Replay: The Wide World Of Passive Real Estate Investing

This is the Invest Like a Billionaire podcast, where we uncover the alternative investments and strategies that billionaires use to grow wealth. The tools and tactics you'll learn from this podcast will make you a better investor and help you build legacy wealth. Join us as we dive into the world of alternative investments, uncover strategies of the ultra-wealthy, discuss economics, and and interview successful investors. Welcome to the Invest Like a Billionaire podcast. We're really excited you're joining us today. We've got a fun episode. I'm your co-host Ben Fraser, and I'm joined by co-hosts Jim Fuccio and Bob Fraser. And we've got a really exciting topic today, which is passive real estate investing. So this is a huge, a huge topic. And, you know, some of our listeners may be familiar with some different ways to invest in real estate. And we really want to just break this down and kind of help create the framework for the ways that you can invest in real estate passively, not just in the public markets through REITs, but directly into these types of investments. And just take a quick step back. So again, the whole concept of this podcast is Invest Like a Billionaire. And what we want to do is learn from the ultra-wealthy, you know, the ones that have been very successful in investing, and what are the strategies that they're using, what types of investments are they making, and what can we do as retail investors, to use that term, to emulate the best practices, and how can we make our portfolios look more like theirs? And so we have this thing called the investing, Alternative Investing Continuum, and, you know, most retail investors are in the 60/40, portfolio, right? 60% bonds.

Yeah. Stock, stocks and bonds.

40% bonds.

And zero alts.

Zero alts.

And that's the big difference with the ultra-wealthy. They're 40% to 60% into alternative investments. So, we're going to look at this. And so, we have this framework called our alternative investment continuum. And on that, there's really 4 different areas. So, this is where we're going to be looking today at kind of just building a framework for real estate alternatives, which have some huge advantages over other kinds of traditional investing. So, we're going to dive in what they are, when they work, and when you should look out.

Absolutely. And just real quick recap, the big 3 of the alternative asset classes we're going to be looking at in this podcast are real estate, venture capital and private equity, and hedge funds. And of those 3, real estate is the biggest by far and the one that— Ultra-wealthy investors are allocating to as a much larger percentage of their portfolios overall. So, it's something that we want to spend a lot of time on. It's so big. It's almost hard to do this in one podcast, but we're going to attempt it. And really, just the whole goal here is to create a framework that will help our listeners, help you guys understand this world a little bit better so you can make better decisions. We're going to discuss pros and cons, different strategies. that investors use in different structures and really how to evaluate different opportunities. And the cool thing is throughout this podcast, we're going to be interviewing a lot of experts that are really deep in specific areas of real estate, so that we can really learn from them and, dive really deep. But that's not today. We're going really high level. And I'm really excited because Jim, he is a longtime real estate investor. So you want to share a little bit of your background? I think it's just really cool and ties in a lot to what we're talking about today.

Yeah, so I, you know, really got started and I had a first career as an engineer working in the corporate world, and for that lasted about 5 and a half years. And I got the bug, I got the real estate bug, and really was mentored by a guy initially who wrote a book, like actual written book, you know, not an ebook, on syndicating real estate. And I was fascinated by it because this guy would put together people's money and he'd go and buy or build an apartment building and And so, you know, he kind of taught me, started teaching me that. So then I got involved in small residential infill development projects in Southern California, which is a train wreck as a small player in a bit, in a big, very small fish in a very big pond. But so yeah, and I've been in and out of just about every kind of real estate, especially in the residential sector. I haven't done as much in the commercial, but I've, I've watched people, investors, you know, make really good money and, you know, be closer to the investment. You know, it's real estate. It's actually, you know, so it's been, it's been fun. It's been a fun 3 decades of—

And then probably 10 or 12 years ago, moved to the debt side of residential, which is when you guys started Aspen Funds, which, you know, we invest in residential mortgages, both performing and non-performing. And we'll explore that in another podcast, which it's a really cool asset class, but You've kind of been all over the spectrum of, you know, development to the built homes, tore down homes, rehabbed homes, lost homes, found homes, just about everything you can do in real estate.

So yeah.

Yeah. Awesome. Well, we're going to jump right in. So kind of before we kind of dive into strategies and types of investing, you know, the two broad categories that we generally see are residential and commercial real estate. These are two very different types of categories in real estate. And residential is pretty self-explanatory. These are either renters or homeowners and single-family properties. And there's a lot of them, but there's not as many ways to invest in them. So there's really a few strategies. One would be rentals, long-term rentals, short-term rentals like Airbnbs. And like what we do on the debt side. So there's hard money lending, there's distressed mortgages and other things in that kind of vein. But the really interesting thing there, in contrast to commercial, is it's driven mostly by comparable values, right? So commercial is driven a lot by the income it generates, right, as a function of the cap rate.

The commercial is treated like a business. The residential is much, much different. So they actually respond very different to market dynamics, respond very different to interest rate dynamics, etc. So they're very different asset classes, even though you would think they would be very related. They're highly uncorrelated.

Yeah. And one of the big macro trends we've been looking at more specifically in residential real estate, that's kind of the area we're in. And Bob Fraser, you know, kind of a side economist, hobby economist, you want to call it that, but has had a great track record and tracks a lot of these trends in real estate. And you wanna talk a little bit about just some, what we're seeing in the residential side of things. It's just been a fascinating time and everyone is concerned and worried about, oh, it's the next bubble. You know, prices are at all-time highs again and it feels, you know, are we outside of normal valuations?

Yeah, we're gonna dive into that, you know, in a different podcast. But we've been bullish and calling for gains in residential markets since 2013.

Yeah.

And in the last— since 2018 have been calling for even a redoubled gain. So we've actually been, been kind of forecasting this latest push we've been seeing and we're still forecasting it's still going up, folks. And so we can dive into some of the reasons, but there's just incredible demand because there's a huge supply shortage and, and all the fundamentals really 100% of the fundamentals are behind residential real estate at this point as tailwinds. So that's going to change at some point. But for now, that is, that is the case. And we'll dive into what those are, you know, in an upcoming podcast.

Yeah, absolutely. And a lot of investors, when they kind of start getting into real estate, residential investing is kind of the easiest entry point for a lot of people because it's easy to understand. They usually live in a home and that's where a lot of investors start. But you know, there's a whole other massive spectrum of commercial real estate investing. And we've got a slide here that we're going to show of some of the most common types of commercial real estate investing. And that includes multifamily apartment buildings, retail, industrial, hospitality, self-storage, mobile homes, senior housing, student housing. You know, so there's a lot of ways to invest there. And each one of those is kind of its own unique animal within this broader category of commercial and with the commonality that they're priced primarily on cap rate.

And you're a banker. So what's a cap rate?

Yeah, cap rate is a very simple calculation. It's the net operating income that a property produces divided by the, the price of the property. And so that creates this capitalization rate and that's used as a very simple metric to value the property. And generally the lower the cap rate, the more expensive the property. The higher the cap rate, the less expensive. And different asset classes trade at different cap rate ranges based on riskiness and other kind of demographic.

So it would really be the net cash on your capital invested if you didn't have debt involved. It would be like if I buy the property for $100,000 and it generates $6,000 a year, the cap rate for that— the net operating was $6,000, the cap rate would be a 6. So yeah, it's been interesting in recent years that because of the low interest rate environment, you can use— you can actually apply some of the commercial type analysis to residential property. And that's actually— I remember I kind of predicted this about 7 years ago, that residential rental housing makes sense again because I'm not talking about the coastal premium markets, but— and I had people look at me cross-eyed and say, yeah, it's too— be too tough to manage, be too tough to manage all these properties. Well, now it's like probably the fastest growing asset class is residential rentals. And I've heard numbers like 60 or 70% of the rental properties in the US right now are owned by large, large institutions. So, you know, so you— that's another thing supporting real estate, you know, residential real estate increasing in value is that it actually does make economic sense. If you take away the cost of the higher speculative markets, their bread and butter markets.

So, but commercial traditionally has been far larger.

Oh yeah.

residential as far as third-party investment. And it is entirely driven by cap rates. And we've seen over the last couple decades massive cap rate compression. So cap rates are coming down with interest rates.

Yep.

And so people are seeking yields, you know, and to keep driving the cap rates down, which means driving the prices up because cap rates are inverse to values. So we've been seeing pretty steep values to a value investor, you know, as I would count myself that Warren Buffett is that, you know, some of the most successful investors are value investors. Is it, is it a good value? And we could argue both sides of that, right?

Right. And we will in future podcasts. We're excited to dive in more.

You know, are cap rates going up or are they going down? If cap rates are going down, you're going to see prices continue to climb. If cap rates are going up, you're going to, you're going to see, you're going to see prices drop.

Yeah.

And so, so which are we seeing? And it really, it really depends on to a large, to large impact or large degree what you, what you think, you know, what you think is going to happen to interest rates in the future. Yeah.

Is primarily all a competition for yield, really.

Yeah.

That's at the end of the day. One distinction I think we should make, it might be kind of self-evident from what you've said, but, you know, we talk about residential versus commercial, residential, residential. Generally 4 units or more, but certainly multifamily actually is a commercial class. Yeah, but it's a residential use. So, so the numbers are— I think that's probably kind of obvious, but yeah, that's a helpful distinction.

So one of the things that, you know, as an investor, as a passive investor, right, we don't want to go operate these, these properties ourselves. You know, we want to work with sponsors and other experts in their field to have teams in place. To operate these. But the, the things we've got to look at are what are the macro trends affecting these. We talked about cap rates, that's, that's a real big one, right? We have inflation as another, another driver. It's kind of in tandem with, with interest rates in the monetary policy. And we've seen, you know, asset price inflation just massively over the last decade. And, and we're actually going to be doing a podcast on kind of the inflationary environment and right housing probably a few episodes from here. But, um, it's really important because these asset classes are all affected a little bit differently. But you want to talk a little bit about just some of those other factors that we pay attention to?

Yeah. And, you know, so, well, right now with COVID you know, and everybody's mind— on my mind is retail and hospitality. So they have been creamed. Well, that's, that's for, for a dis— for a distressed investor, that's when you make you make outsized gains. And so the question is, is it time to invest in retail and hospitality? So we'll get some experts on and we'll be talking about those sectors in particular. We've seen multifamily, I mean, cap rates just continue to compress in multifamily. It's primarily cap rate driven. I think you've seen a lot of pressure because of the forbearance or the eviction moratoriums, et cetera. Right. So, but it's not been, You know, it's not been— it's not damaged these properties too much and damaged the industry. You know, self-storage is, you know, got its own, got its own, own, you know, kind of drivers. I think people as they're going urban, you know, need and going smaller, you know, square footage is decreasing, are looking for storage. It's a good option. Yeah. You know, mobile homes are, are, are definitely lower price. Right. And capture this need for lower price housing that is kind of a big, gap in the market. So there's a lot of our— we'll get some, get some experts in the mobile home area on, on talk about that. Uh, senior housing, of course, you know, we know that the, the world is, is gray.

Silver, silver tsunami. It's, in my case, it's a white tsunami that's coming.

But yeah, and, and so that trend is, is not going away. And it's interesting because they've been massively hit, you know, and right now, so the values have been dashed. So is it a good time?

Right.

You know, and same with, same with student housing, you know, as you know, basically income goes to zero, you know, or, you know, not zero, but, you know, severely crushed. So, so these economic factors are, are something we'll look at, which either each of these asset classes.

It's interesting, I was, uh, uh, have a subscription to some local multi-family brokers in town, Kansas City, where we're at, and they were talking about the cap rates pre-pandemic and post-pandemic. And just in the last year, cap rates on a Class B multifamily property have dropped 1.5%.

Dropped.

Wow. Dropped. Yeah. And it's— and they're thinking it's primarily prices going up. Prices going up. And a 1.5% drop in cap rate is a massive increase in value. And they're kind of attributing that to all the costs right now with lumber is extremely high right now at this point in time. Labor is very difficult to find. And so it's driving up all these extra costs for kind of these value-add plays. And you would think that, hey, we just went through a crisis and there's still a lot of things settling out with forbearance and eviction moratoriums. We don't fully know the impact, but there's all this money coming in. So there's a lot of things we've got to be concerned about and aware of.

Yeah, I mean, and stay with us because the journey that we're on here, we're We're going to see changes. I mean, as a result of this pandemic, there are going to be some systemic changes. I mean, there's a lot of office space that's never going to come back and be utilized the way it was pre-pandemic. A lot of people discovered they can actually— their employee force can actually work from home and be productive. I think in the multifamily, you're seeing a lot of people— so you're seeing demand go up there, cap rates down. A lot of those people aren't necessarily— it wouldn't be their first choice of where to live. I actually think a lot of the millennials, for instance, are going to be looking at, wow, we wanted to do the urban thing. We got really close together and everybody's wearing masks and doing the whole COVID deal. And there's a lot of fear out there. I think you're going to see a lot of people that are going to want to move to the suburbs. But guess what? Cost of lumber, all the things we talked about, the inventory for single-family housing right now is down to nothing. And so it'll be interesting to see how these play out.

And we'll see fundamental changes everywhere. So office space, you know, I is down significantly. I forecast it would come back to 80% pretty rapidly, but still that's a 20% decline in occupancy. Same with senior housing. A lot of people are now exploring home options instead of commercial options. And so there's a whole lot of changes afoot. And so it's a good time to position yourself to capture those trends. You know, or avoid them if you're not sure, you know.

And this is really, you know, you have by the time your institutional investors get involved and it trickles down to the retail level REIT investment, you know, it's the entrepreneurs that go ahead of time and would serve the alternative investment community that find these opportunities, prove them out. And that's where really some good money is made. And it's like it's an exciting place to be an investor because you, you're kind of getting in on the front end of something. That, you know, like I said, now single-family housing, rental housing is an institutional investment class. There's still a lot of opportunity on a retail level, but there's going to be entrepreneurs— there's entrepreneurs doing short-term rental right now. That's Airbnb, VRBO that are, that are killing it. And it's all mostly it's passive investors. It's private investors that are investing in those business models and they're doing really well.

So yeah, absolutely. So we're going to move on to the strategy. So these are the categories of types of investments, but there's kind of, I would say, these, you know, 4 or 5 core strategies that can be applied into any of the asset classes. And so we're going to break them down. We have a slide here, we'll show you. And we kind of arrange them on kind of, you know, most risk to high and highest return to least risk and lowest return. And some of there's, you know, some fungible, you know, ways to massage it within that. But, you know, first off would be kind of a distressed opportunity. So you're buying a property or piece of debt like we do at Aspen, and they're not performing, they're not being paid, it's not being paid. There's something wrong with it. And so you can usually pick these up at very deep discounts.

Right.

And so you're finding something that exists that's broken and you're fixing it.

Yeah, exactly. So outsized gains. So this is— so not only is a risk scale, it's also a return scale.

Exactly.

So, and also an expertise scale. So I think the way to think about this You want— if you're going to invest in distressed debt, you want to make sure that, you know, the operator has skill and experience doing this. It's less important if it's just— this is a Class A office space, what we would call core. Yeah, right. And it's just— this thing is just— you don't need to do anything with it.

Right.

So the stress— so expertise really matters. Your gains can definitely be outsized gains and your risk is also greater. But we love distressed debt, distressed, because there's always distress in the markets. And, and, and those, those distressed, distressed yield great discounts, right, to people who aren't equipped to handle those. And so when you're equipped to handle those, you can make, you can make outsized gains.

And a lot of times when there's fear in the market, you know, at a broad level, it's a lot of times oversold. So a lot of times the discounts aren't even truly reflective of the actual intrinsic value of an asset. Correct. So, you know, there, there is that opportunity for upside just even intrinsically without even creating much more value.

It's so true. So we have our underwriting model in our, in our residential distressed debt market. We, we do model intrinsic value for every note we purchase, and we've never paid intrinsic value. We've always paid a discount to intrinsic value. And because the market is inefficient and because these things are simply priced based more on emotions and on panic than they are on numbers.

Right.

And so, so it's very, very true. And distressed, you know, back in, you know, 2008, 2009, 2010, you know, you, you listed properties for sale, there was just no buyers. You know, I remember, I remember, you know, my daughter, you know, was gonna buy a, just a, a condo, you know, for $64,000. You know, she was like, how much, how How much can I lose? How bad is it going to be? Well, of course, she sold it 2 years later and I think doubled her money or tripled her money, something like that. But it's the fear gets in. And so, you'll make outsized gains when you're buying when everybody else is selling and you're selling when everyone else is buying. So, distressed, we love distressed. The next one is development. So, this is very risky as well. You can typically get real nice gains there too. As an equity side, they're very leveraged a lot of times. So, you have a lot of debt behind you. So—

And do you want to explain kind of what development is just for those that may not be familiar with that term?

Yeah.

So, development is really— so, distressed again is taking an asset that already exists, but some aspect of it, it's broken and you're fixing it. Development is there's a need out there for an asset and you're developing it, you're building it. So, in the real estate world, development is there's a distinction between development and building. Sure. And development would be like buying the raw land, for instance, and then taking it through the entitlement process, getting the subdivision approved, plan development permit. Then you move in, usually a developer will build till you move into the building, which is actually, so you're creating an asset to serve a need that's out there.

So, right.

So the, the, the biggest risk there is market risk because you, and again, speaking from somebody who was doing this in Southern California, you don't know how long it's gonna take to get a project approved. So by the time you lift the curtain, no one shows up for your drama because nobody's buying that anymore. Or the market, the interest rates have gone from 7% to 12%.

Interest rate risk. You have market risk, you have materials risk. Oh yeah. You know, and legal risk permitting can change, right? Or legal challenges, etc. So, so there's a fair amount of risks in there, but also a lot of those things can be solved.

And there's tremendous gain if you do your homework.

If you do your homework, you have a skilled developer. So again, outsized gains if you have an appetite for that and you have a great, great track record.

From a macro view, I kind of view these, um, somewhat, you know, opposite in the sense that distressed is a lot of times counter-cyclical and development is mostly pro-cyclical.

Totally.

What that means is as the economic cycle is booming and doing well, development projects are going to be doing very well because there's demand and there's people that are buying and they need these properties, especially right now. Right. There's such a shortage and the distress. A lot of times there's kind of always some level of distress.

But, you know, like the floods come when, when, when there's a lot of distress. And so, so that's a great point. And, you know, is to have a part of your portfolio be both pro-cyclical and counter-cyclical.

Yeah.

Tomei, I think about that having been creamed in the markets several times, right, as us older gentlemen have been. We're very sensitive to wanting to position our portfolio to both capture the positive in the cycle and capture the negative in the cycle as well. And so, why not build your portfolio to do both? Yeah.

The next strategy that we look at is kind of opportunistic. Slash repositioning. We've kind of alluded to this, and this is generally an existing asset class. And as the trends have changed, like we're seeing in retail and in office and dramatic transformations in a very short period of time, there's going to be a lot of opportunity there because there's other needs that are, you know, much greater that these can be repurposed into. And so some of those common ones that we've seen are, you know, hotels to multifamily.

Or condos, condo complex, right?

And then malls, that's kind of been a big declining trend. And I think especially last year, it's, you know, been—

Amazon loves those—

accelerating. They convert them to warehouses, big space. We got to ship all of our boxes.

We've seen industrial into storage, right?

Industrial.

So it's repositioning, opportunistic repositioning. Again, outsized gains if you have a sponsor who has a lot of track record in this.

Yeah.

I mean, it's risky, but if they're right, boy, can you make a killing.

Real life example. Yesterday, literally, no, day before yesterday, I was actually in Colorado Springs. I had a meeting with a guy at a coffee shop and this, they took this, a developer took this typical 1960s built elementary school that for whatever reason, that school, that facility wasn't needed any longer. I'll just leave it at that. And big L-shaped building, single, super simple building, big parking lot. And they went in and they repurposed this. And now you walk in and there's like the, you know, the central hallway, just like in a, you know, when you're walking down classrooms left and right, but there are all these little retail. There's a baker, there's a microbrewery, there's a coffee shop, there's a real estate office, a mortgage office, and, and on and on and on. And I mean, the place was buzzing. And then they had like, they, they used, they didn't, you don't need that much parking as you do. So they had the outdoor eating areas on the outside and then inside it's like you're in the school building. But they really did it up cool. And I looked at it and I said, these are really cheap tenant improvements. This is a moneymaker.

Yeah.

You know, and now I'm kind of like, whoa.

Yeah. And then the cool thing with that is it's already an existing asset.

Exactly.

That you have to build from the ground up. And so there is less risk there, but sometimes there's permitting issues. You have to get it re-permitted and other things. But something that's very— I think we're going to see a lot of these opportunities pop up like the ones you're saying and other like office and other things. So, you know, the next kind of strategy here, it's a little bit less risky.

It's super common. This is, this is a ton of the offerings out there are value-add.

Value-add.

Yeah. You want to kind of hit what value-add means?

Yeah, I'll give you a perfect example. I know a guy who recently bought an apartment building, so several, several hundred units. And in the area that he was in, remember everything with that's, that's commercial. So you're looking at the net operating income. And when you know that and when you affect the net operating income, It goes straight to the value of the property, because the cap rates are pretty tightly defined by a market. There's enough players. So this guy goes in, he looks at— I think he had something like 60 3-bedroom units in this apartment building, and they were all like— they were large 3-bedroom units. And so they do their marketing studies, and they look at what's in demand and what's oversupplied, what's in demand in the area. Well, what turns out, 1-bedroom, 1-bath units were in high demand. So this guy went in and took all the not all of them, but like 60 of these large 3-bedroom units, general sense, put a wall down the middle, added a kitchen and a bath, created 2 1+1s in place of the 3+1.

Oh, yeah.

And so the, the 3+1 might, might have been rented for $875, but the 1-bedrooms rented for $600. So you take that extra, you know, didn't cost that much to do the improvements. So that adds to the bottom line of the net, net operating income. He created $2 million of value in this $10 million asset, 20% value just by doing that little change. And, and then you have brand new units so you can rent those at the top of the one-bedroom market. So it's a value add.

So other common value add plays, they'll go in and rehab, just update.

Yeah.

You know, so the, the doors, so they look better, they feel better. They also— and we've seen value add in storage. So you buy the mom-and-pop storage, storage units and, and go in add, you know, digital— the whole digital function. So you automate everything in storage. And the same thing in multifamily. You're, you're automating, you know, payment, you're automating, you know, requests for maintenance, you're automating all this stuff. And so they're, they're creating value add there. So it's all basically making it more efficient.

Exactly.

And bringing more revenues in and typically raising rents. And so all of a sudden, as Jim says, that goes to your operating income. Any dollar improvement in your operating income produces $5 in value improvement. So that's, that's the idea.

Well, I know an apartment guy that did— he just added stripes to the parking lot and assigned spaces and then said, if you want to, if you want to know you have a parking space, it's $50 extra a month. Everyone— in fact, one guy rented 2 spaces because he had a brand new Corvette and he parks right in the middle of 2 of them. They just created that value out of thin air.

Sounds like California.

Yeah, that's right. And really the last strategy here is what we'll call core. And there's kind of a few nuances around that, you know, core plus and core. But really the concept is these are generally going to be very institutionalized assets. They're usually very large, you know, Class A in a large metropolitan, you know, think, you know, Miami beachfront and 400-unit apartment building, Class A, that's going to trade at a very low cap rate. Generally, they're going to have, you know, pretty low vacancies. It can be, you know, most of the units are rented. There's not a lot of improvement, but it's a stable asset. It's going to be much lower return.

Right. So you may not make a lot of money, but you're not going to lose any money. Yes.

Capital protective.

And not a lot of upside. Not, not, you know, lower yields, something a bank might own or a pension fund or something else because they're not You know, don't— not going for higher yields, but very, very safe, very low risk. Yeah.

When you compare it to a bond or something, it's pretty attractive even at a lower yield when you're looking at the institutional level. Right. And really kind of the next, the next kind of piece of this we wanted to overlay on this, right? So we have our different categories, our different strategies, and now there's multiple ways to invest in all of these. Strategies, right? So this keeps getting exponentially larger as we lay it over.

But a 5-dimension matrix here is what we're building.

And really just to keep it really simple, we're looking at kind of 3 ways to invest in these. There's debt, there's preferred equity, and then equity. And very simply, debt is— senior debt, we'll say, is generally a first position kind of in a commercialized asset. It's generally going to be your your bank, your lender. But in our case, in the distressed debt side where we're actually working with other institutions, you know, we are working— they're coming in as a debt position, as a senior lender. And so they're taking a first position, but they're, you know, getting a lower rate of return for that. So again, this is, you know, a correlation between risk level and return level. And so the— this is called the capital stack. If you've heard that term, this is what it means is just how are your assets capitalized. And debt is going to be first money out. It's going to be a lot of times secured and the least amount of risk. But also, you know, banks aren't getting paid a whole lot right now to lend against multifamily properties.

And I find, you know, this also is an investor size scale here, too, not as a risk scale. So typically your larger investors, in my experience, the most sophisticated of the largest investors love debt.

Yep.

Okay. Because banks are— banks are, for instance, and so are all a lot of institutional lenders. They love debt. Institutional investors love debt because you get paid first. Right. So, so what if the sponsor screws up? I'm still getting my money out.

Right.

And, you know, you know, so it's that kind of a thing. So the more sophisticated the investor typically, and the larger the investor, the more they like debt, generally speaking. And yeah, and debt, you can think of debt as being low yield, but you can have high yield debt as well. And especially in the distressed state or distressed debt space or in other spaces where there's stress in the market. I remember you could buy debt on oil fields back when that was in crisis. Of course, it is again. But you can buy that debt and they're getting massive discounts. You can get 80% discounts. Do you want it or not?

Right.

You know, but I will say, you know, JPMorgan made all of his money buying distressed debt. You know, he bought distressed, you know, defaulted Russian government bonds. They refused to pay the bonds. He bought them all up and then went and convinced the White House to put pressure on the Russian government to reaffirm the debt. And it worked. You know, so there's a lot of money in debt as well. It isn't just a low-yield play.

And even I was looking at a sponsor the other day where they do actually do venture capital debt. So instead of a lot of times venture capital, you think of someone investing in the upside of a company, but they're taking a different position of we're going to not dilute your equity, you know, capital stack and we're going to charge— they're charging 18 to 20%, you know, so they're making really good returns. Obviously it's higher risk because this is, you know, a startup company versus a real estate play. But there's a lot of ways that that can be applied, you know, You still get good yields and minimize risk. Kind of the next kind of step up there is what we'll call preferred equity. There's also mezzanine debt, which, you know, you know, they act very similarly. But the idea is they're, they're a junior position. They're, they're junior to the senior debt holder, but they're paid before the common equity guys.

Right.

And a lot of times in real estate, you'll see this where a sponsor will offer two types of equity. One's preferred, one's common, and the preferred obviously get— they get paid first. A lot of times it'll be a higher preferred rate. So you'll see an 8, 9, 10% preferred return, but no upside. So you don't— you don't get the upside if the property performs very well, but you get a real nice return, get a real nice return, and you know, very little risk.

So you have the senior— senior debt is in front of you, but you know, if the thing performs at all well, you're still going to get 100% of your capital back. And a nice yield.

Yeah. And, you know, final piece of that capital stack is the common equity. And these are the investors. And usually what you'll see in most of these types of offerings is, you know, you're playing the upside. And so you got to believe in the strategy. You know, if it's a value add, if it's a distressed play, you're taking all the risk on the performance of that strategy.

But if it works, you make the money, but you make the most money. And so, but you're also going to lose the most money.

Yes. Well, and another point about the— on the equity side, because it can sound real negative at first first, like, well, wow, I, I'm the last guy getting out, or, or I'm behind this senior debt. You know, if you think about it, these senior debt, they're typically institutional. They're not dummies. So in a sense, they've done the due diligence for you, as long as it's not overleveraged. So as an equity investor, if you know an institution came on board and put debt in, in front, even if it's in front of you, you know they've done some due diligence and they've at least vetted the sponsor out pretty well.

Yeah, a lot of times it has to do with scale, right? The institutional partners want to deploy more, and a lot of times there's more you know, debt in the capital stack than equity. And so it's easier to deploy larger amounts. And that's part of the reason as well as risk. But, um, those are the most common phrases you'll see. And when you're evaluating an opportunity, you know, those are the things you want to be thinking about is where am I at in the capital stack? You know, how do I get paid and when do I get paid? Um, it kind of— the final piece we want to touch on in this podcast, and I hope this has been super helpful so far, um, is just the general structures, right? So most people, when they think of real estate, if they haven't been a real estate investor before, is REITs, right? Public REITs.

And so what is that, a real estate investment trust?

Yes, exactly. And so when, when most people think, oh yeah, I'm invested in real estate, I invested in ALTS, and that's what the advisors will generally put people into. And there is some, some benefit there, but I would say it's 5 to 10% of the benefit that you get by going through.

Honestly, yeah, the public REITs, the the way most people invest in real estate with public REITs, I think they have so many issues and super unattractive in my book. One, they're generally extremely highly leveraged. So typically, as high as maybe 10 to 1. So for every dollar of equity, they're buying $10 worth of real estate. So that creates just a massive amount of risk if that property value fluctuates. The value of your equity is massively fluctuating, number one. Number two is volatility. So, if you look at the— I was looking at just a large public office REIT, EQR, and I believe it had something like 8 drawdowns since the year 2000 of 20% or more. So, meaning—

What was the drawdown?

The stock price where it drops 20%. So, you're getting a small yield, a 3% or 4% or 5% yield, but you lose 20% of your principal. And there was several that were over 60% drawdown. So, it's incredibly volatile because everybody sells all at once, this stuff just goes on sale. And so, incredibly volatile.

And one of the things that historically REITs provided was some level of diversification and what's called correlation, right, to the S&P. S&P and other kind of indexes. But we've actually seen, and I've seen several articles that all the correlations have gone to 1.

And what that means is they're all correlated. So if the stock market falls, your REITs fall. And so what's happened, you— they're really not diversification anymore. They're really not.

There's actually even a misalignment of interest because I, because I've been watching some guys put together these kind of investments from the sponsor developer end.

Yeah, sure.

And they're not incentivized to find the killer deals.

Right.

They're incentivized to do deals because they can't— they're limited as to what they can take, you know, profit-wise. It has to be distributed. And I, you know, more about the structure than I do. But the point is, it's like we just have to go out and place a lot of capital as opposed to we found this really sweet deal, let's wrap a syndication, a private deal, which I know you're going to move into next. So it just— I just find it to be— and it's correlated. So it's like a stock just goes up and down.

It's really hard to recommend public REITs for me. I just Even though the yields are really low because the public markets are so liquid, there's so much liquidity flowing into these things, it just drives the price way beyond the true value of these assets.

And really, a concept that we're going to be talking a lot about in this podcast is kind of a risk-adjusted return. So a lot of people just look at a gross return and that's the measure of attractiveness or unattractiveness. You have to, you know, risk adjusted means you've divided it or have applied some level of risk to that return. And so, you know, something like this where you are actually not even getting that great of a return, but you have a lot of volatility. So it's a lot of risk to your capital. You know, it just becomes very unattractive when compared to private real estate. And that's really where most of our focus is going to be in a lot of these podcast interviews is the private real estate market, because this is where the big institutions are investing big chunks of their capital in looking at individual deals.

Far more attractive in many ways. And while your financial advisor will tell you, oh, you know, if you want risk, go private. You want to avoid risk, go to the public. I think it's 100% the opposite.

Right.

You know, the public markets, you may not get invested in a Ponzi scheme, but the chances of losing money are very high or certainly not getting much for your money. And the private market, yes, there are more at risk because they're less regulated from regulatory or fraud risk, but that's not that common either, I'll point out. And then, but the gains are potentially much, much better. And really a lot of, not just gains, it's all the advantages. Of liquidity and other things. So let's dive into the private. Yeah.

And when you're going private, what you're essentially doing is investing directly with the operators of this asset. And they have a specific strategy and likely a good track record in this space. And so you get all the tax benefits a lot of times that are associated with these assets.

Which are huge often.

Which are huge. And especially now with, potential changes in the tax code and going up, right? So the kind of two most common structures we see, and these are words you've probably heard, are syndications and funds. So a syndication generally, you know, it's going to be a single asset, a lot of times a larger asset, you know, usually commercial, and it's going to be raising money for that specific asset. It's going to have a specific strategy, a timeline associated with executing that strategy, and then there's a return of capital and you're getting, you know, paid along the way. You know, the pros to that are you have visibility on what the asset is, right? When you're looking, you know what it is, you know what it is, you know the market that it's in, you know, you know what the rental rates are like, you know what the vacancy is like, the value-add needed, etc., etc.

If you're a kick-the-tires kind of guy, you can go kick the tires.

Yeah, yeah. And you can, you can see it. The issue with syndications a lot of times is you lack diversification. And so it's your one deal. It's one deal. So you have a lot riding on that.

So you have sponsor risk, geographic risk, market risk, lots of different kinds of risk related to that single deal. Yes.

Yes. So it's a very, very popular structure. It's very common. And there's, you know, obviously some major benefits of that. But the other side of it is, is fund investing. And this is something that's, you know, what we do at Aspen, our fund investing, and investors come into a fund and a lot of times it depends on the strategy, but it can be kind of a lot of times what's called a blind pool fund. And so you'll be— the sponsor would go raising the capital for their fund and you don't always know exactly what properties they're going to be buying. Sometimes if you come in later at the end of the fundraise, there's more like a box.

Here's, here's the stuff. Generally, the PPMs will describe, here's the box, here's our buy box. Here's the stuff we're looking for. And you got to trust that the sponsor, the operator, is going to do that. So that's as much tire kicking as you get.

Yeah.

So a fund has more to do with deal flow in a particular defined class that you're going after, whereas a syndication is, it's a single deal. So in a sense, every syndication is a fund, but every fund isn't a syndication. Syndication in a loose way. So it's just a different way of structuring depending on what your business model is.

Yeah. So generally a fund's going to have multiple assets, if not hundreds of assets, like in some of the funds that we do, and you're going to have less geographic risk, less market risk. You're going to not be relying on the performance of one single asset. So you get a lot of advantages there, but sometimes you have less visibility as to what it's going to be and you kind of trust, like you're saying, the sponsor track record.

You want to pay more attention to the sponsor in that way because you can't kick the tires. You have to trust that they are kicking the tires and you have to understand their processes and how they underwrite, et cetera, to make sure that you agree and you like what they're doing.

Yeah. And then just kind of one subnote on that is in the fund side, there's kind of two primary types of funds. One's the closed-end fund, one's an open-end fund. So closed-end is the most common type. What that means is it's, you know, capital is raised, that capital raise is done, it's deployed, you deploy it, and then you work out the assets or you operate the assets, operate the strategy, exit.

So you kind of have a fixed period of time where you raise. That's why it's called closed-end. You open it, you subscribe it, it's all funded, you close it, and then you go do what that fund is designed to do. And when it's done, you distribute and everybody's happy or not.

Yeah, exactly. And generally, those are going to have lives of 3 to 4 years all the way up to 10 years, depending on the asset.

We've seen timelines as long as 10 years, which typically a lot of investors don't like. I mean, no one wants to—

It's a hard swallow.

Even though most investors will probably be passively invested for 10 years, but you don't want to have to be, right? Right. So that's the negative. But it just takes time to turn these assets into to do the value add or the development or whatever the strategy is.

So, that type of fund might be good for somebody with a retirement account because I can't really pull that capital, I don't need it anyway. And I think this thing's really going to grow. I don't care if it's a 10-year horizon.

Yeah, sure.

I'm all in.

Yeah. And the other side, which is actually pretty rare, are open-ended funds. And these are typically funds mostly in the debt space, but it can be also in the residential space, but it's typically where the the assets being invested in are more granular. So, like our income fund, we have nearly 700 notes in that fund. And we're buying notes all the time and selling notes all the time. So, we have a lot of— it's very granular. It's not like 3 big assets. So, we can accept new investment capital in these funds every quarter. And we can actually redeem investors if they want their money out every quarter. So, we have a liquidity. Liquidity provision that's built on internal liquidity that's generated by the fund. And so, we've— it's very unique and very rare. But you see the same thing in hard money funds. And typically, there's some open-ended funds. So typically, in the debt space, you'll see open-ended funds which have the advantage of you can get high yields and asset-based investing, real estate-based investing, but having a liquidity provision in addition. Right.

Well, that's a lot of information we just covered, but I think that's really helpful. I, I, yeah, this is, this is really cool. And hopefully you guys got something out of this. Again, this is high level, right? High level, just creating the helpful framework. Um, and we are going to do a lot of deep diving here. And, um, next episode we're going to cover venture capital and private equity and what those worlds look like. It's going to be kind of, kind of fun. And excited for that. But thanks for joining with, with us, and hopefully you'll join us for the next episode.