[00:03:35] Ian Formigle: And while the total year was down 13% for 2022, I would say that it was back-end loaded. What I mean by that is that if we look at the first four or five months of the year, probably through May or so, the CPPI was only down about 1%. And I would say that similar to what we tracked [00:04:00] in the day-to-day of marketplace deal flow, it was pretty similar. The market felt pretty normal. Beginning in May, you really started to see those declines come in. From May through the end of the year is when you really saw 12 points out of those 13 points hit. This fits with our experience as we saw the rising effects of real estate interest rates, month over month. The deterioration of the capital markets really started to set in and took hold around June, and I would say that it accelerated in Q4 of 2022. If we fast forward to 2023, I have often spoken about how I think the commercial real estate market is inefficient compared to other markets, and I think that is doubly the case right now.

[00:04:52] Ian Formigle: Therefore, our approach to the current state of the market is to search for pockets of opportunity where we feel assets are mispriced due to special circumstances while acknowledging that conventional assets simply may not trade or may not present enough value to make sense to pursue. While the first half of the year may present severe challenges to getting deals done, I am hopeful that we might see an uptick in capital markets liquidity, which would then lead to an uptick in demand in the second half of the year.

[00:05:28] Ian Formigle: Moving on to transaction volume, which we consider to be another crucial indicator, we turn to Pricing Real Capital Analytics, another third-party group we have previously discussed. When we look at the end of 2022, we saw that it pegged total transaction volume at just under $729 billion for the year. That was down about 15% relative to 2021, which was a record year of roughly $855 billion. Similar to Green Street’s pricing data, the first half of 2022 was strong from a transaction volume perspective.

[00:06:02] Ian Formigle: In fact, it was actually outpacing the first half of 2021. And then, not surprisingly, volume, alongside with pricing, just started to trail off in the second half of the year. Q4, I’d say in particular, while Q4 of 2021 saw a record quarterly volume of about 366 billion, Q4 of 2022 only experienced about 139 billion of total transaction volume. That was 62% down year over year. So just to provide some context in terms of things really did start to fall off a cliff a little bit towards the end of the year. But just to provide some overall context to the year, it was still up 21% relative to 2019. So I do view that last year’s story was a little bit more about a massive drop-off in second-half volume, and that some of that recency bias cast a little bit of a shadow over the entire year, so to speak.

[00:07:04] Ian Formigle: So, Trey, if we turn and we look at a location, where did that transaction volume occur? We’ve talked about this in the past. Dallas recorded its second straight year as the number one market for transaction volume. The rest of the top five were Los Angeles, Atlanta, Houston, and Phoenix. It’s fair to say, though, that all five of those top markets were down in volume on a year-for-year basis. And if we pull back a little bit and look at the top 10 markets on transaction volume, the only market in that top 10 that actually gained in transaction volume in 2022 was Manhattan. That was up about 8% year over year.

[00:07:50] Ian Formigle: Nashville and Philadelphia were the only other two top 25 markets to see increased transaction volume, and those were up about 25% and 5%, respectively. So, you know, with 2023 starting off to look somewhat similar to the second half of 2022 from a volume perspective, we expect ’23 to end the year with lower total volume than ’22.

[00:08:13] Ian Formigle: But I fully admit there is a large amount of uncertainty in almost every regard, particularly in terms of the pace of real estate transaction volume. So I would say that, to some degree, we’re approaching this year on a one-quarter-at-a-time basis and accordingly adjusting as we go.

[00:08:32] Trey Lockerbie: I think it’s very understandable to say that you expect the volume to go down because what we’re seeing in the news right now is basically banks freezing up, which probably means that not a lot of lending will be going on.

[00:08:44] Trey Lockerbie: And so I’m curious to get your thoughts around interest rates where they are. Not only are they at the highest level in the last 15 years, it’s the rate at which they’ve gone up that I think is yeah, the most catastrophic to bonds and some other, all kinds of asset classes right now and especially, certainly took SVB down and Signature and others.

[00:09:03] Trey Lockerbie: How is all of that generally affecting the commercial real estate market? 

[00:09:08] Ian Formigle: Yeah. Well, Trey, just like the greater macro economy, rising interest rates, and as you mentioned the rate of change of those interest rates is really like the story for commercial real estate, not only in 22 and also for where we sit in so far in 2023 as of mid-March as we’re sitting here recording this conversation.

[00:09:28] Ian Formigle: Right? If we think about this, the Fed has raised the benchmark rate eight times, and that’s the single fastest pace in a year since the eighties. And just like everything else, it’s just that rate of change that’s really affecting the commercial real estate market. I mean, as in essence, we look back to 2022, just every time the market.

[00:09:46] Ian Formigle: The rates would change, the market would have to adjust. Everybody would’ve to kind of go back to the drawing board, they’d have to like reprice assets, determine if their lender is still there, if the lender was still the best lender, if there was another lender stepping in who was ready to transact.

[00:09:59] Ian Formigle: And so it just, it put a lot of trash into the whole market. And it’s fair to say that it has not cooled down. And now if we look at past ma, your recent events, macro events of the past week and stress in the banking sector, sure. That certainly seems to suggest to me that the markets are continuing to struggle and they’re to grapple with this cumulative rate of change, which is now up to 4.75%.

[00:10:20] Ian Formigle: We might find out next week goes up again in terms of the Fed fund rate. And while high interest rates have had numerous effects on the market, I think when we overlay that on the commercial real estate market, I feel like I saw two broader themes playing out every step of the way.

[00:10:37] Ian Formigle: And the first theme. Really throughout 2022, surprisingly not as much in 23 so far, was a constant downward pressure on pricing. So roughly from March through September of last year, as the Fed increased the Fed funds rate, you typically see those two following effects. So first, as I mentioned a minute ago, the commercial real estate would respond in the following days of the announcement, which would typically mean they would tick up their borrowing costs.

[00:11:04] Ian Formigle: Then second, as the borrowers were hit with those increased borrowing costs, buyers that weren’t already locked into fixed prices with sellers would typically go back and they would retrade those assets using the rate bump as justification for price reductions. And in most cases, and I think what was interesting for the first, call it three quarters of last year, what we saw was when those sellers would receive those prices.

[00:11:28] Ian Formigle: For the most part, they were accepting them. And then the deal would go on and it would close at a price that would be roughly five to 10% lower on average than the original negotiated price. And to me, it’s important to keep in mind that during this period, these price discounts, if we look back to the 21 period, well, you would say that those were mostly just giving back some of the excess appreciation that occurred during 2021.

[00:11:51] Ian Formigle: Remember, 21 was just this record year for transaction volume and price appreciation and everything. So while most of last year wasn’t looking good, You had to put into the context of where you were coming from and from a seller’s perspective. Where you were coming from was somewhere in 2018 on average.

[00:12:08] Ian Formigle: So a retrade in the middle of 22, that might be 10% even of what you thought you were going to get lower. It wasn’t so bad. And so that’s why those deals were probably, for the most part, still getting done. Then I would say the second effect of these high interest rates that we’re seeing, which I believe continue to develop over the course of this year, have to do with the consequences of floating rate debt that was issued in 2020 and 2021 and the forecast for which is now resetting to substantially higher interest rates today.

[00:12:39] Ian Formigle: So lemme unpack that for a minute. So for those of you who don’t know, floating rates are essentially variable rates. As opposed to fixed rate debt. And it’s more typical to see for projects that were intended to have a longer holding period versus, or of five years or less. So if we think about this long-term holding period, more likely to have fixed rate debt, five year or less holding period, more likely to have floating rate variable debt.

[00:13:04] Ian Formigle: And so if we go back to 2020 to 2021, you will see that short term interest rates were at that point, as we all know, they were exceedingly low. And the expectation is that they will remain low for years to come. For example, Chatham Financial is a group that we look at that uses forward curves to estimate where they think rates are going in the future.

[00:13:22] Ian Formigle: And if you go back to 21, you’ll see that the FFR curve at that time, which is the sofa, is basically the index, which is all floating rate. Now today’s price off of it was expecting late rates to remain low for years to. And then now today, you fast forward that and that’s now 475 pieces points higher.

[00:13:39] Ian Formigle: So really what’s happening now is that you have this debt that was issued in 2020, 2021. It’s now being, it has to reset. It’s reset at massively higher rates. And whenever you’re buying or building an asset, when you know you, you thought you were going to create value, you would want that floating rate debt.

[00:13:56] Ian Formigle: So pausing for a minute and saying, why not take fixed rate debt back then? The answer is you wanted floating rate debt because it was a tool that allowed you to accomplish that value creation. And then it had flexibility in selling the asset. And so what we’ve now seen is that in a scenario where rates are a lot higher, it’s also fair to say that these deals had caps that were put on them.

[00:14:12] Ian Formigle: Interest rate caps are essentially insurance. They typically have durations of two to three years before they reset to market value. And so in essence, what’s happened now is you’re seeing these other deals that had a lot of variable rate debt around the country that originated in 2021, 2022 to three year duration rate caps.

[00:14:31] Ian Formigle: Fast forward, that’s now 23 rates are a lot higher burning that off, resetting to higher rates. So knocking out cash flow for a lot of assets. And in some cases it’s even resulting in scenarios where those projects need to recapitalize through a bit of a cash infusion, maybe to cover this short-term volatility till we get to the other side.

[00:14:53] Ian Formigle: So there’s a lot going on and when the commercial real estate industry as it pertains to interest rates, but those are a couple of things that we’re, they’re we’re living with day to day. 

[00:15:01] Trey Lockerbie: So it’s sticking with interest rates. I’m curious about cap rates. Do cap rates cause or correlate with interest rates or is it simply just supply and demand?

[00:15:10] Ian Formigle: Okay, this is a great question. This is one that’s been debated many times. I’ve seated over the course of my career and I, the answer is a little bit nuanced, but I think if you start from a causation versus correlation perspective for interest rates and cap rates, my study of the market suggests that it’s really supply and demand that mainly causes cap rates to expand or compress over time.

[00:15:34] Ian Formigle: And interest rates, while they are a component, they’re correlated, but I would say they’re kind of loosely correlated. And so let’s begin just to frame this conversation a little bit. The most common proxy for the risk-free rate that’s used by the commercial real estate industry is the 10 year treasury.

[00:15:49] Ian Formigle: So if you look at cap rates versus the 10 year treasury, and that’s kind of how we typically look at it in the real estate industry over span of decades, you’ll see that there was a decade from the 1970s to the eighties where cap rates were consisting below the 10 year treasury. And then the relationship flipped.

[00:16:04] Ian Formigle: And then from 1991, and really almost since then, cap rates have generally maintained a positive spread to the 10 year treasury that fluctuates over each real estate cycle. So over the span of the last five decades, I think you’ll see that, you’ll see some correlation between cap rates and interest rates, but it’s relatively low and there’s enough periods of time where they run counter to one another to suggest that it interest rate movements don’t really cause cap rate movement, but they do contribute to maintaining a spread to it as cycles kind of gyrate in and out over time.

[00:16:38] Ian Formigle: And so to me, I’d say that the reason that causation is really more supply and demand than interest rates is to think about the fact that in the commercial real estate industry, this is a returns driven industry. And so that means that anytime that you’re, that you have increases in demand.

[00:16:55] Ian Formigle: Or decreases in demand. Those are going to generally move cap rates, right? All things being equal. If you want that asset more than you want it today, you want to step in front of a buyer and take it down, you’re going to increase the price. And if nothing else moves and the price increases, well you just decrease the cap rate a little bit.

[00:17:11] Ian Formigle: So interest rates are a major component of what can drive returns, but to me they’re just one component. And so another example is that if buyers think that rents will increase at a rate that is faster than they believe interest rates will rise, then they will bid that asset to a level that will maintain or even possibly slightly decrease the cap rate.

[00:17:31] Ian Formigle: Rate. So just like step in, buy that deal, decrease the cap rate. You saw that behavior on display from 2016 to 2018. You actually saw treasury rates move up. You saw cap rates move down. And then conversely, in 2022 was as we’ve talked about, this successive series of downward steps in demand as we saw rent growth.

[00:17:49] Ian Formigle: Cool. At the same time that interest rates shifted upward, rapidly. And so as buyers were successively hit with higher borrowing costs and they couldn’t find a justification for returns elsewhere, their return expectations were hit. And when your return expectations get hit and there’s nothing else in a deal to prop them up.

[00:18:07] Ian Formigle: And the final solution is a reduction in price that gives you enough additional yield going in to offset that higher borrowing cost, as I talked about a moment ago. So when we think about supply versus demand on display in 22, in the sense that we saw more cap rated expansion and multi-family despite the fact that it enjoys better access to cheaper debt from agencies like Fannie and Freddy, I think that’s another example of supply and demand.

[00:18:30] Ian Formigle: Because in essence we saw industrial hold up a little bit better. You’d argue that interest rates are more of a driver for the industrial sector but if caps didn’t expand as much, then really what you’re seeing there is that rent growth component. Higher rent growth in industrial demand, maintained an industrial, hence less cap rate expansion.

[00:18:49] Ian Formigle: So that’s my take on the interest rate versus cap rate and versus supply demand. So I hope that provides some context. 

[00:18:58] Trey Lockerbie: I love it. In your recent memos, you were discussing how investing in commercial real estate in 2023 is going to be different, and in your latest piece you write about how investors can discern value by asset class, especially considering how much price dispersion from the mean occurred immediately following the pandemic in the last two years, all things considered, which asset classes do you think offer the most interesting opportunities in this current market ?

[00:19:26] Ian Formigle: Yeah. So the second memo, which you’re referring to Trey, was interesting in the sense that we published them bimonthly and we look for topics that we think just speak to investors. The whole point of drafting these memos and publishing ’em, is just to give some thoughts and some tools to investors too, to contemplate the market and how to navigate it.

[00:19:43] Ian Formigle: So that’s the second memo, which was published recently. It was really born out of this whole concept of relative value in real estate and where we sit over a longer term context. Was born out of the fact that we had a lot of investors asking questions whether this, the current valuations in the market, were they just simply a downtick or a markdown in 20 from 21 values?

[00:20:04] Ian Formigle: Did they really present value from a longer term perspective? And it was a totally fair question because as investors, we don’t want to get carried away and buy the first dip in a down market. And because investing in commercial real estate is really a time horizon of multiple years, you want to step back and you want to assess your entry point.

[00:20:22] Ian Formigle: Against the backdrop of a longer term. So to answer this question and really provide a framework of reference here, my team and I, we looked at current pricing relative to 25 year price trends for all asset classes according to Greentree as well as each. So we looked across all assets as well as each asset class itself on a standalone basis.

[00:20:42] Ian Formigle: And once we conducted that exercise, we actually found some interesting discoveries. The first thing was that from 1998 through 2014, the major asset classes, which include multi-family, industrial, retail, hospitality, and office, all moved relatively in strong correlation to each other. It was about a, roughly about a 6% average annual price growth.

[00:21:05] Ian Formigle: It’s kind of almost fascinating today if you. Office is going to highly correlate to multi-family and industrial. You’d be like, that’s crazy. And the answer is, today, it’s crazy. But for decades it was not. But starting in 2015 is when you saw that meaningful price dispersion started to occur. Asset classes broke out, some went up, some went down, and they started kind of their own path.

[00:21:26] Ian Formigle: And so today, I really do think that asset class matters in a more pronounced way than it did prior to 2015. It’s just a, it’s a different type of market and it actually has been a different type of market for eight years in running. So when you, to answer your part of the question about what do I think is most interesting there were a few things that stand out that once we conducted that analysis.

[00:21:47] Ian Formigle: The first was when we look at the industrial sector after reaching record low cap rates at the beginning of 2022, we’ve now seen about 90 basis points of cap rate expansion this past year and a little, maybe a little bit more this year in 23 for the most part. I think a lot of cap rates have mostly been studied so far this year, but it’s fair to say that might change throughout the balance of this year.

[00:22:07] Ian Formigle: So really what that means for industrial is that we are seeing more un levered yield on cost today on industrial projects than we’ve seen in recent years. And with an outlook of tapering supply and steady single digit rent growth. I think we’re going out of the double digit rent growth period for industrial, but we’re still in solid single digit rent growth.

[00:22:27] Ian Formigle: Personally, we think that pursuing industrial development still makes sense, and particularly in tighter markets with good fundamentals. One thing that we think is standing out in industry, for example, is that we’ve got this fringe-shoring trend that we’re seeing, right? That’s bringing more manufacturing to places like Mexico that we think will continue over the next few.

[00:22:44] Ian Formigle: And so with us, so from our perspective, I think that makes certain Texas markets look increasingly attractive as they stand to benefit from more goods going through the Mexican border into the United States to get further distributed. From a valuation perspective, when we look at that long-term trend, the one thing about industrial is that, I wouldn’t say that it’s a bargain right now, you have pricing down about 15% from peak, but coming off of a peak where it really did shoot up a tremendous amount in 2021, it’s actually still a little bit above its long-term trend.

[00:23:17] Ian Formigle: So, Buying industrial or building industrial, you’re still buying into the idea that it is a fundamentally strong asset class that will continue to outpace its peers in the years ahead. And, if you can get comfortable with that, then you’re a buyer of industry. So the next one that was really interesting to me was retail.

[00:23:36] Ian Formigle: The last time we spoke, I mean, I’ve spoken many times about retail, I think in the last couple years really coming outta the pandemic really came out. I think that brick and mortar retail has been overlooked and I think it still continues to be a hidden buy today. It sits in a really interesting spot.

[00:23:51] Ian Formigle: So to frame that out for you a little bit today, right now retail is still one of the most undersupplied asset classes. We only have about 0.5% of its inventory under construction, and it continues to enjoy one of the highest occupancy rates among major asset classes. We’ve actually seen occupancy rates improve for retail in the last year or two coming out of the pandemic.

[00:24:16] Ian Formigle: A lot of demand is coming back into brick and mortar, and you’re seeing those centers fill up. It’s just, it’s been great to see, I mean, personally it’s great to go out and experience it, but it’s also really bringing some vibrance back to the sector. I also want to mention, just a quick note on this.

[00:24:29] Ian Formigle: When we talk about retail I’m not referring to malls. I do think that’s a bit of a, still a broken asset class that’s sorting itself out. I’m really more referring to grocery anchored centers, neighborhood centers. In our opinion, those tend to perform better, and I think they remain more relevant to our daily lives.

[00:24:43] Ian Formigle: And I think relevance is something that we’ve talked a lot about in the past. Trey, I think that anytime we’re talking about real estate, if you just want to kind of give yourself some context, think about the relevance of that particular piece of real estate to your daily lives. And I think that brick and mortar real retail, particularly when it comes to grocery anchor anchored centers is checking that box.

[00:24:59] Ian Formigle: You the other thing you’ve got a couple of other good things happening in retail the last couple years. We have headlines that continue to tout the emergence and continued dominance of e-commerce, but quietly, in the meantime, Brick and mortar at outpaced e-commerce over the last year in sales growth.

[00:25:15] Ian Formigle: It still accounts for over 85% of all retail sales. And what was really fascinating to see coming out of the pandemic is that if we go back to the 2020 period, we saw this massive spike in e-commerce. Really what’s happened in e-commerce is it’s actually reverted right back to its long-term trend.

[00:25:29] Ian Formigle: So it’s not to say that I don’t think the e-commerce isn’t going to continue to take market share and but as recent history has shown brick and mortar still highly valuable part of the real commercial real estate landscape, I don’t think that changes in the near term. So you take the recent growth and brick and mortar sales and your layer onto the fact that retail tenants are now battle tested and really mean.

[00:25:49] Ian Formigle: What I mean by that is that we can feel more confident about the overall strength of a tenant rent roll in a center because it has already endured the pandemic. Yeah. It’s interesting to note as someone who looks at deals every day prior to the pandemic, It was tough when you looked at a retail center, you had to play this guessing game.

[00:26:05] Ian Formigle: Which tenants do you think could survive? Which ones are going to succumb to e-commerce trends? For the most part, that guessing game is pretty much gone for. I think for this current cycle, you kind of have confidence if they’re there and if their sales are good, you feel like they’re going to remain good for the foreseeable future.

[00:26:21] Ian Formigle: And from a cap rate perspective, as I mentioned last time the retail sector from a cap rate perspective is still valued kinda like a dinosaur sector with little hope of growth. And I think that’s where opportunity continues to sit. A good multi-family or a good industrial property. Okay.

[00:26:37] Ian Formigle: Today cap rates have expanded, so those were fours. Now they look more like fives. Well that equivalent cap rate for a retail center is still north of 7, 7, 7 0.5. Maybe if it’s a really new center, you’re going to, you’re going to see that below seven. But we’re, that’s still considerable. And that spreads important today.

[00:26:55] Ian Formigle: That seven cap is important because in a higher rate, interest rate, higher rate environment, it’s this supply demand, it’s tested, and the fact that with rates, even where they are, you can still see interest rates today. Make sense? You can buy a shopping center and get some cash flow.

[00:27:10] Ian Formigle: And right now cash flow and multifamily and industrial is just really much more, more hard to come by given the fact that the cap rates have compressed more. And so that rise in interest rates has hit those sectors harder. The lasting trade that I thought was interesting was hospitality.

[00:27:24] Ian Formigle: As an asset class it was definitely, I think, more devastated than retail during the pandemic. And that’s probably an understatement. Now if we think about 2022, we look at this sector and we saw a good bounce back year from an operating perspective we’ve talked about in the past.

[00:27:39] Ian Formigle: We track s t r, that’s the nation’s leading data source for the hotel industry. It tracks revenue per available room. That’s RevPAR. You can look at RevPAR on a daily, monthly, weekly. Annual basis after hitting a record high of just under a hundred dollars in the summer of 2019, RevPAR at the national level fell all the way down to $17 back in April of 2020.

[00:28:02] Ian Formigle: That level dropped just never, literally never happened before in the industry. But since that, those days of 2020 RevPAR has, has surpassed the pre pandemic peaks, it’s actually hit $110 in July of 22. We continue to see recovery in 23, and I’d say just the one caveat on this RevPAR recovery is that it’s fair to say that this is on a nominal basis when accounting for inflation.

[00:28:26] Ian Formigle: I’d say real recovery for the industry, it’s still out there a little ways. It’s probably 2024 to maybe 2025. Yeah. The other factor for the asset class, like every other asset class again, is it’s grappling with higher interest. That impedes asset price recovery to some degree. So we’re still watching this sector.

[00:28:43] Ian Formigle: I think with a little bit of caution, it’s a little bit of a case by case scenario, but I think it’s heading in a good direction. And when you look at this asset class relative to its trend, it actually does sit below its long-term trend. So I would say looking back at hospitality over the course of the longer term history, it.

[00:29:00] Ian Formigle: Like a reasonable entry point. The final thing I’d say here is that there still actually are continuing to be pockets of opportunity in the multi-family sector for 2023. The multi-family sector is definitely not as straightforward as it was throughout much of the last cycle, and I think for a few reasons.

[00:29:17] Ian Formigle: First, there’s a lot of supply coming over 1.1 million total units that are under construction today across the US. That’s according to CoStar and it’s also concentrated in certain cities. So about 627,000 of those units were started in 2022 and with the balance started this year. That’s the highest rate of new starts in the last 36 years.

[00:29:39] Ian Formigle: So it is fair to say that multi-family supply is coming. It’s also fair to say that it’s still relatively undersupplied a bit at a national level. Who you ask depends on four or 500,000 units. Perhaps Undersupplied is still at the national level, but we’re catching up on supply. The second thing is that rent growth has really flattened out dramatically over the LA course of the last year.

[00:29:59] Ian Formigle: We saw tremendous rent increases in 2021, 30% in some markets. Okay? Those days are gone now. Nationwide sector looks more like two to 3% rent growth this year. and in some of the previous hottest markets, you’re actually even seeing zero rent growth. I think the third thing, again, has to kind of mention this on every asset class, current interest rate hikes, that makes cashflow very difficult to achieve for multi-family.

[00:30:23] Ian Formigle: But when we come back and look at that long-term trend, now just going back to pricing for a minute, sectors off 20% from its peak in early 2022. Cap rates are up about 130 basis points in some of the previous hottest markets. Maybe take Phoenix, Arizona, for example, we’re seeing quality properties begin to trade at cap rates that look like five and a half percent going in.

[00:30:45] Ian Formigle: That’s just something we haven’t seen there for years, probably not since 2018. And so overall for the multi-family sector, while it’s definitely difficult to acquire and I think the right opportunities are relatively scarce, I do think that there’s going to be some pockets of opportunity to seize upon this year.

[00:31:01] Ian Formigle: So to the extent we find them, we’re going to, we’re going to work on them. 

[00:31:05] Trey Lockerbie: Let’s talk about offices and the future of office in a post-pandemic world, because last time we spoke, the office market was still going through its post covid recovery and the utilization rate was only around 30%. Yeah. Where do we stand in terms of recovery and what, if any opportunity exists in the office sector?

[00:31:26] Trey Lockerbie: I’m keeping in mind that you’re seeing headlines with Facebook, or meta, I should say, letting go 10,000 employees as of today and Twitter being wiped out half their employees. So you were seeing layoffs, right. Playing into this narrative as well. So give us an overview and then what you kind of expect in the short term and for this year.

[00:31:43] Ian Formigle: Yeah, Trey totally correct. I mean you’re beginning with the fact that coming out of the pandemic, the office sector was just trying to get back on its feet, get some people back into the office, try to start acting and behaving a little bit more of a normal space after it’s just. It didn’t have that benefit.

[00:31:59] Ian Formigle:  In essence, that retail and hospitality, they just bounced back. They got knocked down, they picked themselves up, they dusted themselves off, and they got kind of back to feeling much more normal. The office sector just simply hasn’t had that. It’s now so just as it was starting to get some people back into the office, now it’s grappling with the prospect of layoffs, just completely knocking the sector sideways.

[00:32:18] Ian Formigle: So really now, I think working through just a massive transformation, there’s still so many questions that are unanswered for the sector in terms of what it is today and what it will be in the future. That it’s really kind of doing a bit of soul searching, as I would say. And it’s to some degree right now To, just to quantify this a little bit, so to talk about how you were just re referring to utilization.

[00:32:38] Ian Formigle: And when I say that the office market started to recover a little bit and became a little bit more normal, well that 30% utilization rate did get up to 50%. It’s kind of still sitting in that 50% range overall, where we look at this data on a week by week basis, and you can go track this online. If you look at Castle Systems, this is a security company that tracks the swipes coming in and out of  offices in major markets.

[00:33:01] Ian Formigle: They have an index, they that they track the top 10 markets and they report out the data on a week by week basis. So if we look at like right now, what’s going on you’d say that, well, Texas has been leading, the recovery continues to lead that recovery. You’ve got Austin currently sitting in the top. It averaged 68.1% for that last week of March ending March 1st.

[00:33:22] Ian Formigle: And you’ve got San Jose at the bottom at 40.6%. So still well off pre pandemic utilization rates, but better, at least than they have been. And what’s interesting also to look at that data is that we’re now seeing these trends in terms of which days are the highest utilization days versus lowest. And Tuesday is actually showing up to be the highest occupancy day.

[00:33:41] Ian Formigle: And then not surprisingly, Friday is the lowest. So the other thing is that, but when I, when we look at cast systems’ data, I think it’s fair to say that it provides you a good apples to apples comparison over time. Whether or not it is exactly indicative of what’s going on in that. Particular market at any given point in time, it might be a bit understated because there’s some highly utilized class AA buildings in those top 10 markets.

[00:34:05] Ian Formigle: And for the most part, they don’t use Castle systems. So just Castle systems not having access to some of the best, most highly utilized properties in those markets. So from there, let’s find out what’s interesting, I think I would say let’s maybe move to a broader concept and say, Hey, if the office is transforming, where do we stand in that transformation?

[00:34:23] Ian Formigle: We look at a lot of data. We’re constantly devouring stuff that’s talking about the future of the office. It’s fascinating from a study perspective. It really does beg the question of what’s going to happen with billions of square feet of stuff over the next coming years. And to help answer this question, Cushman and Wakefield recently published a report that I think offers some really interesting projections and insights on the US office market for the rest of the decades.

[00:34:45] Ian Formigle: So I think it kind of warrants talking a little bit about, the first was, for starters, it quantifies the total amount of US office space. So it projects that at roughly 5.56 billion square feet today, and it is, it expects the total stock of office real estate to grow just minimally to 5.68 billion square feet by the end of the decade.

[00:35:04] Ian Formigle: Then the report goes on to project that they think 4.61 billion square feet of office space will be occupied at the end of the decade. So on a per percentage of occupancy basis, or I should say conversely, a vacancy rate basis, well, that’s a 19. Vacancy rate across all types of office, or that equates to about 1 billion square feet of vacant space.

[00:35:27] Ian Formigle: So much space that they project to be vacant at the end of the decade. And, what’s also interesting is that Cushman Wakefield, if you go to their, one of their most recent US office re reports, say for example, December of 22, they peg the total US vacancy rated 18.2. So really in essence, what they’re saying is they think office is going to be slightly, but not materially more vacant at the end of the decade than it is right now.

[00:35:52] Ian Formigle: So roughly kind of like flat absorption from here on out for the rest of the decade. Then when we dig into a little bit more of that report, what was really interesting I think, and start to be more insightful, is to think about the f when we think about the future of office is to they break it out into three major categories or they trifurcate the market, so to speak.

[00:36:10] Ian Formigle: So first they call what’s called the top. These are usually defined as 2015 or newer vintage properties. They’re monetized really well. They have lots of natural light. They have maybe fitness in the, on the main floor. They’ve got retail in them. I think probably arguably the best example of this top type of building is one Vanderbilt in New York City.

[00:36:32] Ian Formigle: That building is fully occupied. It’s achieving record rents. It’s actually a setting. Records nationwide ever for office in what is an otherwise challenging New York City office market, this type of building, what they refer to the top. It’s also interesting that it has actually achieved 100 million square feet of positive absorption since 2020.

[00:36:51] Ian Formigle: So it’s actually doing okay. It’s bouncing back post pandemic and for obvious reasons it has a high quality experience. It’s attracting workers back into the office. It’s the type of office people want to go back to and on. And in terms of percentage of total market, right? Kushman Wakefield this represents about 15% of the market.

[00:37:08] Ian Formigle: So when we think about that market going forward, okay, this top 15%, that’s your top. Those of you probably have high confidence in remaining relatively well occupied and highly relevant in the future. Then you move on. The second tier that they talk about is what they call the middle. And this is 60% of the market.

[00:37:26] Ian Formigle: These may be good buildings that are older than 2015 vintage. They might be still a little bit newer than 2015, maybe they’re located in slightly less desirable locations within a market, but they’re probably older. From the standpoint of that. According to Cushman Wakefield, we’re also 70% of all properties that were built in the entire industry, this entire 5.6 billion square feet of space.

[00:37:48] Ian Formigle: Okay, that’s pre 1990 stuff according to Cushman Wakefield. So this middle is really going to be composed of 2000 and older vintage properties, I think and then a lot of, even older than 1990 properties can still fit this bucket. These are properties that are going to be, continue to be, I think, much cheaper to buy.

[00:38:07] Ian Formigle: Than the top. They’re going to offer a lot cheaper rents. And so from a go forward perspective, this is the part of the market that I actually see potential opportunity for later this decade. And you know that beginning, maybe in the next year or so, I do think that this price discovery needs to occur.

[00:38:25] Ian Formigle: But once it does, and once prices start to settle, it’s this next part of the market that I think is interesting. If I think if you take one of those properties and you reposition it properly in a respective market, then I do think the majority of the middle can bounce back. Now that property may never be 95% occupied again, but I think they could be 85 to 90% occupied and they could actually command decent rents.

[00:38:50] Ian Formigle: One thing, we look at rents on a national basis. They’re not really going down right now. Overall they’re just either occupied or not. So I think if you bring a part of this market back and you make it vibrant and compelling again, you actually might see it. Pop back up and become more relevant again.

[00:39:06] Ian Formigle: And again, with office values dropping precipitously across the US right now, this is the segment again, I think it, it has maybe the bargain potential. And so, and when I think about that next 60% and I think about the opportunity, I’d probably say that I think the opportunity is more correlated in the top 50%.

[00:39:25] Ian Formigle: So on a percentile basis. Now I’m talking about the 85th to 55th percentile. Again, it’s a lot of land, it’s a lot of real estate in, so it’s over 1.7 billion square feet. So there’s a lot of properties that might have a potential to be repositioned, reinvigorated and made more modern and compelling in the years ahead.

[00:39:42] Ian Formigle: And then the third segment that Cushman Wakefield talks about is what they call the bottom. Bottom represents about 25% of the total market. So again, 15% right at the top, 60% in the middle. Now we got to the bottom 25. Now we’re in the old commoditized buildings, inferior locations. This is  true functional obsolescence.

[00:40:02] Ian Formigle: They just, they can’t really justify further capital expenditures. I don’t know if there’s a lot you can do with these buildings. They might have low ceiling heights, they might have insufficient power. Either things that are either impossible to fix or just excessively cost prohibitive and just no longer make sense to fix or try to address.

[00:40:20] Ian Formigle: To quantify this is roughly 1.4 billion square feet across the United States. I think their occupancies remain in this solid bottom tier. If you think about this, Cushman Wakefield is correct, and we do have 19% vacancy nationwide, I expect this bottom tier to the extent it still sticks around to be dominating in the vacancy.

[00:40:39] Ian Formigle: Maybe 40 plus percent vacant in this category. This is if you’re basically I think it, if you’re talking about this type of building, if you’re investing it in the future, I think it’s near or at below land basis because ultimately I do think that’s what you were left with. At the end of the day, I think it’s probably more costly to continue to operate than it is to restore it to a vacant lot and try to repurpose it.

[00:41:02] Ian Formigle: In the future. So now if we take this office market and we think about where we sit in 2023, the other interesting thing at this point right now, to your point about some of the headlines that you’re seeing is that I do think that the kicking the can strategy that was pretty pervasive the last couple years.

[00:41:20] Ian Formigle: It’s running out and it’s now giving way to the next phase of market transition, right? This is its next logical step in evolution of where the office needs to get to. You could probably say that, Hey, look, it looks like the industry is kind of bracing for impact, so to speak, as lenders are now being hit with these defaults.

[00:41:36] Ian Formigle: They’re kind of coming sequentially. We’re reading about them one after another. I do think they start to increase in frequency and intensity over the course of this year and into 2024. So as that volume of defaults does increase in dollar value, I think that’s going to force the hands of more borrowers and lenders.

[00:41:54] Ian Formigle: I think it’s at that point that things really do start to get interesting and if typical market dynamics hold true the next steps are now going to be a series of workouts or foreclosures. Assets that are foreclosed upon ultimately get brought back to market once the, and particularly once the debt markets start to begin to function properly again, it’s at that point that I think you begin to see some markets.

[00:42:16] Ian Formigle: Exhibit what we call true market clearing trades that resets the values across the sector and that gives the ability for the sector to start to rebuild. You can look at this, just go back and look at the great financial crisis period. You saw that the price reset occurred by the time that we got into the 2010, 2011 office was really starting to reset itself.

[00:42:38] Ian Formigle: There’s nothing like a reset to make a property begin to start to compete again. That’s something that we saw. I, it’s a little bit trickier today because we have to address a lot more than just rental rate, but I do think that you gotta get to these resets to start really changing the landscape.

[00:42:55] Ian Formigle: And when we think about this, this is where we sit in terms of the office market overall. So at the end of the day, we’ve got some time to get to work. We have more, I think, kind of a little bit of cautious waiting for the next shoe to drop, so to speak.

[00:43:09] Ian Formigle: I think once you get through that, I think you, you begin to set the stage for the potential to reactivate some great nodes of our urban and suburban centers. If you think about what that does for those locations, if you can start to repurpose or reset or reinvigorate these buildings, you start to drive some retail activity in those locations, that influx and demand improves property values.

[00:43:30] Ian Formigle: That starts to increase tax revenues again and then also has the potential for investors to profit. So I think taking in its totality just as no doubt that there’s short term pain still ahead for the sector, but as we digest this next wave, I do think that it creates the opportunity for creative destruction to take hold and rehash the sector in the years ahead.

[00:43:49] Ian Formigle: So I think. 2025 to 2028. Really interesting part of the decade for the office sector. 

[00:43:56] Trey Lockerbie: And we will be talking about it in 2025. We’ll make sure to have you back on and see if we’re at that buying point. So with a lot of distress and the repricing ahead for the office that you’ve been kind of highlighting there, or something that stood out to me earlier about retail that I’m, I have a curiosity about.

[00:44:11] Trey Lockerbie: So you mentioned 0.5 0.5% is under construction in retail. So I was thinking, is there just a high barrier to entry for that asset class in and of itself? Meaning, I mean, you’re competing with things like offices, et cetera, so I’m curious if you’re expecting to see more opportunities for repurposing office buildings into other uses.

[00:44:31] Ian Formigle: Yeah, I’ll touch on the retail and then we’ll jump into office repurposing. So if we think about that retail and like why is there no supply? It’s just for that basic reason of like nobody wanted to build it , nobody and banks didn’t want to finance it. There weren’t a lot of retailers expanding their footprints.

[00:44:46] Ian Formigle: If we go back to 2014, even 20 15 1 data points, kind of going all the way back to that memo and the study of long-term cycles. Do you know what the number one most valuable asset class in 2015 was? It was malls, . So we are only eight years removed from malls being at the top of the stack. Wow.

[00:45:04] Ian Formigle: So, wow. How much has changed in eight years? It’s amazing. So if we get into the beginning of the e-commerce trend again, I think that’s really where e-commerce kicks in and industry takes off. From that point forward, it became increasingly challenging to develop new retail real estate, right? You started to see some store closures, some dislocation.

[00:45:23] Ian Formigle: You started to see stress coming into the malls. Once mal stress started, it just. Just started to topple the overall industry. And like if you’re a real estate developer and you say, Hey look, I can develop real estate, I can develop retail real estate, I can develop multi-family or industrial real estate.

[00:45:37] Ian Formigle: Well, I think the answer starts to become a little bit more clear. Like, Hey, if I’ve got some options for what the zoning allows for this, I’m going to go to where the money is and where the demand is. And that was in other asset classes. And that’s why I think re retail sits in this interesting state because it rode all the way into the pandemic with like no new supply.

[00:45:52] Ian Formigle: Then it got completely flatten. Then it’s really balancing back. The market isn’t really there yet to provide new capital to go out and provide new construction. Maybe that comes back again the next couple years, but really what you get now is you. And it’s also fair to say that going into the pandemic around 2019, there was a lot of discussion about how we were oversupplied nationally on retail.

[00:46:13] Ian Formigle: I love the term when people say retail isn’t overdeveloped, it’s under demolished. And so there was a little bit of that definitely going in 2019, but now we’re actually starting to absorb it again and we actually want to use it again. And so it’s possible that it actually might become economically feasible to create it again, but also rents dropped enough and rents are just starting to pop back up in retail where it makes, and also again, asset values, and again, this all boils down to discount to replacement cost.

[00:46:40] Ian Formigle: So right now it’s just, it’s more feasible to buy. It’s cheaper to buy than it is to build it. If it starts to touch what it costs to develop it, it gets to be in excess of what it costs to develop it. That’s when you see new development come in. But for right now, you’re basically, that’s why I think that opportunity sits in that space is interesting because I think right now it’s like, Hey, if I buy it, there’s nobody creating.

[00:47:01] Ian Formigle: I have a relatively captive market. If I have a good asset in a good location, I think I’m going to have more retailers want to be in it tomorrow than today. That’s the basic investment thesis for retail. So now let’s talk about office redevelopment, because that’s a really interesting sector. It’s part of the transformation of the office.

[00:47:16] Ian Formigle: It’s definitely going to continue to be something that you’re going to hear more about over this decade. I think we see more opportunities for office conversion in the future, but it’s also fair to say that today in 2023, they’re still relatively rare. I remember at the end of last year, CBRE’s America’s head of office research reported that there were 125 office conversions underway nationwide.

[00:47:39] Ian Formigle: And of that 125, about 50% were conversions to life science space. About 30% were conversions to multi-family, and the remaining 20% were either hotels or other uses. So if you think about 125 conversions across the whole country into all those different asset classes and how big those asset classes really are, I mean, we’re kind of talking about a drop in the bucket, right?

[00:48:02] Ian Formigle: But you know, there are few. They are out there, and they’re interesting. We’ve actually participated in some conversions of office space into all three of those types, and also self storage. But even in our experience when we were talking about fewer than 10 projects out of more than 740 since our inception.

[00:48:17] Ian Formigle: So there’s a number of reasons why I think that office conversions are not yet occurring at a more frequent rate, and I think they boil down to a few factors, including feasibility and economics and regulations. So just for starters, a lot of office properties are simply challenging to convert into other uses.

[00:48:34] Ian Formigle: For example, if you’re trying to convert an office property into multi-family, you need proximity to windows. In that new multi-family project, typically speaking industry would say no more than 25 to 30 feet away from a window at any point, any location of that new property, that new residence. A lot of office buildings that were built since the 1950s.

[00:48:55] Ian Formigle: They’ve got big floor plates If you go into the cities, particularly, meaning that you might be over 50 feet away from a window on a given floor. So if you’re taking one of those office buildings with those deeper floor plates and you’re trying to convert it to a residential use, that’s going to require punching light wells all the way down through the middle of that property.

[00:49:14] Ian Formigle: And sometimes it’s just not physically feasible, just simply not there. Or if you’re trying to convert an office building into life science uses that 50% that we just talked about. Well, now you need additional clear height on each floor. You gotta route things like venting. There’s a lot of power that comes in.

[00:49:32] Ian Formigle: There’s a lot of use that’s specific to a life science lab. And a lot of office buildings, they just don’t simply have enough space to offer that conversion. And setting aside from the fact that no matter if you’re converting it to life sciences, you’re converting it to, in multi-family, you gotta do some major upgrades to the plumbing infrastructure.

[00:49:51] Ian Formigle: So that’s just a as physical challenge of that building as well. So let’s assume that you actually, you can find an office building where the conversion is feasible. The next hurdle you gotta get through are the economics of that conversion. So typically speaking, conversions are expensive. For example, there’s a project that we looked at.

[00:50:08] Ian Formigle: We had exposure to the estimated conversion cost on that particular project, which was going from office to multi-family, $600,000 per unit just to convert it. That’s over and above the price to acquire the vacant office building, which equated to about $230,000 per unit. So we’re talking about $830,000 per unit all in.

[00:50:28] Ian Formigle: That’s an expensive project, which means that it’s only economically feasible in a location that can command high rents. And so it’s for that reason. When you think about how expensive office conversions really usually are, particularly for sources, I mean life science is actually even more expensive. But even for multi-family, it’s for that reason that you’re going to say that look, conversions make a lot more sense in places that can pencil somewhat in major gateway markets, right?

[00:50:55] Ian Formigle: The New York dcs of the country. And it’s fair to say that with that said, I have seen conversion projects that have occurred in other cities, more affordable cities such as Cincinnati, Kansas City, and Cleveland. But in all of those projects that we saw in some of those Midwestern markets, they were heavily required major incentives.

[00:51:15] Ian Formigle: They relied upon them such as new markets and historic tax credits to make them economically feasible. And in some instances, you can see, I’d say probably the last piece here is in some instances you can see a property trade at such a compelling value that it enables the conversion. I think one example of this is not long ago, the Coer Tower in downtown Dallas that comes to mind, that’s a 60 story tower.

[00:51:41] Ian Formigle: It’s 1.5 million square feet. It recently traded it at $83 per square feet, a huge discount to what it originally cost to build all the way back in the eighties. And that property is actually not even a full conversion. That’s a partial conversion. So it’s going to take part of the office tower, converting it into apartments and hotel and some retail, and then it’s actually going to remain office for a good chunk of the total space.

[00:52:03] Ian Formigle: And the last thing is, as I mentioned a minute ago, the third thing I think to think about is this. The regulations that can present obstacles. So you might actually now have an office building that’s viable from a physical standpoint. It might be feasible from an economic standpoint. But to convert it, you actually need the appropriate zoning, right?

[00:52:22] Ian Formigle: So whether or not it’s a regulatory concern, it’s an economic incentive. I think sometimes it ultimately hinges on a municipality to help you to get a conversion deal done. And so, I mean, despite, so there’s challenges there. No doubt, despite those all, I am a big fan of adaptive reuse of commercial real estate.

[00:52:41] Ian Formigle: I’m even a member of the Redevelopment and Reuse Council at the Urban Land Institute. So I dedicate time on an annual basis to studying with pe the space to meeting with groups across the country that focus on finding higher and better uses for the existing stock of commercial real estate. And as I mentioned I do think overall, as  we’re starting to rethink the future of commercial real estate, particularly in this office sector, I do think that you’re going to see more conversions, but you’re going to probably have to see owners and municipalities lean in together, roll up their sleeves, and go to work to figure out some new and better uses for those, for that real estate.

[00:53:15] Trey Lockerbie: Let’s step back for a minute and take the focus off of specific asset classes. I’m curious if there are any particular investment strategies you feel are best positioned to exploit opportunities in this current market.

[00:53:28] Ian Formigle: In a market with dislocation, particularly when it comes to capital markets. You step back, you think about what does make sense in a dislocated market, and then you kind of start to drive towards finding that kind of deal flow.

[00:53:41] Ian Formigle: And what’s particularly difficult and different about this market, this current turbulence that we’re experiencing. Right and it’s kind of strange in a sense because we’re not really for the most part, I mean setting office aside, but if we think about main asset classes of multi-family, industrial, hospitality, retail, this is not about deterioration of real estate fundamentals.

[00:54:01] Ian Formigle: This is about dislocation in the capital markets like first and foremost and second and third and fourth and fifth, right? It’s like we can find, there’s sometimes that you can find operational distress, but it is really financial distress out there for the most part. And so really where, why the dislocation in the capital markets makes practically every single deal, no matter what you’re looking at, challenging and a transact, it does create some interesting opportunities and it gives you an opportunity to possibly actually think more creatively about some deals.

[00:54:29] Ian Formigle: So there’s a lot of different ways you can approach it. I think there’s two that kind of stand out in my mind and how we’re looking at the market right now and we’re pursuing deal flow that we think fits these categories. The first. Our non-performing loans. So this is a situation where a group comes in and they buy a loan from a lender that is probably currently in default.

[00:54:50] Ian Formigle: There’s what’s called non-performing loans. There’s sub performing loans, so they can be in different states, but it’s really when they’re in non-performing in their state of default. That I think creates the most interesting opportunity because it has a lot to do with banking. I’ll talk about that in a minute.

[00:55:02] Ian Formigle: You know this and to like parlay that into like what kind of asset are we talking about? It might be a hotel that closed during the pandemic, it had never reopened, could be an office building in this current market. Absolutely. The compelling aspects in my mind of why non-performing loans are interesting, they’re primarily twofold in one is that you’re often able to purchase the loan at a substantial discount.

[00:55:26] Ian Formigle: To its outstanding principal balance, and that potentially provides an opportunity for a relatively attractive basis. And that’s if you end up foreclosing on the asset and taking possession of it and end up operating it in one day, selling it. Now, the second is that taking this position by coming in and buying the note and becoming the new lender, right, that opens up a lot of options for how you exit that transaction because you’re buying the loan and you’re buying it at a discount.

[00:55:54] Ian Formigle: And that loan also will come with things like accrued fees and default interests. You have a lot of leverage, a lot of leverage with that new borrower and you have a lower basis and that enables you to negotiate with that borrower. And a minute ago, my, I talked about this having a lot to do with banks. The reason that this creates opportunity is that banks need to set aside excess reserves on a loan the minute it becomes impaired.

[00:56:19] Ian Formigle: So they have a strong incentive. To get that loan off of their books as quickly as possible, if that means taking a loss in their minds, that’s better than them. Setting aside a lot of excess capital, the ratio that I recall was that you can roughly lend 10 to $1 of deposit, sequel is a $10 loan.

[00:56:38] Ian Formigle: The minute you become impaired, you’re now one to one. So if you think about that capital requirement, particularly in today’s current market environment, particularly you can understand that the minute that a loan becomes impaired bank really is focused more on removing it from their balance sheet than they are trying to focus on setting aside the extra $9 for every dollar currently reserved that they’re going to have to keep it to service it going forward.

[00:57:01] Ian Formigle: So really in essence, what that does is that creates opportunities for private capital to step in, purchase that loan, and then negotiate with that lender and then negotiate with that borrower either through a discounted payoff or if necessary foreclosure on the asset. Ultimately leading to ownership, rehabilitation of that asset, and then ultimately disposition of it.

[00:57:22] Ian Formigle: And really since a low basis, gives you a lot of options, gives you options to profit in the real estate investment as well. So buying non-performing loans I think can be a good strategy when the opportunity presents itself. The second is discounted recapitalizations or recaps. Again, tying this back to interest rates, given the recent spike in interest rates, the overall decrease in transaction volume, the challenging market to sell assets, it’s a kind of market dynamic where if you don’t have to sell an asset you prefer not to until liquidity returns.

[00:57:57] Ian Formigle: So, but despite the fact that maybe you don’t want to sell an asset today, you might have investors in it that need to exit or are highly desirous to exit. So in that situation, you could create an opportunity where you restructure the ownership of the project. That is the recap. You bring new investors in, you replace current investors, but the asset itself continues to be held and operated by the existing general partner who’s in charge of that asset.

[00:58:25] Ian Formigle: Doesn’t change, it’s the limited partner capital that comes in and swaps out the asset continues on. The key right now for recaps in my mind is identifying a compelling strike price. And what I mean by that is that there’s a lot of groups out there that like the idea of swapping out new investors for old investors and not selling that property, but continuing to have the opportunity to carry on, manage it and keep it in their portfolio.

[00:58:50] Ian Formigle: But at the same time, they may have unrealistic expectations as to what the current value of that property really is. So when these deals become compelling, it’s a situation where I would say the asset and the sponsorship are of high quality. In other words, you can see how the property can continue to perform.

[00:59:08] Ian Formigle: You have a set of investors that are motivated to exit and they’re willing to do so at a discounted value relative to what the current market value would be, where that property to go transact. And so again, this, to me, this draws back to remembering that part of the risk in a commercial real estate transaction is sometimes finding out all the things that you couldn’t discover during due diligence over the first year of ownership happens all the time in the scenario.

[00:59:33] Ian Formigle: This scenario happens all the time in the industry. You buy a property, you think you know everything about it. In the first year, you realize that you didn’t know everything about it. Sometimes the surprises are a little bit good. More times they’re more likely to be bad. So in a recap scenario, you can have greater confidence that if you have a strong sponsor, you’ve removed the discovery element of risk right now, you can move forward, you can, and that can prove meaningful to the future performance of the asset.

[00:59:59] Ian Formigle: So there’s a lot of different ways, I think, to approach this market right now, Trey, but I think those are two that stand out. That whenever we see those scenarios and the stars align, so to speak, we really do we lean in. And when we try to figure out if we can get that done, 

[01:00:14] Trey Lockerbie: What would you say is appropriate, if you can, we can use that word, or even optimal debt service coverage ratio when considering leverage on a potential deal.

[01:00:26] Ian Formigle: That is an interesting question. I think the answer to that question really varies widely depending upon who you ask, especially in the current market environment. I think it also greatly depends on the asset class, the risk tolerance of the borrower and the investors in that deal, and the durability of the income received from the rents.

[01:00:46] Ian Formigle: So there’s a lot there, but I will, I’ll do my best to unpack this one a little bit. So, first, just to define debt service coverage ratios, really what we’re referring to right, is the amount of excess net operating [01:01:00] income over and above the amount of required debt service for a given period of time, which is typically measured as one year.

[01:01:06] Ian Formigle: The concept here is that lenders want to be comfortable that the asset that they are lending on has more than enough operating income to cover their debt service. So the ratio is net operating income divided by the total amount of debt service payments on an annual basis. I’ll run through major asset classes.

[01:01:26] Ian Formigle: I’ll provide some context, I’ll give you some ranges. So in order of lowest to highest debt service coverage ratios that we see as typically required by lenders on stabilized assets. And that’s an important part when you get to unstabilized assets, there’s so many things that factor into the equation that it really becomes very difficult to talk about broad numbers.

[01:01:48] Ian Formigle: So I’ll talk about stabilized assets because really from that point forward you’re talking, the lender looks at the in place income and they say there, the assumption now is that in place income is relatively stable. I think it will grow incrementally over time, but I don’t really think it’s going to go down much either.

[01:02:05] Ian Formigle: So they give you kind of like the credit, so to speak, that they can give you for what that asset type is. So on an apples to apples basis, if we look at stabilized assets and we think about debt service coverage ratios starting at the bottom are multi-family and industrial. Those are typically 1.25 to 1.3.

[01:02:23] Ian Formigle: This is just how lenders would look at it. From there, you’re going to move up to. Retail’s going to look for 1.5 to 1.7. Office can also be 1.5 to 1.7, and I think that’s maybe like a more of a generalization of how things were. I wouldn’t really say that’s how things are. So I probably, for the sake of this answer, just throw office out the window for the time being, and maybe it’ll begin to look more normal in the next couple years.

[01:02:47] Ian Formigle: But right now there isn’t a number for the office that even looks normal today. Caveat on that one statement is if you have a, you have an office building with really high credit, durability of credit, long-term tenant maybe publicly traded with a sterling credit rating, 1.5 would definitely check the box for that kind of asset.

[01:03:03] Ian Formigle: Just that they’re relatively rare. Finally, hospitality, probably about 1.75. And with some markets being maybe like some smaller secondary to tertiary markets, stretching that to 2.0. And I think there’s a few things to note with these ranges. The first, as I mentioned about right, there are situations, so if we think about non stabilized assets, there are lenders that will accept lower debt service coverage ratios at acquisition, but in exchange, they’re going to want other forms of security in the deal, such as interest rate reserves possibly control over the operating cash flow.

[01:03:34] Ian Formigle: So there’s a lot that goes into that negotiation when there’s any form of non-stabilized asset. I think the second thing is that while interest rates change regularly, the amount of coverage the lender wants in that equation in a deal, it’s kind of constant over time. And so what that means is that when interest rates go up, as they have recently, the percentage of the value that they are willing to lend on the asset typically goes down.

[01:04:00] Ian Formigle: This is what we refer to as the loan to value ratio or ltv. We’ve seen LTVs drop by 10 to 15% over the course of this last year, and that’s, I think in scenarios where the asset looks pretty good, if it’s a little bit more stabilized or it’s a little bit more nebulous, it’s, I think the A, those LTVs are going down even more.

[01:04:16] Ian Formigle: But just important to note that proceeds when intrinsics go up, proceeds on a percentage of the project typically go down. I think the third thing here is that these ratios should give you a sense of the overall risk that a lender perceives across each asset class, in essence, by wanting a higher coverage ratio for a stabilized hotel or an office building relative to an apartment complex, I think that lender is telling you that they view them as possessing more risk, which really translates to a higher probability of defaulting on the loan at the same coverage level.

[01:04:47] Ian Formigle: So just let me think through that. Lenders are all about risk mitigation. Higher ratios equal, I need more income there to mitigate my risk as a lender. And then finally it’s worth mentioning that the certainty or what I just mentioned a minute ago, as what we refer to, in the industry as the durability of the income is important when analyzing these debt service coverage ratios, right?

[01:05:09] Ian Formigle: So I talked about that scenario with that office building. Anytime that you own something with good credit in it, if it’s an industrial deal, for example, and it’s leased to Amazon for 30 years, well that lease is effectively as good as Amazon’s corporate debt. So it’s really a bond. And in those few scenarios, we’ve seen an operator of an Amazon lease warehouse, they’re able to borrow perhaps up to 95% of the value of the property, drop their debt service coverage ratio, all the way down to 1.1 because that is how certain that net operating income is.

[01:05:41] Ian Formigle: Or conversely, how low a probability it is that Amazon would ever default on its lease obligation. So there’s a lot to think through regarding debt service coverage ratios. Like I said, the condition of the market plays a lot into this, but I hope that provides some insight to the question. 

[01:05:56] Trey Lockerbie: When we’re speaking about high interest rates, one  thought that comes to mind is the possible impact on investors’ cash on cash returns wouldn’t be servicing this more expensive debt cut into the returns.

[01:06:10] Trey Lockerbie: And in that case, how do you justify making an investment at all? 

[01:06:14] Ian Formigle: So, Trey, I think the short answer is yes, investors’ cash on cash returns can definitely be negatively affected when the cost of debt increases. But whether or not that means the deal is still worth investing in, I think that requires further analysis.

[01:06:28] Ian Formigle: So I’d say around the middle of last year we actually published an article discussing this conundrum of high interest rates and their impact on returns through the use of leverage. And one really important concept that flows out of this discussion is the topic of positive versus negative leverage in a commercial real estate deal.

[01:06:50] Ian Formigle: So let’s start with positive leverage. Essentially what we’re referring to here is that positive leverage means that using the debt can actually help improve the annualized yield to the equity because the debt costs less to service than the cash flow that you are receiving from the leveraged portion of the property.

[01:07:10] Ian Formigle: To understand, but kind of think about this in terms of cap rates. If you’re buying a six cap property and you’re able to borrow it 5%, maybe interest only, well then you’re getting more income that you can actually pour over onto the equity, so you’re improving your equity yield. So in other words, when the operating cap rate from a deal is greater, Then the interest rate of its debt, that’s positive leverage.

[01:07:33] Ian Formigle: Now, we’ll flip it around. Negative leverage occurs when the operating cap rate is now lower than the interest rate of the debt. Now, in that scenario, using debt actually decreases the annualized yields on the equity because the debt costs more to service than the cash flow that is received from the leveraged portion of the project.

[01:07:53] Ian Formigle: So in a scenario where the debt audit a project is expensive enough that it wipes out, most of all, the cash flow for the equity is sometimes happening today in transactions right now, it is absolutely fair to ask why would anyone even consider negative leverage going into a deal? And I think the answer to that question is like, well, there’s really two things that I think need to be in place if you are going to consider using or pursuing negative leverage to justify why you would do it.

[01:08:20] Ian Formigle: Well. And the first is that, Negative leverage could be justified during periods of market volatility, like what we’re experiencing right now. And when that volatility translates to a price that you pay for the asset that is discounted enough to more than compensate the investor for the reduced yields or essentially no cash flow, then it may be warranted as long as that basis is really attractive.

[01:08:44] Ian Formigle: But in this scenario, the potential for high returns, it’s now totally concentrated into the profits at sale rather than into periodic yields of the holding period. So you’re changing the whole context of that investment and you’re going in on an equity multiple basis, and you’re not thinking about cash flow anymore.

[01:09:02] Ian Formigle: So I think in those scenarios, you really do have to think about what your exit value is, but there may be enough discount in the current deal to justify doing it in the second. Is that negative leverage, I think, can be justified when the project’s rents are well below current market rents. We saw some of that in the course of this last year, particularly in the multi-family sector.

[01:09:22] Ian Formigle: Some of those markets where rents moved so fast, the in-place rents might be so much less. Than the current market rep, that while you might enter with negative leverage on a deal, as soon as you adjust your rents to market and you work through that rent roll, you can actually flip it to positive leverage.

[01:09:38] Ian Formigle: And so, and then this scenario, a lot of times it’s also a little bit blended with that discounted asset scenario. So sometimes an investor is weighing these two things simultaneously. I think the final option here, I think is just worth mentioning is that when we are thinking about positive leverage and negative leverage, well there’s an option and that’s to forego leverage altogether.

[01:09:59] Ian Formigle: [01:10:00] Particularly if the perspective returns on the deal look attractive without using debt and debt So hard to get right now that I do think there’s starting to be deals that show up and they look pretty attractive on an un levered basis. But it’s also fair to say that when you’re, when you, if you’re thinking about using debt typically is the majority of the total cost of the project.

[01:10:17] Ian Formigle: So foregoing it. It might require more equity than just what is simply available. So I think to sum it up, Trey there’s ways to make expensive debt work in a deal. They are challenging, but you need to get compensated appropriately in other ways in the deal for it to make sense. 

[01:10:35] Trey Lockerbie: Let’s talk about capital calls and private commercial real estate deals, because while I know that they are rare, I understand that they are becoming more and more common in down markets.

[01:10:44] Trey Lockerbie: So since many investors are not really that familiar with them, or maybe it’s just me, but can you explain what a capital call is and then how investors should approach them if they are ever faced with one? 

[01:10:56] Ian Formigle: Yeah. Trey, this, is this an important topic? You’re correct that  it’s not typically discussed in a lot of parts of the market cycle.

[01:11:03] Ian Formigle: When markets are booming and rents are going up fast and assets are appreciating, it’s a very rare circumstance, but in down markets, they become the potential for them. I think it will definitely become more common. So it’s worthwhile to understand. So I think first and foremost, when we talk about capital calls in a private commercial real estate deal, it’s important to note that we’re referring to what we call as unplanned capital calls.

[01:11:27] Ian Formigle: Those are scenarios where a project requires an infusion of capital that was unforeseen when the partnership was originally formed. There’s many projects that plan for funding over multiple installments, but because those capital calls are anticipated in a much different scenario, right? The investor understands that they set aside the capital, they infuse it on a periodic basis as it’s called, but a very different scenario with that.

[01:11:53] Ian Formigle: When you invested in a project, you weren’t expecting to contribute more money to it, but years later, you’re being asked to do so. [01:12:00] So if an investor receives an unplanned or unforeseen capital call as certain private real estate investors across the US are experiencing right now in some situation due to the types of interest rate resets that I, that we discussed previously in our conversation, I do think that there’s some steps that investors can take when approaching the situation that can help them gain some objectivity for the decision that they’re faced with.

[01:12:23] Ian Formigle: First, anytime a capital call occurs, I think the first thing that you do is you go back, you read your operating in agreement, you understand what your rights are, as well as what are the rights of the general partner to call capital. The rules on what’s permissible in a real estate private partnership, they’re all typically spelled out.

[01:12:41] Ian Formigle: It’s in a specific section within the operating agreement. So first and foremost, read the operating agreement. Understand what a partner can and can’t do and what your rights are whether or not you decide to participate. Part of that now moves onto the next phase. Now you’re reading it. Now you’re starting to understand what the provisions are in those provisions.

[01:13:01] Ian Formigle: Look for any punitive language that may be enforced if you elect not to participate. This is what is referred to as a punitive dilution in a private equity investment. Punitive dilution can vary. I’d say in my experience, I’m looking across documents over hundreds of deals. Thousands of deals. I guess 1.5 x is fairly standard.

[01:13:22] Ian Formigle: It might translate up to two x and that is on the capital call itself, not the total investment. Punitive provisions are intended. Why are they? They exist while they’re intended to help ensure that the limited partners, all limited partners, they’re motivated to participate in the capital call.

[01:13:39] Ian Formigle: And if they don’t, we’ll then potentially reward those investors who do step up and participate at some expense to those who opt out. But again, the expense is supposed to be somewhat like not material, because if it’s on the capital call itself, that capital call was, say for example, 10% of the original investment, then we’re talking about multiplying 10% times 1.5.

[01:14:01] Ian Formigle: That’s the amount. So $15,000 of dilution instead of 10 if there was no dilution. So once you have an understanding of the rules and the economics of the situation, I think now it’s time to evaluate the situation. In the current state of the deal and even in the current state of the market. So for example, how much is the current state of the project due to circumstances that are, that exist at a macroeconomic level or perhaps related to I’d say is an exogenous shock?

[01:14:29] Ian Formigle: These are going to be things like spikes in interest rates, a recession, a bankruptcy or a vacancy of a major tenant. These are all things that I would classify as generally outside of the control of the sponsor. Essentially bad circumstances, but not necessarily error on the part of the sponsor. Now, conversely, failing to lease a property, failing to manage expenses within budget.

[01:14:52] Ian Formigle: These are things that I would classify as within the control of the sponsor. The situation proves to be more of the former than the [01:15:00] latter. Then that makes you more comfortable, that you still have a good project that will recover in the months and years ahead. But if it looks more like the latter than the former, well then now you ask yourself if you’re contributing more money, that may simply prolong a bad outcome.

[01:15:15] Ian Formigle: And that’s kind of a situation. That’s what you refer to as throwing good money after bad. So assuming that is really more that former scenario, it’s an exogenous shock or it’s just a macroeconomic story, it’s just something that it’s circumstance rather than something particularly wrong with the asset itself or with the operator of the asset.

[01:15:32] Ian Formigle: Another approach. I think so, but now if we’re in that scenario, it’s a more severe scenario, more downside scenario. Now, I think a way that you can take a further look at it, is to think about what you think you’ll receive. As a potential return on the capital call itself, set aside the original investment.

[01:15:52] Ian Formigle: And then sometimes that’s hard for us to do. We have this subjectivity, we think about our original investment in that deal. But when an asset faces a serious exogenous shock, it might be more productive to set aside the original investment, consider that a sunk cost, and now really focus on the capital call itself.

[01:16:11] Ian Formigle: What you will get in exchange, you’ll usually will get defined terms in exchange for the capital call and then ultimately what you, what potential return you think you can get on the capital call, and then measure that against what else you might receive if you deploy the capital elsewhere. Because I think at this point in an asset that has had a major exogenous shock and this capital is coming in to effectively rescue it, you’re reinvesting in the new deal.

[01:16:37] Ian Formigle: I think you can kind of forget about the old deal if the sponsor shows you a plausible path to an outcome. That targets an opportunistic rate of return on the capital court itself. And that’s one, and that is a scenario that you, in your judgment, you can really believe in. Then that’s all you can really ask for.

[01:16:54] Ian Formigle: In that circumstance. It’s great if the new capital comes in to protect the entirety or a portion of the original investment, but in a real downside scenario, that’s just upside in that more rare scenario, right? When that property is in a state of distress, the decision to contribute more capital boils down to that analysis of a risk of adjusted return on the capital call investment itself.

[01:17:17] Ian Formigle: So I, I think, Trey, by overall, by focusing on the current state of the project, the revised business plan, and in some cases the expectations for the capital call alone, I think that can help investors make a more objective decision . 

[01:17:31] Trey Lockerbie: Well, Ian, you are always just such a wealth of information and I can’t even believe it sometimes how much knowledge you bring to these discussions.

[01:17:39] Trey Lockerbie: It just blows me away. I would love to do this again in a couple months and just keep a pulse on this market because things are changing. I think you put it on a dime earlier. So this would be an entirely different conversation depending on which way things go. So let’s do that and wrap up here.

[01:17:53] Trey Lockerbie: But before we do, please hand off to our audience where they can learn more about you and Crowdstreet, which is just an unbelievable platform with also amazing resources. 

[01:18:03] Ian Formigle: Well, thanks Trey. As always, these are fun conversations, and I certainly do concur that at a minimum we’re going to have a lot to talk about later this year. There’s, I don’t even know what we’re going to talk about. That’s how much it’s probably going to change. But in the interim, the easiest way is to go to our website, Crowdstreet.com, to learn more about us and what’s going on. There’s a host of information there. That’s where our online marketplace lives, and everything else that you would need to get a glimpse into understanding a little bit more about the commercial real estate market. We post educational content there.

[01:18:48] Ian Formigle: Another thing, as I mentioned, we are publishing memos for investors this year. Given the dynamic state of the market, we’re trying to speak to investors on a regular cadence and inform them of what we see and what we think on a regular basis. These are essentially three to five page documents where I share my thoughts on the real estate market and trends and just try to keep investors up to date. And in conjunction with those memos, we actually host monthly flash calls. These are just straight: what are we seeing today in the market? How are we pivoting? How are we reacting? We’re running those at least monthly for the first half of the year, and then we’ll continue to consider the cadence on a go-forward basis. In any event, you can find all that information on the website. You can search for the Office of the CIO. As the CIO of Crowdstreet, we’ve created a separate page to talk about where you can find some of this thought leadership content, but yeah, feel free to check it out.

[01:20:01] Ian Formigle: Finally, as I always mention, you can find me on LinkedIn. I am the only Ian Formigle on the LinkedIn platform, so it’s very easy to find me.

[01:20:12] Trey Lockerbie: Ian, always a pleasure. Thanks again. 

[01:20:15] Ian Formigle: Thanks, Trey. 

[01:20:16] Trey Lockerbie: All right, everybody, that’s all we had for you this week. If you’re loving the show, don’t forget to follow us on your favorite podcast app. And if you’d be so kind, please leave us a review. It really helps the show. If you want to reach out directly, you can find me on Twitter @TreyLockerbie. And don’t forget to check out all of the amazing resources we’ve built for you at theinvestorspodcast.com. You can also simply Google TIP Finance, and it should pop right up. And with that, we’ll see you again next time. 

[01:20:54] Outro: Thank you for listening to TIP. Make sure to subscribe to Millennial Investing by The Investor’s Podcast Network and learn how to achieve financial independence. To access our show notes, transcripts, or courses, go to theinvestorspodcast.com. This show is for entertainment purposes only. Before making any decision, consult a professional. This show is copyrighted by The Investor’s Podcast Network. Written permission must be granted before syndication or rebroadcasting.