Not Another Investment Podcast
Understand investing beyond the headlines with Edward Finley, sometime Professor of Finance at the University of Virginia and veteran Wall Street investor.
Not Another Investment Podcast
Decoding Commercial Real Estate: Investment Strategies and Market Dynamics with John Sweeney (S2 E5)
What if you could transform your understanding of the commercial real estate market in one insightful conversation? Join me, Edward Finley, as I engage with John Sweeney from Park Madison Partners, who guides us through the complexities and potential of this dynamic sector. Together, we uncover how commercial real estate is anything but a singular asset class, highlighting its diverse components and the significant role location plays in its valuation. From the ripple effects of corporate giants like Amazon on local economies to understanding commercial real estate as a hedge against inflation, this episode provides a comprehensive view of the market's intricacies.
Our discussion takes a deeper dive into the strategies investors use to navigate the commercial real estate landscape. We categorize investment opportunities into Core, Core Plus, Value-Add, and Opportunistic, demystifying industry jargon like Internal Rate of Return (IRR) and capitalization rates (cap rates) along the way. By examining how major market shifts and macroeconomic factors affect each investment type, we offer listeners the tools to assess risk and return potential in this fluctuating environment. John shares real-world insights into how recent economic conditions, including post-COVID realities and rising interest rates, have reshaped investor strategies and asset pricing.
With an eye on the future, we explore the transformative changes that the commercial real estate market faces today. The evolution of workplace dynamics and the pervasive shift towards high-end office spaces are set against the backdrop of hybrid work models and remote collaboration. As we reflect on the challenges and opportunities these changes present, it becomes clear that active management and strategic foresight are essential. Whether you're a seasoned investor or simply curious about the future of real estate, this episode invites you to consider new perspectives and adapt to a rapidly changing market landscape.
Thanks for listening! Please be sure to review the podcast or send your comments to me by email at info@not-another-investment-podcast.com. And tell your friends!
Hi, I'm Edward Finley, a sometime professor at the University of Virginia and a veteran Wall Street investor, and you're listening to Not Another Investment Podcast. Here we explore topics in markets and investing that every educated person should understand to be a good citizen. Welcome to the podcast. I'm Edward Finley. We've got a very interesting episode today of something that I think is super topical and that is talking about the current state of the commercial real estate market. We're very lucky to have with us John Sweeney. John is a partner and the chief operating officer at Park Madison Partners, a real estate private placement firm focused on equity raises for real estate sponsors. John's been with the firm for 13 years. John started out as an associate and moved his way up the ranks as the firm grew from six to 16 people. John, welcome to the podcast.
Speaker 2:Thank you, ed, it's nice to be here.
Speaker 1:Nice to see you as well. For those listeners who have listened to season one of the podcast, you'll be reminded that it might not be a bad idea to re-listen to episode 19 on Real Assets just to get a lay of the land. And if you've not listened to season one, you certainly can go back and listen to episode 19. But John and I are going to make sure that we flesh everything out fully, so if you haven't or don't want to, don't worry, carry on, we'll still have some fun with it.
Speaker 1:So, john, we're talking about real estate, and in episode 19, I frame up for listeners real estate is a real asset, and if that phrase means anything, it means that these are assets that are expected to be very positively correlated with inflation and to have returns that are independent of stock and bond returns. But it is never the case of any kind of real asset. It doesn't really fit that strict academic definition, and so what we concluded in talking about real assets in episode 19 is that really real assets are assets which are non-directionally related to stock and bond returns and that have expected positive real returns. In other words, fancy speak for their diversifiers. Fair definition, not so fair. Where do you fall?
Speaker 2:Well, I think, first of of all, it's a little bit simplistic to think of commercial real estate as a monolithic asset class. It's not. There are many different property types. They have different demand drivers. Uh, what affects the office market is not necessarily going to have an impact on the self-storage market. They just have different demand drivers and secular catalysts. So you do have to parse across property types rather than painting it with a broad brush. But, broadly speaking, investors want real estate because of its diversification benefits, as you alluded, and the idea is that it serves as some sort of inflation hedge, but also it's levered to growth and economic expansion. So it's a little bit of a tweener between fixed income and equity return.
Speaker 1:And let's unpack that idea a little. So, levered to growth, if I understand you, means partly there's leverage, usually involved in owning these assets, and growth meaning it's exposure to the productive economy, or do you mean something different?
Speaker 2:When I said leverage to growth, yes, there is leverage, but when I said leverage to growth, I just meant it's correlated with growth. So if growth and sometimes it's the growth the impact of growth will have an outsized impact on the returns, and vice versa if there's a downturn.
Speaker 1:And you know, there's the old saying about real estate that the three most important elements of any real estate investment are location, location, location, and so I often think the exposure to economic growth is going to be very idiosyncratic. Property to property. Is that fair, or do you think that there is some systematic exposure to growth in any real estate?
Speaker 2:asset. As humans we place certain value on things, usually based on scarcity, and whenever there's more demand for something it's more scarce. So when you have a lot of demand in, say, a large metropolitan area like New York City, the plot of dirt in the middle of Midtown is going to be worth more than one out in the middle of nowhere, midtown is going to be worth more than one out in the middle of nowhere. But it's not that simple, because land can be valuable for different uses. For instance, like we think of real estate as what's the highest and best use of this land In New York City, if you've got a nice piece of dirt in Midtown, you might say highest and best use of this lot is to go vertical, build multifamily or build an office building and versus in the middle of a more rural area, it could be single-family housing, it could be warehouse, distribution, self-storage.
Speaker 2:A lot of the one of the hottest real estate asset classes right now is data centers, and data centers are a of residents and a lot of human demand drivers, foot traffic, et cetera. Data centers you want access to power, so location is different in that regard.
Speaker 1:I like this distinction that, yes, location is important, but don't attribute any kind of singular meaning to that, that it just means the location is important for the use. I guess my question then, framed up a little bit differently, is when you say it's levered exposure to economic growth, is that exposure to economic growth going to differ materially, use by use?
Speaker 2:I think it does differ from one use to the next and economic growth generally is good for real estate. I don't think that there's not really a real estate property type that benefits from economic contraction that I'm aware of.
Speaker 1:A fun anecdote. So John and I both are alumni of the University of Virginia, that I'm aware of university and it gave the price per acre of land and I used a very simple inflation of 3% and I adjusted that to today's dollars to compute the value of an acre of land and the value of an acre in today's dollars of what Mr Jefferson bought to build the university is almost the same as an acre of land costs today out in Albemarle County where I live, but of course the university is not in Albemarle County. The price per acreage of the university's acreage is far higher than just that adjusted growth rate. Why I like this illustration is it shows the exposure to economic growth is going to differ depending on where. You alluded to this when you talked about well with data centers, if it's near certain sorts of things and if it's residential or it's going to be near other things in midtown Manhattan. I think that the where and what has an impact on how much of that economic growth is going to feed through to the value of those assets.
Speaker 2:Yeah, it goes back to that concept of scarcity and if you have a major demand driver like a university, that's a unique demand driver in that market and there's going to be more people who want to have properties that are located next to the university versus in a more rural area. It's lower barriers to entry.
Speaker 1:This is also a really interesting point that you make. So it's really when the university plants itself there. It's not like it becomes more valuable due to the university's existence. More valuable due to the university's existence, it's that surrounding land becomes more valuable because of its proximity to the university, which in turn means the university's dirt becomes more valuable. But you see what I mean. It's a second degree effect, as opposed to I build the university now the land's worth more.
Speaker 2:I think there are first-order effects and second-order effects there. I think there are certain institutions or companies that if they come to a market2 in Long Island City, that immediately brought tons of attention to Long Island City just for the fact that Amazon was going to be there. And that's a first order effect. And then there would be many other second order effects from the clustering of tenants that would come with that, all the different service businesses that would come with Amazon's presence in the market, from restaurants for those workers to other Dry cleaners.
Speaker 2:Dry cleaners, other ancillary services that a large office presence needs. Right, there was a study several years ago about the impact of STEM jobs on job growth and the number that they came up, stem being science, technology, engineering, mathematics and sort of knowledge-based industries broad brush and so a company like Amazon like that's thousands of STEM jobs, and this particular study is many years ago now, but the estimate was that for every one STEM job created in a market, it created five other jobs just an ancillary.
Speaker 1:It's quite a multiplier. It's quite a multiplier.
Speaker 2:So there is, I think there is a first order effect from, you know, a large company or institution, organization, whatever it is coming to a market and just by virtue of being there they've improved the value. But then there's also there's a spillover effect. Now I should just clarify as we all know, amazon did not come to Long Island City and so that first order effect was not realized, and it was a big disappointment for the market. But the impact was immediately discernible as soon as they made the announcement. It did put Long Island City on the map in some form or fashion.
Speaker 1:Yeah, I mean it's an interesting point and we talked also in season one in the earlier episodes on some basics about finance theory that really markets exist because there's uncertainty and so actors are trying to price in their expectations of what the most likely outcome will be. This is a great example of I'm sure that what you described as prices going up on the rumors that Amazon was coming probably led later to a somewhat muted sense of that increase right Once they're not coming.
Speaker 2:Muted sense of that increase right Once they're not coming. Yes, it was a short-lived dream, so there wasn't a huge impact, but yes, there was an initial pop in interest, like the level of tours for people that started to see Long Island City as perhaps an alternative to Midtown Manhattan. It is just across the river, so it was ultimately good for the market. In that sense, I got you.
Speaker 1:This might be a nice segue, then, to fleshing something out that certainly we didn't talk about in season one because it's a little too detailed about in season one, because it's a little too detailed. But as I understand it, when investors like you think about commercial real estate, you kind of break the world into three broad categories. Can you talk about those three categories, and what is each one telling you about the risks of what you own and the expectation of returns, if there is anything?
Speaker 2:Right. So on the equity side, in real estate, we price things, or we think about things, based on risk and return and we bucket them into three broad buckets Core core plus value add, opportunistic and core core plus. Those are going to be stabilized assets that are cash flowing and your returns are going to be probably single digits to maybe low double digits.
Speaker 1:I suppose that's because, since it's when you say stabilized I just want to make sure listeners understand the term means that they've got tenants and those tenants are kind of regular and the building is usually fully occupied or close to.
Speaker 2:Yes, generally speaking, fully occupied, credit tenants and cash flowing.
Speaker 1:So credit tenants means.
Speaker 2:Credit. Tenants would mean. Well, it depends on the property type, but in an office building, for instance, you know a public corporation or a private company where the bonds are going to be investment grade, like high quality Right, a high quality tenant In a multifamily building, it would mean you know your tenants are, you know they're earning decent incomes and they're paying the rent on time.
Speaker 1:Got it. You know they're earning decent incomes and they're paying the rent on time, Got it. So core core plus are these assets where the property has a stable base of tenants that are of high quality, and I suppose that means there's less risk involved in owning that asset. So that's why the returns you expect are lower.
Speaker 2:Less risk. They're going to command a premium on price because of that and the returns are going to be lower. Like I said, single digits to low double digits, and when I say that I mean that in an IRR standpoint.
Speaker 1:This might be a good moment, though, as long as we're getting a little nerdy in terms of statistics, that in real estate investing often that discount rate is called a cap rate. Can you just tell listeners what that means exactly?
Speaker 2:So the cap rate is not necessarily a discount rate. So the IRR, yes, it is a discount rate, but it's also it's what the effective compound rate of interest would be that you would earn holding it to maturity. So that's the idea it's like you're shooting for. Like, say, I own a building and I'm expecting an 8% IRR on it. That means I want an 8% compounded rate of return on it.
Speaker 1:Measuring both your cash flows and the change in value of the asset. Correct.
Speaker 2:So it'd be a combination of current cash flow and appreciation. Current cash flow is going to have a higher weight because dollars are coming in sooner, versus the appreciation on the back end. It's going to get discounted more over time by that IRR. Cap rate is something else. So I think the easiest way to think about cap rates are it's sort of an inverse earnings multiple on a building. So if you have a 5% cap rate on a building, it's equivalent to a 20 times earnings multiple on and the earnings would be the net operating income or NOI of a building.
Speaker 1:So and cap stands for.
Speaker 2:Capitalization and you might ask like why does? Why does the real estate industry do that? And it seems like it's a very fixed income oriented thing, and it is. We talked about how real estate is sort of a tweener between fixed income and equity and this is a great example of that.
Speaker 2:Command. A premium on multiple, a building where the rents are growing, or even a market where the rents are growing, could see lower cap rates, because the expectation is, you know, it makes sense to overpay today, perhaps because you think you're going to grow into a better yield in the future. It ultimately comes back to it's kind of like the dividend discount model, like it all comes back to what are, what are my expected future cash flows. But why it's also sort of like fixed income and why we look at cap rates is because the Interest rates have almost a gravitational pull on cap rates and there's an expectation that whenever you buy real estate and you borrow money for that real estate, you want to be able to achieve what's called positive leverage.
Speaker 2:And positive leverage means you are borrowing at a rate that is lower than the yield on the property, either the going in yield or the expected stabilized yield. So if I'm buying at a six cap rate. I want to be borrowing below six, that's positive leverage. If I'm above six, if I'm borrowing at seven, that's called negative leverage. And negative leverage can get you in trouble if things don't go well on your business plan.
Speaker 1:Well, and it's very intuitive, isn't it? I mean, if you're borrowing at 6%, so you're paying out 6% a year, but the property, the asset that you buy is yielding only 4% a year, where are you getting that other 2%? Well, you've got to dig into your pocket for it, right?
Speaker 2:Well, you don't lever it to the gills, right? You try to use prudent leverage. In core it's usually around 50% in more value-add opportunistic, which we'll get into those definitions in a second. You usually see leverage more in the tune of 65% to 70% loan-to-value or loan-to-cost and what you can do is, if you have negative leverage, there's still some excess cash flow beyond the debt service. You just have to make sure you can cover your expenses and you have to make sure your expenses aren't going to grow to the point where they overwhelm your cash flow. They overwhelm your cash flow. Negative leverage will work if there is a path to stabilization and a higher yield. I mean, by definition, every development, like every ground-up development project that uses construction debt, is negatively levered from the get-go right. Like you're, by definition, taking on negative leverage because there's no income, yeah, Until you build it.
Speaker 2:Until you build it. So it's not to say that negative leverage is universally bad. It is just an extra risk factor.
Speaker 1:But staying with your category of core and core plus. So in a core or core plus building where you've got pretty much full occupancy, pretty much high quality tenants, which means good, stable cash flow, I can see why you would say negative leverage in an asset like that might be an issue.
Speaker 2:It would be an issue? Yeah, because you don't expect tremendous growth there, unless you have a secret that no one else knows about. So for value add, we'll just get into the definition of it. Value add implies that there is some either CapEx or some sort of business plan to increase the cash flow of a building, and there are many different flavors of value add, ranging from and this doesn't mean distressed.
Speaker 1:This just means the building may not currently be managed to its best use. Maybe it requires some freshening up, right, but that it's otherwise. It could be a core or core plus asset. It's just not being properly run. Is that a fair way to think about value add?
Speaker 2:That's one flavor of value add. So there are many ways to improve a building. So the simplest ways would be just changing the tenants. If you have tenants that are paying below market rent and they can't afford more but the market rents are higher, you could just change out the tenants mark the rents to market, maybe not have to invest a lot of CapEx, but just by re-tenanting the building you could boost your we read a lot in the papers these days about how a lot of office buildings are retooling to be residential, especially in dense urban areas.
Speaker 1:Is that an example of retenanting that you're sort of changing the nature of the tenants?
Speaker 2:So that would be an, that would be an, a change of use and that's more CapEx intensive than retenanting, so adaptive re. So I gave you a very like light value add, uh know, low capex type of uh strategy. A heavier uh value add, more capex intensive, would be something like a redevelopment or an adaptive reuse. So you know, a great example would be, uh, the one you just highlighted which is taking an office building and repurposing it for residential, which papers like to talk about. It's very difficult to do. It's not a new concept. It's been around for a long time, this idea of converting antiquated office to residential.
Speaker 1:There are a lot of reasons why it can work, but probably more reasons why it doesn't work If you look at the existing stock of office and the buildings that need to be converted, it's a very because the demand just isn't there for them. Well, and I have to believe also, it's probably an example of something that's limited to very specific locations. We might talk about that in New York City or Chicago, but I'd be surprised if you talk about that in Charlottesville, virginia, for example. I'm not so sure. I think it's a very narrow kind of thing, right is a very narrow kind of thing Right.
Speaker 2:You see conversions be successful, usually with older office buildings that have smaller floor plates.
Speaker 1:So there's more Like the Flatiron building.
Speaker 2:I think I read recently Flatiron's a good one because you're going to have lots of rooms with windows. It kind of comes down to the windows and the light and air. Uh, a deeper floor plate building, you know something's like big, huge office floors, like you think about a bank trading floors or something like that. Um, those are deep cores and so you're going to have a lot of rooms far into the interior that are just windowless and that doesn't work very well. The infrastructure in the building also just isn't suited for conversion oftentimes.
Speaker 1:So, as we're talking, john, you're looking out a set of windows that faces the old Waldorf Astoria Hotel, which is under construction and, as I understand it has been for a long time, has been for a long time and, as I understand it, they're seeking to convert some portion of the space from hotel rooms to high-end residential. Is that also a conversion going from hotel to residential or are they kind of the same, just lengthening how long you stay?
Speaker 2:They're not the same, because the things that you want in your home are not necessarily the same things that you want in a hotel. A hotel, you need a bed and a shower. In a home, you want more than just those things. You also want to have a kitchen, for instance. So that conversion. That is an example of an adaptive reuse. It is one of the more straightforward types of adaptive reuse projects than, say, converting office to residential.
Speaker 1:So my intuition that hotels and homes are sort of similar isn't way off base. It just means that the conversion is a more straightforward conversion in a way.
Speaker 2:Yes.
Speaker 1:Gotcha Okay, straightforward conversion, in a way, Gotcha Okay. So we've got these core properties usually buildings with great tenants and full and highly stabilized and therefore not so much risk and we expect to earn sort of modest returns, I imagine. Then the value add properties there's more risk because maybe they get it right and maybe they don't get it right. Value-add properties there's more risk because maybe they get it right and maybe they don't get it right, and maybe the demands that they anticipate are there where it sounds like one would have higher expected returns because there's more risk.
Speaker 2:So in value-add you would expect returns probably in the mid to high teens IRR. So contrast that with core. I also said core plus. Core plus is like maybe a little premium to core but you can lump them in the same category for all intents and purposes. Gotcha, value add is going to be the more CapEx intensive, a little higher risk and higher returning for that reason.
Speaker 1:What's your third category?
Speaker 2:Opportunistic is. You know that's going to be be more far out on the risk spectrum, but also the highest returning. Hopefully is what you'd expect. So I'd put ground-up development in that Some might even put certain types of adaptive reuse projects in opportunistic.
Speaker 1:Because they're just so uncertain about the result.
Speaker 2:Right Interesting and you would expect returns of 20% plus and opportunistic Gotcha, everybody.
Speaker 1:I mean you have to kind of be living under a rock not to pick up a newspaper or tune in to a news show in which you hear about the dire straits of the commercial real estate market, and the news presentation of these things is not terribly nuanced and doesn't really help us understand it in a careful way, and I think I'd like our listeners to understand it in a careful way. Can you walk us through what are the sort of? Let's start macro. What are the macro things that have happened, are happening, that present some challenges, and then, if you like, while you're talking about them, maybe relate those as effects differently to the different categories or, if you want, to save it up, and then we can talk about the categories at the end. But let's start with the macro.
Speaker 2:Sure, yeah, I mean, as you alluded, if it bleeds, it leads, and the real estate industry has been. Well, the commercial real estate industry, I should say, has been very challenged in the last couple of years and it's really driven by two things. One is, and maybe three things. The first thing it's driven by is just the, you know, very rapid pace of monetary tightening that happened in the wake of inflation and we can get into what that affected, like how that brought the industry to a standstill.
Speaker 1:Well, yeah, do that. So what's the mechanism like? So the Fed is raising rates, and that has listeners from season one will know that this kind of changed the so-called level risk. It just means, on its own, all else being equal. You've just got parallel shifts in the yield curve, so they're raising rates. That's a parallel shift. What's the effect on real estate investment? You already alluded to one of them.
Speaker 2:Yeah, so when the Fed raises rates, borrowing costs go up for everybody. That's generally how it works. So across the real estate industry you saw borrowing costs roughly double. So across the real estate industry you saw borrowing costs roughly double. And we talked about cap rates and how interest rates have somewhat of a gravitational pull on cap rates because of the wake of COVID is. Asset prices ran really hard and cap rates compressed to an unprecedented degree. They reached record lows.
Speaker 1:We saw Sure, because when interest rates are that low, pretty much any deal is going to be a positive leverage deal.
Speaker 2:It is. You could borrow at such cheap rates, especially if you borrowed floating. You could be buying a multifamily building in a high-quality market and buy it at a 3.5% cap rate and still be positive leverage on that, and people were doing it. Where that's dangerous is obviously like there's very little margin of safety if things don't go your way. Most real estate investors on the institutional side, when they invest in a property and they're underwriting the assumptions they put in their assumptions for rent growth, for expense growth and then for the exit cap. Whenever they're going to exit they usually underwrite some element of cap rate expansion. They don't.
Speaker 2:If the cap rates go down further, it's icing on the cake and real estate has benefited from about 40 years of falling cap rates up until recently. But that was never the assumption that cap rates would keep falling. The industry was generally prudent in assuming that cap rates would be flat at best or increase mildly at worst. But the relationship between cap rates and price is not linear. So if you think about it like an earnings multiple, what do I mean by that? It's sort of like the convexity of a bond, if you're familiar with that, if your listeners are familiar with that term, the earnings multiple implied if you have 33. If it's a four cap, it's 25. So, okay, you go from a 33 to a 25. If your cap rate goes from three to four, from four to five, you go from 25 to 20. From five to six, you go from 20 to declining percentage as you go up, yes, um.
Speaker 2:so the impact on price as cap rates get really, really low, um, is very pronounced. And what happened as the fed raised rates is things were priced to perfection. You know, we had cap rates in the sub fours and when interest rates went up, uh, they started to revert more to five, six or higher, depending on the property type. So big moves, big moves. And the other thing that happened was you had expenses were increasing quite rapidly because of inflation.
Speaker 2:This is now you're talking about post COVID. Talking about post COVID around the time that the Fed's raising interest rates. So say you. Say you bought a multifamily building at a three and a half cap in 2021. And you were expecting to see continued double-digit rent growth and relatively tame expense growth and interest rates that are going to be slightly higher at exit cap. Rates that are slightly higher, maybe 100 basis points higher A typical sort of set of expectations.
Speaker 2:Well, not really typical. Because double-digit rent growth was not normal. It became the new normal. Because double-digit rent growth was not normal, it became the new normal. And if you wanted to compete in the market at that time, you had to bake that into your underwriting, otherwise you just weren't going to win the deal. You couldn't justify paying that low of a cap rate for something. And the reason people justified is they said well, we can grow out of it, we can grow to a higher yield, because we think that rents are going to keep running. And a lot of things happened that just went against that expectation.
Speaker 1:That's interesting. So really, if I'm understanding you, the rise in interest rates kind of sets in motion a series of other things that have pretty big impacts, but it's not itself a standalone issue. Let me pause on this for just a second, and I think I know. But so, if I understood your description of the three categories, the rise in interest rates post-COVID probably had a much bigger effect on the value add and the opportunistic properties than it did on the core properties. Could you give us orders of magnitude of the relative effects?
Speaker 2:It's probably not that straightforward, because the one benefit of the value add and opportunistic strategies is you do have the ability to drive value at the property level through good business plan implementation. There's a lot of levers you can pull. If you are and typically if you are engaging in a project like that you're already expecting to stabilize at, hopefully, a premium to market cap rates. So you've maybe gone in with a certain valuation. You're expecting, like, say you buy at a, going in five cap.
Speaker 2:Or go back to my example like you're going in at a at a four cap and your forecast to stabilize at a seven, hopefully. Uh, if you can stabilize at a seven and then sell at anything less than a seven, it still works. Um, if you're stabilizing at a seven and selling at a seven, you might be just breaking even. I see uh, but if uh, on the core side again, you're paying premium prices for core, so you're probably paying the lowest cap rates for core and when cap rates revert you you know if you don't have to sell, then you just take a big hit on the mark to market and we can get into how the industry has handled that, because different players have handled that different ways and it's caused a lot of friction and equity capital markets in terms of this disagreement over values in the wake of rising interest rates.
Speaker 1:Yeah, I mean so okay, I got you. So I think then it's more complicated than that, but it sort of sets the stage, because one of the things that you mentioned was you might, when you're pricing things in this perfect world with double digit rent growth and very low cap rates, you say, oh well, it's okay because I'll grow myself out of it. But one of the things that's happening is, as interest rates go up, is that it's post-COVID and the world's relationship with structures, with places, is changing, and so I suppose that kind of doubles down on the problem.
Speaker 2:Well, I mean the three assumptions behind buying at sub-4 cap rates just didn't transpire the way anybody expected. Rent growth came down from double digits to single digits, or flat. Expense growth continued to accelerate as insurance costs went up.
Speaker 1:Well, it's the reason the Fed raised rates. There's inflation, there was inflation. It affects everyone.
Speaker 2:It did not go away overnight.
Speaker 1:But is it fair to say then that there wasn't nearly as much rent inflation for owners of commercial property as there was expense inflation? Or is it that the nature of these leases means that there's a timing problem?
Speaker 2:So, for instance, in multifamily, I think rent growth fell before expense growth did, so expense growth continued to persist while rent growth was falling and while your borrowing costs were going up, for either I mean, if you bought floating- Well, it's just moving with prevailing rates. Yeah, if you borrowed floating rate during that time period and your borrowing costs have doubled and your rents aren't growing the way you expected and your expenses are growing more than you expected, you're toast, you're underwater.
Speaker 2:You're giving that back to the bank, probably because you just can't service the debt anymore, right?
Speaker 1:So, rather than growing to a five, which I mean, but I guess what I'm getting at is that story. So I like that anecdote. That anecdote is not going to be as dire, it seems to me, if it's a core property, because you probably wouldn't have structured your acquisition in that way. It's more likely to be dire because it's either a value add or an opportunistic property where you borrow, floating rate etc.
Speaker 2:Yeah, so, if you like, one of the most classic value add strategies out there is value add multifamily. So buying units that are or buildings, you know, 20 plus years old and just updating them like think about it like the road paving business of the commercial real estate industry, like this is just a maintenance gig where every once in a while these things need to touch up. So you go and you replace the countertops and the cabinets and the floors and, uh, you know, you paint the halls.
Speaker 2:You just make the whole like you address any deferred maintenance, like if there's a boiler that's malfunctioning, like just just upgrade all that stuff very light capex work. Doesn't take a rocket scientist to do it, but there are certain groups that are better at it than others. Um, and that is an evergreen strategy in any market, like we will always need that, and it's a good business. That's a very reliable stream of returns for commercial real estate investors. But if you go in at a 3.5 cap and now cap rates are at 5, you've got to grow your NOI by 43%.
Speaker 1:NOI.
Speaker 2:Net operating income.
Speaker 1:Right. So your rents Less expenses.
Speaker 2:Well, your rents less expenses. Right, you have to grow that to. You have to grow that 43%. That's enormous. Just to break even, yeah yeah.
Speaker 1:Is that an explanation for why you know sort of post-COVID? The other thing that we read a lot about in the press is rising rents. Is that sort of a driver? Is that part of what was going on? Are property owners trying to grow that NOI by 40% and jacking up the rents, or is that a different phenomenon, do you think?
Speaker 2:Well, I don't think I'm giving away any trade secrets and saying that landlords are incentivized to raise the rent, that is their job is to maximize rents, just like any vendor selling whatever they're making is trying to maximize price for what they're making.
Speaker 2:Building owners are profit-seeking players in our capitalist system, just like anybody else. But what really drove the rents during COVID? I mean, there were a lot of things and it will be debated and studied for years, I'm sure. But there was massive wage inflation so people had more money to spend. There was less social mobility, so people couldn't move as easily. They preferred to stay in place, and there was a shortage of housing that emerged from. I don't know how much of this had an impact, but I suspect a lot, and it's hard to measure. But I suspect a lot and it's hard to measure. But during the pandemic, if you had like, you often had roommate situations where, because of different COVID protocols that people wanted to follow Couldn't do it. Those roommate situations just didn't work and people split up Right. So you had you had like more household formation, just from the, the dispersion of people from group situations to wanting to live on their own, and just created this massive demand for housing.
Speaker 1:That was just unprecedented, and so but concurrently right in terms of the demand for office space. I think imploded.
Speaker 2:COVID was a nuclear bomb for the office market when the pandemic hit. I mean, we all know what happened with work from home. You just had intense demand destruction and a lot of uncertainty across the office market, and it has continued to this day. It's actually interesting If you go back and look, remote work started to become more prevalent really in 2019. The pandemic just brought a lot of demand forward. For many things it was an accelerator.
Speaker 1:It also changed what was in the realm of the possible for most employers, where it was kind of gurgling up to the surface in 2019. And, by the way, if you're as old as I am, you remember that the big accounting firms and the big consulting firms in the mid-1990s had a similar sort of flirtation with that sort of thing. But it sounds like COVID changed it for real. Yeah.
Speaker 2:Necessity is the mother of invention. So if you have people who don't like the idea of talking on a screen to each other and they're saying I'm not going to do that, Well, COVID suddenly made it so you have to and, like you said, it opened up the realm of the possible and a lot of companies decided I don't need these office leases in my cost structure, I can do everything that I need to do remotely. Now let's talk. I mean, we can talk about how absurd that notion is. I think it works for certain companies, but in the lead up to COVID, the big narrative in the office market was how do we create spaces where you can increase the number of chance interactions between employees, because collaboration is so important and those chance interactions, that's where innovation and creativity thrive.
Speaker 1:This is when Silicon Valley led the world.
Speaker 2:Right, but then all of a sudden, oh, we don't actually need any of that anymore. It was just, it was a start to begin with.
Speaker 1:The business didn't fall apart when you didn't have it. And I wonder whether and culturally I think this happens from time to time is that there's a zeitgeist, there's a kind of prevailing wisdom like we need chance interactions to spur creativity. A nuclear bomb goes off, everything changes, and so there's a change in the prevailing narrative. I mean, it doesn't have to be that it's wrong or right, it's just changed.
Speaker 2:Right. So we overcorrected to one side, I would say, in the office market, and thinking that there was going to be permanent work from home for a lot of organizations. Like I said, I think for some companies, certain business models, it works fine to be everybody remote, you don't need office space, fine. But for large companies, the collaboration is important and they started to figure that out as we sort of came out of. Uh well, once we were out of the lockdowns, particularly after Omicron, there was sort of this uh, we were starting to feel organizations and cultures atrophy, like the collaboration and just like even knowing you know personal details about your colleagues, like things that foster camaraderie, it just doesn't break through. When you have pre-scheduled Zooms, you get on the Zoom and you're, you know you've got a bunch of people and they're just like looking at each other's faces, like let's talk about how unnatural that is. Like looking at a bunch of faces looking back at you while you're talking is intimidating and for most people it's not natural.
Speaker 1:It's also there's some real science behind how we, how we process information depends a lot on three dimensions. Yes, and to lose one of the three dimensions really changes the nature of the learning or the interaction.
Speaker 2:So much of communication and building trust is nonverbal body language and none of that comes through on zoom. So it was always a preposterous idea that we were going to be just like fully remote and office was dead. But that was the truth. Everybody kind of suspected was probably somewhere in between, and that's kind of where we've shaken out. Hybrid work is sort of the new norm, I think. Maybe if a company used to have five days in the office, they need four, or they have, you know, more like certain functions can work remotely while others need to be in the office.
Speaker 2:So there has been some demand destruction in the office market. It's going to take a long time for office to work through it. Like commercial real estate writ large, office is not a monolithic asset class. There's modern office and then there's everything else. There's stuff that's newly built and the stuff that's newly built is leasing up and it's commanding, you know, very high rents, some higher than before the pandemic, uh, which is why you're seeing continued development in office. You would expect that there'd be no development, no new supply in the office market, but because new buildings will lease up, people are still building them.
Speaker 1:Well, I mean right now again, I'm looking out a set of windows on what looks like a massive construction of JP Morgan's corporate headquarter tower. I mean, they simply demolished a building that you and I worked in and we know it to have been renovated in 2008 and a perfectly good building, but it seems like there's demand for that sort of thing.
Speaker 2:Yeah, and so there's within the office market there's that kind of top strata or top stratum, and then there's probably two other tiers beneath it. There's the very bottom tier which you think of very commodity, office, older stock, kind of antiquated. That's going to be hard like that.
Speaker 2:Stuff might never be coming back and or maybe it becomes the next value add or the next opportunistic could be investment, um, and we're seeing we're seeing some some of that, but most of the time that involves tearing it down and changing the use. So a lot of office is worth nothing more than the dirt that it's on right now, and in some cases it's worth less because it's encumbered by office. You have to tear it down and that's expensive.
Speaker 1:That's an expense.
Speaker 2:So, um, there is, there is a lot of that, that that I think there's, think there's a bottom rung of the office market that is probably done for and not coming back, and that's a value trap for anybody that owns it. Then there's the middle area of the market where the assets are older, challenged, probably need some CapEx injections, need some, you know, probably need some capex injections. But as as the office market reaches a new equilibrium, um, I think that's where some investors will someday make a lot of money. Whenever the whenever there's not enough trophy office building to absorb all the demand and the demand has to spill over into other existing buildings, um, but that is a really hard business to be in when you have, you know, you've got 20% vacancy nationally across the office market. Landlords have no pricing power. They have no pricing power and they still have rising expenses. And tenants are pickier than ever in terms of the types of amenities they want to make the office commute worth it.
Speaker 1:And is this broadly true, john, not just in big metropolises like New York City, but true even in second-tier, third tier, fourth tier cities? Does office really exhibit the same qualities, do you think?
Speaker 2:It does. It is different market to market. It just depends on how robust the local economy is, so, for instance, that demand spillover could be happening at a local level in some markets and just not in others. I see the New York City office markets actually come back quite a bit. The people who said that New York City is dead and it's never coming back.
Speaker 1:Well, they've exaggerated New York City's death many, many times in the decades and it's still here.
Speaker 2:Many times, but it's actually. It is interesting where we are this particular moment with the New York City office market. There's some green shoots. I don't think anyone is really prepared to call the bottom yet. Most investors would rather be late than early to this trade. But I wouldn't be surprised if in 2025, you start to see some of that healing process begin.
Speaker 1:You've alluded to the nature of this asset class. Like any asset class, is investors trying to price uncertainty, and here we've gave it some very specific terminology and we've talked about some of the macro effects that have had some consequential effect on real estate. You also mentioned REITs and we talked about that. These are public securities where the value of the asset inside the security is the so-called NAV, but that because it trades in public markets, investors can readily express their own view of price. And that's what you meant by discount to NAV. But of course, public REITs aren't the only way that commercial real estate is owned. It can also be held in private REITs or different kinds of private funds, or even directly. Without getting into the nuances of those different vehicles, can you talk a little bit about this challenge of pricing uncertainty and how those changes in prices, when those are the vehicles through which investors make their investments, maybe experience a different effect? The same, how does that compare, say, to the massive change that you could see happen instantly in public REITs?
Speaker 2:Right, so I mean public REITs. The theory is that they're ultimately the fundamentals are going to win out at the end of the day. They are volatile, just like stocks, but they're ultimately tethered to the underlying value of the real estate. And I think it's fascinating that REITs persistently trade at discounts at AV. You would think it's the opposite, like you'd think that there'd be a liquidity premium for being able to sell it as soon as you feel like it, versus a private holding like it's illiquid. But for some reason REITs traded a discount.
Speaker 2:It wasn't always that way in the business when the business started. The public REIT business started back in the nineties. Uh, they typically traded at premiums to NAV and it was great for the REIT business because your stock, you could issue stock and buy assets with it and it was instant alchemy, uh, for your shareholders. Now it's a source of frustration for every REIT CEO out there because they feel like their stock isn't appropriately valued. But these different vehicles serve different purposes. The REIT world it is a public security. It mostly owns core like REITs mostly own core assets.
Speaker 1:Got it, so you're not going to find. Find it's going to be unusual to find a publicly traded reit that owns value adder opportunistic there.
Speaker 2:There are some reits that will engage in development, um, and you know they'll call it build decor it's. You know it's sometimes cheaper to develop to a seven cap than to buy it at a five, but the dotted line is to core it's. It's ultimately like REITs are about cash flow, like the tax structure is one, where you know it, it needs to be cash flowing in order for it to work. Um, so that is that is typically the objective. Within a public REIT is like you're buying core. In the private markets it spans the gamut a lot more. So there are.
Speaker 2:I think the most traditional private investment vehicle in real estate is just going to be your traditional closed end fund. So that's like a private equity fund. There's an investment period, there are return objectives and there's a deployment period where you're going out and buying real estate and then, hopefully, if it's value add, you're going through a typical buy, fix, sell sort of business plan for the whole thing liquidate at the end. That's the most common vehicle. There's also open-end funds. Those would be perpetual life vehicles that are also. So those would be perpetual life vehicles that are also.
Speaker 2:You know they're buying real estate and they're holding it forever and investors can. Well, they're not forever, but they could sell it. But in theory, like you're holding it for the long term and investors can buy into those funds and make new commitments, the fund could then either use that to go out and buy assets. But the idea is you can also redeem out of that early or just whenever you want. You can redeem out of that if you need the capital and if you have investors coming in, you can either use those new commitments to fund your redemptions or, if you don't have new investors coming in and you have redemptions, you could sell assets and redeem people that way.
Speaker 1:So one of the things that listeners have learned about is that the use of volatility as a measure of risk can sometimes get a little dodgy when we start looking at private investment vehicles, where there are valuations which have a lag, and also they are valuations not traded, and so the notion, for example, that you might look at commercial real estate in a conventional private vehicle as having lower volatility may be a bit of a fiction, I guess I would say, particularly because we know what the volatility would look like if we look at the public REIT market. And so it's not that it isn't there, it's just volatility is a poor measure of risk in those private structures as investors. Then what would you look at as a good measure of risk if volatility is of no use?
Speaker 2:So I think in I'm not a portfolio theory expert so I can't, and I'm a private markets guy, so I don't really speak in terms of volatility, as you just alluded, or think about it that way but I think when you're looking at the risk of any individual property, investment or a vehicle, one of the things to pay attention to is just the factor risk for each property type that is in the portfolio. And by factor risk I mean how correlated is it to a single industry, or to interest rates, or to migration trends, and are there any idiosyncratic risks that are difficult to hedge, difficult to manage out of, should they strike? An example would be if you are developing spec land for residential development in a path of growth, that you think the demand is going to spill out into the suburban area, but then it just doesn't. And you've just improved the land, you've got a lot of sunk cost, and what do you do with it? How many value levers can I pull to?
Speaker 1:manage my way out of a situation should it strike, and also, is my capital structure appropriate enough to weather that storm? Idea that when we're talking about asset classes like this, it's like you made the comparison, say, to private equity. It's like private equity in the sense that, unlike public securities, where I can create a sufficient amount of diversification to be left only with the systematic risk here that's very, very complicated to do that at the end of the day you have some systematic risk of real estate as an asset class. But in any investment, whether it's a public read or whether it's a private vehicle, there's going to be a very large dollop of idiosyncratic risk along the lines of what migration trends did you think you're capitalizing on in that investment? What demographic changes? What are these other things? I think that's cool.
Speaker 2:Yeah, I think one of the biggest myths about real estate is that it's a passive asset class. You can't be a passive owner of real estate because there's always going to be some market force that's changing. I mean, it wasn't that long ago that books a million would have been a credit tenant, and now they're gone.
Speaker 1:Yeah, no, that's fair. And I mean, you know there are these kinds of things that you can like at some macro level. If I had unlimited capital, I suppose I could own enough commercial real estate to diversify away those idiosyncratic risks and be left with just the systematic risk of owning commercial real estate. But I think in the real world it's impossible. Even if you've got hundreds of millions of dollars to commit to the asset class, you're still going to be left with some dollop of that kind of risk.
Speaker 2:Yes, especially when it comes to the major factors like interest rates and growth, because if interest rates go up, your cap rates are going to go up pretty much across the board, and so that is one risk that almost all commercial real estate assets are going to be exposed to. But, like I said, the risks to an office or a retail building very different from something like self-storage or multifamily.
Speaker 1:John, this has been terrifically interesting. I can't thank you enough. No-transcript wisdom.
Speaker 2:Yeah, well, I'm glad you didn't ask me something hard like what my hobbies are right now. Let's see, I don't know if it's really wisdom, but there's a quote I like and it's uh, maybe a little bit cliche, but I'll share it anyways, and it's uh, life is a chess board and the player opposite you is time and I like that. I like because of the, you know, there's the underlying message like you know, um, make sure that you're doing what you want with your time, spending it the way you know you want to spend it because it's finite and, you know, don't procrastinate on things that are important to you, all those lessons. But I also like it because, um, you know, I think a lot of people think of time as sort of an hourglass and I like the contrast of like.
Speaker 2:This is, uh, it's more of like you have an opponent and, um, for a couple of reasons, like the hourglass analogy is, um, it's very passive, uh, you know, you see, you see you think of an hourglass and time's just flowing forward and there's no control and you're just kind of along for the ride. You're just like watching it and it's kind of existential and depressing to think about it that way. Long for the ride. You're just like watching it and it's kind of existential and depressing to think about it that way, um, whereas um thinking about his time as an opponent, um, there's some agency there. Like you have some control over you, know your next move, um.
Speaker 2:I also like it because, um, because, again contrasting it with an hourglass An hourglass there's predictability and you see when it starts and you know when it's going to end and you have a warning that it's about to end. But in a game of chess, you know you can lose in an opening move, like it can go different ways very quickly and you know it's a reminder that eventually time is going to checkmate your ass and you need to be thinking about your next move very carefully and you need to be thinking several moves ahead, and I just think that that's a healthier way to go through life, um, in terms of you know how to prioritize, um and to establish your values and, like, what's important to you, um, is to think about time as, like your opponent, and then it's also just, I think, a little more fun.
Speaker 2:That's great, John thanks a million. Appreciate it, thank you.
Speaker 1:You've been listening to Not Another Investment Podcast hosted by me, edward Finley. You can find research links and charts at notanotherinvestmentpodcastcom. And don't forget to follow us on your favorite platform and leave comments. Thanks for listening.
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