads. So it's a pretty good proxy, and that was down 7.5% for the year. And that's an unlevered number. And I'll get into that in a minute. So for the commercial real estate sector, when we think about private returns, there aren't really any good publicly available data for price indexing, but there are good proprietary sources of data. And Green Street Advisors' commercial property price index or their CPPI is one of the better ones,

Starting point is 00:02:56 as it tracks a large sample size of private U.S. real estate returns on an unlevered basis. So across all asset classes, Green Street CPPI was down 8.2% for 2020. But blending across all asset classes, I think creates noise in the data because of that massive price dispersion that we witnessed in 2020. So now when you break out that data by asset class, you have two types of real estate that were up across the board last year. And they were industrial at 9.5% and manufacturing. housing at 11.5%. And on the downside, you have retail at negative 20.7% and hospitality at

Starting point is 00:03:41 negative 25.1%. And I think those numbers shouldn't surprise anyone, as we all saw the massive distress that hit these property types throughout the pandemic, still continue to do so, really. You know, apartments, they were down a bit in 2020 on a blended basis, but nominally at 3.4%. But when you take these data, I think to truly get a sense of how private investors actually fared in real commercial real estate deals across the United States in 2020, you need to apply additional filters. The first is leverage. Practically all commercial real estate is leveraged to some degree.

Starting point is 00:04:22 So an unlevered analysis, I just don't think it really gives you a correct assessment of levered returns. So if we want to apply a leveraged assessment, a benchmark number, for example, I think assuming 60% is a decent blended assumption across all risk profiles. And when you apply a 60% leverage assumption to the unlevered analysis, you create a multiplier effect of 2.5. So now let's go back and look at that Green Street CPPI index data on a levered adjusted basis. And now we see industrial and manufactured housing spike up to nearly 24% and 30% respectively. So pretty strong returns on the upside. And then on the downside, well, the returns get pretty dire.

Starting point is 00:05:09 You see negative drops for hospitality at 51.6%. And then on the downside, you see pretty dire drops. For retail, you see it hit negative 51.6% and negative 61.6%. and negative 61.6% for hospitality. The second filter that I think you have to apply when looking at 2020 performance is geography. Because the price dispersion that I mentioned a minute ago, not only occurred by asset class,

Starting point is 00:05:37 but it also really occurred by location. So to get a sense of how location effect returns, let's look at apartments, for example. As I just mentioned, apartments were down 3.4% on an unlevered basis, or roughly 8% on a levered basis across the U.S. But the blend doesn't really tell the story for apartments. Because on the downside, locations such as New York City in San Francisco,

Starting point is 00:06:03 they were hit pretty tremendously. Asset values are probably down 20% in those cities. So applying that 60% leverage assumption to that scenario, that's going to equate to a negative 50% return. Conversely, apartment values were up in many cities, many secondary markets. Phoenix, for example, is a great example. We saw 4.4% rent growth in that city in 2020. Pricing is up there double digits and multiple sub-markets.

Starting point is 00:06:30 So if you assume a 10% price appreciation there, well, now you're up 25% on a levered basis. So taken in its totality, it really mattered what you were invested in and where you were invested when it came to estimating total returns for commercial estate in 2020. It's amazing whenever you went through those different classes, like how they performed. I mean, this is unprecedented. Now, Ian, here on the show, we talked about the excessive money printing and the impact it really had on asset prices and we primarily talk about stocks. You mentioned how the S&P had performed in 2020, probably something that we didn't expect

Starting point is 00:07:08 to happen, giving everything that's been going on. And here we are. So how have the money printing in 2020 and also the expected money printing in 2021? affected commercial real estate prices as an asset class in general. At Crowdstreet, we've also been paying attention to how the debasing of the dollar is affecting the commercial real estate market. And, you know, I think the data point that really stands out to me and continues to somewhat astound me is that over 20% of all dollars now in existence were created in 2020.

Starting point is 00:07:42 You know, I'm not an economist, but I simply don't see how this much liquidity pumped into in the market this fast doesn't put at least some upward pressure on commercial real estate prices over time. And when you combine that level of injected liquidity with a telegraphed stance from the Fed of holding interest rates down over the next two years, even if it is at the expense of some inflation, I think you have a recipe to suggest that while some inflation will occur, even if its effects may be relatively temporary, maybe a few years or so. So let's discuss why inflation puts upward pressure on asset prices.

Starting point is 00:08:21 So when we combine an inflationary scenario with a return to economic growth, you will typically see rent growth. And as rents are a key driver for asset values, well, you would expect values to increase over time. And as long as interest rates remain low, we would not expect cap rates to increase much, if any at all. when net operating income of properties grows faster than cap rates, prices rise. And in fact, right now, not only are cap rates not rising, we're actually seeing them continue to compress as multiple asset classes sit at historically high spreads to the 10-year treasury.

Starting point is 00:09:03 And you can see that over time, and you can look at data on this, you know, cap rates tend to migrate within bands relative to the 10-year treasury rate. So that spread is just, it's bumped out. And now that interest rates are how low, well, prices got to go up. So I think when you roll it all up, I expect to see upward pressure on asset prices over the next few years. It's crazy what you see going on. You mentioned 20% of all dollars were just created. It really makes me think of Charlie Monger, Vice Chairman of Berksie Heatherwe. He used to say whenever people were asking him about macro, especially at times like this,

Starting point is 00:09:37 he said that if you're not confused, you don't understand what's going on. So I think that would be my disclaimer going into the next question. And throughout 2020 and again here in 2021, we've seen many people in the commercial real estate space calling for more fiscal stimuli to provide a safety net for the market, which might seem a little counterintuitive to what we just talked about. And also on the other side of the spectrum, we heard multiple concerns about inflation taking off, urging investors to seek hard assets. So how do you see the role of fiscal stimuli for commercial real estate investors whenever we assess our portfolio?

Starting point is 00:10:14 Well, for starters, I think it's easy to understand why people in the commercial real estate sector would call for fiscal stimulus, as it's absolutely good for the sector, both in terms of stabilizing operations, as well as for providing a floor under values. So let's consider both of those. First, the two rounds of stimulus in 2020 provided a tremendous. amount of temporary relief for all kinds of commercial real estate throughout the year. The biggest beneficiaries, while those were hotels and senior housing, as we saw the PPP loans that rolled out in middle of the year, they literally provided lifelines to those operators, and they filled multiple months' worth of negative operating deficits. The PPP was what we would call a direct form of support to the sector.

Starting point is 00:11:02 But from there, you also have to consider indirect forms of support. I think the biggest example of that is the $600 per week of additional unemployment benefits that were distributed throughout the year. They might not have directly benefited the commercial real estate market, but I think they definitely indirectly benefited it with apartments as the biggest winner. This money going into people's pockets, well, it helped them keep paying rent. And I think that showed up in the data. So for example, despite the fact that most analysts out there were predicting a precipitous drop-off

Starting point is 00:11:36 and rental collections in Q4 2020. When the time actually came, we never saw them drop below 93% at the national level, and that's according to data provided by the National Multifamily Housing Council. So continuing with multifamily, we can also see how 2020 stimulus

Starting point is 00:11:55 provided a pricing floor under this asset class, with collections remaining strong in interest rates dropping. When actual operators were bidding for deals out there, most of them that we talked with, they noted a feeling of what they described as paying a bit more to get a bit less. And to me, there's just little doubt that the stimulus dollars helped ensure the stability of multifamily operations, and that translated into the stability of asset prices. And finally, as we've already discussed, the massive amounts of liquidity injected into the market by the Fed,

Starting point is 00:12:31 in conjunction with their rate guidance, supports a thesis around hard asset appreciation over the next few years. So across the board, I just think commercial real estate has been one of the winners for sure when it came to 2020 stimulus. Interesting. Let's take a quick break and hear from today's sponsors. All right. I want you guys to imagine spending three days in Oslo at the height of the summer.

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Starting point is 00:17:12 It's the way we commute or not commute to work. Like, everything is just different. many habits have changed. And what we investors are trying to think about is what kind of impact does it have for our portfolio? We try to guess, like, make the right investment and figuring out how can we benefit from estimating the impact of those habits. So in your space, which habits do you think that we have changed for good in 2020? And how would that have an impact on how we'll invest in commercial real estate going forward? Well, SIG, I think there's definitely a lot of behavioral changes that have just occurred. I think some have,

Starting point is 00:17:46 short-term, mid-term, and long-term effects. I see two primary behavioral changes coming out of COVID that I do think have substantial effects on the commercial estate market, and they're in the office and industrial sectors. I would say that as we get into these two, it's hard to categorize either of them as permanent, but I do see multi-year effects. So first, let's talk about office. The first change that I see coming is how we will use office space moving forward. I think there is enough data out there now to support the argument that companies will utilize office space differently in the years ahead in comparison to how they utilized it in 2019. And the way that I see this changing most is in the percentage of daily use by office employees, since we clearly have a

Starting point is 00:18:33 trend right now towards granting them more flexibility for how often they work in an office. There's a bunch of research out there that's been published so far. And also, we've spoken with a number of office leasing brokers around the country that are getting live, dynamic real-time feedback. And I think there's a general consensus has emerged, and I'm sure it's going to evolve over time. But it kind of currently looks like the following. You see about 60% of workers out there that when the office reopens, they want to return to it full-time. Then on the flip side, you've got about 10 to 12% of workers who want to remain fully remote indefinitely. And then you have that balance, that 28 to 30%, now they want some form of hybrid environment.

Starting point is 00:19:16 That's part of the interesting part of the story. I think there's a couple of things to note in this data. First, you know, pre-COVID, about 6 to 8% of our office employees were already remote. So increasing to 10 to 12%? Well, to me, that's a material change, just not necessarily a drastic one. you know, second, the big question immediately becomes, wow, this is a lot of change to the office environment. Does this movement, you know, spell doom for office demand in the United States? And while we don't have real evidence out there and probably won't for at least a year or so,

Starting point is 00:19:50 I think the answer is no, as I see the results as being mixed on demand once things shake out. And I think a simple example will help illustrate this. So for starters, if we take a condensed open office format from 2019. It's tech-oriented. It's a pretty fairly dense build-out. That use is going to equate to about 125 square feet per employee. So if we assume 100-person office, we now need about 12,500 square feet to house that company. And that's going to assume up to 100% daily attendance, although we knew for the people who have those offices, that never actually happens. So now let's consider the change in use that I just discussed. If 10% of work, are now fully remote and 30% are now hybrid users.

Starting point is 00:20:37 And let's assume that the hybrid users come into the office three days per week. Well, now you're averaging about 80% of your previous daily attendance, all else equal. So now you stop and say, well, does that mean that we need 20% less space? The answer is no. And the reason for that is that in the new hybrid office, you're going to have to repurpose at least 50% of that space, if not more, to accommodate. your hybrid, part-time workers in what looks like a hotel office environment. And when we have this hoteling environment, we have to create more space around them.

Starting point is 00:21:15 And that's an 125 square feet per employee, just simply won't accomplish that. And also one thing that I think is that we're just simply going to need to give people some more space just to make employees feel comfortable. And I think that's a multi-year trend. So now adjusting for the new hybrid office buildout, we're pretty. probably now looking at about 150 to 175 square feet per employee to retrofit that same 100 employee office. Taking the midpoint of that range, applying an 80% utilization factor to it, as I just mentioned,

Starting point is 00:21:47 it's going to translate into a need of 13,000 square feet. So I think you can easily move these numbers around a little bit. Different users are going to have different stresses that are going to want more or less space, but I think my point is that the space demands of the new hybrid environment are probably going to look somewhat similar to the overall space demands of the pre-COVID, you know, quote-unquote, full attendance office once everything is considered and these spaces are actually built out, which we will see happen in the next couple years. So that's office. So let's talk about industrial. The change that I see is relatively permanent in the industrial space is the adherence to the jump

Starting point is 00:22:28 our country just took in the percentage of our retail purchases coming from e-commerce. We entered 2020 with about 12% of our total sales coming from e-commerce. And then we saw 40 to 50% year-over-year growth during the pandemic, saw this total percentage of e-commerce sales spike up to 17 to 18% during 2020, even hitting 20% according to some sources. So, I mean, I fully expect this rate of growth to come back down to, single digit levels in 2021 as we start to have a more normal lifestyle and we focus more about getting out and doing things and buying things and shipping them to our houses.

Starting point is 00:23:07 But then when you look to most research groups, from there, they project a return to a roughly 10 to 15% year-over-year growth rate over the next decade. And that's going to get us all the way up to 30% of all retail sales occurring by e-commerce by 2030. And so I think the key point here is that no one is expecting anything to go backwards on e-commerce sales. And that, to me, means that the vast majority of the behavioral changes that we just made in 2020 and how we utilize e-commerce in our daily purchases, well, those are sticking. And so once we apply this to the industrial real estate market, it's interesting because it means

Starting point is 00:23:51 that we are now roughly undersupplied by between 100 million square feet and 2,000. 200 million square feet. And, you know, according to JLL, we're going to need an additional 1 billion square feet of industrial real estate in the United States by 2025. So just a really interesting time and just overall strong underlying demand for the industrial sector. You know, I think there's a couple of additional smaller behavioral changes that I see out there as interesting. You know, I think there's revised hospitality expectations of consumers out there that may change staffing requirements at the hotels as they really get back up and running. But I think those are minor compared to the two major changes that I see in office and industrial.

Starting point is 00:24:32 So, Ian, one of the questions that I'm most excited about asking you here today is really going back to one of our earlier discussions. Actually, I think we quite a few times have talked about your investment thesis for the 18-hour cities and the opportunities that it entail for the investors. Now, whenever we see a shock like this happening, this is not just commercial real estate, I guess that goes for everything. We are asking ourselves, has the investment thesis changed? And I know that it hasn't changed for you. If anything, you have a stronger conviction than ever. Why? Yeah, I think it's interesting because, you know, as we saw 2020 unfold, what we saw actually happen in terms of job and population migration, you know, it gave us

Starting point is 00:25:16 greater than every conviction around the thesis. And so I'll get into it, but let's start with population migration. And I think that as we all spent time in our home sheltering in place in 2020, I think it's fair to say that we all thought a lot about how we want to spend our time post-pandemic and where we want to spend it. So to me, I view the population migration data from 2020 as arguably more strategic, maybe perhaps than in other years. I mean, in essence, if you moved in 2020, I think,

Starting point is 00:25:46 think there was more conviction in your decision than somebody moving in previous years. So the actual migration data in 2020, they saw people leave a lot of large markets such as California and New York. And, you know, that population outflow on a percentage basis. It wasn't large, but I think it did tell a story. And so, for example, we saw Californians depart the state last year and moved to places like Boise, Phoenix, and Austin. amongst a bunch of other places, but those are some of the ones that received more than their fair share. And I think, for example, there's an interesting data point that popped up in November that during that month, it cost eight times more to rent a 26-foot U-Haul truck one-way from San Francisco to Phoenix than it did to rent the same truck for the opposite one-way trip. Wow.

Starting point is 00:26:38 It just tells you where people were going. And then that's a West Coast. And if we look to the East Coast, you see where New Yorkers were moving. Well, they mostly moved to Florida, as well as some other locations such as Charlotte and Nashville. So moving on, the other thing that was really interesting to watch in 2020 was job migration. You know, at Crowd Street, we've had conviction for multiple years around the growth of Texas and Florida and how it will translate and is translating to increased demand for commercial real estate. So for Texas, it was a winner.

Starting point is 00:27:11 in 2020 from a jobs perspective, right? You saw major announcements come out from companies such as C.B. Richard Ellis, Hewlett-Packard and Oracle, announcing they will move their headquarters to Dallas and Houston and Austin, respectively. As for Florida, well, we've seen a slew of financial firms, such as Goldman Sachs and JPMorgan, come out and announce that they're looking to move either major divisions, contemplating either, you know, possibly even moving their entire HQs to Miami. And so I think in many respects, COVID acted as an accelerant of certain existing trends. So when we saw some of our favorite secondary markets see strong growth, both in terms of

Starting point is 00:27:56 population and job migration during the pandemic, well, that's what really gave us confidence coming into 2021, that not only are these trends still in place, they're strongly in place, and we believe they're likely to continue through the next real estate cycle. So as you're talking about there, Ian, we have seen pandemic-induced population migration spiking in certain markets. You mentioned also central and south Florida. We can include the mountain region too. And also some secondary market seems to have been the beneficiaries of a pandemic-induced

Starting point is 00:28:28 decision-making as companies recognize. change within their organization and adapt accordingly. How much of these trends are already reflected in the market? And what are your expectations of that in the next few years? For both markets that are winners and losers coming out of the pandemic, the trends overall, I guess I would view them as only partially priced in. And I think that the downside trends, well, I expect them to reach a trough and then recover faster than what will play out in the upside trends. And so, you know, so let's consider both of those. So on the downside, markets such as New York and San Francisco, I think it's fair to say that they have yet to find

Starting point is 00:29:10 their bottom as transaction volume mostly evaporated in these cities during 2020. But I think they might find their trough as early as later this year. Typically speaking, when downside corrections occur, they tend to do so faster than upside trends, you know, because as, you know, because you have buyers that quickly step out of the way and they let the knife fall, so to speak. Then, when signs of stabilization occur, it's at that point that buyers will quickly step back in. So I think that once you hit a trough, you can also see a bounce come to that market relatively quickly. So the upside trends, they're different. They typically take longer to play out. And I think that's the case because they rely on the realization of things that are unknown.

Starting point is 00:29:59 And, you know, I think a really interesting case study right now is Boise, Idaho. So in 2020, we saw Idaho attract more population on a per capita basis than any other state in the U.S. Now, Boise is still a relatively small metro at about 750,000 people. And why that's important is that means for the most part, it's still off the radar of major institutional owners. It's just still too small. And that to me means that while pricing will almost certainly increase in 2021, because of the momentum that we're seeing occur here, it's probably not going to spike majorly because the capital inflows that are coming into this market will tend to be smaller than those that are flowing into larger markets where the big institutions play. And this to me is the opportunity. If you can front run those larger institutional capital flows, essentially buy in now, and then later this decade, see Boise hit the institutional radar, it's at that point that those large capital inflows will occur, and you're going to see a more dramatic acceleration of appreciation.

Starting point is 00:31:10 So, you know, we see other upside trends also taking multiple years to really take shape. I think an example of one is you've got large secondary markets such as Dallas and Atlanta. and Seattle. And I think over time, those markets gain primary market recognition status. If they do, they're going to see new forms of capital flow into them, predominantly offshore capital. But again, I think those kinds of trends, they simply take longer to play out because they depend upon the realization of speculative factors. So, Ian, whenever we talked back in August, we discussed a report from Green Street advisors, discussing the cities it sees as the best position to thrive post-pandemic,

Starting point is 00:31:52 whenever that would be, if I just might add. And its top five cities at the time was Ronald Gurnham, Denver, Charlotte, Austin, and Phoenix. So I guess the first part of my question is whether or not that has changed, but also I know that Crowstreet also created their own list, and what does that show? Yeah, so for starters, to my knowledge, the Green Street advisor rankings, and again, check this data recently, it hasn't really changed. in terms of what they're seeing right now post-pandemic. But to your point, what has changed is that, you know, in the last few months,

Starting point is 00:32:23 Crowd Street has gone through and created a top 20 consolidated markets ranking for 2021. We're going to publish that in the month of February. And we also even broke out our top rankings of markets by individual asset types, because industrial is going to have very different kinds of drivers than apartments will versus office, right? So as we talked about at the beginning at the top of the show, like you really do need to think about asset class and location when you want to get specific about where to invest. So to rank Crowdstreet's top 25 markets, when we went through it, you know, we considered 25 different factors that blend across macroeconomic and microeconomic drivers, geographic factors, market dynamics and quality of life measures. And so when we created our rankings, our top five were similar, not exactly the same as Green Streets,

Starting point is 00:33:17 but our top five markets for 2021 are number one, Raleigh, Durham, two, Austin, number three, Phoenix, number four, Salt Lake City, number five, Dallas. So when we compare that to Green Street's top five markets, we concur on three of them, and we rank Salt Lake City and Dallas ahead of Denver and Charlotte. Now, we definitely like Denver and Charlotte a lot. Those two markets came in at number 13 and number 11, respectively, in our top 20. So a little bit lower, but we definitely like those markets as well. See great opportunity there.

Starting point is 00:33:55 And aside from our favorite growing secondary markets, we're also, I think, you know, maybe a bit unique to us ourselves, we're staking a claim to a couple of additional mountain regions. So as I mentioned, Salt Lake City. We're a big fan of that market. We see great upside growth for it in the years ahead. And as I just mentioned a minute ago, Boise, well, that came in as a top 10 consolidated market for Crowdstreet in 2021. I think that's probably a little bit different than most other institutional sources.

Starting point is 00:34:24 And we even went in and ranked Bozeman, Montana in our top 10, specifically under the strategy of multifamily development. So as I mentioned, we're in the process right now of publishing this entire 2021 marketplace outlook. It's going to be a detailed report. It's probably 50 plus pages when it hits the street. And like I said, we're going to probably publish it in the month of February. So it's not available as the date of this recording, but maybe by the time someone listens to it, it should be available. Ian, in stock investing, ranking agencies and investment banks, they typically have three

Starting point is 00:34:57 different recommendations on stocks. And I do apologize for making this a bit pop if I could use that term. But, you know, we are used to hearing like it's a buy recommendation, a hold recommendation or sell recommendation. So using those terms, what was not a buy before the coronavirus hit and what is it by today? Yeah. So let's talk about what was not a buy pre-COVID and what were we cautious on and how is that maybe changed.

Starting point is 00:35:26 So two asset classes, I think, are mainly characterized by us as not a buy pre-COVID coming into 2020, and those were hotels and senior housing. So for hotels, at the time, even before the pandemic hit, we were getting cautious on the space as we viewed this as the asset class that is most immediately exposed to a downturn, given simply for the fact that rents are marked to market every day at a hotel. And we were also in a market cycle that was demonstrably over 10 years in existence by January of 20. So we were long in the tooth, so to speak, on the market, and we just, we were a little bit trepidacious about what hospitality was looking like coming into that year. We also saw a lot of supply stacking

Starting point is 00:36:12 up in many markets. For example, my hometown of Portland, Oregon was a good example of oversupply hitting the market in 2019 and leading to hyper supply by 2020. For senior housing, that sector also entered 2020 in a weakened state, primarily as the result of a spike in supply. that was driven by an overestimation of the demand by that sector, and that led to a drop in occupancy levels. So between roughly 2017 to 2020, we saw the average age of a new assisted living resident increase from 81 to 83 years old.

Starting point is 00:36:52 So a two-year swing when you're 20 years old doesn't necessarily mean a lot, but a two-year swing in a demographic when you're over 80 years old is a meaningful difference. And that's going to change demand significantly on commercial real estate as it pertains to assisted living. So now when we think about these two asset classes today, hopefully now post-pendemic in 2021, I think that hotels are becoming a buy. And I think senior housing is still a little bit out, but will become a buy eventually. So hotels, obviously, they encountered more immediate distress in 2020.

Starting point is 00:37:27 So to me, they sit much closer to their pricing trough right now. hotel investing is certainly high risk in early 2021, will be throughout the entire year. But I do think that at an appropriate discount to 2019 values, hotels can present a strong argument for opportunistic acquisitions. So now when we think about senior housing, ultimately we're going to regain our bullishness on senior housing. We do have the baby boomer demographic that's going to drive what is called the silver tsunami is they're calling it on the street, probably by about the middle of this decade.

Starting point is 00:38:05 So if it were to occur in 2021, and we saw, you know, opportunities to purchase senior housing deals at significant discounts to 2019 levels, that could be attractive. I think our expectations are definitely tempered for operations in the immediate term. So probably to me, senior housing looks more like a buy in 2022, but, you know, as you know, The commercial real estate market is really inefficient. Sometimes the right deal is only going to come along once every few years. So you might have to kind of make that decision when it's presented. One thing that we see in most financial markets is that after a crisis, we see a consolidation

Starting point is 00:38:42 happening. What do you expect to happen post-pandemic and perhaps already today? And how do we take advantage of that consolidation happening? Consolidation is an interesting concept for the commercial real estate market and the cycle that's now emerging. If I think about consolidation, I mostly see it coming to two asset classes, retail and self-storage, but for very different reasons. So first, for retail, I see consolidation coming to the sector as this asset class finds its footing as we exit the pandemic and emerges, you know, from some of that distress. You know, brick and mortar retail is still highly relevant

Starting point is 00:39:23 to our lives. I mean, like we discussed a minute ago, even by 2030, most economists and research groups are projecting that we're still going to do 70% of all of our purchases through brick and mortar retail. So it's not like it's going away. And that relevancy today, and I think going forward, I think it's fair to say that it is still more heavily weighted, will be heavily weighted going forward towards grocery anchored centers, as well as what I would think I characterize as kind of the one or two best located shopping centers in each sub-market. So as a result, I say that I feel like we see opportunity in that best located center as it's going to be the location that will be able to backfill any vacancies that occurred during COVID by the other surviving tenants post-COVID that are going to look to improve their location. So it's to me, it's those less well-located centers in our cities. They might not ultimately be able to survive. and if they don't, I expect them to be repurposed into other things such as, well, self-storage, for example, or last mile distribution, or potentially demolished and reformatted into multifamily housing.

Starting point is 00:40:36 So this repurposing, that's what would translate into the consolidation for the sector at the ground level. And investors who buy into, you know, best located centers today at discounts to 2019 values, you know, to the extent that they trade because there hasn't been a lot of retail trading, well, I think they actually probably do pretty well. So now, think about self-storage. I do see consolidation coming to that sector, but the consolidation is really more in the ownership and not necessarily the actual real estate itself.

Starting point is 00:41:09 Self-storage is a growing asset class, and what's interesting is that it has historically been mostly operated by what we would call mom-and-pop operators. There has been a sustainable trend in place for many years that is leading to a gradual transition to institutional ownership, particularly with publicly traded reeds. And I see this trend continuing in the next cycle. And it's for this reason that we often like opportunities in self-storage where we can partner with a developer who has a live conversation going with one of the public reeds, translating into operating, management by that REIT. Typically right now, CubeSmart and extra space are the two leading providers that are most active. And once you build and stabilize that property, it's at that

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Starting point is 00:45:35 And you were talking about how you saw this year. And you divided that into different asset categories within commercial real estate. One of the things that you mentioned was hotels, and you also mentioned this previously here in our conversation. And while you also say that it's on the higher end of the risk spectrum, it's also an interesting perhaps long-term opportunity that you can find. So could you please elaborate a bit more on hotels as an investment class right now? What's really interesting as we entered 2021 for hospitality, it does.

Starting point is 00:46:09 does sit in a unique position for a number of reasons relative to every other asset class. The first is the near uniformity that we saw in the distress to the sector in 2020. Shelter in place in March and April, it caused an 80% drop in occupancy levels nationwide by April 2020. And there's a little bit of variation across geography and category. I mean, generally speaking, COVID was just a massive. massive tsunami for the sector that wiped out everything. And this means that almost without exception, every hotel in the United States is worth less today than it was in January of 2020.

Starting point is 00:46:53 And that fact alone means that there is opportunity out there. Just haven't seen this kind of like uniform level of massive distress hit a market. This is even more than we saw in the GFC. The second thing about hospitality is the fact that while the distress was inflicted uniformly across the board, it was also just unprecedented in its level of distress. We've just never simply seen any market anywhere in the United States dropped by 80% level of occupancy in a month, just simply never happened before. And because that level of sector-wide distress was so unprecedented, to me, it suggests that the market will be

Starting point is 00:47:37 highly inefficient in pricing it. So to me, that also supports the notion that there's opportunity to be found out there. There's also a lot of risk to be found out there. So, you know, again, to our point about why it is high risk. And then the third thing that I think it's really interesting for hospitality is that given everything that's happened, you know, you have an outlook that now strongly supports the thesis of a near certain recovery for the whole sector with groups such as Green Street calling for a full recovery to 2019 revenue levels by around 2024. So I personally believe that there is just a ton of pent up demand for the hospitality sector predominantly right now in the, you know, the leisure hospitality part of the sector that will start to show up and

Starting point is 00:48:22 force by 2022. You know, this is totally anecdotal evidence, but I think if you get out there and you talk to anybody, it seems as this one of the first things that we are all looking forward to do once we reach mass immunization is to go somewhere. And I think we can even look at that phenomenon. Now let's take that concept. Let's apply it to our largest hospitality market in the United States, which is Orlando. And its peak we saw in 2018 to 2019, we saw roughly 75 million annual visitors to that market. I mean, bigger than New York, right? New York comes in about 50 million. Orlando is at 75. Major market. So once Disney is back up and running in full capacity in 2022, I mean, do you really think it's

Starting point is 00:49:11 going to struggle to attract visitors and hordes? Like, I think that market snaps back fast. I think you could even hit, break a new record in 23. I mean, think about all the families out there. Their kids are aging. Time is short. You got to get your kid the Disney experience before they're too old to, you know, to really get it. So I think that just like Orlando.

Starting point is 00:49:32 a market to me that just like comes back roaring in hospitality once everybody really feels safe to get out and move around. So, you know, so I think when we think about Green Street's data, for example, I mean, they call for full recovery in 2024. I mean, who knows, that might be a little bit conservative. We might see full recovery by by some time in 2023. There's another thing about hospitality. There's just a bunch there, right? So the fourth thing about hospitality is how the pandemic has turned off the spigot of new supply. Lenders, totally understandably, they were simply not willing to capitalize a new hotel development in 2020. So if you play this forward and understand that typically speaking, you need about two years to develop a hotel,

Starting point is 00:50:15 this is going to suggest now that when we hit 2023, we're going to have a relative dearth of new supply. So now what's interesting is that if you get to the timing of when the market is really coming back and acting strong, at the same time that you actually have a market that is historically now under supplied. Now you see the opportunity for some real growth in Rev part that year. You know, and this is all fair to say that we are, you know, we're not yet out of the pandemic. There's still today in early 2021, a lot of distress in the sector. It's going to continue to play out over this year. We're going to see hotels continue to fail.

Starting point is 00:50:52 There's no doubt about that. So everything about hotel investing is certainly very risky right now. However, I do think that if you can find a hotel asset priced at a substantial discount to its 2019 value and you buttress it with enough operating reserves to see it through to 2022, I think that's your potential for real upside by 2024. Yeah, I really like you say that. And to your point about Disneyland, I planned on bringing the family to Disneyland in May, and that clearly didn't happen.

Starting point is 00:51:24 And all I heard sense was when are we going? So, completely anecdotal, but I completely agree with your assessment that once the world opens, that's probably going to be the first stop, not just for my family, but for so many others. And I really like also, Ian, how you talked about hotels as an opportunity. I think most people would say, that's the last place you want to be. But you're comparing price with the value and not just the value today with the long-term value.

Starting point is 00:51:50 And I think that's so important for people to understand. There have been investors who made a killing in airlines in 2020 because they were selling so cheaply and people were thinking that they were almost surprised as they were never, ever going to fly again. Obviously, they eventually would. But I wanted to transition into that outlook you talked about before. Multi-family also stood out to me. Specifically, you mentioned New York City and San Francisco in your outlook, and you also did

Starting point is 00:52:15 that previously here in the conversation we had because they're trading at a discount to the 2019 prices, and you argue that they will bounce back perhaps by 2024. So could you please go through your investment thesis on multifamily? Sure, Stig. And I think what's interesting about what you just mentioned is that I think whenever we look at any type of investing, you see a recency bias show up, right? Anytime something goes bad, people tend to want to extrapolate what's currently happening and then draw that out to infinity and then determine that everything is either going to be

Starting point is 00:52:50 the most valuable thing ever imaginable or going to go to zero. And as you and I both know that over time, that generally tends to not be the case. So I think, and I mean, now when we think about some of the markets that were hit pretty hard in 2020, there's definitely some recency bias showing up. So like, let's talk about New York and San Francisco. I think those are the two markets that really stand out as hit hardest, you know, during 2020. But now let's think about like, are these cities, over time, they've demonstrated resiliency. Take New York, for example. People called for the end of New York in the 1980s, right?

Starting point is 00:53:26 That's during its period of high crime. Then you go to 9-11, New York's over. It's not coming back. And then during the great financial crisis, again, it's over. In every instance, that city came roaring back, and it only took a few years. So I think, you know, it's just like betting against New York, historically been a pretty bad bet. San Francisco, you know, maybe to a slightly lesser degree, but it's also, you know, it is a bit of a roller coaster market sometimes, but it is also demonstrated resiliency.

Starting point is 00:53:56 We also have a dark period in the 1980s for New York in the early 80s. You know, things did not look good. It also bounced back really strong after the GFC. So again, these are two major cities that demonstrate resiliency. You know, the second aspect I think about to think about these markets is you have this intersection of desirability and relative value. And so, you know, what I mean by that is that we starters for like, well, New York City and San Francisco, they are desirable. These are both world-class cities. They have amazing culture. They've got amenities. They have global connectivity. And they have strong intellectual capital. And those things, you just don't find that in every city. And these types of things, they don't evaporate overnight.

Starting point is 00:54:39 And so now when we think about relative value, it's definitely fair to argue that both New York and San Francisco were reaching unsustainable levels of affordability in 2019. When you have a small condo that's trading a well over a million dollars in both cities and a small studio can rent for over $4,000 per month, it sets a really high bar on the level of income that it takes to afford life there. So if you reset real estate values now to a degree, right, and rents down, which are down like 20% in these cities, now these cities start to price more in line relative to other cities that have been actually surging during the pandemic. It also presents a window of opportunity. Now, if we think about from an affordability factor, if somebody was starting to feel priced out of that market in 2019, well, now they feel like they can jump in and they have.

Starting point is 00:55:36 what they feel like as a relative bargain. And I think the third thing to factor to acknowledge us here is that while each city took this tremendous hit in 2020, and then when you ask yourself whether the underlying factors are temporary or permanent in nature, you know, as we discussed as recency bias, I think it's going to support the argument that they're going to be a little bit more temporary than permanent. And so considering that the pandemic hit these cities heavily, both in terms of the rate of infection and then the real estate utilization rates, right? I mean, for example, New York and San Francisco, their offices hit as low as 10% for office utilization, right?

Starting point is 00:56:15 And when other markets were kind of trending in the 40s. And then you also saw apartment dwellers flow out of both cities in fear of infection. So that makes it fully logical to see these cities end 2020 as the biggest losers from a market perspective during the pandemic. And then while 2020 may have lingering effects in both New York and SF, you know, I don't, you know, I just don't see these effects as permanent. Neither city has ceased being great, in my opinion, just maybe a bit beat up. As I mentioned just a minute ago, right, great cities, they have resilience over time. I think that still applies here. So as a result, I think if you could find substantially discounted asset values, either multifamily

Starting point is 00:56:59 or an office in 2021, we'd be buyers in both markets. Time will ultimately tell, but I'm going to not be surprised if you see New York and San Francisco being back to full swing by 2025. So using either multifamily or hotel as an example, let's try to put some numbers on this. Could you be as specific as possible about how to determine and value the expected cash flows of potential deals that you see here in 2021? I think of kind of those recent examples. Let's use multifamily, an asset as an example.

Starting point is 00:57:35 I think it's just easier to understand. And so when we think about a private multifamily investment on Crowdstreet, it's on average you can have about a five-year business plan associated with it. And so that would then be the number of years that we would expect to hold the investment going in, although it's totally fair to say that the actual holding period, it could be shorter or it could be longer depending upon how things go. So if we are acquiring an existing multifamily property, let's just use Salt Lake City, for example, one of our top five markets, in most cases, that multifamily property in Salt Lake

Starting point is 00:58:11 is going to have three forms of cash flows associated with it. The first form of cash flow is going to come from distributions back to the limited partners out of net cash flow over the course of the holding period. Net cash flow is really what's left over after you collect rents, you pay all of your operating expenses, pay the mortgage, and then you also fund reserves for things like upcoming capital expenditures, maybe a roof replacement or modernizing the pool. These distributions are typically issued on a quarterly basis, and they commence after the property has been owned for a period of time, perhaps a few quarters or so, and that's at that point where the property would start to amass some excess cash. And on an annualized basis, these distributions may start out at a relatively modest level, maybe three to five percent on an annualized basis, but they tend to grow over time as properties are improved.

Starting point is 00:59:12 and rents increase. And when rents increase, they often increase at a faster rate than operating and debt costs. So let's move on to the second form of cash flow. And that is what we would characterize as a return of capital. And this can occur either at the time of a refinance

Starting point is 00:59:30 or if it's not refinance at the time of a sale of the property. If you're invested in that multifamily property in Salt Lake and you see rents at your property grow substantially, let's say that they grow at 5 to 6% over the first few years, that would be pretty strong. Your net operating income will increase to the point that there is now a decent chance that the operator of that property can refinance it and return a substantial percentage of your originally invested equity to you. What's important to note here is that refinances, they are a non-taxable event.

Starting point is 01:00:07 This is why they're really popular for private investors. So, for example, anytime that you can invest a dollar and you can get 50 cents back maybe within three years with no tax consequence to you, you're free to reinvest that full 50 cents elsewhere and start earning a return on it while you still own your same multifamily property in Salt Lake. And so again, like I said, this is just an aspect of why commercial real estate can be very attractive to private investors. They tend to want to do this repeatedly over time. and when you do it repeatedly over time, you can really generate tremendous compounded rates of return.

Starting point is 01:00:44 The third form of cash flow is coming out of this private deal is going to be the profits at sale. Now, that assumes the property goes well. We make money. We could lose money, right? And that is what we call a form of return on capital. So if we sell that property, we have $50,000 invested in it, for example. Well, we've got some operating cash flow throughout the way. We've got to get back to the $50,000 first to get repaid. our money, anything above that, that's the return on capital. And this final form of cash flow, it's going to almost invariably occur at the time of sale, right, when the property is disposed. All funds that come out of that property after the cost of the sale are netted out,

Starting point is 01:01:23 and the sponsor has calculated its profit percentage share. And then what's left over is return to the partners, limited partners, and when we see that come out, it's typically in two installments. You're going to see a large distribution that occurs relatively quickly after the sale. And then you're going to see a smaller installment months later kind of after all the final bills are paid and the investing entity is wound down. In a normal multifamily deal that we think has some value to be created and is owned over a five-year period, you know, we might see that property deliver a mid-teens annualized rate of return compounded. And maybe that doesn't even even need a refinance. Now, when you see this disposition cash flow occur, that's probably going

Starting point is 01:02:09 to equate to roughly 50% of your total net gain in that scenario, while the other 50% was paid out over time through those operating cash flow distributions. So I think that's just kind of a way to think about a hypothetical scenario when you invest in a private real estate deal. Fantastic. Ian, as always, it's been a pleasure to speak with you. I'm sure that the audience have learned a ton again from hearing from you. Why can the audience learn more about you, Crowd Street, and perhaps take a look at some of those deals that you were talking about before?

Starting point is 01:02:42 The easiest way to find me is to pull me up on LinkedIn. I'm the only Ian Formigli on the LinkedIn platform. So it's pretty easy to find me there. I'm happy to have conversations with investors. They ping me all the time. And we chat about real estate. I always love talking deals. Love talking real estate.

Starting point is 01:03:01 Happy to educate anybody. And then also our website is just there's a lot of resources there. You know, that's www.crowdstreet.com. We're popping up new deals every day. It's obviously free to join. You could just start checking things out, look at information. We always say the first thing to do when you come on to Crowd Street and join is just to start reading some information and get up the learning curve.

Starting point is 01:03:25 Private equity investing can be pretty exciting. It can also be, you know, a little bit daunting going in. But I think if you kind of take it a step at the time, you can start getting really further up the curve pretty quickly and get to the point where making an investment makes sense. Absolutely amazing. Ian, thank you so much for taking time out of your schedule to speak with me here today. Thank you so much. It's an absolute pleasure to come on again.

Starting point is 01:03:49 Look forward to doing it again in the future. All right, guys. So as we're letting Ian go, make sure to subscribe to the We Study Billioness feed. This was the sixth time we had Ian from weekly on. So if you want to listen to the seventh interview with Ian Famigli and all other interviews, make sure to subscribe to our feed on Apple Podcasts, Spotify, or wherever you listen to a podcast. Next week, Trey and I will be back with an outlook on the current microconditions. Thank you for listening to TIP.

Starting point is 01:04:17 Make sure to subscribe to Millennial Investing by the Investors Podcast Network and learn how to achieve financial independence. To access our show notes, transcripts or courses, go to the U.S. investors podcast.com. This show is for entertainment purposes only. Before making any decision consult a professional, this show is copyrighted by the Investors Podcast Network. Written permission must be granted before syndication or rebroadcasting.

We Study Billionaires - The Investor’s Podcast Network - TIP337: How to Identify Value in Commercial Real Estate w/ Ian Formigle

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