We Study Billionaires - The Investor’s Podcast Network - TIP537: The Surprising Opportunities in Commercial Real Estate w/ Ian Formigle

Starting point is 00:00:00 You're listening to TIP. My guest today is TIP fan favorite Mr. Ian Formigli. Ian is the chief investment officer of Crowdstree and our go-to expert on all things real estate, especially commercial real estate. In this episode, you will learn Ian's outlook for 2023, especially as it pertains to the risks surrounding bank failures and other illiquidity issues. How interest rates and cap rates affect one another? Which asset class has the most upside opportunity and which strategies will be

Starting point is 00:00:30 be most optimal. Ian's predictions for the future of office and retail, the risks of capital calls, especially in a downward market, and a whole lot more. Ian is always a pleasure to have on the show. The amount of knowledge he brings is unbelievable and always blows me away. If you're looking for the most cutting-edge, data-driven analysis on the real estate markets, you've come to the right place. So with that, please enjoy this conversation with Ian for Migli. 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. All right, welcome to the Investors Podcast.

Starting point is 00:01:22 I'm your host, Trey Lockerbie, and we have back on the show a fan favorite, Mr. Ian Formigli. Welcome back, Ian. Trey, thanks for having me. It's a pleasure to be back. I'm doing well. I mean, this is a crazy time we're living in, but I'm holding up. How about you? Same. Navigating a tough market, but still finding some way to discern some opportunities. So I guess all things considered will take it.

Starting point is 00:01:47 We were kind of talking before the recording and I was saying there's a lot of noise out there right now. And hopefully we can be good investors and keep our heads straight through all of it. And I've been dying to talk to you. It's been a really crazy year for the stock market and even bonds. But I have no clue what's happening in commercial property. So that's why I'm really excited to have you back on. And I know that most investors know last year was a huge down year for the Dow and S&P, but maybe you could tell us a little bit about what it was like with commercial property

Starting point is 00:02:13 transaction velocity, because I remember that being sort of a key indicator in your universe and went as far as deals go. Yeah, happy to dive in and talk about the last year in the commercial estate. You're totally correct, Tray, that it's been an interesting year and it continues to be an interesting 2023 so far. So just to start, similar to the S&P, 2020. was a down year for the commercial real estate industry across the board. As we've talked about before, Green Street publishes data that we track on a regular basis. They, in particular, they

Starting point is 00:02:43 publish what's called the commercial property price index or the CPPI. We pay pretty close attention to that. And as I've cited sometimes during our previous conversations, this last year, it was down 13% for the entire year of 2022. And this index actually tracks private commercial real estate as well as public commercial real estate across a host of asset classes. And while that total year, you know, 13% for 2022, I would say that it was back end loaded. And what I mean by that was that if we look at the first four or five months of the year, probably through May or so, CPPI was only down about 1%. And I'd say similar to what we tracked in the day to day of marketplace deal flow, I'd say it was pretty similar. Market felt pretty normal. Beginning in May,

Starting point is 00:03:31 you really started to see those declines come in. And then from May through the end of the years, when you saw really that 12 points out of those 13 points hit. And this fits with our experience as effects of like we saw the rising effects of real estate interest rates, you know, month or month, the deterioration of the capital markets really started to set in, took hold around June. And I would say that it accelerated in Q4 of 2022. If we fast forward to 23, I have often spoken about how I think the commercial real estate market is inefficient compared to other markets. And I think that is doubly the case right now. So therefore, how we are approaching the current state of the market is that we are searching for pockets of opportunity where we feel

Starting point is 00:04:09 assets are mispriced due to special circumstances while acknowledging that conventional assets simply maybe won't trade or may not present enough value to make sense to pursue. And while the first half of the year may very well continue to present severe challenges to getting deals done, I am hopeful that we might see an uptick in capital markets liquidity, which I would then lead to an uptick in demand in the second half of the year. And so if we think about transaction volume last year, you know, now, so setting pricing aside, moving on to the volume side of the equation, you know, that outcome was similar to pricing. Real Capital Linux, which is another third-party group that we've talked about multiple times in the past. And I do still believe it's one of the

Starting point is 00:04:53 leading sources that we look at for transaction volume. When we look at the end of 2022, we saw that it pegged total transaction volume at just under $729 billion for the year. That was down about 15% relative to 2021, which was a record year of roughly about $855 billion. And similar to Green Streets pricing data, the first half of 2022 was strong from a transaction volume perspective. In fact, it was actually outpacing the first half of 2021. And then not surprisingly, volume alongside with pricing is it really just started to trail off in the second half of the year. Q4, I'd say in particular. And while Q4 of 2021 saw record quarterly volume of about $366 billion, Q4 of 2022 only experienced about $139 billion of total transaction volume.

Starting point is 00:05:46 That was 62% down year over year. So just to provide some context in terms of things really did start to fall off a cliff a little bit, so to speak, at the end of the year. But just to provide some overall context to the year, it was still up 21% relative to 2019. So I do view that last year's story was a little bit more about a massive drop-off in second half volume and that some of that recency bias cast a little bit of a shadow over the shadow of the entire year, so to speak. And so, if we turn and we look at location, where did that transaction volume occur? We've talked about this in the past. Dallas recorded its second straight year as the number one market for transaction volume. The top of the rest five, the rest of the top five were Los Angeles, Atlanta, Houston, and Phoenix.

Starting point is 00:06:33 And it's fair to say, though, that all five of those top markets were, you know, down in a volume on a year-over-year basis. And if we pull back a little bit and look at the top 10 markets on transaction volume, The only market in that top 10 to actually gain in transaction volume in 2022 was Manhattan. That was about up 8% year-over-year. Nashville and Philadelphia were the only other two top 25 markets to see increased transaction volume and those were up about 25% and 5% respectively. So with 2023 starting off to look somewhat similar to the second half of 2022 from a volume perspective, we expect 23 to end the year with lower total volume than 22.

Starting point is 00:07:10 But I fully admit there is a large amount of uncertainty. in almost every regard, and particularly in terms of the pace of real estate transaction volume. So I would say that to some degree we're approaching this year on a one quarter at a time basis and just accordingly adjusting as we go. I think it's very understandable to say that you expect the volume to go down because what we're seeing in the news right now is basically banks freezing up, which probably means that not a lot of lending will be going on. And so I'm curious to get your thoughts around interest rates where they are.

Starting point is 00:07:41 not only are they at the highest level in the last 15 years, it's the rate at which they've gone up that I think is the most catastrophic to bonds and some other all kinds of asset classes right now and especially certainly took SVB down in signature and others. How is all of that generally affecting the commercial real estate market? Yeah. Well, Trey, just like the greater macro economy, rising interest rates and as you mentioned, the rate of change of those interest States is really like the story for commercial real estate, not only in 22 and also for where we sit in so far in 2023. As of mid-March, as we're sitting here recording this conversation, right? If we think about this, the Fed has raised benchmark rate eight times. And that's the

Starting point is 00:08:27 single fastest pace in a year since the 80s. And just like everything else, it's just that rate of change that's really affecting the commercial real estate market. I mean, in essence, we look back to 2022, just every time the market would, the rates would change, the market would have to adjust. Everybody would have to kind of go back to the drawing board. They'd have to like reprice assets, reprice, determine if their lender is still there, if the lender was still the best lender, if there was another lender stepping in, who was ready to transact? And so it just put a lot of thrash into the whole market. And it's fair to say that it has not cooled down. And now if we look at past, your recent events, macro events of the past week and stress in the banking sector,

Starting point is 00:09:05 sure, that certainly seems to suggest to me that the markets are continuing to struggle and to grapple with this cumulative rate of change, which is now up to 4.75 percent. We might find out next week goes up again in terms of the Fed fund rate. And while high interest rates have had numerous effects on the market, you know, I think if we overlay that on the commercial real estate market, I feel like I saw two broader themes, you know, playing out every step of the way. And the first theme really throughout 2022. Surprisingly, not as much in 23 so far was a constant downward pressure on pricing. So roughly from March through September of last year, as the Fed increased the Fed funds rate, you typically see those two follow-in effects. So first, as I mentioned a minute ago,

Starting point is 00:09:52 commercial real estate would respond in the following days of the announcement, which would typically mean they would take up their borrowing costs. Then second, as the borrowers were hit with those increased borrowing costs, buyers that weren't already locked into fixed prices with sellers would typically go back and they would retrade those assets using the rate bump as justification for price reductions. And in most cases, I think what was interesting for the first, call it three quarters of last year, what we saw were that when those sellers would receive those price retrates, for the most part, they were accepting them. And then the deal would go on and it would close at a price that would be roughly 5 to 10% lower on average than the original negotiated price.

Starting point is 00:10:31 And to me, it's important to keep in mind that during this period, these price discounts, if we look back to the 21 period, well, you would say that those were mostly just giving back some of the excess appreciation that had occurred during 2021. Remember, 21 was just this record year for transaction volume and price appreciation and everything. So while most of last year wasn't looking good, you had to like put into the context of where you were coming from and from the seller's perspective, where you were coming from was somewhere in 2018 on average. So a retrade in the middle of 22 that might be 10% even of what you thought you were going to get lower, it wasn't so bad. And so that's why those deals were probably

Starting point is 00:11:11 for the most part still getting done. Then I would say the second effect of these high interest rates that we're seeing, which I believe continue to develop over the course this year, you know, have to do with the consequences of floating rate debt that was issued in 2020 and 20, 2021 and the forecast for which is now resetting to substantially higher interest rates today. So let me unpack that for a minute. So for those of you don't know, floating rates are essentially variable rate debt as opposed to fixed rate debt. And it's more typical to see for projects that were intended to have a longer holding period

Starting point is 00:11:47 versus, you know, or five years or less. So if we think about this long term holding period, more likely to have fixed rate debt, five year or less holding period, more likely to have floating. rate variable debt. And so if we go back to 2020 to 2021, you will see that short-term interest rates were at that point, as we all know, they were exceedingly low. And the expectation is that they would remain low for years to come. For example, Chatham Financial is a group that we look at that uses forward curves to estimate where they think rates are going in the future. And if you go back to 21, you'll see that the Sofer curve at that time, which is Sofer is basically the index,

Starting point is 00:12:23 which is all floating rate now today's price off of. It was expecting late rates to remain low for years to come. And then now today, you fast forward to that and that's now 475 pieces points higher. So really what's happening now is that you have this debt that was issued in 2020, 2021. It's now being it has to reset. It's reset at massively higher rates. And whenever you're buying or building an asset when you thought you were going to create value, you would want that floating rate debt. So pausing for a minute and say, why not take fixed rate debt back then? The answer is you wanted floating rate debt because it was a tool that allowed you to accomplish that value creation and then had flexibility on selling the asset. And so what we've

Starting point is 00:13:01 now seen is that in a scenario where rates are a lot higher, it's also fair to say that these deals had caps that were put on them. Interest rate caps are essentially insurance. They typically have durations of two to three years before they reset to market value. And so in essence, what's happened now is you're seeing these other deals that had a lot of variable rate debt around the country that was originated in 2021, 2020, two to three year duration rate caps. Fast forward, that's now 23. Rates are a lot higher, earning that off, resetting to higher rates. So we're knocking out cash flow for a lot of assets.

Starting point is 00:13:36 And in some cases, it's even, you know, resulting in scenarios where those projects need to recapitalize through a bit of a cash infusion maybe to cover, you know, this short-term volatility until we get to the other side. So, you know, there's a lot going on in when the commercial real estate industry is it pains to interest rates, but those are a couple of things that we're living with day to day. So sticking with interest rates, I'm curious about cap rates. Do cap rates cause or correlate with interest rates or is it simply just supply and demand? Well, this is a great question. This is one that's been debated many times I've seen it

Starting point is 00:14:10 over the course of my career. And the answer is a little bit nuanced. But I think if you start from a causation versus correlation perspective for interest rates and cap rates, my study the markets suggest that it's really supply and demand that mainly causes cap rates to expand or compress over time. And interest rates while are a component, they're correlated, but I would say they're kind of loosely correlated. And so let's begin just to frame this conversation a little bit. The most common proxy for the risk-free rate that's used by the commercial real estate industry is the 10-year treasury. So if you look at cap rates versus the 10-year treasury, and that's kind of how we typically look at it in the real estate industry, over a span of decades, you'll see that

Starting point is 00:14:52 there was a decade from the 1970s to the 80s where cap rates were consisting below the 10-year treasury. And then the relationship flipped. And from 1991, it's really almost since then, cap rates have generally maintained a positive spread to the 10-year treasury that fluctuates over each real estate cycle. So over the span of the last five decades, I think you'll see that you'll see some correlation between cap rates and interest rates. But it's relatively low. and there's enough periods of time where they run counter to one another to suggest that interest rate movements don't really cause cap rate movement, but they do contribute to maintaining a spread to it as cycles kind of gyrate in and out over time. And so to me, I'd say that the reason

Starting point is 00:15:36 that causation is really more supply and demand than it is interest rates is to think about the fact that in the commercial real estate industry, this is a returns driven industry. And so that means that any time that you have increases in demand or decreases in demand, those are going to generally move cap rates, right? All things being equal, if you want that asset more than you want today, you want to step in front of a buyer and take it down, you're going to increase price. And if nothing else moves and price increases, well, you just decreased the cap rate a little bit. So interest rates are a major component of what can drive returns, but to me, they're just, there's just one component. And so another example is that if buyers think that rents will increase at a

Starting point is 00:16:16 rate that is faster than they believe interest rates will rise, then they will bid that asset to a level that will maintain or even possibly slightly decrease the cap rate, right? So just step in, buy that deal, decrease the cap rate. You saw that behavior on display from 2016 to 2018. You actually saw treasury rates move up. You saw cap rates move down. And then conversely, in 2022 was, as we've talked about, this successive series of downward steps and demand. As we saw rent growth cool, at the same time that interest rates shifted upward rapidly. And so as buyers were successfully hit with higher borrowing costs and they couldn't find a justification for returns elsewhere, their return expectations were hit.

Starting point is 00:16:57 And when your return expectations get hit and there's nothing else in a deal to prop them up, then the final solution is a reduction in price that gives you enough additional yield going in to offset that higher borrowing costs, as I talked about a moment ago. So when we think about supply versus demand on display in 22, in the sense that we saw more cap rate expansion in multifamily, despite the fact that it enjoys better access to cheaper debt from agencies like Fannie and Freddie, I think that's another example of supply and demand, you know, because in essence we saw industrial hold up a little bit better.

Starting point is 00:17:30 You'd argue that interest rates are more of a driver for the industrial sector, but if cap rates can expand as much, then really what you're seeing there is that rent growth component, higher rent growth in industrial, higher demand maintained in industrial, hence less cap, rate expansion. So that's my take on the, on the, you know, interest rate versus cap rate and versus, you know, supply demand. So I hope that provides some context. I love it. In your recent memos, you were discussing how investing in commercial real estate in 2023 is going to be different. And in

Starting point is 00:18:01 your latest piece, you write about how investors can discern value by asset class, especially considering how much price dispersion from the mean occurred immediately following the pandemic in the last two years. All things considered, which asset classes do you think offer the most interesting opportunities in this current market? Yeah, so the second memo, which you're referring to, Trey, was interesting in the sense that we published them bi-monthly and we look for topics that we think to speak to investors. It's the whole point of drafting these memos and publishing them is just to give some thoughts and some tools to investors to contemplate the market and how to navigate it. So that's the second memo, which was published recently. It was really

Starting point is 00:18:43 born out of this whole concept of your relative value in real estate and where we sit over a longer term context, you know, was born out of the fact that, you know, a lot of investors asking questions, whether the current valuations in the market, were they just simply a down tick or a markdown in 20, from 21 values? Did they really present value from a longer term perspective? And it was a totally fair question because we, you know, as investors, we don't want to get carried away and buy the first dip in a down market. And because investing in commercial real estate is really a time horizon of multiple years, you want to step back and you want to assess your entry point against the backdrop of longer term trends. So to answer this question and probably

Starting point is 00:19:23 provide a framework of reference here, my team and I, we looked at current pricing relative to 25-year price trends for all asset classes according to Green Street, as well as each, so we looked across all assets as well as each asset class itself on a standalone basis. And once we conducted that exercise, we actually found some interesting discoveries. The first thing was that from 1998 through 2014, the major asset classes, which include multifamily, industrial, retail, retail, hospitality, and office, they all moved relatively in strong correlation to each other. It was about a roughly about a 6% average annual price growth. It's kind of almost fascinating. Today, if you said office is going to highly correlate to multifamily and industrial, you'd be like, that's crazy. And the answer is,

Starting point is 00:20:09 today it's crazy, but for decades, it was not. But starting in 2015 is when you saw that meaningful price dispersion start to occur. Asset classes broke out, some went up, some went down, and they started kind of their own path. And so today, I really do think that asset class matters in a more pronounced way than it did prior to 2015. It's just a, it's a different type of market. And it actually has been a different type of market for eight years and running. So to answer your part of the question about what do I think is most interesting, there was a few things that stand out that once we conducted that analysis. The first was when we look at the industrial sector, after reaching record low cap rates at the beginning of 2022, we've now seen about 90 basis points of cap rate expansion this past year. And maybe a little bit more this year in 23.

Starting point is 00:20:56 For the most part, I think a lot of cap rates have mostly steadied so far this year. But it's fair to say that that might change throughout the balance of this year. So really what that means for industrial is that we're seeing more unlevered yield on cost today on industrial projects than we've seen in recent years. And with an outlook of tapering supply and steady single digit rent growth, I think we're going out of the double digit rent growth period for industrial, but we're still in solid single digit rent growth. Personally, we think that pursuing industrial developments still make sense and particularly in tighter markets with good fundamentals. One thing that we think is standing out in industrial, for example, is that we've got this. French shoring trend that we're seeing, right? That's bringing more manufacturing to places like Mexico that we think will continue over the next few years. And so from our perspective, I think that makes

Starting point is 00:21:44 certain Texas markets look increasingly attractive as they stand to benefit from more goods going through the Mexican border into the United States to get further distributed. You know, from a valuation perspective, when we look at that long-term trend, the one thing about industrial is that I wouldn't say that it's a bargain right now. You have pricing down about 15% from peak, but coming off of a peak where it really did shoot up a tremendous amount in 2021, it's actually still a little bit above its long-term trend. So buying industrial or building industrial, you're still buying into the idea that it is a fundamentally strong asset class that will continue to outpace its peers in the years ahead.

Starting point is 00:22:27 But if you can get comfortable with that, then you're a buyer of industrial. So the next one that was really interesting to me was retail. The last time we spoke, I mean, I've spoken many times about retail, I think, in the last couple of years, you know, really coming out of the pandemic, I think that retail has been, you know, brick and mortar retail has been overlooked. And I think it still continues to be a hidden buy today. It sits in a really interesting spot. So to frame that out for you a little bit, today right now, retail is still one of the most undersupplied asset classes. You only have about 0.5% of its inventory under construction. And it continues to enjoy one of the, of the highest occupancy rates among major asset classes. We've actually seen occupancy rates improve for retail in the last year or two. Coming out of the pandemic, a lot of demand coming back into brick and mortar and you're seeing those centers fill up. It's just, you know, it's been great to see. I mean, personally, it's great to go out and experience it, but it's also really bringing some vibrance back to the sector. You know, I also want to mention just a quick note on this. When we talk

Starting point is 00:23:27 about retail, I'm not referring to malls. I do think that that's a bit of a still broken asset class that's sorting itself out. I'm really more referring to grocery anchored centers, neighborhood centers. In our opinion, those tend to perform better. And I think they remain more relevant to our daily lives. And I think relevance is something that we've talked a lot about in the past tray. I think that anytime we're talking about real estate, if you just want to kind of give yourself some context, think about the relevance of that particular piece of real estate to your daily lives. And I think that brick and mortar retail, particularly when it comes to grocery anchored centers, is checking that box. The other thing, you've got a couple of other

Starting point is 00:24:00 good things happening in retail the last couple of years. We have headlines that continue to tout the emergence and continue dominance of e-commerce. But quietly in the meantime, brick and mortar it outpaced e-commerce over the last year in sales growth. It's still today accounts for over 85% of all retail sales. And what was really fascinating to see coming out of the pandemic is that if we go back to the 2020 period, we saw this massive spike in e-commerce. Really what's happened in e-commerce is it's actually reverted right back to its long-term trend. So it's not to say that I don't think the e-commerce isn't going to continue to take market share. And, you know, but as recent history has shown, brick and mortar, still highly valuable, part of the commercial real estate landscape.

Starting point is 00:24:39 I don't think that changes in the near term. So you take the recent growth in brick and brick mortar sales and you layer onto the fact that retail tenants are now battle tested. And really what I mean by that is that we can feel more confident about the overall strength of a tenant rent role in a center because it is already endured the pandemic. You know, it's interesting to note as someone who looks at deals every day prior to the pandemic, it was tough when you look at a retail center. You had to play this guessing game. Which tenants do you think could survive? Which ones are going to succumb to e-commerce trends? For the most part, that guessing game is pretty much gone, I think, for this current cycle. You kind of have confidence if they're there and if their sales are good,

Starting point is 00:25:17 you feel like they're going to remain good for the foreseeable future. And from a cap rate perspective, As I mentioned last time, the retail sector from a cap rate perspective is still valued kind of like a dinosaur sector with little hope of growth. And I think that's where opportunity continues to sit. A good multi-family or a good industrial property. Okay, today cap rates have expanded. So those were fours. Now they look more like fives. Well, that equivalent cap rate for a retail center is still north of seven, seven, seven point five, maybe.

Starting point is 00:25:45 If it's a really new center, you're going to see that below seven. But that's still a considerable spread. and that spreads important today. You know, that seven cap is important because in a higher rate interest rate, you know, higher rate environment, it's this, you know, supply demand. It's tested. And the fact that with rates even where they are, you can still see interest rates today makes sense.

Starting point is 00:26:06 You can buy a shopping center and get some cash flow. And right now, cash flow and multifamily and industrial is just really much more hard to come by given the fact that the cap rates have compressed more. And so that rise in interest rates has hit those sectors harder. The last thing trade that I think from this exercise that that was interesting was hospitality. You know, as an asset class, it was definitely, I think, more devastated the retail during the pandemic. And, you know, that's probably an understatement. Now, you know, if we think about 2022, we look at this sector and we saw a good bounce back here from an operating perspective.

Starting point is 00:26:38 We've talked about in the past, we track STR. That's the nation's leading data source for the hotel industry. It tracks revenue per available room. That's RevPAR. You can look at Rev Par on a daily, monthly, weekly, annual basis. After hitting a record high of just under $100 in the summer of 2019, Rev Par at the national level fell all the way down to $17 back in April of 2020. That level of drop just literally never happened before in the industry.

Starting point is 00:27:05 But since those days of 2020, Rev Par has surpassed the pre-pendemic peaks. It actually hit $110 in July of 22. We continue to see recovery in 23. And I'd say just the one caveat on this red part recovery is that it's fair to say that this is on a nominal basis. When accounting for inflation, I'd say real recovery for the industry, it's still out there a little ways. It's probably 2024 to maybe 2025. Yeah, the other factor for the asset class, like every other asset class, again, is it's grappling with higher interest rates. That's impeded asset price recovery to some degree.

Starting point is 00:27:41 So we're still watching this sector, I think, with a little bit of caution. It's a little bit of a case-by-case scenario, but I think it's heading in a good direction. And when you look at this asset class relative to its trend, it actually does sit below its long-term trend. So I would say looking back at hospitality over the course of the longer-term history, it looks like a reasonable entry point. The final thing I'd say here is that there still actually are continued to be pockets of opportunity in the multifamily sector. For 2023, the multifamily sector is definitely not as straightforward as it was throughout much of the last cycle. And I think for a few reasons. First, there's a lot of supply coming. It's over 1.1 million total units that are under construction today across the U.S. That's according to Kostar. And it's also

Starting point is 00:28:25 concentrated in certain cities. So about 627,000 of those units were started in 2022 and with the balance and started this year, that's the highest rate of new starts in the last 36 years. So it is fair to say that multifamily supply is coming. It's also fair to say that it's still relatively under supplied a bit at a national level. Who you ask depends. Four or five hundred thousand units, perhaps undersupplied still at the national level, but we're catching up on supply. The second thing is that rent growth has really flattened out dramatically

Starting point is 00:28:57 over the course of the last year. We saw those tremendous rent increases in 2021, 20, 30 percent in some markets. Those days are gone. Now nationwide, sector looks more like two to three percent rent growth this year. And in some of the previous hottest markets, you're actually even seeing zero rent growth. I think the third thing, again, have to kind of mention this on every asset class.

Starting point is 00:29:19 Current interest rate hikes, that makes cash flow very difficult to achieve for multifamily. But when we come back and look at that long-term trend, now just going back to pricing for a minute, sector is off 20% from its peak. Peak was early 2020. Cap rates are up about 130 basis points. In some of the previous hottest markets,

Starting point is 00:29:37 you know, maybe take a Phoenix, Arizona, for example. We're seeing quality properties begin to trade at cap rates It looked like five and a half percent going in. That's just something we haven't seen there for years, probably not since 2018. And so overall for the multifamily sector, while it's definitely difficult to acquire, and I think the right opportunities are relatively scarce, I do think there's going to be some pockets of opportunity to seize upon this year. So to the extent we find them, we're going to work on them.

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Starting point is 00:34:12 All right. Back to the show. Let's talk about offices and the future of office in a post-pandemic world because last time we spoke, the office market was still going through its post-COVID recovery and the utilization rate was only around 30%. Where do we stand in terms of recovery and what, if any, opportunity, exists in the office sector. I'm keeping in mind that you're seeing headlines with Facebook or Met, I should say, letting go 10,000 employees as of today and, you know, Twitter being wiped out after their employee.

Starting point is 00:34:47 So you were seeing layoffs, right, playing into this narrative as well. So give us an overview and then what you kind of expect in the short term and for this year. Yeah, trade, totally correct. I mean, you're beginning with the fact that coming out of the pandemic, the office sector was just trying to get back on its feet, get some people back into the office, try to start acting and behaving a little bit more of a normal space after it's just, you know, it didn't have that benefit in essence that retail and hospitality, they just bounced back. They got knocked down. They picked themselves up. They dusted themselves off and they got kind of back to feeling much more normal. The office sector just simply hasn't had that. It's now, you know, so just as it was starting to get

Starting point is 00:35:24 some people back into the office, now it's grappling with the prospect of layoffs, just completely knocking the sector sideways. So really now, I think, working through just a massive transformation, There's still so many questions that are unanswered for the sector in terms of what it is today and what will be in the future, that it's really kind of doing a bit of soul searching, I would say, and it's to some degree right now. You know, to disqualify this a little bit, so to talk about how you were just referring to utilization. And when I say that the office market started to recover a little bit and became a little bit more normally, well, that 30% utilization rate did get up to 50. It's kind of still sitting in that 50% range overall. where we look at this data on a week-by-week basis, and you can go track this online.

Starting point is 00:36:06 If you look at Castle Systems, this is a security company that tracks the swipes coming in and out of offices in major markets. They have an index. They track the top-10 markets, and they report out the data on a week-by-week basis. So if we look at like right now what's going on, you'd say that, well, Texas has been leading the recovery, continues to lead that recovery.

Starting point is 00:36:26 You've got Austin currently sitting in the top spot. it averaged 68.1% for that last week of March, ending March 1st. And you've got San Jose at the bottom at 40.6%. So still, well off pre-pandemic utilization rates, but better at least than they have been. And what's interesting also to look in that data is that we're now seeing these trends in terms of which days are the highest utilization days versus lowest. And Tuesday is actually showing up to be the highest occupancy day. And then not surprisingly, Friday is the lowest.

Starting point is 00:36:56 So the other thing is that, but when it's a lot of it. When we look at Castle Systems data, I think it's fair to say is that it provides you a good apples to apples comparison over time, whether or not it is exactly indicative of what's going on in that particular market at any given point in time, it might be a bit understated because there's some highly utilized Class AA buildings in those top 10 markets. And for the most part, they don't use Castle System. So just Castle Systems not having access to some of the best most highly utilized properties in those markets.

Starting point is 00:37:28 So from there, what's interesting, I think I would say, let's maybe move to a broader concept and say, hey, if office is transforming, where do we stand in that transformation? We look at a lot of data. We're constantly devouring stuff that's talking about the future of office. It's fascinating from a study perspective. It really does beg the question of what's going to happen with billions of square feet of stuff over the next coming years. And to help answer this question, Cushman and Wakefield recently published a report that I think offers some really interesting projections and insights on the U.S. office market for the rest of the decades. So I think it kind of warrants talking a little bit about. The first was, for starters, it quantifies the total amount of U.S. office space. So it projects that it roughly 5.56 billion square feet today. And it expects the total stock of office real estate to grow just minimally to 5.68 billion square feet by the end of the decade. Then the report goes on to project that they think 4.61 billion square feet of office

Starting point is 00:38:23 space will be occupied at the end of the decade. So on a percentage of occupancy basis, or I should say conversely, a vacancy rate basis, well, that's a 19% vacancy rate across all types of office, or that equates to about one billion square feet of vacant space. So a lot of space that they project to be vacant at the end of the decade. And but what's also interesting is that it, that Christian Wakefield, if you go to their one of their most recent U.S. office reports, say, for example, December of 22, They peg the total U.S. vacancy rate at 18.2%. So really, in essence, what they're saying is they think office is going to be slightly, but not materially more vacant at the end of the decade that it is right now. So roughly kind of like flat absorption from here on out for the rest of the decade. Then when we dig in a little bit more of that report, what was really interesting, I think, and start to be more insightful is to think when we think about the future of office is to they break it out into three major categories.

Starting point is 00:39:22 or the trifricate the market, so to speak. So first, they call what's called the top. Those are, these are usually defined as 2015 or newer vintage properties. They're amenitized really well. They have lots of natural light. They have maybe fitness on the main floor. They've got retail in them. I think probably arguably the best example of this top type of building is one Vanderbilt in New York City.

Starting point is 00:39:45 That building is fully occupied. It's achieving record rents. It's actually setting records nationwide. ever for office in what is an otherwise challenging New York City office market. This type of building, what they refer to the top, it's also interesting that it is actually achieved 100 million square feet of positive absorption since 2020. So it's actually doing okay. It's bouncing back post-pandemic. And for obvious reasons, it has a high quality experience. It's attracting workers back into the office. It's the type of office people want to go back to. And in terms of percentage of total market,

Starting point is 00:40:18 right, because from Wakefield, this represents about 15% of the market. So when we think about that market going forward, okay, this top 15%, that's your top. Those you probably have high confidence in remaining relatively well occupied and highly relevant in the future. Then you move on. The second tier that they talk about is what they call the middle. And this is 60% of the market. These may be good buildings that are older than 2015 vintage.

Starting point is 00:40:43 They might be still a little bit newer than 2015. Maybe they're located in slightly less desirable locations within a market. but they're probably older from the standpoint of that, according to Cushman-Wakefield, also 70% of all properties that were built in the entire industry, this entire 5.6 billion square feet of space. Okay, that's pre-190 stuff, according to Cushman-Wakefield. So this middle is really going to be comprised of, you know, 2,000 and older vintage properties, I think, and then a lot of even older than 1990 properties can still fit this bucket. These are properties that are going to be, continue to be, I think, much cheaper to buy than the top, they were going to offer a lot

Starting point is 00:41:23 cheaper rents. And so from a go forward perspective, this is the part of the market that I actually see potential opportunity for later this decade. And, you know, that beginning maybe in the next year or so, I do think that this price discovery needs to occur. But once it does and once prices start to settle, it's this next part of the market that I think is interesting. If I think if you take one of those properties and you reposition it properly in a respective market, then I do think the majority of the middle can bounce back. Now, that property may never be 95% occupied again, but I think they could be 85 to 90% occupied, and they could actually command decent rents. You know, one thing we look at, rents on a national basis, they're not really going down right now

Starting point is 00:42:08 overall. They're just either occupied or not. So I think if you bring a part of this market back and you make it vibrant and compelling again, you actually might see it pop back up and become more relevant again. And again, with office values dropping precipitously across the U.S. right now, this is the segment. Again, I think it has maybe the bargain potential. And so, and when I think about that next 60%, you know, and I think about the opportunity, I probably said I think the opportunity is more correlated in the top 50%. So on a percentile basis, now I'm talking about like that 85th to 55th percentile, you know, again, it's a lot of more, it's a lot of real estate and there's over 1.7 billion square feet. So there's a lot of properties that might, you know,

Starting point is 00:42:51 it has a potential maybe to be repositioned, reinvigorated, and made more modern and compelling in the years ahead. And then the third segment that Kushman-Weigfield talks about is what they call the bottom. Bottom represents about 25% of the total market. So again, 15% right at the top, 60% in the middle. Now we've got this bottom 25. Now we're in the old commoditized building. inferior locations. This is true functional obsolescence. They just, they can't really justify further capital expenditures. I don't know if there's a lot you can do with these buildings. You know, they might have low ceiling heights. They might have insufficient power. Either things that are either impossible to fix or just excessively cost prohibitive and just no longer

Starting point is 00:43:33 make sense to fix or try to address. To quantify this, this is roughly 1.4 billion square feet across the United States. I think their occupancies remain in this solid bottom tier. If you think about this, if Cushman-Wafield is correct and we do have 19% vacancy nationwide, I expect this bottom tier to the extent it still sticks around to be dominating in the vacancy, maybe 40 plus percent vacant in this category. This is, you know, basically I think if you're talking about this type of building, if you're investing it in the future, I think it's near or at below land basis because ultimately I do think that's what you were a lot. left with at the end of the day. I think it's probably more costly than it to continue to

Starting point is 00:44:13 operate than it is to restore it to a vacant lot and try to repurpose it in the future. So now, if we take this office market and we think about where we sit in 2023, the other interesting thing at this point right now, to your point about some of the headlines that you're seeing, is that I do think that the kicking the can strategy that was pretty pervasive the last couple years. It's running out and it's now giving way to the next phase of market transition, right? This is its next logical step and evolution of where office needs to get to. You could probably say that, hey, look, it looks like the industry is kind of bracing for impact, so to speak, as lenders are now being hit with these defaults. They're kind of coming sequentially. We're reading about them

Starting point is 00:44:55 one after another. I do think they start to increase in frequency and intensity over the course of this year and into 2024. So as that volume of defaults does increase, number, or dollar value, I think that's going to force the hands of more borrowers and lenders. I think it's at that point that things really do start to get interesting. And if typical market dynamics hold true, you know, the next steps are now going to be a series of workouts or foreclosures. Assets that are foreclosed upon ultimately get brought back to market, and particularly once the debt markets start to begin to function properly again, it's at that point that I think you begin to see some markets exhibit what we call true market

Starting point is 00:45:34 clearing trades, that resets the values across the sector. And that gives the ability for the sector to start to rebuild. You can look at this, just go back and look at the great financial crisis period. You saw that price reset occur. By the time that we got into 2010, 2011, Office was really starting to reset itself. There's nothing like a reset to make a property begin to start to compete again. That's, that's something that we saw. It's a little bit trickier today because we have to address a lot more than just rental rate, but I do think you've got to get to these resets to start really changing the landscape. And when we, you know, when we think about this, you know, this is, this is kind of where we sit in in terms of the office market overall. So at the end of the day,

Starting point is 00:46:19 we got some time to get to work through. We have more, I think, you know, kind of a little bit of cautious waiting for the next shoot-ed drop, so to speak. I think once you get through that, I think you begin to set the stage for the potential to reactivate some great nodes of our urban and suburban centers. If you think about what that does for those locations, if you can start to repurpose or reset or reinvigorate these buildings, you start to drive some retail activity in those locations. That influx and demand improves property values. That starts to increase tax revenues again. And then also, you have the potential for investors to profit. So I think taking in its totality, you know, just no doubt that there's short term pain still ahead for the sector. But as we

Starting point is 00:46:58 digest this next wave, I do think that it creates the opportunity for creating. of destruction to take hold and refashion the sector in the years ahead. So, you know, I think 2025 to 2028, really interesting part of the decade for the office sector. And we will be talking about it, 2025. We'll make sure to have you back on and see if we're at that buying point. So with a lot of distress and the repricing ahead for office that you've been kind of highlighting there, something said out to me earlier about retail that I have a curiosity about. So you mentioned 0.5% is under construction and retail. So I was thinking, is there just a high barrier to entry for that asset class in and of itself,

Starting point is 00:47:39 meaning, I mean, they're competing with things like offices, et cetera. So I'm curious if you're expecting to see more opportunities for repurposing office buildings into other uses. Yeah, I'll touch on the retail and then we'll jump into office repurposing. So if we think about that retail and why is there no supply, it's just for that basic reason of like, nobody wanted to build it. Nobody, and banks didn't want to finance it. You know, there weren't a lot of retailers expanding their footprints.

Starting point is 00:48:04 You know, if we go back to 2014, even 2015, one data point, kind of going all the way back to that memo and the study of long-term cycles, do you know what the number one most valuable asset class in 2015 was? It was malls. So we are only eight years removed from malls being at the top of the stack. So how much changes in eight years? It's amazing. So if we get into the beginning of the e-commerce.

Starting point is 00:48:28 And again, I think that's really where e-commerce kicks in, industrial takes off. From that point forward, it became increasingly challenging to develop new retail real estate, right? You started to see some store closures, some dislocation. You started to see stress coming to the malls. Once mall stress started, it just started to topple the overall industry. And if you're a real estate developer and you say, look, I can develop real estate, I can develop retail real estate, I can develop multifamily or industrial real estate. Well, I think the answer starts to become a little bit more clear.

Starting point is 00:48:57 You're like, hey, if I've got some options for what the zoning allows for this, I'm going to go to where the money is and where the demand is. And that was in other asset classes. And that's why I think retail sits in this interesting state because it rode all the way into the pandemic with like no new supply. Then it got completely flattened. Then it's really bouncing back. The market isn't really there yet to provide new capital to go out and, you know, provide new construction. Maybe that comes back again the next couple of years. But really what you get now is, and it's also fair to say that going into the pandemic around 2019, there was a lot of discussion about how we were oversupplied nationally on retail. I love the term when people say retail isn't overdeveloped. It's under demolished.

Starting point is 00:49:35 And so there was a little bit of that definitely going in 2019. But now we're actually starting to absorb it again. And we actually want to use it again. And so it's possible that it actually might become economically feasible to create it again. But also rents dropped enough and rents are just starting to pop back up in retail where it makes and also get asset value. And again, this is all boils down to discount to replacement cost. So right now, it's just, it's more feasible to buy. It's cheaper to buy than it is to build it. If it gets to start to touch what it costs to develop it, it gets to be in excess of what

Starting point is 00:50:08 it costs to develop it. That's when you see new development come in. But for right now, you're basically, that's why I think that opportunity sits in that space is interesting because I think right now it's like, hey, if I buy it, there's nobody creating it. I have a relatively captive market. If I have a good asset in a good location, I think I'm going to have more retailers want to be in it tomorrow than today. That's the basic investment thesis for retail. So now, let's talk

Starting point is 00:50:29 about office redevelopment because that's a really interesting sector. It's part of the transformation of office. It's definitely going to continue to be something that you're going to hear more about over this decade. I think we see more opportunities for office conversion in the future, but it's also fair to say that today in 2023, they're still relatively rare. I remember at the end of last year, CBRE's America's head of office research reported that there were 125 office conversions underway nationwide. And of that 125, about 50% were conversions to life science space, about 30% were conversions to multifamily, and the remaining 20% were either hotels or other uses. So if you think about 125 conversions across the whole country into all those different asset

Starting point is 00:51:15 classes and how big those asset classes really are, I mean, we're kind of talking about a drop in the bucket, right? But, you know, there are a few, they are out there and they're interesting. We've actually participated in some conversions of office space into all three of those types and also self-storage. But even in our experience, when we were talking about fewer than 10 projects out of more than 740 since our inception. So there's a number of reasons why I think that office conversions are not yet occurring at a more frequent rate. And I think they boil down to a few factors, including feasibility and economics and regulations. So just for starters, a lot of office properties are simply challenging to convert into other uses. For example, if you're trying to convert an office

Starting point is 00:51:54 property into multifamily, you need proximity to windows in that new multifamily project. Typically speaking, industry would say no more than 25 to 30 feet away from a window at any point, any location of that new property, that new residence. A lot of office buildings that were built since the 1950s, they've got big floor plates. If you go to the cities, particularly so, meaning that you might be over 50 feet away from a window on a given floor. So if you're taking one of those office buildings with those deeper floor plates and you're trying to convert it to a residential use, that's going to require punching light wells all the way down through the middle of that property.

Starting point is 00:52:33 And sometimes it's just not physically feasible, just simply not there. Or if you're trying to convert an office building into life science uses, that 50% that we just talked about. Well, now you need additional clear height on each floor. You got to route things like venting. There's a lot of power that comes in. There's a lot of use that's specific to, you know, a life science lab use. And a lot of office buildings, they just don't simply have enough space to offer that conversion. And setting aside from the fact that no matter if you're converting it to life sciences, you're converting it to your multifamily, you got to do some major upgrades to the plumbing infrastructure. So that's just a physical challenge of that building as well. So let's

Starting point is 00:53:13 assume that you can find an office building where the conversion's feasible. The next hurdle you got to get through are the economics of that conversion. So typically speaking, conversions are expensive. For example, there's a project that we looked at. We had exposure to the estimated conversion cost on that particular project, which was going from office to multifamily, $600,000 per unit just to convert it. That's over and above the price to acquire the vacant office building, which equated to about $230,000 per unit. So we're talking about $830,000 per unit all in. That's an expensive project, which means that it's only economically feasible in a location that can command high rents. And so it's for that reason when you think about how expensive office

Starting point is 00:53:58 conversions really usually are, particularly for services. I mean, life science is actually even more expensive, but even for multifamily. It's for that reason that you're going to say that, look, But conversions make a lot more sense in places they can pencil somewhat in major gateway markets, right? The New York's, the D.C.s of the country. And it's fair to say that with that said, I have seen conversion projects that have occurred in other cities, more affordable cities such as Cincinnati, Kansas City, and Cleveland. But in all of those projects that we saw in some of those Midwestern markets, they were heavily

Starting point is 00:54:31 required major incentives. They relied upon them, such as new market and historic tax credits. to make them economically feasible. And in some instances, you can see, I'd say probably the last piece here is in some instance, you can see a property trade at such a compelling value

Starting point is 00:54:49 that it enables the conversion. I think one example of this is not long ago, the Comerica Tower in downtown Dallas. That comes to mine. It's a 60-story tower to 1.5 million square feet. It recently traded it at $83 per square feet. So a huge discount to what it originally cost to build all the way back in the 80s. And that property is actually not even a full conversion.

Starting point is 00:55:12 That's a partial conversion. So it's going to take part of the office tower, converted it into apartments and hotel and some retail. And then it's actually going to remain office for a good chunk of the total space. And the last thing is I mentioned a minute ago, the third thing I think to think about is the regulations. Those can present obstacles. So you might actually now have an office building that's viable from a physical standpoint. It might be feasible for an economic standpoint, but to convert it, you actually need the appropriate zoning.

Starting point is 00:55:41 So whether or not it's a regulatory concern, it's an economic incentive. I think sometimes it ultimately hinges on a municipality to help you to get a conversion deal done. And so, I mean, despite, so there's challenges there, no doubt. Despite those all, I am a big fan of adaptive reuse of commercial estate. I'm even a member of the redevelopment and reuse council at the Urban Land Institute. So I dedicate time on an annual basis to studying with the space to meeting with groups across the country that focus on finding higher and better uses for the existing stock of commercial real estate. And as I mentioned, I do think overall, as we're starting to rethink the future of commercial real estate, particularly in this office sector, I do think that you're going to see more conversions, but you're going to probably have to see owners and municipalities lean in together, roll up their sleeves and go to work to figure out some new and better uses for that real estate. Let's take a quick break and hear from today's sponsors.

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Starting point is 01:00:07 position to exploit opportunities in this current market. In a market with dislocation, particularly when it comes to capital markets, you step back, you think about what does make sense in a dislocated market, and then you kind of start to drive towards finding that kind of deal flow. And what's particularly difficult and different about this market, this current turbulence that we're experiencing, right? And it's kind of strange in a sense because we're not really for the most part, I mean, setting office aside, but if we think about main asset classes of multifamily, industrial, hospitality, retail, this is not about deterioration of real estate fundamentals.

Starting point is 01:00:43 This is about dislocation in the capital markets, like first and foremost and second and third and fourth and fifth, right? It's like we can find, there's sometimes that you can find operational distress, but it is really financial distress out there for the most part. And so really why the dislocation in the capital markets makes practically every single deal no matter what you're looking at challenging a transact. It does create some interesting opportunities. And it gives you an opportunity to possibly actually think more creatively about some deals. So there's a lot of different ways you can approach it. I think there's two that kind of stand out in my mind and how we're looking at the market right now. And we're pursuing deal flow that we think fits these categories.

Starting point is 01:01:22 The first are non-performing loans. So this is a situation where a group comes in and they buy a loan from a lender that is probably currently in default. There's what's called non-performing loans. There's sub-performing loans. So they can be in different states. But it's really when they're non-performing in their state of default that I think creates the most interesting opportunity because has a lot to do with the banking.

Starting point is 01:01:44 I'll talk about that in a minute. You know, this and to like parley that into like what kind of asset are we talking about. It might be a hotel that closed. during the pandemic and it never reopened, could be an office building in this current market? Absolutely. The compelling aspects in my mind of why non-performing loans are interesting, they're primarily twofold. And one is that you're often able to purchase the loan at a substantial discount to its outstanding principal balance. And that potentially provides an opportunity for a relatively attractive basis. And that's if you end up foreclosing on the outset and taking

Starting point is 01:02:19 possession of it and end up operating it one day selling it. Now, the second is that taking this position by coming in and buying the note and becoming the new lender, right, that opens up a lot of options for how you exit that transaction. Because you're buying the loan and you're buying it at a discount, and that loan also will come with things like accrued fees and default interest, you have a lot of leverage, a lot of leverage with that new borrower and you have a lower basis. and that enables you to negotiate with that borrower. And a minute ago, I talked about this has a lot to do with banks. The reason that this creates opportunity is that so banks, they need to set aside excess reserves

Starting point is 01:02:59 on a loan. The minute it becomes impaired. So they have a strong incentive to get that loan off of their books as quickly as possible. If that means taking a loss in their minds, that's better than them setting aside a lot of excess capital. The ratio that I recall was that you can roughly lend, you know, $10 to $1 of deposits equal as a $10 loan. The minute you become impaired, you're now one to one. So if you think about that capital requirement, particularly in today's current market environment, particularly,

Starting point is 01:03:29 you can understand that the minute that a loan becomes impaired, bank really is focused more on removing it from their balance sheet than they are trying to focus on setting aside. The extra $9 for every dollar currently reserved that they're going to have to keep it to service it. going forward. So really, in essence, what that does, that creates opportunities for private capital to step in, purchase that loan, and then negotiate with that lender, and then negotiate with that borrower, either through a discounted payoff or, if necessary, foreclosure on the asset, ultimately leading to ownership, rehabilitation of that asset, and then ultimately disposition of it. And really, since a low basis gives you a lot of options, gives you that options to profit in the real estate investment as well. So buying non-performing loans, I think, can be a good strategy

Starting point is 01:04:14 when the opportunity presents itself. The second is discounted recapitalizations or recaps. Again, tying this back to interest rates, given the recent spike in interest rates, the overall decrease in transaction volume, the challenging market to sell assets. It's a kind of market dynamic where if you don't have to sell an asset, you prefer not to until liquidity returns. So, But despite the fact that maybe you don't want to sell up an asset today, you might have investors in it that need to exit or highly desirous to exit. So in that situation, you could create an opportunity where you restructure the ownership of the project.

Starting point is 01:04:56 That is the recap. You bring new investors in, you replace current investors, but the asset itself continues to be held and operated by the existing general partner who's in charge of that asset doesn't change. It's the limited partner capital that comes in and swaps out. The asset continues on. The key right now for recaps in my mind is identifying a compelling strike price. And what I mean by that is that there's a lot of groups out there that like the idea of swapping out new investors for old investors and not selling that property, but continuing out the opportunity to carry on, manage it and keep it in their portfolio. But at the same time, they may have unrealistic expectations

Starting point is 01:05:37 as to what the current value of that property really is. And so when these deals become compelling, it's a situation where I would say the asset and the sponsorship are of high quality. In other words, you can see how the property can continue to perform. You have a set of investors that are motivated to exit, and they're willing to do so at a discounted value relative to what the current market value would be or that property to go transact. And so, again, to me, this draws back to remember that part of the risk in a commercial

Starting point is 01:06:06 real estate transaction is sometimes finding out all the things that you couldn't discover during due diligence over the first year of ownership. It happens all the time in the scenario. This scenario is common. It happens all the time in the industry. You buy a property, you think you know everything about it. In the first year, you realize that you didn't know everything about it. Sometimes the surprises are a little bit good. More times they're more likely to be bad. So in a recap scenario, you can have greater confidence that if you have a strong sponsor, you've removed the discovery element of risk, right? Now you can move forward. And that can prove meaningful to the future performance of the asset. So there's a lot of different ways, I think,

Starting point is 01:06:44 to approach this market right now, Trey, but I think those are two that stand out that whenever we see those scenarios and the stars align, so to speak, we really do, we lean in and we try to figure out if we can get that done. What would you say is inappropriate, if you can, you know, use that word or even optimal debt service coverage ratio when considering leverage on a potential deal? That is an interesting question. I think the answer to that question really varies widely depending upon who you ask, especially in the current market environment. I think it also greatly depends on the asset class, the risk tolerance of the borrower, the investors in that deal, and the durability of the income received from the rents. So there's a lot there, but I will, I'll do my best

Starting point is 01:07:32 to unpack this one a little bit. So first, just to define debt service coverage ratios, really what we're referring to, right, is the amount of excess net operating income over and above the amount of required debt service for a given period of time, which is typically measured as one year. The concept here is that lenders want to be comfortable that the asset that they are lending on has more than enough operating income to cover their debt service obligations. So the ratio is net operating income divided by the total amount of debt service payments on an annual basis. I'll run through major asset classes.

Starting point is 01:08:10 I'll provide some context. I'll give you some ranges. So in order of lowest to highest debt service coverage ratios that we see as typically required by lenders on stabilized assets, and that's an important part when you get to unstabilized assets, there's so many things that factor into the equation that it really becomes It's very difficult to talk about broad numbers. So I'll talk about stabilized assets because really from that point forward, the lender looks at the in-place income and they say the assumption now is that in-place income is relatively

Starting point is 01:08:43 stable. I think it will grow incrementally over time, but I don't really think it's going to go down much either. So they give you kind of like the credit, so to speak, that they can give you for what that asset type is. So on an apples to apples basis, if we look at stabilized assets and we think about debt service coverage ratios, starting at the bottom are multifamily and industrial. Those are typically 1.25 to 1.3. This is just how lenders would look at it. From there, you're

Starting point is 01:09:09 going to move up to retail. Retail is going to look for 1.5 to 1.7. Office can also be 1.5 to 1.7, and I think that's maybe more of a generalization of how things were. I wouldn't really say that's how things are. So probably for the sake of this answer, just like throw office out out the window for the time being. Maybe it'll begin to look more normal in the next couple of years. But right now, there isn't a number for office that even that looks normal today. Caviot on that one statement is if you have an office building with really high credit, durability of credit, long-term tenant, you know, maybe publicly traded with a sterling credit

Starting point is 01:09:44 rating. 1.5 would definitely check the box for that kind of asset, just that they're relatively rare. Finally, hospitality, probably about 1.75. And with some markets being maybe like some smaller secondary to tertiary markets, stretching that to 2.0. And I think there's a few things to note with these ranges. The first, as I mentioned about, right, there are situations. So if we think about non-stabilized assets, there are lenders that will accept lower debt service coverage ratios at acquisition. But in exchange, they're going to want other forms of security in the deal, such as interest rate

Starting point is 01:10:15 reserves, possibly control over the operating cash flow. So there's a lot that goes into that negotiation when there's any form of non-stabilized asset. I think the second thing is that while interest rates change regularly, the amount of coverage the lender wants in that equation in a deal, it's kind of constant over time. And so what that means is that when interest rates go up, as they have recently, the percentage of the value that they are willing to lend on the asset typically goes down. This is what we refer to as the loan to value ratio or LTV. We've seen LTVs drop by 10 to 15% over the course of this last year. And that's, I think, in scenarios where the asset it looks pretty good.

Starting point is 01:10:55 If it's a little bit more unstableized or it's a little bit more nebulous, I think those LTVs are going down even more. But just important to note that, you know, proceeds when interests go up, proceeds on a percentage of the project typically go down. I think the third thing here is that, you know, these ratios should give you a sense of the overall risk that a lender perceives across each asset class, in essence, by wanting a higher coverage ratio for a stabilized hotel or an office building relative to an apartment complex.

Starting point is 01:11:22 I think that lender is telling you that they view them as possessing more risk, which really translates to a higher probability of defaulting on the loan at the same coverage level. So just saying to think through that lenders are all risk mitigation, higher ratios equal, I need more income there to mitigate my risk as a lender. And then finally, it's worth mentioning that the certainty, you know, or what I just mentioned a minute ago as what we refer to the in the industry is the durability of the income is important when analyzing these debt service coverage ratios, right? So I talked about that scenario with that office building.

Starting point is 01:11:56 Anytime that you own something with good credit in it, if it's an industrial deal, for example, and it's leased to Amazon for 30 years, well, that lease is effectively as good as Amazon's corporate debt. So it's really a bond. And in those few scenarios, we've seen an operator of an Amazon leased warehouse. They're able to borrow perhaps up to 95% of the value of the property,

Starting point is 01:12:19 drop their debt service coverage ratio all the way down to 1.1. because that is how certain that net operating income is, or conversely, how lower probability it is, that Amazon would ever default on its lease obligation. So there's a lot to think through regarding debt service coverage ratios. Like I said, the condition of the market plays a lot into this, but I hope that provides some insight to the question. When we're speaking about high interest rates, one thought that comes to mind is the possible impact on investors' cash on cash returns. wouldn't servicing this more expensive debt cut into the returns? And in that case, how do you

Starting point is 01:12:56 justify making an investment at all? So, Trey, I think the short answer is yes. Investors' cash-on-cash returns can definitely be negatively affected when the cost of debt increases. But whether or not that means the deal is still worth investing in, I think that requires further analysis. So I'd say around the middle of last year, we actually published an article discussing this conundrum of high interest rates and their impact on returns through the use of leverage. And one really important concept that flows out of this discussion is the topic of positive versus negative leverage in a commercial real estate deal. So let's start with positive leverage.

Starting point is 01:13:37 Essentially, what we're referring to here is that positive leverage means that using the debt can actually help improve the annualized yield to the equity because the debt costs less to service, then the cash flow that you're receiving from the leveraged portion of the project. Kind of to understand, but kind of think about this in the terms of cap rates, if you're buying a six cap property and you're able to borrow it 5%, maybe interest only, well, then you're getting more income that you can actually pour over onto the equity. So you're improving your equity yield. So in other words, when the operating cap rate from a deal is greater than the interest rate

Starting point is 01:14:15 of its debt, that's positive leverage. Now we'll flip it around. Negative leverage occurs when the operating cap rate is now lower than the interest rate of the debt. Now, in that scenario, using debt actually decreases the annualized yields on the equity because the debt costs more to service than the cash flow that is received from the leveraged portion of the project. So in a scenario where the debt on a project is expensive enough that it wipes out most of all the cash flow for the equity is sometimes happening today in transactions right now. it is absolutely fair to ask why would anyone even consider negative leverage going into a deal? And I think the answer to that question is like, well, there's really two things that I think need to be in place if you are going to consider using or pursuing negative leverage to justify why you would do it. Well, and the first is that negative leverage could be justified during periods of market volatility like we're experiencing right now. And when that volatility translates to a price that you pay for the asset that is discounted enough to more than compensate the

Starting point is 01:15:22 investor for the reduced yields, or essentially no cash flow, then it may be warranted, as long as that basis is really attractive. But in this scenario, the potential for higher returns, it's now totally concentrated into the profits at sale rather than into periodic yields of the holding period. So you're changing the whole context of that investment. And you're going in on an equity multiple basis, and you're not thinking about cashful anymore. So I think in those scenarios, you really do have to think about what is your exit value, but there may be enough discount in the current deal to justify doing it. And the second is that negative leverage, I think, can be justified when the projects rents are well below current market rents.

Starting point is 01:16:03 We saw some of that in the course of this last year, particularly in the multifamily sector, some of those markets where rents move so fast, the in-place rents might be so much less than the current market rent that while you might enter with negative leverage on a deal, as soon as you adjust your rents to market, you work through that rent rule, you can actually flip it to positive leverage. And so, and then this scenario, a lot of times it's also a little bit blended with that discounted asset scenario. So sometimes an investor is weighing these two things simultaneously. I think the final option here, I think, is just it's worth mentioning is that when we're thinking about positive leverage and negative leverage, well, there's an option,

Starting point is 01:16:42 and that's to forego leverage altogether, particularly if the prospective returns on the deal look attractive without using debt. And debt's so hard to get right now that I do think there's starting to be deals that show up and they look pretty attractive on an unlevered basis. But it's also fair to say that if you're thinking about using debt, debt typically is the majority of the total cost of the project. So foregoing it, it might require more equity than what is simply available. So I think to sum up, Trey, there's ways to make expensive debt work in a deal. They are challenging, but you need to get compensated appropriately in other ways in the deal for it to make sense. Let's talk about capital calls and private commercial real estate

Starting point is 01:17:24 deals because while I know that they are rare, I understand that they become more and more common in down markets. So since many investors are not really that familiar with them or maybe it's just me, but can you explain what a capital call is and then how investors should approach them if they are ever faced with one? Yeah, this is an important topic. You're correct that it's not typically discussed in a lot of parts of the market cycle. When markets are booming and rents are going up fast and assets are appreciating, it's a very, very rare circumstance.

Starting point is 01:17:56 But in down markets, they become the potential for them, I think definitely does become more common. So it's worthwhile to understand. So I think first and foremost, when we talk about capital calls in a private commercial real estate deal, it's important to note that we're referring to what we call as unplanned capital calls. Those are scenarios where a project requires an infusion of capital that was unforeseen when the partnership was originally formed. There's many projects that plan for funding over multiple installments, but because those capital calls are anticipated, much, much different scenario, right? The investor understands that. set aside the capital. They infuse it on a periodic basis as it's called. But very different scenario with that when you invested in a project, you weren't expecting to contribute more money to it, but years later, you're being asked to do so. So if an investor receives an unplanned or unforeseen capital call as certain private real estate investors across the U.S. are experiencing

Starting point is 01:18:53 right now, in some situation, due to the types of interest rate resets that we discussed previously in our conversation, I do think that there's some steps. that investors can take when approaching the situation that can help them gain some objectivity for the decision that they're faced with. First, anytime a capital call occurs, I think the first thing that you do is you go back, you read your operating agreement, you understand what your rights are as well as what are the rights of the general partner to call capital. The rules on what's permissible in a real estate private partnership, they're all typically spelled out. It's in a specific section within the operating agreement. So first and foremost, read the operating agreement,

Starting point is 01:19:33 understand what a partner can and can't do and what your rights are, whether or not you decide to participate. Part of that now moves on to the next phase. Now you're reading it. Now you're starting to understand what the provisions are. In those provisions, look for any punitive language that may be enforced if you elect not to participate. This is what is referred to as a punitive dilution in a private equity investment. Punitive dilution can vary. I'd say in my experience, and looking across documents over hundreds of deals, thousands of deals, I guess. 1.5x is fairly standard. It might translate up to 2x, and that is on the capital call itself, not the total investment.

Starting point is 01:20:14 Punitive provisions are they're intended. Why are they exist? Well, they're intended to help ensure that the limited partners, all limited partners, they're motivated to participate in the capital call. And if they don't, well, then potentially reward those investors who do step up and participate. at some expense to those who opt out. But again, the expense is supposed to be somewhat like not material because if it's on the capital call itself, that capital call would say, for example, 10% of the original investment, then we're talking about multiplying 10% times 1.5. That's the amount.

Starting point is 01:20:48 So $15,000 of dilution instead of 10 if there was no deletion. So once you have an understanding of the rules and the economics of the situation, I think now it's a time to evaluate the situation in the current state of the deal and even in the current state of the market. So, for instance, how much is the current state of the project due to circumstances that exist at a macroeconomic level or perhaps related to what I'd say is an exogenous shock? These can be things like spikes in interest rates, a recession, a bankruptcy or a vacate of a major tenant. these are all things that I would classify as generally outside of the control of the sponsor. Essentially bad circumstance, but not necessarily error on the part of the sponsor. Now, conversely, failing to lease a property, failing to manage expenses within budget,

Starting point is 01:21:39 these are things that I would classify as within the control of the sponsor. The situation proves to be more of the former than the latter. Well, then that makes you more comfortable that you still have a good project that will recover in the months and years ahead. but if it looks more like the latter than the former, well, then now you ask yourself if you're contributing more money that may simply prolong a bad outcome. And that's kind of a situation, that's what you refer to is throwing good money after bad. So assuming that it is really more that former scenario, it's an exogenous shock versus macroeconomic story, it's just something that it's circumstance rather than something particularly wrong with the asset itself or with the operator

Starting point is 01:22:18 of the asset. You know, another approach, I think so. But now if we're in that scenario, but it's a more severe scenario, more downside scenario. Now I think a way that you can take a further look at it is to think about what you think you will receive as a potential return on the capital call itself set aside the original investment. And then sometimes that's hard for us to do. We have this subjectivity. We think about our original investment in that deal.

Starting point is 01:22:45 But when an asset faces a serious exogenous shock, it might be more productive to set aside the original investment, consider that a sunk cost, and now really focus on the capital call itself, what you will get in exchange, you usually will get defined terms in exchange for the capital call. And then ultimately, what potential return you think you can get on the capital call, and then measure that against what else you might receive if you deploy the capital elsewhere. Because I think at this point, in an asset that has had a major exogenous shock, and this capital is coming in to effectively rescue it, you're reinvesting in the new deal. I think you can kind of forget about the old deal. If the sponsor shows you a plausible path to an outcome

Starting point is 01:23:29 that targets an opportunistic rate of return on the capital call itself, and that's one, and that is a scenario that you, in your judgment, you can really believe in, then that's all you can really ask for in that circumstance. It's great if the new capital comes in to protect the entirety or a portion of the original investment, but in an original investment. real downside scenario, that's just upside. In that more rare scenario, right, when that property is in a state of distress, the decision to contribute more capital boils down to that analysis of a risk of adjusted return on the capital call investment itself. So I think, Trayb, overall, by focusing on the current state of the project, the revised business plan,

Starting point is 01:24:10 and in some cases, the expectations for the capital call alone, I think that can help investors make a more objective decision. Well, Ian, you are always just such a wealth of information, and I can't even believe it sometimes how much knowledge you bring to these discussions. It just blows me away. I would love to do this again in a couple months and just keep a pulse on this market because things are changing. I think you put it like on a dime earlier. So this would be an entirely different conversation depending on which way things go. So let's do that and wrap up here. But before we do, please hand off to our audience where they can learn more about you and CrowdStreet, which is just an

Starting point is 01:24:46 unbelievable platform with also amazing resources. Well, thanks, Trey. As always, these are fun conversations. And I certainly do concur that at a minimum, we're going to have a lot to talk about later this year. I don't even know what we're going to talk about. That's how much it's probably going to change. But in the interim, the easiest way is to go to our website, crowdstreet.com, to learn more

Starting point is 01:25:07 about us and what's going on. There's a host of information there. That's where our online marketplace lives and everything else that you would need to get a glimpse into understanding a little bit more about the commercial real estate market. We post educational content there. Another thing, as I mentioned, we are this year publishing memos for investors, given the dynamic state of the market, we're trying to speak to investors on a regular cadence and apprise them of what we see and what we think on a regular basis. These are essentially three to five page documents. I share my thoughts on the real estate market and trends and just try to keep

Starting point is 01:25:38 investors up to date. And in conjunction with those memos, we actually host monthly flash calls. These are just straight. What are we seeing today in the market? How are we pivoting? How are we reacting? We're running those at least monthly for the first half of the year. Then we'll continue to consider the cadence on a go-forward basis. But in any event, you can find all that information on the website.

Starting point is 01:25:58 You can search for the office of the CIO. Since as the CIO of Crowdstreet, we've created a separate page to talk about where you can find some of this thought leadership content. But yeah, feel free to check it out. Finally, as I always mentioned, you can find me on LinkedIn. I am the only Ian for Migli on the LinkedIn platform, so very easy to find. Ian, always a pleasure. Thanks again. Thanks, Tray.

Starting point is 01:26:21 All right, everybody. That's all we had for you this week. If you're loving the show, don't forget to follow us on your favorite podcast app. And if you'd be so kind, please leave us a review. It really helps the show. If you want to reach out directly, you can find me on Twitter at Trey Lockerby. And don't forget to check out all of the amazing resources we've built for you at the investorspodcast.com. You can also simply Google TIP Finance and it should pop right up.

Starting point is 01:26:41 And with that, we'll see you again next time. Thank you for listening to TIP. 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 theinvestorspodcast.com. This show is for entertainment purposes only. Before making any decision consult a professional.

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We Study Billionaires - The Investor’s Podcast Network - TIP537: The Surprising Opportunities in Commercial Real Estate w/ Ian Formigle

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