Stig Brodersen  1:28  

You’re definitely right, Ian, things are very, very different. I guess that’s a sentence that we tend to say a lot more these days. We have talked about how one of the strengths of having commercial real estate in your portfolio is how uncorrelated it is to other assets and external shocks to the market in general. 

I think that we used the example that it was more important with stores to open next door, rather than we see an escalation in the trade war with China, for instance. Let’s kick this interview off with this question: How has commercial real estate performed so far in 2020, given everything that has happened?

Ian Formigle  2:08  

Stig, you’re absolutely correct that we’ve previously talked about the importance of microeconomic drivers on commercial real estate values. I think what’s interesting right now is that we are currently experiencing how a pandemic affects commercial real estate value. The performance of the overall commercial real estate market in 2020 has really varied substantially by asset class. The performance of each asset class has strongly correlated to the effects of the pandemic so far. 

However, regardless of being a pandemic, the underlying common denominator here is demand; both current and perceived future demand. This concept goes back to some of our first conversations on commercial real estate. In that, the ultimate driver of value in real estate is demand relative to its supply. You just can’t get around that. 

Right now, the pandemic is exposing this concept once again. I’ll walk through major asset classes fairly quickly, in the order of what I call “worst to first”. To kick it off, the most affected asset class so far in the pandemic is hospitality. We’ve seen a precipitous drop in occupancy rates across the country. They hit as low as 22% nationwide in early April, and that pushed this asset class into a rapid state of distress all over the country. 

After hospitality, retail is next up. The worst-hit segments here are malls, followed by any type of retail that is experiential in nature, particularly those with a heavy food and beverage component. 

However, moving into the middle of retail, there are certain types that are faring relatively well right now. For example, if you own a power center anchored by Home Depot or Walmart, your shopping centers are doing pretty well. And then, you’ve got grocery-anchored centers. We’ve seen per square foot sale numbers for grocery stores instantly double. To me, that demonstrates that this type of retail is still important to our daily lives. 

After retail, office is next up. It’s probably going to see some distress in certain locations, particularly in downtown locations of major metros. Overall, it’s still too early to tell a lot about what office is going to do. The results may end up being spotty. There just haven’t been that many trades yet, but one indicator that you can look to is the publicly traded reads. Office reads are down a fair amount right now, so that at least tells you what the public market is thinking about this space right now. Overall, we’ll know a lot more about the office market by the end of the year. 

Moving on to more promising asset classes, multifamily is hanging in there surprisingly well right now. The National Multifamily Housing Council reports apartment collection data nationwide every month. For June, year-over-year collections were practically unchanged relative to 2019. On the transaction side, we’ve seen small price discounts this year for deals that have traded since March. I’d say anywhere from 2-8% lower than when we’d see that property trade pre-COVID. 

The big question right now looming out there for multifamily is what happens as the additional $600 per week of unemployment benefits burns off with, as of today, no new stimulus package in place. In June, the Aspen Institute published a study conducted by the COVID-19 Eviction Defense Project. It estimated that roughly 1 in 5 tenants in the United States is at risk of eviction by the end of September, absent another major stimulus, because of this possible disruption we might see later this year. 

We’ve been focusing on the higher quality properties that are less exposed to high unemployment rates. These are more of the properties that are more populated by people working at home, high-Class B, and Class A properties. 

If we can find a great multifamily property today in a great market, which would have been bid up last year, and yet we can get it at a discount this year, then we’re pretty interested in that deal. We’re pursuing ground-up multifamily deals in strong markets, thinking that if a deal delivers in late 2021 or 2022, we’re now past most of the distress associated directly with a pandemic. We will now have a property that will be the nicest and newest on the block with little new supply behind it for about a year. 

Finally moving on, certain asset types are as strong as ever, and their pricing reflects it. In a world where most of our content assumption is now being delivered. We’re seeing shallow bay, last-mile industrial properties see record demand. We are a little bit concerned with large Class A distribution centers that are near major ports, given the downtick in international trade, but generally speaking, industrial is doing great and its outlook is strong. 

As a final note, some additional niche asset classes are also doing well right now, such as needs-based medical offices, data centers, and manufactured housing. That sums up what we’re seeing out there per asset class.

Preston Pysh  7:37  

Ian, when we look at the recent rent collection numbers in contrast to the unemployment numbers, they haven’t been too bad to date, but depending on whether [or not] a lot of the government programs that are providing assistance could potentially change, and some people are saying that this is the calm before the storm. Without asking you whether we’re in a U or V-shaped recovery, what is your broad outlook for the rest of 2020? 

Ian Formigle  8:05  

Preston, I’ll definitely say I’m not a macroeconomist. I’m just a real estate person out there in the market trying to figure it out. I will say that from a macroeconomic perspective, I’m somewhat concerned about the rest of 2020, the next 12 to 18 months. To your point, I think we are in a recession. A recession has to run its course, and markets have to clear. Once we get to the backside of that, we can see growth. 

In this case, I do believe that the pandemic has already inflicted enough lasting damage. There’s more downside ahead before we can see the emergence of a meaningful recovery. As a lot of intelligent people out there point out, the consumer is 70% of our economy. I also have a thesis that until we see a vaccine or a treatment in place for COVID-19, we may end up stuck in what The Economist refers to as “the 90% economy.” 

Now, from a real estate investment perspective, this outlook has translated into us asking the same question repeatedly, which is: How will this deal make it to 2022? I think this market is looking at a trough within the next year or so. We’re hyper-focused on making sure existing portfolio assets and new assets that we bring to our marketplace are equipped to navigate choppy waters before entering the growth phase of this cycle, which will occur by 2022. 

Remember that in real estate, we’re investing for multiple years. It’s not just having the right idea, but building a business plan around that idea, which will ensure that you have enough runway to realize your vision. Overall, I think real estate will present some amazing investment opportunities over the next year, but you have to be well-positioned in the short term to realize outsized profits in the midterm.

Stig Brodersen  10:05  

Ian, you have this great resource on CrowdStreet. It’s called StreetBeats. You do weekly updates on commercial real estate. We will, of course, make sure to link to that in the show notes. What I’ve noticed going through these videos is that you’re talking a lot about metrics that you’re paying close attention to. 

Examples would be consumer confidence, job reports, and rent collection. Those are just to name a few. For someone like me, who is not an experienced commercial real estate investor, how do I process all of that information out there, when evaluating the current situation and the recovery?

Ian Formigle  10:44  

The debt markets are critical to the function of the commercial real estate market because unless you’re a major institutional investor without a loan on a property, you just can’t buy it. We tend to see a high correlation between how many lenders are in the market making loans and how many deals are actually transacting. 

Transaction levels are critical to market visibility as we rely upon those most recent trades to tell us what’s happening to valuations right now, and to give us a stock market analogy. Imagine a stock market where 80% of the volume just disappeared overnight, it’d be pretty difficult to have any conviction as to where values are heading. In May, that’s what it was in the commercial real estate market. That’s why we’re just out there trying to gather up as much data as we can, and synthesize it in hopes of making better-informed decisions. 

To answer your question, for investors who want to process that information, I’d say pay attention to the trends. For example, one statistic I cite in my video series each week is the ending occupancy data for hotels provided by STR. This is the nation’s leading hotel research group. From the beginning of April until the end of June, in this hotel market, for example, we saw 12 weeks of successive increases in national hotel occupancy from a low of 22% back up to roughly 46% today. That kind of a balance over a 3-month period tells me that the hotel industry is now in the early phase of a protracted recovery. 

However, a 46% weekly occupancy rate is still really low. From a historical perspective, it also tells me that the market is still weak, and that any new hotel investments we contemplate must be capitalized with a large number of operating reserves to help see it through to 2022 as I mentioned a few minutes earlier. That’s the point where we expect better demand for hotels. Just like any market, we’re using data in the commercial real estate market to try to help us make better investment decisions as we navigate the pandemic.

Preston Pysh  13:01  

Ian, I know you’ve been through quite a few boom-and-bust cycles through the years. I’m curious whether you’ve made any changes to your portfolio here in 2020 or made any drastic updates to the way that you look at the markets.

Ian Formigle  13:17  

My existing portfolio consists largely of illiquid investments. Some of my existing investments are doing somewhere between okay and well. I’m probably just waiting until the other side of this cycle [ends] and seeing where we can go from here. I would say that the number one biggest change that I have discretion over in my portfolio is that I have increased my cash position relative to 2019, and that’s because real estate does move in multi-year cycles. 

Now that we are entering a down cycle, I’m looking forward to the opportunity to potentially invest in distressed assets over the course of the next year or so, with hopes to realize profits on those investments within a 3 to 5-year holding period. I’m still 20 plus years away from my retirement, maybe more. That means that I’m comfortable taking additional risks and prioritizing total return over cash flow. That’s just my situation. The investing environment over the next 12 to 18 months should provide opportunities to invest opportunistically. To the extent they appear, I do plan to invest in a handful of them.

Stig Brodersen  14:28  

It’s a very interesting response, and I also think it tells people something about the advantages of being such an illiquid type of investment. You guard yourself against your own biases. Here on the show, where we talk a lot about stock investing, we just know from our listeners that a lot of them have been selling out, when they were at the very bottom, because it just looked so brutal. It just looked like it was just never going to stop, so I really liked your take on that. 

For the next question, I just want to preface that we are recording here on the 22nd of July, and you’ll be listening to this 8th of August. Right now, there are some talks about a new fiscal stimulus. We don’t know exactly how it’s going to pan out. What we can say so far is that fiscal stimulus has been supporting the market very strongly for many types of real estate investments. Which type of fiscal stimulus do you look for in the time to come and why?

Ian Formigle  15:21  

So far through the pandemic, we have seen sponsors of CrowdStreet portfolio assets benefit from three types of fiscal stimulus. Two of them have been direct, and one of them has been indirect. You’re correct that fiscal stimulus has been a huge beneficiary to commercial real estate assets all over the country. 

To dig into that, the first form of direct support that we’ve seen occur already had been Economic Injury Disaster Loans (EIDL). Those are the EIDL loans. They’re made from the SBA. The maximum loan size of this program is $2 million. They have a 3.75% interest rate for companies, and they amortize over 30 years. You also get one year of deferral and interest payments, and that’s huge right now. We have seen hotels in our portfolio receive these loans up to the maximum amount. 

The second form of direct support has been funds received from the Paycheck Protection Program (PPP). The PPP that we’ve all talked about and heard a lot about. From what we saw, hotels and senior housing facilities were the 2 largest recipients of this form of support, and these loans provided a critical lifeline for some of these properties. They were used to retain property-level employees during the first three months of the pandemic. Based on that, we expect them to be substantially or fully forgiven in the months ahead. 

The third form has been an indirect form of support. As we talked about a minute ago, that’s coming from that $600 per week of additional unemployment benefits. We believe this form of stimulus has been propping up multifamily collections at the lower end of the spectrum. In the industry, we refer to these as lower Class B or Class C properties. Class C properties tend to be more highly occupied by lower-earning, service-oriented workers, and as we all know, this is the type of employment that’s been hardest hit during the pandemic. 

To answer your question on looking ahead, I see 2 primary types of fiscal stimulus that are having the largest impact. The first, assuming this happens before August 7th, would be a second fiscal stimulus that would extend these outsize unemployment benefits and perhaps a second check directly to individuals. That’s going to benefit almost all forms of commercial real estate, but as I mentioned, I think most notably the Class B and Class C multifamily stands to benefit the most. 

Personally, I’m concerned about a potential huge drop-off in multifamily collections for these types of properties if we don’t see that second package passed in Congress over the next couple weeks. Second, we finally start to see the effects of the $600 billion Main Street Lending Program later this year. Remember that the Fed announced this program in April, but we’re just starting to see it actually hit the street. It’s been slow to come out, but I do think it will ultimately start making a difference later in 2020. 

I’m a little bit optimistic there. I’d say that overall, there’s no doubt that $3 trillion of stimulus has gone a long way to bridge our economy, but I think we’re going to need more stimulus to see it through. Without that second package, I do fear for what Q4 might look like. We’re all crossing our fingers that it’s going to get done.

Preston Pysh  18:56  

Ian, due to COVID-19, those who have been able to work from home, they’ve done so. Even after a 4 reopenings, some will continue to work from home and others might only go back to the office a few days a week. Has this changed the office space investment thesis for commercial real estate investors?

Ian Formigle  19:13  

I think it’s changed some things in some ways. Some may be short term, and some may be long term. Overall, when I think about the office right now, I do find it fascinating to study. Right now, the pandemic is affecting our lives so much every day, [especially] when it comes to the office space, as we all continue to work from our homes. And so, we’re thinking about it every day, yet at the same time, we don’t know what it’s going to look like 2 years from now. 

There are so many thoughts and ideas out there as to the future state of office. A lot of them tend to conflict with each other, yet most of them make sense. That tells me that we have a long way to go to gain some clarity on what the future of office is really going to look like. 

Regarding my office thesis, I published an article on Forbes earlier this year. It was called, “Three Predictions for the Post-Pandemic Office.” In that article, I highlighted changes that I already see coming to the sector, as well as changes that I expect to see in the years ahead. It all boils down to essentially a mixed bag of effect[s] on net demand. 

The first thing is that we’re retooling spaces across the country right now with significantly more allotted space per employee. We’re already seeing this, and we’re a living example of it. My company is doing this as well. To me, space is the new amenity. I think that companies are going to use increased space to recruit employees as we roll out of the pandemic. This is going to take precedent over these formerly important social amenities, such as free food and ping pong tables and things like that. I think they’re going to fade in the background for a while, but space is going to be the new thing. 

Increased space as a trend is important because it’s reversing a nearly 20-year trend that we saw take place since the beginning of the century. We saw office space drop from roughly 250 square feet per employee, all the way down to just over 100 square feet per employee in those most densely clustered open office settings. That 100 to 125 square feet per employee office, it’s gone right now. We honestly don’t know when [it’s going to return], or even if it’s going to return. 

When we look at office space, I think it’s interesting to see how Cushman & Wakefield has already created a prototype for the post COVID office in its Amsterdam location, and they’re calling it the “6 Feet Office.” One item of note that I found particularly interesting, when I was studying that 6 Feet Office, is that in one part of the office, in an area that previously had 28 desks, it now has 16. That translates into a 43% reduction in density. 

Now, I don’t think that means we’re going to necessarily see a 43% increase in office space demand nationwide. However, I think it’s fair to say that our new-distance office environments are going to create demand for more space per employee for the foreseeable future. 

The second thing that I see is that while we will see office spaces spread out, we will also see reductions in office space demand in 2 forms. The first of which is that office tenants are simply not looking to expand right now, since they aren’t even fully utilizing their current space because everyone’s at home. We’re going to see office demand also just lag relatively year-over-year because we’re in a recession, and we’re not hiring like we used to. I think this is going to continue to be a drag on demand if the unemployment rate remains high, and we have a protracted recession. 

As you noted, Preston, there’s little doubt that we’re going to see a greater percentage of our workforce remain working remotely after we exit the pandemic, [especially] with companies like Twitter announcing that all employees are free to remain working remotely indefinitely. You have Morgan Stanley CEO, James Gorman, going on record to say that his company could operate with much less real estate. It’s clear to me that we are at the beginning of a trend that we’ll see more people working remotely indefinitely. This is going to have a drag on demand for office space. 

The third trend that I see emerging is shifts in the location of office demand. For example, if you’re a company officing in a high-price tower in a central business district, and now you need to roughly double the allotment of space per employee. Even with that offset of some remote workers, your existing space no longer pencils. As companies grapple with office occupancy costs, particularly in our highest price markets, I see 2 things happening. 

The first thing I see happening is that office tenants will relocate a portion of their employees from higher-cost to lower-cost metros. For example, if a company was thinking of opening a second office in Austin, rather than growing its HQ in San Francisco. I think the pandemic may have just pushed that decision past the tipping point. Considering that Austin office rents are less than half of those in San Francisco. 

The other thing that I see occurring is a resurgence in demand for suburban office space. This has already started to occur so far in 2020. We can even trace it back to 2019. For example, in 2019, 69% of Class A net absorption occurred in the suburbs, and that was up substantially over its 10-year average of 60%. 

When you think about it, the suburban office offers a lot of things right now that are compelling to workers who are uncomfortable entering an office right now, such as it’s plentiful, nationwide vacancies, about 2% higher than downtown locations. It has free parking. It’s usually low-rise, which lets you use the stairs, rather than crowd into elevators. They’re typically closer to employees’ homes, so that offers an easier commute. But most importantly, it’s a lot cheaper. 38% cheaper nationwide at the Class A level. 

Moving forward, I think we see large companies with a downtown HQ at a suburban satellite office. As I mentioned a second ago, this is a trend that we are already seeing. Seeing some major users in the largest metros reach out to brokers and start to look for 50,000 to 100,000 square feet of suburban office, when they occupy roughly a million square feet in the city core. To sum it all up, I know there’s a lot to unpack there, but there are definitely changes coming to our office environment over the next year or so. Some of those changes are going to continue to play out throughout this cycle.

Stig Brodersen  26:14  

Ian, on the show, we previously talked about retail, and retail has been struggling for quite some time going into the pandemic. Now, looking at the pandemic today, it has hurt most businesses. Brick and mortar retail businesses have been in a world of pain. You mentioned malls before as an example. Now, as a value investor, I just can’t help but think that this might also be an opportunity. Is there an opportunity in retail right now, because it is so much unloved?

Ian Formigle  26:49  

I do think there’s some opportunity out there for retail. But to begin, it’s fair to say, as we mentioned about a minute ago, retail has taken the second-largest hit so far during the pandemic. It’s also fair to characterize the space overall as having a relatively tough road ahead of it. I even had a value-oriented thesis around retail coming into 2020, but certain aspects of it I don’t think are valid anymore. 

However, it’s not all doom and gloom out there in retail. I do think that there is an opportunity. The area that I see the most opportunity right now is in that grocery-anchored shopping center. As I mentioned a few minutes ago, we have seen store sales roughly double at grocery store anchors during the pandemic. 

The rate at which they doubled is just mind-boggling. We just haven’t seen that kind of activity in retail before. It tells you that the space isn’t dead. What that translates to is that we now have the percentage of our food consumption that we currently purchase at grocery stores is back up to the mid 60% range. That’s a level that we haven’t seen since the mid-1990s. 

Knowing that we’re probably going to see some regression towards the mean as we exit the pandemic, I do expect grocery store sales to remain strong for several years. What that translates to right now is that whenever we see a grocery-anchored center at a compelling price, with a set of inline tenants that we think and mostly survive, we’re interested because the price on that center is getting very low. 

An example of this is that we did just have our first post-COVID grocery-anchored shopping center in our marketplace recently. It was located in Salt Lake City. It’s anchored by Lucky, which for this center means it’s Albertsons’ credit. It was priced at $93 a square foot. It’s really far below replacement cost. It’s even below other Western U.S. trades that we saw for Lucky anchored shopping centers in recent years, which had traded probably closer to more like $200 per square foot over that time period. 

In an environment where you know that nobody is going to build a competing shopping center, they just really aren’t building retail anymore across the country, and yet you still have strong car traffic in front of you. In this example, it was 66,000 cars per day, which is good for a grocery-anchored shopping center. If you can buy that for under $100 per square foot that’s pretty compelling in my opinion. So, we would look for more opportunities similar to that moving forward.

Stig Brodersen  29:22  

Ian, another thing that I wanted to follow up on is our conversation about finding value in the megatrend of the rising popularity of 18-hour cities. Which impact do you expect COVID-19 to have on this trend, and do you see mispricing in the market that just hasn’t been captured yet?

Ian Formigle  29:43  

I think anyone who’s listened to one of our previous conversations knows that I am a huge fan of the 18-hour city trend around the country. As we study it in 2020, I think the main effect that we’re seeing so far during the pandemic is just simply an acceleration of it. It’s been fascinating. Right now, you’re seeing a spike in population migration out of some of the largest metros, and it’s going to those secondary 18-hour markets. 

It’s going to tertiary markets, as well. It’s doing so, because you have with this pandemic hitting some of the largest cities the hardest, with some of the employers in those metros now offering workers the flexibility to work remotely on an indefinite basis. You’re definitely seeing people take advantage of that situation and relocate to cheaper metros that still offer a good quality of life. 

For example, Marcus & Millichap recently published a migration trend study on this topic, a little over a month ago. We’re studying that, and we’re even seeing regional effects of this trend. For example, I think we’re seeing some East Coast behavior and West Coast behavior. On the East Coast, people are leaving New York City right now. I do think that’s a short-term trend. I do think that 9/11 and the Great Recession prove that New York is a resilient market, so it will be amazingly popular again. 

But for today, people are leaving and they’re leaving for places such as Florida, and other places like Charlotte. So, a lot of markets in Florida, as well as Charlotte and Nashville. 

Now, over on the West Coast, you’re seeing population migration flow out of California, particularly concentrated in the Bay Area and L.A. Again, those workers that can start to have flexibility in where they work are continuing to relocate to Texas. This is a trend that’s been going on for multiple years, particularly Austin. At the same time, we’re seeing them leave to smaller metros, such as Boise and Salt Lake City. 

Green Street Advisors also recently published a report on this trend, and it discussed the cities that it sees as best positioned to thrive post-pandemic. Its top 5 cities were Raleigh-Durham, Denver, Charlotte, Austin, and Phoenix. 

When we think about mispricing in this market, we’re definitely taking advantage of the current market opportunities to invest in deals, and to either acquire assets or develop assets in locations we like the most. Those include Austin, Charlotte, and Nashville, in addition to pretty much most of the other cities that are listed in these studies from Green Street and Marcus & Millichap. 

We’re seeing discounts relative to those prices. I’d say the total swing right now is about 10%, so we would see a roughly 5% downtick in pricing this year over what would have likely been a 5% uptick in 2020 with no pandemic. 

It’s not a major shift, but it’s giving us access to get into great assets and great locations at a discounted price. Anytime we can see that kind of opportunity, we’re definitely interested. The last thing that’s worth pointing out is that in 2020 in a recessionary environment, a way to get a good deal in commercial real estate price is one way, but the other way is the structure of the deal. 

We are now in a market where equity is harder to obtain relative to what it was a year ago. That means that investors can receive more advantageous splits on profits, as well as preferred returns in private equity deals. Online capital, which is our segment, is fluid and dynamic. We’re seeing developers and operators come in motivated to [incentivize] investors with attractive terms to raise the capital that they need. 

Overall, I’m excited to see that CrowdStreet’s secondary market thesis is gaining more momentum in 2020, because we’ve spent the last 6 years positioning ourselves to obtain the best deal flow in these markets. Right now, it feels pretty good to be in that position, and we’re seeing some great deal flow as a result.

Stig Brodersen  33:45  

Let’s talk about the resurgence of the commercial mortgage-backed securities market. The underlying loans are securitized loans for properties such as apartment buildings and complexes, factories, hotels, office buildings, and many of these other types of commercial real estate. They also diversified the amounts and terms too. Could you please talk to our audience about why the commercial mortgage-backed securities market is so important for us as investors to understand, and whether [or not] you see any bad debt hidden?

Ian Formigle  34:19  

CMBS plays an important role in debt issuance in commercial real estate. It’s relatively important also for all asset classes other than multifamily. When you back out multifamily, and the reason that you would back out multifamily is that agency debt namely, Fannie Mae and Freddie Mac, they dominate that space. 

CMBS does lend in the multifamily space, but it’s an outlier source of capital. It’s important for all other asset classes, and it accounts for about 23% of all commercial real estate debt, absent multifamily, that was issued last year. It doesn’t make up the lion’s share, but it’s meaningful. 

I’d say that the reason that I pay attention to the CMBS markets is that for me, they can serve as what I would refer to as a canary in the coal mine for the greater commercial real estate market. They do so for a few reasons. The first reason is that they are typically placed on riskier assets. 

This is a type of debt that you can have a property with some vacancy or some transition that needs to occur, and CMBS execution is something that you can get. What that tells me is that it is oftentimes the first type of debt to show signs of weakness, when the market turns. We’re seeing this right now. 

For example, CMBS delinquency rates are skyrocketing today on hospitality and retail loans. For June, delinquencies are now up to about 25% and 20% respectively, when both of those asset classes had sub 5% delinquency rates as recently as March. 

Since other forms of debt as I talked about the agency, and also bank debt, they haven’t shown a real spike in delinquency rates yet. To me, that exemplifies how CMBS can be a leading indicator for future distress in a commercial real estate market. 

Now, when we think about the bad hidden debt that’s out there, I do think it’s reasonable to estimate that we will see some of that emerge in the hotel and retail sectors later this year. It’s also important to note that even within CMBS, industrial, office, and multifamily delinquencies, they are still sub 5% as of June. 

It’s also highlighting that we have a disparity going on right now in terms of performance across the different asset classes as we discussed earlier in the conversation. I think that this disparity also highlights a key difference between our current recession and the 2008 recession. And that this recession so far has been about how this pandemic crisis affects real estate, specifically. 2008 was all about how a financial crisis affects real estate. 

Now, we may still see a bit of a financial crisis ensue before this current recession is over. However, I do think that our current recession will continue to play out differently than the last one. I think it’s wise for investors to look at it from, “This is not 2008. This is 2020,” and to pay attention to those differences. 

Another thing that I do, when I look at CMBS, is when it dries up quickly as it did in March, you know that transaction volume is going to drop. And then, that means that a market is going to cease to function normally. 

So on top of that, when we have these markets that stop ceasing to function normally, and you have CMBS issuance rates that drop precipitously as they just went to 0 in March and April, that activity in the CMBS market acts as a general psychological indicator out there. What that means is that all market participants start to get skittish about everything. It’s an important bellwether just to pay attention to in terms of what’s going on out there. 

What’s interesting is that when it’s sidelined, but then it starts to come back as it’s starting to come back right now, it becomes a leading indicator for a potential return to a better functioning market. This doesn’t necessarily mean that prices are going to immediately rise. What it tells me is that when a market starts to function more normally, you have a better opportunity for markets to clear. 

This again will create a bit of a psychological indicator out there. It will start to get all participants in that market a little more comfortable about resuming doing deals, so there’s a lot to look at when we think about the CMBS market. It’s certainly worth paying attention to, and that’s why industry professionals do so every day.

Preston Pysh  38:46  

Ian, I’m pretty sure everybody has some form of availability bias focusing too much on recent information and has a hard time zooming out, looking at investments from a helicopter perspective. As we’re sitting here in the middle of COVID-19, is there any part of commercial real estate that has fundamentally changed, or will this be business as usual in a few years?

Ian Formigle  39:11  

To begin with, Preston, I completely agree that as a society, we tend to overemphasize the effects of short-term trends. Personally, I’m always skeptical of any argument that uses the short-term trend extrapolation approach. To me, that’s a methodology for making massive miscalculations a few years out. 

I say that despite some of the temptation to get caught up in these emotional swings. I try to always take a step back, and I look at situations like our current one in 2 ways. First, I identify short-term trends that look like simple knee-jerk reactions, and then I like to play them counter-cyclically when given the opportunity. 

Second, I also seek to identify short-term trends, but those that play into strong underlying demographics. When you see that, those are the ones to run with. 

Let’s give some examples of that. We can begin with the knee-jerk reaction. For example, there’s a lot of people out there that are calling for an absolute end to the downtown central business district office with the focal point of this thesis centered on Manhattan. I can certainly agree that there’s short-term pain coming to the Manhattan office space, but if we were to see prices drop precipitously there, I’ll become a buyer.

 As I mentioned before, I think New York has repeatedly demonstrated resilience over the long run. I think it will do it again. If we saw a massive drop in New York office prices, then I want to opportunistically buy. 

Now, also remember, there’s another important reason why sometimes we can see this knee-jerk reaction translate into future opportunities. For real estate, lower asset values create the ability for new buyers to come in, purchase those properties, and then profitably operate them at lower rents. Sometimes there’s just nothing better than a basis reset to reinvigorate a market. Anytime we can look at a scenario and say we like that market long-term, we like the opportunity to go in and buy it on a low basis and essentially outcompete all the higher basis competition. It’s a good way to make money over 3 or 4 years. 

Now, let’s talk about a short-term trend that plays into an underlying demographic movement. An example of this movement that I see happening is towards a form of residential housing called “build-to-rent.” These are essentially purpose-built, small single-family communities, but they have the amenities of a multifamily complex. Imagine small bungalows. All clustered in a single community, but they have a clubhouse. They have a pool. They have a fitness center, and they are 100% for rent. In this case, I see the pandemic as a driver of a short-term trend towards this type of housing, because right now people are opting out of downtown living to feel safe. It just makes sense. 

However, when we look at the demographics of the millennial generation, who are now on average about 30 years old, and they’re a cohort that is looking to absorb this type of housing. Keep in mind that many of them now are in relationships. Some of them have dogs, and almost all of them are saddled with student debt. 

Now, we have a short-term trend, but one that is driving a shift in behavior in the direction of strong underlying demographic fundamentals. In this case, I see this trend as potentially sticking due to the fact that I think this will play greater and greater into the ongoing demographic shift of the millennial generation, who will increasingly see this form of housing as an alternative to mid-rise and high-rise downtown multifamily.

Stig Brodersen  42:55  

Let’s talk about timing the market. I do apologize to you, Ian. I can’t help myself whenever I talk about timing the market, because every time we talk about it, we talk about our crystal balls and how they’ve always been broken. Timing the market is definitely hard. Having said that, there’s also a difference between the volatile stock market, and then something like commercial real estate that you also mentioned here. The cycles are just different. There’s different volatility there. 

Going back in history, what we’ve seen in previous crises, again, not to make too many comparisons, is that for single-family homes in the previous crisis, many of the best deals have come after say, 12 months or later. This is because people will typically do everything they can to keep their homes, and even if they try selling, they have a pre-crisis reservation price, which just takes time to come down. 

Even instant foreclosures, that’s a lengthy process, too. That’s something that might be a bit more familiar for the audience because they do see the “For Sale” sign, whenever they’re driving around. However, transitioning into commercial real estate and keeping in mind what you have seen historically, would it be better to wait with your cash on the sideline before you invest in commercial real estate right now?

Ian Formigle  44:15  

When we think about the commercial real estate market, just like any market, I think it’s impossible to time it. Right now, all we know is that the previous cycle just ended. We’re going into a down part of the cycle. We know that a trough is out there at some point, and then we know recovery at some point after that. But to think that I can figure out when that’s going to occur and try to load up at the bottom, then I can probably say that, for me, that’s a fool’s errand. 

Rather [than time the market], what I’m going to do is I’m going to just simply look to layer into opportunities that look attractive relative to the previous peak at the time when I have that opportunity. Also, keep in mind that commercial real estate is a really inefficient market, and that not all assets are going to trade all the time. You may have a one and only opportunity to invest in a specific asset during this part of the cycle. The next time it trades, it may be 5 or 6 years from now in an entirely different part of the cycle. 

It’s interesting that you mentioned the single-family residential market, because the commercial real estate market can really behave differently than the single-family market for a number of reasons. The first reason that I see as a difference is debt maturity. One of our first conversations on this show, we discussed how perhaps one of the worst positions to find yourself in is with a real estate investment asset that is at the point of debt maturity during the trough of a market. 

Now, remember, the single-family market, we all have these 30-year amortizing loans, and people are going to make decisions to either buy or sell or continue to pay based upon their own ability to pay or if they move or so forth. 

In commercial real estate, it’s different. We have these shorter term loans that mature, and if you mature during the trough, then that’s when you’re most exposed. This means that some of the best deals will be timed actually to their debt maturities as they occur over the next year or two, rather than a particular point in time where an owner throws in the towel. I think debt maturity is just something really important to look at, and that’s going to create certain types of opportunities. 

Another thing to look at is that during periods of distress, institutional owners can become fatigued, or they can also determine that an asset is simply no longer a core part of their business strategy. If this occurs, they tend to shed that asset, and they get aggressive on price in order to liquidate it quickly. This was the case for a distressed hotel acquisition that we participated in earlier this year that’s located in the Baltimore Inner Harbor.

I think the third thing to look at is the nature of this downturn, [which] has vastly different effects so far on these different asset classes. I think this is going to translate to the “best deals” for some of the asset classes, such as hospitality and retail to emerge earlier. 

While other sectors such as office, they may take more time to materialize. From that perspective, you want to pay attention to when the opportunities present themselves. Again, I fall back on the “if-the-deal-looks-compelling-today” relative to “what-it-looked-like-yesterday.” That’s when you don’t want to take a hard look at it, knowing that this may be the one and only time to look at that type of opportunity before it changes and goes away. 

When you put that all together, I think this means that as buyers, we tend to be rewarded if we pay constant attention and acknowledge that there’s no one magic moment during the downturn to load up on all your investments. Instead, [we should] continue to pay attention, and then jump on compelling opportunities as they arise. I think if we do that, we’re setting ourselves up to profit in the growth part of this next cycle.

Stig Brodersen  48:01  

I think that’s a great segue into the last question here. With everything we’ve talked about in this episode, Ian, what are the main key takeaways for the listener, whenever they consider if they should be jumping into the commercial real estate market for the first time or perhaps adding to a position that they already built?

Ian Formigle  48:21  

There are so many takeaways from today, but I think I’ll leave you with four and hit the highlights of these. Number one, our last cycle just ended in February. As we study multiple real estate cycles, those data suggest that the next 12 to 18 months should bring us some of the best opportunities that we’ve seen to invest in commercial real estate since the last recession. I think the opportunity is coming, but we have to layer into it. We have to be a little patient. 

Number two, I’d say is that this recession is already demonstrating strong signs that it’s going to be different than the last recession. Some types of assets and deals, they’re going to become more distressed and discounted than even in 2009. Hotel is a good example of that right now. However, others such as industrial [real estate], they probably don’t become distressed at all. They just continue to appreciate. If you wait to see distress in the best performing asset classes in this downturn, then I think you missed this trough altogether. I just don’t think you can have it all. You’re going to have to pick your spots. 

Third, when you do look at distressed deals, really look at the discount to replacement cost. Distressed assets can be nearly impossible to reliably forecast. It’s just so hard when you’re looking at a vacant hotel right now and asking, “When does it get back to its normal occupancy level?”

Back in my private equity real estate days, when we invested in 2009 and 2010, we had a methodology where we would just stare into the abyss and make a gut call that if the world returned to a normal state one day, and if we bought this asset at a current price that was offered to us, and that would be compelling in a normal world, then we would make that call. And then, we would pair it with a strategy of looking at good assets in good locations. We’d make assumptions, but we would know that those assumptions were almost surely going to be wrong. And then, we took a risk. When we did it during 2009 and 2010, we were rewarded with double and triple our equity within a few years. 

Fourth and finally, the most frustrating thing in time like right now is to have the right idea, but the wrong execution. When we invest passively, my recommendation is to pay attention to the strength of the sponsorship and make sure that the deal that you’re investigating has enough runway to get to the other side of the pandemic. 

As I mentioned right now, when we look at opportunities today in the marketplace, we’re looking at the beginning of opportunity around 2022. However, if we’re only going to get the opportunity to purchase it either today, later this year or early next year, then we just simply need to have enough money in the deal to get us there. Remember that we’re trying to earn profits from 2023 to 2025, and simply not get washed out before 2022. So I think in essence, if you do those four things, you’re ahead of the game. 

Preston Pysh  51:30  

Ian, thank you so much for this outstanding discussion today. I thoroughly enjoyed it. I know every time you come on the show, I just learn so much. If the audience wants to learn more about you, where should they check you out?

Ian Formigle  51:42  

Stig and Preston, as I always point out in each of our interviews, I’m very easy to find on LinkedIn as I’m the only Ian Famigle on that platform. People can feel free to connect with me there. As you can tell, I always love to talk about real estate and I’m always happy to engage in conversations that help investors make better real estate investment decisions. 

For those who want to study real estate investing in more depth, I also got a book on Amazon. You can find it there. Some people have read it and said it’s helpful. It’s a relatively quick read. 

Finally, there’s always a ton of great content on the CrowdStreet website, so that’s www.crowdstreet.com. Feel free to log in there. Lots of great information that our team puts out on almost a daily basis. It’s a great resource for anybody who wants to learn more.

Preston Pysh 52:33 

All right, Ian, thanks again for making time and coming on the show. That’s all we had for everybody today. We look forward to seeing everybody again next week. Everyone, have a safe and healthy week ahead.

Outro  52:46  

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