Ian Formigle  1:30  

Yeah, sure. I’d be happy to. I think to begin with, if for investors who are new to commercial real estate investing, I think one of the main things to understand is it is the world’s largest alternative asset class. The types of underlying assets and commercial real estate, they include things like multifamily, office, industrial, retail, and hotels. It can even include self-storage, senior housing, [and] mobile home parks. Commercial real estate investors are typically looking to earn returns through a combination of annual income and appreciation that’s realized its sale. Everywhere you go, you’re going to encounter commercial real estate, and a lot of it is privately owned. 

Also, I would say that similar to stocks, you can pursue different strategies within commercial real estate. Some strategies are going to focus on total return, while others are going to focus on current income. I think the part and the beauty of commercial real estate is it can be structured in myriad ways. 

In addition, those ways can be tailored to suit the goals of the investor. So when we think about it holistically, commercial real estate complements a well diversified portfolio because it’s proven over time to produce attractive returns that are not perfectly correlated with the overall market. This means that it can enhance overall returns in a portfolio, while also reducing volatility. And that is why you will regularly see it utilized by sophisticated investors such as pensions and endowments. 

Preston Pysh  2:52  

So Ian, let’s be more specific. We’ve previously talked about the Sharpe ratio here on our show, and in short, the Sharpe ratio is the measurement of the expected return compared to the volatility of your portfolio. Could you provide some numbers based on how the Sharpe ratio changes for a 100% stock investor, if they would start to include commercial real estate in their portfolio? 

Ian Formigle  3:15  

This is an interesting question because we actually ran a similar type of analysis late last year in tandem with a registered investment advisor here in Portland, Oregon. We began with actually not taking 100% stock portfolio but a 60/40 stock bond portfolio. And we analyzed the expected return, the standard deviation, and the Sharpe ratio for that portfolio over the next 10 years. Because this particular RIA has a reasonably conservative outlook, when they think about the next 10 years, the return estimate for that 60/40 portfolio was 5.49%. 

It had a standard deviation of 9.19%. And that resulted in a Sharpe ratio of .39. So then, we began with that portfolio, and then we created a second portfolio, where we reduced the equity component to 50%, and we substituted a 10% allocation of private equity real estate. So to determine the expected return on that 10% component, we use the 10-year targeted average of returns for the entire CrowdStreet marketplace up until that point, which is about a 14% IRR, annualized rate of return over that 10-year period. 

So, this is a hypothetical scenario, but that’s the data that we had to work with at that point. When we added the 10% private equity component to the portfolio, the returns went up, they went up from 5.49% to 6.28%. The standard deviation did definitely go up. It went up from 9.19% to 9.76%. But it didn’t go up proportionally, and that’s due to the non-correlated aspect of the real estate component. In the final analysis, the Sharpe ratio increased in this case, from .39 to .46, and that was by infusing that 10% allocation of private equity. And so to sum it up, I think this is part of the reason why I believe that adding a commercial real estate equity component to a diversified portfolio increases the overall portfolio returns for each level of risk taken.

Stig Brodersen  5:10  

Is there such a thing as an optimal commercial real estate percentage in your portfolio? And here in this example, for instance, you mentioned 10%, but could you provide some of your thoughts in terms of how should we think about including it in terms of “optimal” allocation of commercial real estate in a stock portfolio?

Ian Formigle  5:28  

Real estate as a component within a portfolio will range, and we will see that range in a portfolio from high single digit percentages 7% or 8%, all the way up to 30% or 40%. The right level of allocation is really going to boil down to who is the investor, so we’ll kind of walk through a couple examples. That high single digit percentage, that’s sometimes a reasonably conservative allocation from a pension for example. When we think about endowment investors, they’re going to range typically between 10%, and then, maybe 20%. Maybe as high as 25%, when they over allocate. 

They’re going to come to their own conclusions on where they think they fit within that cycle. And they’re going to look to span commercial real estate as a percentage of the portfolio, where, where they deem they are in the cycle. And then, in that scenario where we are seeing 30% or more, that’s typically very high net worth [or] ultra high net worth investors, or in this case, probably family offices because they have a strong cash position. 

Also, they have the luxury of investing over a long period of time. That’s where they’re going to seek to infuse real estate as a long-term store of wealth in their portfolio. So I guess to sum it up, anywhere from 6% or 7%, all the way up to 40%. And it really just depends on what type of investor you are and what your objectives are.

Stig Brodersen  6:50  

And one thing I would like to introduce you to the listener is liquidity premium. I have a discussion about that because generally you can say that investors prefer to have liquid investments. Now, it gives us more flexibility to put money into the best investment with a very short notice. 

So for instance, everything else [being] equal, investors would prefer tradable securities instead of equity in their home because the latter is liquid. And they will need to go to the bank to get a new loan, have interest in that, or sell the house which is even worse, I guess. I’ve heard you argue [that] a liquidity premium can also be an advantage for you if you’re a long-term investor, why is that?

Ian Formigle  7:27  

I will oftentimes speak with investors about the concept of saying the real estate component is not the component to seek for liquidity in your portfolio. You do need to think about it more holistically in this case, and then if you can give up the liquidity, then you have the benefits of earning the return. 

So, let’s dig into that a little bit. [The] liquidity premium as from the get-go is really associated with commercial real estate investments. And its concept is rooted in the fact that because you are seeing the ability to liquidate your investments with the click of a button, you must be compensated in the form of greater returns. Or to put it another way, if you’re not getting compensated, then why give up the option of liquidity?

When we see this, we can even look and see this effect in the equity markets. When equities go from private to public through an IPO. Oftentimes, the IPO process results in a jump in valuation for that company. In fact, there’s an NYU Stern School of Business study that estimates that the average valuation premium for a private company going public is about 20-30%. 

Another way to quantify this is to compare commercial real estate returns to S&P returns. If we begin with the long run average return of the S&P is about 10%. When I think about equating that level of risk and return to the S&P return, but from a commercial real estate perspective, I tend to land on the profile of a core plus real estate investment that’s located in a great market, and that is leveraged at about 55-60%. 

So with that risk profile, you will typically target a net annualized rate of return of approximately 12-13%. And that will assume a holding period of roughly five to eight years. That means that provided that you are able to commit to a five to eight-year period, potentially of illiquidity. And when I say potentially, I mean a shorter period most likely in a strong market and a longer period in a weak market. You stand to earn an additional 200-300 basis points per year on that capital relative to what you would normally expect to return in the S&P over that same timeframe. 

But I would say that, again, the key is that you are committing to hold for multiple years. Consistent returns and commercial real estate, they take the cyclical nature of the real estate market into calculation. We don’t know when a market will turn, and if it does, as an investor, you must be prepared to be patient, and sell when the market regain strength. And if you’re prepared to do that, then you will greatly smooth the volatility of expected returns in real estate. 

Preston Pysh  10:02  

So Ian, let me play devil’s advocate here for a second. When I’m thinking about commercial real estate, I’m also thinking about the risk of the commercial real estate owner. On our previous interviews with you, you talked about how commercial real estate on an unlevered basis historically has achieved about a 9% return and up to about 16% with leverage. So if you could elaborate on the different risk factors using leverage and how we should manage leverage to maximize return and minimize the risk. 

Ian Formigle  10:34  

Sure, and I would say to begin with, you are absolutely correct that you never want to be forced into selling an asset into a weak market. That is a recipe for disaster. When we think about cycles, year in, year out, and we look at the course of history, we would definitely say that if there is a weakness in commercial real estate, it is the possibility of being exposed to that exact scenario. That is something that we have control over. So let’s talk about how to think about it, and how to potentially insure yourself against the possibility of being caught in that situation. 

Applying correct amount of leverage on commercial real estate is critical, right? It helps to ensure that assets are going to make it through those downturns relatively unscathed. So when we look at leverage going into a deal, we can use three metrics. And those metrics are one, loan to cost. Two, debt yield. And three, the debt service coverage ratio. 

So let’s begin with that first metric, loan to cost. This is the ratio of the total amount of debt used to the cost of the asset factoring in closing costs and reserves. For example, the average loan to cost across all 360 plus offerings on the CrowdStreet marketplace to date is roughly 67%, 50% or below is typically considered low leverage, and anything above 80% is typically considered high leverage. And I would caveat that these ratios are not absolutes, and they must be weighed on a case-by-case basis. 

The second metric is debt yield, and that is calculated by taking the net operating income of the property and dividing it by the loan amount. It’s almost a proxy for determining at what cap rate, a lender would be willing to own the property. It’s basically the cap rate for the lenders level of exposure in a deal. 

Debt yields are more commonly used in office retail and industrial, and less so for multifamily. The third metric really pertains to multifamily, and that is the debt service coverage ratio. This ratio is calculated by taking the annual net operating income of an asset, which as we’ve discussed before is essentially all revenues less all expenses, and then dividing it by the amount of the annual loan payments owed to the lender. 

This metric can be particularly useful because it will tell you how much cushion you have in your net operating income before you can no longer service your debt, and like debt yields, debt service coverage ratios, they vary. 

And they’re going to depend upon the amount of debt you use, but in this case, they also changed with interest rates. So when we think about these metrics, I think the most interesting and illustrative aspect for investors to grasp is that the lending industry seeks debt yields and debt service coverage ratios to fall into certain ranges, depending upon the asset class. 

These are two key metrics for how lenders analyze loans and determine loan proceeds that yields–they can, they can range, and they’re going to depend upon the asset type and the quality. But in general, you could say that a debt yield of 7% is relatively low, 8-9% is good, and 10% or above is considered strong. Let’s turn to multifamily assets. Fannie Mae and Freddie Mac are two of the largest lenders in the space. And when they think about sizing up their loans, they’re often going to size to a 1.25 debt service coverage ratio. Debt service coverage ratios for multifamily in general, they can range from 1.1 to maybe 1.6 given relatively normal levels of leverage, say high 60% to mid 70% loan to cost. They rarely exceed 2.0. 

And if you find them on that high, it’s usually going to require low leverage to get there. All three of these metrics require some learning on behalf of investors. I would say a little bit more so with debt yields and debt service coverage ratios, but they really are helpful for understanding the risk of leverage in commercial real estate assets [and] understanding how banks and other lenders look at them and look at risk of lending into a commercial real estate deal. And if you can understand them a little bit like a bank does, you’re ahead of the game.

Stig Brodersen  14:39  

Thank you for your response to that. Let me go back to the first ratio [that] we talked about, just [as] an example. You think that a lot of listeners for instance, with their own home, they used to be thinking, “Well, it’s levered at 60%, or 70%, or 80%, and you talked about how less than 50% that would be considered conservative, and more than 80% probably would be highly leveraged. Is there such a thing as whenever you mentioned the value on a case-by-case basis? Is there such a thing as you are willing now to take on more leverage? Because that number, that 60% that you might turn up to like 80% or even more, it’s just not as severe for this type of property.

Ian Formigle  15:19  

When we look at scenarios, where we want to contemplate levering a deal more highly, it’s really going to depend upon the following things. One, where is the net operating income today? And two, where do we think the net operating income will go tomorrow? 

The key difference about a commercial real estate asset than a single family home is that, well, you’re paying the mortgage on your single family home with your income. If you feel confident in your ability to service your own mortgage, and you see your own income going up over time, that’s the scenario where you might feel comfortable sticking your neck out a little bit, and levering a home 80 to 90%. 

If you thought your income was going to go down, well, you’re going to put a pretty conservative amount of leverage on that property because you need your mortgage payment to fit within your budget. That same concept applies to commercial real estate. This would be a good example of where we see adding leverage in a deal, but doing it in a way that makes sense. And that is what we call future funding. In some instances, you put an initial amount of leverage on a property. Maybe that is 65% of the purchase price, but then you believe that you can improve the property. Maybe you’re going to buy an apartment complex, and you’re going to rehabilitate units, and improve rents. If you can do that, then you’re going to increase your net operating income. 

And in that scenario, oftentimes you can find lenders who will lend you additional proceeds to help you do that work. The reason that the lender is going to do that is because it sees the opportunity for you not only to improve the quality of the asset, but to improve its net operating income, and as we just discussed a minute ago, it’s analyzing debt yields and debt service coverage ratios. 

If you improve your NOI, well, then all things being equal, your debt service coverage ratio in that scenario is going to go up, and your debt yield is going to go up. So the bank is feeling like it is decreasing its risk in that deal, so that’s an important way to think about leverage in a deal–is to really understand the NOI and understand how the NOI will change potentially over time.

Stig Brodersen  17:25  

Thank you for your response. Thank you for making it very relatable. I guess that most people, whenever they do hear about commercial real estate, they automatically think about their own home, and how to manage that. To make it again more relatable, especially for our listeners, I would like to draw a parallel to stock investing because we as stock investors look at different indicators for the entire stock market. 

One of the indicators that we often talk about here on this show, that’s the Shiela of P/E, so we are looking at what is the stock market valuation for the US, or what’s the stock market valuation for Germany, or whatever kind of market it is because it gives us a more high level perspective that now might be the time to start looking specifically at stocks in that country. Of course, you can always be lucky to catch a fish. But if you know its pond is the right one to start fishing, you increase your odds. 

That’s also how I would like to draw this parallel to commercial real estate. We previously, here on the show, talked about a few of the metrics that you can use for the individual asset. For instance, the cap rate you mentioned before. How do you take the temperature of the entire commercial real estate market, kind of like to give you an indicator that perhaps this is the pond that I should start fishing in?

Ian Formigle  18:36  

Yeah, and it can be a little bit challenging to understand where the commercial real estate market is today and where it’s going. That’s because a lot of that market is private. And for individual investors, it’s important to note that the most relevant data sources are provided by third party groups, and they gather data through what I would describe as grassroots collection efforts. Within the industry, we watch transaction volume and price per square foot data on a national basis, and this kind of data is provided by companies such as CoStar and Real Capital Analytics.

Unfortunately, for the individual investor this data is proprietary, and it is expensive to obtain. But for people that don’t have access to the same types of industry data as market professionals do, there are a few alternatives, so I’ll, I’ll be happy to walk through them. The first is the NAREIT Index, and NAREIT stands for the National Association of Real Estate Investment Trusts. This is an index that tracks the performance of 221 publicly traded reads. 185 of those trade on the New York Stock Exchange. And so, that index currently has a total market cap of about 1.25 trillion, which is a pretty good amount of total assets within the market, so that’s not a bad place to start. 

The second, I would say is the NCRIEF Property Index or the NPI. NCRIEF stands for the National Council of Real Estate Investment Fiduciaries. This is a group that has been tracking a nationwide property index dating back to 1977. It looks at the returns for commercial real estate properties held for investment purposes only, and it analyzes them on an unleveraged basis. The NPI is a lagging indicator. It’s published every quarter, and it’s going to look back on that previous quarter, but it is helpful to view. It could give you a sense of where the market has been and where it might be going. 

The third, I would say is the Dow Jones US Real Estate Index. Now, we have an index, where investors can track public real estate equities on a daily basis if they choose. It does have some highly relevant industry stocks in it such as AvalonBay, Prologis, Simon Property Group, and Equity Residential. I would say that there’s also some noise as well in that index. 

For example, Crown Castle is one of the stocks and that’s a cell tower company, which honestly doesn’t really correlate to what we see in the private equity real estate market. Finally, what I would say is that when we think about all of these different indexes is that one common thread that you’re going to find across them is that they tend to move more slowly than something like the S&P. And that is a reflection of the industry as a whole. 

Commercial real estate is comprised of a lot of private decision makers. Assets are trading on a monthly basis, quarterly basis, [and] yearly basis. They’re not trading within microseconds. If you think about any index that you can think about for publicly traded securities, slow that down in time, and then you’re going to start to understand that commercial real estate does move, but relatively speaking, it moves at a glacial pace. 

Preston Pysh  21:36  

So Ian, what are the major macro trends that you see for commercial real estate in the next 5 to 10 years?

Ian Formigle  21:42  

We see a number of trends across product types, geography, environment, just to name a few. And I’m going to touch on two of them because I think they’re pretty relevant to our environment today, and they’re both anchored in the concept of affordability. So first, we see a growing housing affordability crisis in the US that only looks to intensify over the next 5 to 10 years. 

Right now, about half of all US renters, or roughly 21 million households spend 30% or more of their income on housing. So we are seeing opportunities to refresh aging 1970s and 80s vintage multifamily housing across the United States. And we don’t see this opportunity bading anytime soon, and as evidence of this trend, I often look to Starwood Capital Group as a company that sees trends and mobilizes on them pretty well. 

For example, they were one of the first institutions to acquire large amounts of single family residential real estate coming out of the Great Recession. So when you look at what Starwood is doing today, they’re acquiring affordable housing. They’ve actually acquired 20,000 affordable units across Texas and Florida just in the last couple of years. 

And as for demographics, Harvard’s Joint Center for Housing Studies is projecting that a formation of roughly 1 million new households per year through 2035. And if we combine that new household formation data with an environment, where three out of four new jobs in the US are relatively low paying, you can see why the US is going to continue to produce more renters than homeowners over the next decade, and those renters are going to need affordable housing. 

Second, moving on with this idea of affordability, we see that moving into another trend as well, which we call “the middle market for senior housing.” Similar to the multifamily market, we’ve seen a strong market for senior housing, but I would say that unfortunately, developers have been over supplying the high end of this market, and that has led to an overall occupancy level of 88% nationwide, and that marks a seven-year low. 

And so, according to this study done by the National Investment Center, the next big trend in senior living is specifically in this middle income senior housing market. This middle market is anticipated to grow by more than 6 million people within the next decade. And that’s going to translate into more than 700,000 senior housing units that will be needed to serve this middle income bracket. 

Right now, the majority of middle income seniors are not going to be able to afford assisted living that costs $60,000 or more per year. However, if we reduce that annual cost to $50,000, you pick up an additional 2.3 million seniors, who can now afford assisted living. If the price drops further to $45,000 per year, you add yet another 3.6 million seniors, and that would bring the total estimated market size to 10.2 million people. 

So when we look at the middle income demand and supply gap out there right now, we see that as an underserved market, and a market opportunity. I would expect that the industry over the next 10 years is going to adapt to serve it, and in addition, as it adapts to serve it, we would expect to see that a lot of these units are going to be delivered in 18-hour cities. 

That is an alternative to the price here [of] 24-hour cities. And we’re going to need to see some of that because as I talked about, we really need to think about affordability. We have to find a way to get senior housing assisted living down to $45,000 per year.

Stig Brodersen  25:22  

Perhaps not too surprisingly, for our listeners, I want to transition back into stock investing and make this parallel between stock investing and commercial real estate. We’ve talked about insider trading here before on the show and different case studies. And as we all know, it’s legal, whenever you are involved in stock investing. 

That’s also why all insider trading, all the activity is disclosed, and why insiders are so heavily regulated. When it comes to commercial real estate, it seems like it’s played by different rules. It’s generally not illegal and if anything that’s often how and why most deals are made. I’m curious, Ian, with all the experience that you have in commercial real estate, do you have a good story about how you or  Crowd Street have utilized insider information?

Ian Formigle  26:09  

I do. There’s a story in our background. You make a really good point because I would start by saying that insider information in the commercial real estate industry, it’s really just referred to as “imperfect information,” and its use is prevalent. I often speak with investors about how commercial real estate is a highly inefficient market. And imperfect information is really just one example of those inefficiencies.

A story that illustrates the concept of imperfect information in commercial real estate transactions occurred for us at–towards the end of 2016. In this case, we had a sponsor that is based in the Bay Area, who brought us a 350,000 square foot office building located in San Jose. This sponsor had it under contract to purchase for $36 million. 

So for starters, $105 per square foot going in basis looked great, but what I would say that what made that deal immediately compelling was the fact that by talking the seller into letting the buyer, in this case, the sponsor start leasing that property, while it was under contract. This sponsor had been able to increase occupancy from 55% to 67% just by the time they approached us with the deal. 

If we think about that from a net operating income perspective, right? Because NOI is the key value driver of the value of commercial real estate. In this case, the NOI had increased from $2.1 million to $2.7 million during that contract period. Now, if we apply the assumed exit cap for this particular deal, which was 7.5%, that translated into an additional $8 million of what we would say is imputed asset value. 

So in essence, this was a $36 million transaction that was already arguably worth $44 million before we even closed on it. So we viewed that situation as a form of risk arbitrage because the sponsor had a contract to acquire the property below its current value. It’s almost equivalent to a situation in the stock market, when you’ve been given the option to buy call options below where they’re currently trading in the market. 

There’s definitely still risk, right? There’s still a risk that we have to acquire the property. We still have to execute the business plan, and we ultimately have to exit it, but there’s expected value going in. And so, in this case, we closed that deal with a sponsor in March of 2017. Within two years, that group was able to refinance the property, return 91% of originally invested equity to the investors, [and] still own the asset. 

And now, as we enter the fall of 2019, that sponsor is now looking to sell the asset, and at its current estimated value, investors might be looking at somewhere around double their money inside of three years, again, but we’ll find out when it actually occurs. So I would say that periodically, we find opportunities like this, where we see immediate value going in. And when we find them, we definitely jump on them. 

Preston Pysh  29:03  

So commercial real estate is a huge $15 trillion market that often goes under the radar because when you say real estate investing most people think [of] single family residence. Could you please outline the different value drivers behind both types of investments. 

Ian Formigle  29:20  

There are multiple common drivers for the underlying value of single family residences and commercial real estate, but there’s also one key differentiator. And so, I’ll describe both. Let’s begin with, with the commonalities. 

First, when we look [at] both types of real estate, I would say that we see five similar drivers, and those are in the form of one, population growth. Two, job growth. Three, supply growth. Four, replacement cost. And five, interest rates. 

All types of real estate no matter what they are are driven by the basic economic concept that when more people demand real estate in a given location, when they have more money to spend on it, when its supply is constrained, and when the cost to build it is increasing. Well, then demand is going to exceed supply and prices are going to increase. And that fifth component interest rates, well, those are going to fluctuate. 

Generally speaking, you will see inverse pressure on real estate prices with those fluctuations in interest rates. So while single family and commercial real estate might have similar drivers, there definitely is a key differentiator. And that differentiator gives commercial real estate a business model. And as we’ve discussed, that business model is the net operating income or NOI. 

I actually wrote a Forbes article about this concept. Exclusive to commercial real estate is the fact that much of its value is derived from its NOI, [which is] something that we’ve talked a lot about on the podcast so far. 

And just to reflect NOI, again, [it’s] what’s left over after deducting all operating expenses from a property’s total revenue. And because NOI is a major factor in determining the value of a commercial real estate asset, this means that its value can increase or decrease, regardless of what is occurring in the underlying market. That is simply just not the case for single family residential real estate. 

And so, this is what I mean by saying that commercial real estate has a business model. If you’re able to acquire commercial real estate assets and increase its NOI through things such as leasing or increasing rents, then you can earn a return. All else equal, regardless of the market. You don’t need to hope that that underlying market is moving in your favor.

Stig Brodersen  31:39  

Ian, we will definitely make sure to link to your Forbes article here in the show notes of this episode. We have previously talked about how finding the right investing strategy for you that fits with your personality and why that is so important. Now, for those of our listeners, they’re not too familiar with real estate investing, and I don’t know if you can make a strict distinction here, but could you talk about which type of investor that might be more suited for single family residence and which type of investor that would be better suited for commercial real estate?

Ian Formigle  32:11  

I’d be happy to. And I do think that owning single family rentals as an investment is markedly different than passive investing in commercial real estate. And in this case, I think I can actually offer a balanced perspective because I’ve done both over a period of multiple years and have had good experiences with each one. 

To begin, when thinking about single family rentals, there are a couple of key things to keep in mind. First, when you acquire a rental property, you typically place a mortgage on that property that has recourse to you, which means that you personally guarantee its repayment. This aspect of it is important because it means that you are potentially risking more than 100% of your equity investment in the worst case scenario. And this aspect of a single family rental is just one example of how you take an active role in its operation. 

Aside from mortgages, there’s things like property insurance, capital expenditures to manage, [and] leasing. The list is going to go on, and it is possible to outsource some of the day-to-day issues through third party management. But the cost of that for single [family housing] in the single family space is relatively high. And I will definitely say that that company will never care about the property like you do. 

Because of the nature of single family rentals, I often speak with investors about the idea of viewing them more as operating a small business than making an investment because that’s what it’s going to feel like a year into it. I used to own and manage a portfolio of single family rentals for years, and I felt that doing it well usually meant being actively involved. And for some investors, that’s perfect because those investors might be looking for a way to turn their own elbow grease into wealth. 

And if that’s the case, it is a great vehicle for doing so. However, I don’t really recommend them for an investor that is seeking a passive investment. So now, in contrast, let’s talk about commercial real estate investing, and where we begin there is to say that as an investment, I think it fits better into the perspective of diversifying an investment portfolio through exposure to alternative assets. 

With passive commercial real estate investing, you can more easily translate your opinion on things like markets and asset types into an investment thesis. Just think about the scenario of…as we saw the rise of Amazon 5, 7 years ago. If you believed in the rise of Amazon, then you could have made a calculated bet in a market like Seattle, and if you had, you would have been rewarded handsomely. 

With this approach, generally when you’re looking at commercial real estate deals, you get to select a professional investment manager, which is the operator or developer. And in some instances, these are companies that have acquired billions of dollars of commercial real estate in that same market. You evaluate the operator similarly to how you would evaluate a fund manager. 

Once you find one that you like, and the one that you like has a deal that you believe in. Well, now you can take a calculated risk. And by repeating this process and diversifying across multiple operators, and asset types, and geographies, you begin to generate greater returns in your portfolio that have less correlation within the portfolio to stocks and bonds as we discussed earlier, but you are taking a passive approach. 

So I think to wrap it up, I’d say that single family rentals and passive commercial real estate investing, they’re different, and selecting the right one for you, it really just boils down to your objectives. 

Preston Pysh  35:43  

So Ian, for almost all investors, our end goal is what we typically refer to as passive income. Many stock investors try to achieve this by investing in dividend stocks and rely on the dividends rather than capital gains to provide them with a smooth and perhaps even growing passive income. Is it possible to turn commercial real estate into passive income? 

Ian Formigle  36:05  

There is such a thing. I definitely think it is possible to achieve relatively, and I would say relatively, reasonably targeted passive returns through commercial real estate. So let’s walk through it. So in the beginning, in a yield starved world, I definitely do think that there’s ways to structure yield into real estate deals to generate consistent returns. And it’s going to especially occur when you combine credit tenants with long-term leases. 

If you have that scenario, real estate can begin to function much like a corporate bond. I’ll provide a recent example from our marketplace. We recently recapitalized the Nobu Restaurant in Washington, D.C. with the company, who redeveloped this building along with 59 luxury residential condos that were stacked above it. And so, rather than selling the commercial condo space that housed the restaurant along with the rest of the condos, the development group saw an opportunity to earn a stable long-term yield. In this case, we were able to collaborate with the developer to determine strike price, where investors are targeted to receive a 14% total annualized rate of return over a five-year hold, but with a 6% initial yield, and the possibility to grow that yield up to 10%, assuming that the restaurant’s sales grow, and its percentage rent kicks in. Percentage rent is sometimes structured into retail leases. 

And what that is, well, it’s essentially additional rent over and above the base rent that is tied to sales. So the keys to this deal were that the term of the Nobu lease is 20 years. The restaurant sits in a prime location in D.C.’s West End. Nobu has a strong balance sheet, and it doesn’t hurt that one of the co-founders of Nobu is Robert De Niro. 

So in this case, receiving a 6% initial yield that might grow to 10%, but we have to see how sales go at the restaurant location, while investing in a core Washington, D.C. location can offer a great way to earn a consistent, passive yield through commercial real estate.

Stig Brodersen  38:11  

And hey, you don’t mess with Robert De Niro, right? I mean, if that isn’t the truth…but Ian, that’s a great example of what you and CrowdStreet  are doing. Where can the audience learn more about you and CrowdStreet if they want to see some of these projects themselves?

Ian Formigle  38:29  

So to begin with, I’m easy to find on LinkedIn as I’m the only Ian Formigle. I always invite investors to ping me there and begin a conversation. It’s fairly obvious that I always love talking [about] real estate. And then otherwise, to learn more about CrowdStreet, well, check out our website. It is www.crowdstreet.com. There’s a lot of information there. There [are] articles that I’ve written. There [are] upcoming events. There’s a wealth of information there, and I invite investors to check it out.

Stig Brodersen  38:57  

Fantastic, and we will, of course, make sure to link to Ian [and] to link to CrowdStreet together with Ian’s article at Forbes that we talked about before. Ian, thank you so much for taking the time out of your busy schedule to speak with Preston and me here, today.

Ian Formigle  39:12  

Preston and Stig, it was my pleasure. I love coming on to this podcast. I love what you guys are doing. Keep up the great work.

Stig Brodersen  39:19  

Well, thank you. Thank you so much for your kind words. All right guys, that was all that Preston and I had for this week’s episode of The Investor’s Podcast. We see each other again next week.

Outro 39:29  

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