#9 - Wes Whitman: Real Estate Investing, Outlook

23:57If you're trying to access something on a more broad base, then you are leveraging. There is value being created at each level of that structure. And so there's just trade-offs there. And if we go back to where we started, one of the things that you love about real estate is it's a hard asset. It's something you can touch and feel, and it requires somebody to operate that asset. So as an investor, if you want to come in, there's layers of expenses associated with accessing that asset because it's something that has to be managed. And you can effectively outsource those expenses to an operator, and then you can outsource the allocation decision to an allocator.

24:32And your choice as a passive investor is, I'm going to get that real estate and I'm paying fees. But the alternative is I could go do it myself. It's not going to be as diversified as a fund. And I have to go hire all these people. And do I really know what I'm doing and the value add of those layers? So I think that's one of the reasons it exists and it persists. That's right. Because it's a necessary part of the structure. I think that's exactly right. People would prefer to not have two layers of fees. I mean, like anybody would. But then you go look at the biggest allocator funds out there and they're continuing to raise capital at the highest rates they've ever done.

25:06And so it is fulfilling a need. Our business model is a little different in that we're accessing a part of the capital stack that doesn't have double fees and promotes. We can go into that later. So we're trying to differentiate ourselves within the industry and there's trade-offs we make to do that as well. So each person has their unique model. But I will say this, for people who are investing in allocator funds, and I can say this, I believe, without being biased because we sort of deem ourselves to not be a typical allocator fund, but we work alongside a lot of them. And there are some incredibly smart, disciplined people at those funds who are really taking good thought and preparation and diligence as to what sectors they're going into, what partners they're partnering with, what assets they're going to invest in.

25:50And then those operators that they're investing with are also, as you mentioned, at the asset level, I mean, it is a real blocking and tackling business. You take the full-time equivalents to operate, say, a self-storage facility, right? Where that probably has the fewest full-time equivalents of any asset classes. And then you take something like memory care in seniors housing, where you might have 90 full-time equivalents per hundred rooms. There is a vast difference in sort of operational intensity, but even at the self-storage business, there's revenue management decisions that need to be made.

26:22There's where are we marketing? There's a lot of decisions that even are made in the least operating intensive side of it. And so you can imagine how those decisions trickle through as you kind of go up from there to multifamily, to lodging, to seniors housing. And so there is a lot of value. I think having been at Graystar really helped me see that. Think about this, even the scale of the platform who's doing the operations, if they have a broad-based national scale, the cost to repaint an apartment building, the cost for insurance across all of the, which insurance costs have been one of our biggest costs that have gone up over the last two or three years.

26:56There's other economies of scale that come, technology costs others, that can actually drive more profit per room, more profit per key or per bed or whatever the metric is, depending on the sector you're in. And so those operating decisions actually do matter. So I think everybody's playing a role. And there are structures where people can access it more efficiently. It's just that you've got to look at that trade-off of how much did I have to staff up internally to access and manage those opportunities as well as the other structure does. Right. And because it's a relatively inefficient market, there's more potential for value add at each of those levels.

27:30And if you have expertise and experience, you're more likely to make good decisions. And if you do it really well, maybe you even offset your costs at that level. And so the investor who has these multiple layers of fees may actually benefit from that, assuming they do a good job of picking which allocator to go with. I think that's right. And over the last 10 years to 12 years, those funds have actually produced quite good returns and mid-teens net returns for a lot of them. And so on an absolute basis, you can sort of look at, okay, well, how would I have done in the public markets? And each person might have their own unique access point, right?

28:05But I think talking on a broad base, the private funds have done quite well. And I should clarify, I'm talking about opportunistic funds that are really out seeking properties that are in need of some sort of repositioning, either operationally or from a renovation perspective. That's sort of the world that I'm really talking about. And I should clarify that because, I mean, look, if you're investing in a core fund that's managed by an institution, I think you do have to ask the question of, okay, what is the alpha I'm getting relative to the public markets? or is there some unique access point that those folks are getting?

28:38And again, the folks managing the core funds, we know a lot of them, as I said before, all very smart, very thoughtful. They're out trying to do a really good job. And there is still operations that happen even for stabilized assets. So who they have as operators, all those things really matter. It's just, if you look at the absolute return targets relative to historical averages in the public markets, I think it provides you a chance to sort of say, okay, well, if I'm looking at stabilized assets, core real estate, where do I find more value? And we're really focused on that sort of value add to opportunistic part of the sector.

29:09So a lot of my comments are sort of more applicable toward that part of the risk spectrum. Yeah. That core area, you can think of it as less risk. Would you talk about the riskier segments of the market, not just opportunistic, but just the sectors and how you think about those areas and avoiding taking undue risk? Yeah. Certainly as you get into the more operations intensive real estate, there's just more opportunities to fumble, right? I mean, the more touch points you have with the customer, the more parts there are in the value chain, just like any business, there's just greater chance for higher standard deviation of outcomes on the returns.

29:46And so the way that we think about investing in those sectors is really a basis focused approach because there are a lot of unknowns. The standard deviation of outcomes can be wider. And so you better have a basis and be buying at a time in the cycle where your basis allows for tremendous volatility. Now, I say tremendous. We wouldn't be investing in something if we thought it was tremendous volatility. But if you understand how that band of outcomes works, having a great basis can really solve that. I think that where people start to make mistakes is where they continue to allow the basis to creep up at a time where the operational risk isn't necessarily going down.

30:23And so that means that the more you pay for that asset, the tighter the band of outcomes needs to be in order to hit your return. And if you're relying on a tighter band of outcomes than is likely, then you're more than likely going to be disappointed in those returns. And so we tend to invest in those types of segments of the market at a time where your basis allows for a lot of things to go wrong and you'd still end up earning really high returns. We have a higher threshold of what we think we should expect in those types of investments. And we have a broader distribution curve. we do a probability weighted analysis for each investment.

31:00And we have a higher probability weighting on those that things might not turn out how we thought they were going to turn out. So Bob taught a class at Stanford Business School once, and the title of it was Why I Hate Hotels and Why We're About to Buy a Lot of Them. And this was sort of at a time in the market where you could buy them for pennies on the dollar. And so there's an opportunity there. I think right now for us, though, Alex, we're in a period of time where the demand side of some of these sectors has really changed, in our opinion, with the pandemic. So you take office, which we historically just haven't been focused on office, but there's no argument that office from a demand side is different than it was three to four years ago.

31:40Arguably hotels as well. I mean, hotels went to very, very low occupancy. And business hotels today, even though in some markets in the Sunbelt they've recovered, there's other markets and there's even sub markets within certain cities where people just have not come back to the office. People are doing Zoom meetings. They're not traveling for business as often as they were before. Exactly. We're not taking as many meetings, right? I mean, you think about even for us, as we meet with our investors or new investors, usually the first meeting is a Zoom meeting. It used to be the first meeting was in person.

32:10So things are changing there. And in seniors during the pandemic, as an example, people had to get creative on home healthcare and how do they help service their mom and dad or their grandma and grandpa when things were changing and they didn't want to take him to a senior's facility. So for us, where the demand side of the equation has had a fundamental shift and where it's difficult for us, at least at Woodman-Peterson, to predict what's going to happen, there's almost not a basis that's low enough for us, and I say almost, to be able to really understand how that distribution of outcomes may come.

32:43How wide is it going to be? Because we used to be able to predict that, hey, look, we've seen the hotel cycles go. We can come in. As long as we have 10 million of office space that's occupied around us. If we go into a downturn, we can unleash our salespeople. We can fill the hotel, at least stay fully occupied. In today's market, it's different. That's not the same. So I think wrapping up the answer to that question, I think as you look at the different asset classes within real estate, it's very important to sort of say, is there something that's changed on the demand side relative to how things used to be?

33:14Because as you sort of look back to historical averages and historical trends, when there's been a shock, like we just saw with the pandemic, to certain sectors, things are just different. And so you have to be really, really cautious on how you approach it. I'm curious, when I look at public markets and my experience with investors, oftentimes what happens is public markets go down, most investors look backwards, and they see downturn and they want to sell. And then when you get a big rally, they look back and say, oh, great returns, I want to buy, which oftentimes is the wrong decision. I'm curious, do you see the same thing in the private real estate world?

33:47You hear people talking about it a lot today, like, is it time to get into office? And I think there's going to be companies that do really well doing it. But I think that the great financial crisis and the pandemic, they're so recent in terms of our memories that I think institutional capital is still going to be very cautious. I don't think you're going to see just a huge upswing in office transactions. And I was talking to somebody even in San Francisco where office transactions, the basis has gone down by probably 75 % or call it 65 % to 75%. If you talk to the people on the ground there who really know what's going on, most of the buildings that have traded have not been the buildings that historically have been the buildings people wanted to own.

34:29And so it is really idiosyncratic as to where this stress is being seen, at least today, might become more systematic as we get a little further down. But for the best assets in great markets, lenders have been willing to continue to give people time. You know, you've had to pay down a little bit of the loan, put reserves in to make sure they feel comfortable that you're going to meet your debt covenants. But that, I would say, is slowing the idea that there's just going to be this fire sale across the board. I was actually quite impressed having gone into the great financial crisis and you see how institutions underwrote real estate then.

35:02I would say there actually was a tremendous amount of discipline going into, and I'll talk about where the discipline maybe came sort of off the rails a little bit in 2021, two and three. But leading up to that, we're involved in a lot of transactions where the biggest allocator funds, insurance companies, pension funds are on the other side of our transactions, where we're in the GP position with a lot of these best in class operators. And the discipline that they exhibited in terms of not allowing a lot of MES debt or PREF equity to come in on top of them, underwriting in a way that you feel like there's very reasonable underpinnings on sort of the underwriting metrics.

35:37We observed that throughout. Now, what did end up happening in 21, 2, and 3 is with interest rates being so low and people having raised so much capital, the market got very, very hot. And you saw cap rates coming into - It was very tempting. The 4s, then the 3.5s, then the 3s. In LA, even sub 3 for industrial in some locations. And then this is what you saw going into the great financial crisis. You saw a lack of discipline in terms of where the assets are located. So Minneapolis is being priced the same as Dallas or Phoenix. And so you start to see certain markets being priced also at a four cap or at a three and a half cap.

36:15And that's when you sort of step back and you say, okay, obviously we're reaching a peak here in pricing. Our model for what it's worth, we saw that frenzy happening and really decided we just weren't going to be part of that. And so, A, we were never on the acquisition side of that bet. So we were developing into that. But B, we just never believed that cap rates got as low as they were. And so when we were under a new development deals, we were looking at our spreads relative to a much higher spot cap rate than was actually happening in the market and transacting. And that having been through a couple of cycles, my partners hadn't been through four or five cycles.

36:49That was very helpful as we started to see what was happening in 2001, two and three in that. Yeah, the challenge in those periods that I've experienced is it lasts longer than you feel that it should. And then eventually you capitulate and say, OK, this is the way it's going to be for a while. The market's reset. Yeah. Yeah. And it always corrects. You just don't know how long. So I think you do have to be extremely disciplined to avoid getting sucked into that. You do. What we did was there were a lot of people who were disciplined. And so not trying to pat ourselves on the back here. But what we did is we just said, look, now is a time to keep optionality, to take time to push out closings, to reassess.

37:27We let go of a lot of deals. We restructured a lot of deals. We tried as good as we could to hold on to the best real estate and see if we couldn't restructure those. And we did in a lot of cases. And a lot of others did that, too. I think those who were willing to do that and not feel like, oh, I have to do this because the seller is telling me. There's a phrase that Bob Faith says. He's the CEO of Graystar. says there is always, always, always another deal. And having that mentality is very liberating. If you think about, I don't have to do anything right now. My investors will not be disappointed if we get on the sidelines, assess, reassess, let's wait.

38:04And there's always, always, always another deal. And sometimes when you're the deal person, and that deal means you're putting food on the table or whatever, there can be in certain circumstances, a bit of a misalignment, right? Because that person, they want to get the deal done. They want to put those points on the board. They want to help get the deal. And I think they really do have a fiduciary mindset in most cases, but there is the potential for what we say here is a fiduciary mindset, which is, hey, I need to keep this business going. And the best operating partners will actually call it as it is.

38:36They'll say, hey, listen, it's okay. If we have a capital partner as a lower cost of capital, and they want to get this deal done, that may not be the best for our opportunistic investors. It'll be great for our fee business. It'll be a lower return for somebody. And our partners, really, they're all focused on the fiduciary deals. But you can see how there's a chance for incentives to be misaligned there. And so for us, it's really important to have sort of that nomenclature that way to approach things. Say, hey, guys, listen, is this a fiduciary deal? Is it a fiduciary deal? If it's a fiduciary deal, that's great.

39:04You guys can do it with your balance sheet. And maybe that's the right thing for the company, not the right thing for the fund. It really is liberating because we've all felt it. You've all felt there's a deal that you think, gosh, we've worked so hard on this thing. We're almost there. Our band of outcomes looks like things will go right. But then having the discipline to say, you know what, it's okay. There's always another deal. That goes back to the cost basis, what you're paying for a deal. That's one of the most important things. One of the challenges is that in order to get that margin of safety and buy the asset at a lower price, you need some inefficiency in the market because everybody would rather pay lower price.

39:39But if you're always going in there with the low offer and you never get a deal done, then you don't really get anywhere. Would you talk about some of the inefficiencies that you've experienced and why you think some of those may persist? First of all, this is where the operating partners really play a key role. When you have a national organization that is tied in with every local broker, a bunch of local landowners across the market who really know their local markets well, they're going to see the opportunities on the front end of them coming even before they'll go to a broad marketed process.

40:12But they're also able to create opportunities where they don't exist. So take the San Fernando Valley as an example. One of our partners has been extremely skilled at taking what would otherwise be smaller parcels where you wouldn't have the land, the acreage to do a 200 ,000 square foot industrial last mile warehouse. And they've effectively negotiated with three or four different landowners, and they'll negotiate independently with those landowners to assemble a parcel where they can then combine them together and build a 200 ,000 square foot last mile box. That is extremely valuable. The ability to create something, create an opportunity where it doesn't exist.

40:51You can pay each of those building owners a very good value for what they individually own and have a nice arbitrage when you can kind of aggregate and combine that together. The same thing can happen in other parts of real estate, where there's a lot of deals that we'll do that are sort of below the threshold of the largest private equity firms in the country. So there's inefficiencies at certain amounts of capital, deal sizes, if you will. So something that might be a 10 to$20 million total capitalization for the deal, there's just less competition there. So both in the idea to manufacture cashflow or opportunities where they don't exist, to maybe target parts of the market where they might be less efficient, to maybe repurpose that land to something that might make it a lot more valuable than it currently is.

41:36For example, we have this outdoor lodging business where we'll buy existing RV parks and we'll completely repurpose them into sort of boutique hotels through an Airstream hotel concept. So there's a lot of interesting strategies, Alex, that you can do that really is idiosyncratic to a given sector, maybe to a geography, but where both the sourcing of that site, how it's sourced, where it's sourced, and the creative way that you program it can really create value. So those are a couple of the inefficiencies that we've found. And then also where you play in the capital structure. I mean, I think today you're seeing a lot of funds coming in and playing on the credit side of the business because there's a lot of inefficiencies there.

42:16A lot of the big banks are out, especially for regional operators. They may have a deal that they think is going to work and they want to get it done. And so they're going to alternative sources for debt. And people are getting equity-like returns in many cases for providing debt. You think about debt funds usually coming in, if your first mortgage would get you to 65 % or 70%, the debt funds used to come in. In the hot times, debt funds will come in and go from 70 % to 80 % or 70 % to 85 % in the capital structure. And they might charge low teens returns to get you there. Today, the first mortgage might get you to 50 % or 55%.

42:51And so the debt funds are stepping up. And I think very smartly for certain assets, I say smartly, depending on what the overall basis of the assets were, getting between 55 % and 65 % or 55 % to 70%. And they're in the mid-teens for that capital, low to mid-teens for that capital. And so I think there are interesting opportunities that different people are taking advantage of because the market is inefficient. We are coming and filling an inefficiency where if you're an owner of a big operating business and you thought you were going to be selling a bunch of assets and getting a bunch of capital back that was coming back to the house that you could then use to invest in your technology, into your teams, into co-investment capital for your investments, those distributions haven't come back.

43:34We've had a huge bid-ask spread in the market the last year and a half. And so those distributions aren't there. And these operating companies are saying, gosh, I have a big opportunity now. I'm so well positioned to take advantage of the opportunities that are coming and they need a partner. So we've come in and we've done a few different operating company investments in the last 12 months. They're a relatively small portion of our overall fund, less than 10%, but those are unlevered. We don't have to have any debt on those. They're unlevered deals where we see high growth and good returns. And so that's another inefficiency in the market today, which is sort of opco deals that may not have been as available the last few years.

44:09Would you talk about the whole GP side, that part of your business and how that structure works and how the economics work? Most real estate is not acquired in a fund structure. You think about all the local deals that get done all over the country. They're generally done in a joint venture structure where 90 % of the equity is coming from an outside investor and 10 % of the equity is coming from the person putting the deal together, the deal sponsor. and that's done in a single purpose venture. There's an LLC that's created and that 90 % equity might come from a high net worth family. It might come from an insurance company or it might come from an allocator fund as we were talking about before.

44:49Depending on the level of sophistication of the sponsor and the amount of capital they need to execute on their pipeline, they might choose different sources. If somebody generally has a relatively small pipeline of say three to five deals a year, which by the way, I say small, That might be a fantastic pipeline for the size of the business that person has, and they can do very well. But relative to the national operators with whom we're partnered, our partners are doing 30 to 40 to 50, in one case, 90 deals a year. If you think about the capital that is required at the asset level to do 20 to 30 deals a year, that could require hundreds of millions of LP or JV equity.

45:28and alongside that hundreds of millions can be 10 millions of GP equity that's required that that sponsor put in. And that's required because the LPs who are investing in the deal, they want the people managing the properties and involved in that same deal to have skin in the game. That's exactly right. Right, and so that's just standard, is that 90-10 split. That 90-10 structure is very standard in the market and for exactly the reason you mentioned. What's happening though, or what has happened is as these companies get bigger and bigger, there's actually an acknowledgement by the 90 % partners that, hey, we recognize this is now tens of millions, hundreds of millions of dollars, in some cases, billions, literally billions of dollars of GP capital.

46:09And the largest institutional investors out there acknowledge that that is just a huge amount of capital for any operating company. And they want that operating company to keep building their systems, to keep investing in the technology and other things. And so they'd be using 100 % and more of all their balance sheet capital to just put it into the real estate and not into the operating companies in order to grow the businesses. And so a lot of operating companies have started to look to external sources to help supplement that GP capital. And you could look at it and say, well, how did the LPs feel about it?

46:40Well, I think generally, obviously an LP would rather have the GPs put in as much as they can. But when the GPs can explain the absolute dollars they're investing across all their deals, like I mentioned, there's an acknowledgement that they're putting in very substantial, both on a nominal basis and on a percentage basis in the deal, still putting up a lot of capital. So the dollars are large enough where that box of skin in the game is checked. Yeah, absolutely. And so what's happened is we sort of saw this 13 years ago from the inside out when I was at an operating company to sort of say, wow, I mean, we're investing a huge amount in technology, a huge amount in expanding the platform, building the right teams, et cetera.

47:16And so by doing that, you can't use all your balance sheet capital, just put it in the real estate. And so what we will do at the Whitman Peterson side is we will come in and find those operators. Counterintuitively, people will say, well, if they can raise billions of dollars, why the heck do they need you guys? It is a counterintuitive idea that the companies raising the largest amounts of LP equity, the companies that are the most proficient at sourcing and executing on deals who can then attract that capital are actually the ones that find the greatest need for - Because the dollars are so large.

47:48The dollars are so large. So we have come in and essentially filled that gap for some of the nation's largest platforms in our target sectors. And what they're looking for is not just capital. They're looking for somebody who can really be a partner in there. At least that's what we hope they would say is that we might be viewed as sort of a Sherpa team that can carry a lot of heavy weight, maybe help them avoid some crevasses along the way. Maybe there's even some mountains that we've climbed in our careers that maybe they haven't climbed yet. Or maybe we're both tackling something together that neither of us have done, but they feel like we'd be a good partner on that journey.

48:22And that's important, right? Because if you're going to be on the GP side of the house, the integration that's required for somebody to bring you in on their side of the house, where you have a preferred economic structure, you have preferred access to their deals. It's a very unique partnership. They take a long time to form. And there is a tremendous amount of work that goes into it on both sides. And I think that there's over the years been a lot. In fact, we've had people that we've gone to raise money from who sort of said, hey, I really like that idea. Maybe we'll just do it. And they've come back five years later saying, you know what, that was way harder than we thought.

48:54Because we're actually in the details of every joint venture agreement that they have with each partner, right? We're making sure that our GP equity isn't subordinated, that we're protected, that if there's anything we need to do at the next level up in the structure, we're thinking about that. We're bringing in our asset management, we're bringing, in many cases, lender relationships. We've got teams in some of our platforms that are actually helping source property level transactions and think through product creation, other things. And so it's a very involved process from our perspective. But since we started that way, we've sort of staffed to do that.

49:27So that's where we play. You're a partner that is an expert in the space. You're not just providing capital. And that adds value in addition to the capital that you provide. We hope our partners would say that. They're nice enough to say that. we have to earn the right every day with our investors and our partners to be what we say partners for life. We're not solving a temporary need for them. And the structures we create with them are really to say, if they keep growing the way that we think they can, that we will become a permanent part of their capital structure. And so the way that we integrate our teams, the way that we look at the economics that we share with them and so forth, it's with this lens of we are going to be a long-term, decades-long partner.

50:08And for the last 13 years, all of our partners, they've all re-upped. And the latest one we just did was a future 12-year partnership where we have exclusive rights to provide that GP capital for 12 years. And so as we do more together, that idea of sort of a tight integration over long duration is something that we really value. We value those partnerships. We hope our investors do as well. And that kind of circles back to what you found so attractive about real estate is it's hard asset, things you can touch, but it also is relatively inefficient. And so you just described a pocket of inefficiency and you can be very creative.

50:42That was the other thing that attracted you. And this is a very creative solution to an inefficiency that you saw that maybe many others haven't. And you found a really interesting niche within this. And it would be helpful to understand how does that advantage the end investor? So somebody invests, traditionally they get the asset return minus maybe a couple layers of fees. So what happens in this setup? So in our GP investments, what happens is since we don't pay fees or carry at the asset level, and then we share in some of the fees and carry that are paid at the asset level by the outside investors, our investors end up actually paying on the RGP investments a little bit less than a full fee or carry.

51:24And so our goal is to essentially have our net returns be at or above the gross returns of other funds that are in that double fee, double promote situation. And so for our GP only investments, that's sort of what our goal is for each of those. And over time that has happened. And then we also, what's been interesting is, and I would say it's been consistent since fund one, but it's been more prevalent in our later funds is our investors who are putting their money with a lot of different people are sort of saying, hey, if you guys are already in the GP position and you're underwriting those deals as if you were going to buy the whole thing, could we leverage the platform to put more capital to work, whether through co-investments or sidecars or other things?

52:09And so that's something that we've been doing is providing access points. Since we do see every deal that comes across the platforms, it's also helpful to our platform partners because it provides a little bit more of a single source of capital for them as well. So we're finding that we can start to provide a little bit of a diversity of opportunities for our investors across the risk spectrum, because they may say, hey, look, I'm investing in core real estate in multifamily. Could you leverage one of your platforms to get us priority access to do that? Or could we do the same thing in student or storage or other things?

52:40And so it's providing us a little bit of a unique view, we think, to be able to start to at least make available to our investors a broader base of investments. That makes sense. Why don't we talk about your real estate outlook for a second? Obviously, the real estate market typically goes through long stretches of good returns, and then there are these infrequent, potentially devastating downturns. And all of that can be magnified by the leverage that is inherent in typical real estate deals. And recently, we've had a lot of shockwaves. You had COVID that you alluded to earlier, the rapid rise in interest rates.

53:12You had this big dislocation in retail, office. You have the regional banks that you talked about as well that are typically the big lenders to commercial real estate. A lot of them are stepping away. How do you take all this information in and what's the outlook given this backdrop? There's a lot of uncertainty, Alex, out there right now. We haven't done very many new deals in the last 12 to 15 months because we're not sure our investors get paid for us to step out in a time where it's very uncertain to step out and sort of take that first leap into a given space. And so what you're seeing us do is try to be really cautious.

53:46I think you're seeing others do that too. You hear about all the dry powder that's out there. Well, it's dry for a reason. People are a little cautious to put it to work. You want to see when are we going to hit the trough. We'd rather miss the trough and catch it a little bit after you hit the trough and you can really say, okay, we really believe we have hit the trough and now we're on the upswing. We're okay to give away some of that upside to sort of play for the long haul. And so I think in this backdrop, being thoughtful, being cautious, being patient is, we think, a smart idea. Does that mean that we're not going to do deals?

54:16No. I mean, there's certain sectors where the fundamentals continue to be strong, where we can earn yields on costs that are well above our debt rate. There's not very many, by the way, but there are a couple. And those are the sectors where we are getting things done, but at a much slower pace than maybe we used to. So I think our view is if we find a great piece of land, we find a great asset, let's tie it up at a basis that we feel good about. Let's push out closing. Let's spend some pursuit potentially to see if this thing could work so that we're ready when we may have better visibility, but very limited pursuit dollars, very limited exposure, put some non-refundable money down to get it tied up, et cetera.

54:53And so that's where we are today. I think where you're going to see cracks in the system is when people acquired real estate at very low cap rates. I'm going to contrast that to developing real estate, even at lower cap rates than we're at today. But if you acquired real estate at a three and a half or four cap, and you put at the time 65 % debt on that real estate, there is a good chance that depending on the market, depending on the asset, depending on the sector, most of that equity, if not all that equity could be gone. Because asset values reset, equity values reset. Like the perfect storm.

55:28It's a perfect storm for that scenario. If you developed real estate though, okay, and let's say that cap rates got down to three and a half or four in a given sector, but you were developing to a five and a half. That's too low to develop to today, by the way. Let's say that's a six and a half today or even a seven. But even at a five and a half yield, if you put 65 % leverage, which going into this is actually more like 55 % to 60 % leverage, that's on loan to cost, not loan to value. If you believe that you're developing to 65 % of cost, but your cost represents a reasonable discount to where value would be once you're stabilized and built, which is the only reason you'd ever develop something versus acquire it, right?

56:10Is if you can develop to a nice spread to what you think you could acquire the assets for, then your loan to cost or your loan to value, even with reset values, is that you have an equity cushion. You have a couple layers of cushion. You've got some cushion there. And so for us, I think what we're starting to see is you're starting to see in certain sectors that the person who put three-year debt on an acquisition loan that they thought they were going to just fix and flip quickly, they're staring at a very substantial loan pay down or loan pay off to extend their runway. That's going to get tricky.

56:45They're going to have a hard time refinancing that. They will. And a lot of these lenders, while they don't like to take back assets, in asset classes that are less operationally intensive, they're more likely to do that. Especially with regional developers versus the national developers where they're saying, wait a second, I want to be lending to this institution for the next 15 to 20 years. They have a bunch of deposits with me. I got to be somewhat cautious as to like how heavy my hand is on this extension. I think you're going to start to see that. So as we sort of think about the landscape, you sort of look at, well, how do you even underwrite in today's environment?

57:18Well, first of all, go back to what I said before of the idea that you have to prepare. If you can't predict, you got to prepare as Howard Marks shared. For us, it is sector selection. That is a really key part. I mean, we have taken full advantage of distressed investing over time. In our fund one, like 40 % of deals we did were distressed hotels that we bought and those all turned out very well. But I think that having gone through the pandemic, this reset of interest rates, there are certain sectors where, like I said, the basis is going to look phenomenal, but it's just so difficult to predict that demand pattern that I think we're just going to probably not do very much in those.

57:56And we'll probably watch some of our peers do great. And we'll be cheering them on all along the way. And we'll probably say we wish we, gosh, that would have been great had we taken full advantage of that. But I think our sentiment now is why invest in something where the standard deviation of outcomes is uncertain. Let's continue to focus on the sectors where we believe we have high conviction, where there's demand tailwinds, where the supply side, and that's something we haven't talked about today, Alex, the supply side dynamics are quite different than going into the great financial crisis or than going into other.

58:26I mean, usually the supply side is what ruins the party for real estate. And in this case, even though the levels of supply have been higher than they've been on an absolute basis in like multifamily or industrial, the levels of demand have also been a lot higher than they've ever been as well. And we didn't see a dramatic overhang of stock. Like if you look at sort of percentage of stock, we're seeing some overhang certainly, and vacancy rates might go from 95 or 96 down to 93 or 94. But those occupancy rates are very similar to long-term historical averages. And so that overhang probably brings us back to sort of a long-term historical average occupancy level.

59:01But what's interesting, though, is that if you look at like multifamily development starts today, they're down 60 % because of lack of availability of debt and bid-ask spreads between land sellers and buyers. Industrial down, in some reports, as much as 70%. So the question is, what happens two to three years from now? if you believe in the demand side of that, and you believe we continue to have a housing shortage, you believe that people are going to continue to order products and want it faster and faster and faster. I remember it used to be five days was amazing. Then it was like, wait, I can get this in two days.

59:34And now it's like, if it doesn't come this afternoon, you're frustrated. So depending on where you are investing, being in the development business today, if you can get deals done in great locations where that demand tailwind is with operators who we believe are going to you still be able to get things done, you can make a pretty good argument that investing in development today will reap benefits two to three years from now when you're opening up and leasing up against half or even less competition than you've ever had. And so there are a lot of interesting dynamics out there. And you can play the other side of that bet and say, well, yeah, but why would you ever develop if you could acquire below replacement costs?

1:00:10And I think one answer may be, certainly if you can acquire assets, new assets at a discount to what those new assets cost to build, there is no argument to build. What we're focused on and some others are focused on though, is that we're building things that don't otherwise exist either in the locations or sector wide. So active adult apartments, new active adult apartments don't exist at scale across the United States. We can't just go acquire old distressed active adult. A, it's not distressed and B, there's not enough product. This auto camp outdoor lodging stuff we're doing. It doesn't exist.

1:00:45We're creating that from scratch. Last mile warehouses in these new suburban locations that will allow for that same day delivery of goods, you can't just go acquire an existing building. So as you talk about inefficiencies, nuances by sector, by geography, by return thresholds, there are a lot of ways that you can play in the real estate business. And so I think focusing on those areas where you're creating differentiated product that that consumers really want, that capital really wants once it's built, in sectors that have a demand tailwind, in geographies that are likely to get more than their fair share of demand, and being patient and investing in a place in the capital stack where hopefully your investors get an advantageous fee structure.

1:01:29That's how we're viewing the world. So a long answer to your short question there. No, and you just had a couple major shockwaves. And some people will view that as a bad environment, others will see the opportunity in that. And I think you're being patient in letting the opportunity come up and doing all the other things you just described, but also maybe an opportunity to get things at a much better price given the dislocation we've experienced. Absolutely. And we've already seen a reset in land values. I think this is also a time where construction costs that were just escalating and really difficult to predict.

1:02:02It's hard to say that construction costs are coming down, but not escalating as much as they used to, for sure. And I believe they will come down. I mean, if you have a lot less construction going on, you have more general contractors, more subcontractors that need work, and there's going to be more labor available to do that. So there's other dynamics here that are at play. In addition, just being able to buy cheaper is to say, okay, great. What are all those inputs on your cost basis? What does that look like? And I think that we're going into a time that is very interesting. So we're optimistic.

1:02:34We're cautiously optimistic though. So that's usually a good approach. Why don't we end it with a unique insight that you've learned in your nearly 20 years in the real estate business? Is there something that you've seen maybe major mistakes people make in this space or anything that you feel is unique that maybe most don't think about? My experience has been greatly informed by where I started at Graystar. And I think that Bob Faith and the Graystar team had an insight that not a lot of people have in real estate, which was if you have a services business that can be an evergreen business, meaning no matter what the seasons are, no matter what the cyclicality is, that services business not only keeps the lights on, but can build up reserves to allow in difficult times to keep your best people, to attract the people that others had to let go because they didn't have that business.

1:03:26That was an insight that he didn't need to have because he'd had this big win co-founding Starwood Capital, they could have just gone and said, look, we're in the more attractive parts of the business. We're doing acquisitions. It's the high-flying part of the world. It's what all the people coming out of business school want to go do. But he had this insight to say, wait a second, I want to have a services business. Maybe that's not the glitzy part of the place to be, but that's where all the blocking and tackling happens. Not only does it have sort of the component of smoothing out the income streams, but the information that comes from that.

1:03:58Sourcing deals, figuring out what's really happening with the operations, being able to actually drive more NOI per door because of the scale, et cetera, is just such an insight. And I think that a lot of investors in real estate don't think that way. A lot of platforms even as they're building their companies, they're thinking about how do I put more acquisition people, more development people out there. And what happens is when the market turns, those are the companies that have to lay a bunch of people off and they don't have the balance sheets or the income statement to actually support that growth.

1:04:26And so as I was thinking about that question, that's something that comes to mind. It's a little different. I mean, we're investing with those companies, but I share that not to provide it as a Whitman Peterson, but we do own pieces of those operating businesses. We are partnered with those platforms who are vertically integrated, and we just see the advantages of that on a daily basis. And it is a little counterintuitive. And Bob here always points out that if you look back over the last 30 or 40 years, there are not that many national real estate platforms who have survived for decades. There's just not that many of them.

1:04:59And the ones who have, have actually had that services business that has been part of it. It could be investment management services. It could be property management services, but there's some services component. So that's something that I would share and that I share with a lot of people. Like when I visit like universities or talk to students or something, sort of think about guys, think about the company you're joining. What happens in bad times? Do they have the ability to keep the lights on? Do they have the ability to acquire their competitors to do those other things. And I think that that is not something that is intuitive to a lot of people when they think about the real estate business.

1:05:30They think about the more glitzy parts of it. But the operating side of this business can also be highly valuable and can drive a lot of value. And so that would be maybe one thing I would share with you there. That's great. Your love of real estate and your passion really comes through. So I appreciate you spending some time with me today. And I look forward to continuing our friendship and our long-term relationship. Thank you, Alex. And I would look forward to flipping this the other way and sitting down with you for an hour and asking all these questions because we always learn a ton when we talk with you.

1:05:59So thanks. We'll do it. All right. Thanks for listening. We hope you enjoyed this episode. Please visit our website at insightfulinvestor.org to access past shows and learn more about our podcast. If you have questions, feel free to email us at info at insightfulinvestor.org. And if you enjoyed the discussion, please subscribe to this podcast to ensure you don't miss future episodes. And don't forget to forward today's conversation to others you think would enjoy listening. This podcast is provided for informational purposes only and should not be relied upon as legal, business, investment, or tax advice.

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1:07:14Thank you.