#94: Talking About the Current Real Estate Market ft. Nathan Clayberg

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Welcome to the Passive Income MD Podcast, where we talk about creating your ideal.

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Hope you're having a great week.

For this week's episode, we're gonna be talking to Nathan Klayberg, an assistant vice president at MLG Capital. We did a great interview where we talked about the market, what they're seeing in terms of opportunities out there, how they think about inflation, how they think about all these current issues that people are thinking about when they're thinking about investing in real estate right now, especially large, multifamily large syndications or funds or whatever that might be. So I think you'll enjoy this episode. But before we get to that, wanted to make a few announcements. If you didn't know already, the Leverage and Growth Summit for physicians for 2022 is gonna take place on March 9th through 13th. That's actually coming up pretty soon. And if you're listening to this a little bit later, it's coming up real soon. We're gonna be sharing stories of physicians doing some really, really amazing things both in and out of medicine to help shape their lives, however they want to create their ideal lives, particularly through entrepreneurship. If you want, you know, if you're interested in that kind of topic, you're interested in creating something else for yourself and another stream of income, I would highly suggest you participate in it. I will let you know. It's absolutely free, so there's really no downside to it. I hope you enjoy it. Look out for the registration to come very soon. Let your friends and colleagues know about it, and honestly, we put it out for you, the audience, and I really hope you enjoy it. Number two, since we've been asked so much about it, people have been asking when the next class of Passive Real Estate Academy is happening. For those who don't know, it's a course where in four weeks, we take you to a place of confidence when it comes to investing in passive real estate investments like syndications and funds. We do that twice a year. The next time that we're gonna be opening up the cart or opening up the doors to this is gonna happen on April 11th. Now, I know this coming up pretty soon, but so many people have asked us, and.

And so we decided to let people.

Know on this, so look out for that whenever that might come. But in any case, hope you're doing well. Whether you're listening to this in your car, in the office, at home, hope you enjoy this interview.

Thanks. I'm really excited today to talk to Nathan Klaiberg. He's probably well known to a lot of people. If you've been in this group for a while. He comes in and he provides a ton of value for our group in terms of what's the market doing. What are different types of investments? If you don't know him, he's the assistant vice president of MLG Capital, a group that's well known to a lot of people in passive income MD because it was one of the very first investments I made in terms of passive real estate. I've talked about it quite a bit, had some great returns, and always been very impressed with how they run their company and their business. And so they've always focused number one on education. And so we've always invited them back here to come talk to us. And Nathan's always been a big part of that. So welcome. Nathan. How you doing?

Doing great. Thanks, Peter. Appreciate the intro and appreciate everyone taking the time to listen in here. Excited to share more about what we're doing and how we're seeing the real estate world these days.

All right, we're going to get into good stuff about, like, the market. I know inflation is raging. People want to know. Stock market's quite volatile right now. Bubbles, you know, talk are happening. Before we get to that, do you mind just sharing a little bit about what is MLG Capital and what is your role there?

Yeah, you bet. So MLG Capital is a private real estate investment company. We've been around for 35 years. And really what we offer to the marketplace is the opportunity for investors to invest in a fund of assets. So a basket of real estate deals trying to get diversified across different geographies and across different asset classes and help investors to identify their private real estate holdings in that way. So, like he's mentioned, I'm assistant vice president here. I work a lot with our investors. So those who are listening, if you're calling in, there's a good chance you're going to talk to me on the phone. But I also work a lot with our deals. I do all of our deals in the Midwest, so I'm pretty intimately involved in the numbers. And, you know, I'm always being asked questions by our investment committee, you know, about what's going on and what we're seeing in the market overall. So excited to be able to share some of that as well.

All right. Cool. I mean, you guys are invested in, I would probably say. How many states do you think you're invested in at this point?

Across all of our funds, probably around 20. In any given fund, you might be in around 15, but yeah, probably 20 in total.

Yeah. So you guys have a good sampling of what's going on in the real estate market. You've been doing this for over 30 years now, I'm sure a lot of the talk right now, I've heard a lot of people in our community ask about it. Are we in a bubble right now? Is this a real estate investment bubble? And how do you talk to people when people ask about that and whether this is a good time to invest or not?

Yeah, that's a great question. And there's certainly a lot of different angles that you can take in thinking about where we're at in the market. But what we like to do is really boil things down to the fundamental principles of supply and demand. Right. That's the kind of key driving in most industry is certainly true in real estate, and it's especially true in apartments, which is where we do the bulk of our investing. When you look out across the country, Nationwide, apartments are 95 to 96% occupied. The reality of the situation is demand is continuing to grow. We see about 7, 10 of a percent of population growth per year, obviously a key demand driver. And we continue to see households being formed, you know, people moving out from having roommates, people moving out from living with their parents. Culturally, that that's something we start to see. And the challenges on the supply side, it's not only very expensive to build new product today, but it's also takes time. Right. And especially with a year of supply being muted by Covid demand is outpacing supply right now. And in our view, we still think that there's actually going to be Runway. One thing that a lot of people don't realize is if you look back at the past 20 years, dating back to year 2000, and you look at the average annualized rent growth over that time, it's actually been only been about 2.7%. You had some of that huge blip in that growth with 2008, 2009 and the recession that came along with it. But really the trend has actually been pretty reasonable in that 2.7%. Over the same time period, construction costs have gone up by about 3.5%. So it's still more expensive to build than it is to rent. It's becoming harder and harder to get into single family homes, home prices are about 70% in the last seven years. Rental rates in the same time up about 40%. So there's still a lot of reasons that we believe that the demand and supply equation is imbalanced. And for that reason we still think it's a good time to invest. With some huge caveats maybe we can get into. But overall, I would say it's still a good time to invest.

Yeah, why don't we get into? I mean, that's some great information, but I think for people, they want to know, what are some of those caveats? What are some of those reasons where investors have to worry about investing in some of these opportunities? You're saying that there are some reasons, maybe there's certain key indicators or something they should look for. Do you mind sharing on that?

Yeah, well, one of the ways that in the market that we're in, there's no question that cap rates are a little bit compressed relative to where they've been in the past. I think that's definitely a function of pricing just being hot. And the primary driver of that is there's so much capital chasing private real estate from big institutions, from high net worth individuals and everything in between that it's really just become a very competitive marketplace. The other challenge of the, you know, what I think is really contributing to a lot of the increase in pricing recently is the availability of debt in the marketplace right now. People can get crazy debt terms and they can get really high leverage even on really low cap rate deals. And so for breaking that down a little bit, if you're buying at a low cap rate, your cash flow inherently is going to be lower and it's going to make it harder and harder to cover your debt service, which gives you a smaller and smaller margin of error if something goes wrong. So as investors are considering deals, I think it's important to look at the leverage point, so how much debt they're putting on and then the terms of that debt as well. What covenants are in place? Are there cash flow covenant requirements from the bank or from the debt fund or whoever you're borrowing from? Because that's the quickest way to really get yourself over your skis. So that'd be one big thing, I'd say. And then the second one, I think it's really important just to be cognizant of basis wherever you're at. And that means just price you're paying for things. You see some of these markets and it's really starting to creep up there. In a lot of cases, people are buying existing product for more than it would cost to build it new. And we always refer to that as replacement cost. But it is a key metric because like I mentioned in that supply demand imbalance, as demand continues to grow, that means there's going to be new supply. And if people can build brand new, sexy, shiny stuff for more or for less and cost less to the tenant than you're buying existing stuff today, that can be a way that you get yourself in trouble.

Okay. I mean, those are some great things, I think for some people. I want to unpack that a little bit more because I'm assuming that everybody understands where cap rates and, you know, debt service covers ratio. Well, maybe they don't. So you might kind of even getting a little bit more. You know, I would say for me just to kind of take it down a little bit a notch. What do you. What is a cap rate and what are things like, what does it mean to have like the low or compressed cap rate? And then you're talking about debt service coverage ratio, just for the educational side of that. Like, how can people understand what that means?

Yeah, that's a good question. So a cap rate is the real estate equivalent of a price to earnings ratio or multiple on earnings. And it's basically the inverse of it. So say you have an apartment complex that produces, let's say, $1 million of operating income. So all your revenues, collecting all your rents and other income, whatever else, minus all of your expenses, produces $1 million. Typically, we always see apartments trade around a 5% cap rate or a 20x multiple. I guess maybe that was true a couple of years ago. But. But for our sake of easy math, I'll say suppose it trades at 20x multiple. That means that you're producing a million dollars of net operating income. And a 20x multiple on that would land you at a $20 million valuation. So as cap rates begin to get lower, the multiple gets higher and people start to pay higher prices for the same amount of operating income. Now, operating income, we're getting a little bit finance terms here, but operating income happens before you pay the bank for any debt that you put on the project. Okay. So people and lenders specifically measure the quality of a loan based on how great the operating income is relative to what it costs for your debt. So as cap rates get lower, your operating income that you get for the purchase price that you're paying gets tighter relative to the debt service you owe for the loan. And that's where I'm talking about. You start to have a Smaller margin of error.

I think it's a great explanation. Some of the ways that we talk about cap rates is sometimes it's kind of a measure of something kind of like the temperature, the demand, or how hot maybe a property is. Because as that cap rate gets lower, it's a lower amount that people are willing to accept to buy that property essentially, right. In terms of kind of like a return. And so as demand, just like, just remember people, if demand is like really hot in a certain area, you'll see that cap rate kind of be shrink, shrink, shrink, shrink, shrink. As the cap rate starts to increase. That usually means that, or it's a little higher. That just means that people, like I said, it's not quite, I'd say in terms of a demand or supply or how hot it is, it's a little bit of a colder type property. So I mean that's just complete generalization. But again, that cap rate is determined of like, hey, what do people want to pay for that property? Essentially? And that's what he's talking about. Over time, as a property gets like the market gets hotter and hotter and hotter, and maybe a lot of you who have single family homes, you probably notice that your house, the value of it has started to go up, these kind of things, the market goes up and down, it's hot or cold, and cap rates are an indicator for that. And so when you're seeing those cap rates and now you're, you've talked about these cap rates are getting lower, right? And as, as you're doing that, like what are the opportunities that you're seeing? Like where are you guys actually investing that? Where some of these numbers start to continue to make. Well, they continue to make sense for you guys.

Yeah, that's a great question. That's really the million dollar question in the real estate industry right now is where are you finding opportunities that make any sense? We have a couple key strategies that we've been pursuing that we feel like have really given us a little bit of an edge. And the first is called a loan assumption. And what that means is a seller put on a debt note, say they bought the deal three or four years ago, and say they put on 10 year fixed rate financing. Lenders require something called yield maintenance. Basically they're expecting that they've promised a note for 10 years and if you want to prepay it sooner than that, then you have to pay a significant prepayment penalty or a yield maintenance fee to the lender. So sellers don't really want to pay that Fee. And what we've done is we've come in and just assumed the existing debt instead of going out and finding a different loan that benefits us in a couple ways. One is that prepayment penalty is captured by us. And so our purchase price is lower as a result of the financing and assuming the debt. And two, there are less buyers that like to assume loans and it limits the buyer pool and makes a little bit less of a competitive process. So we really like that strategy. We've actually done a lot of deals that way and it's helped us to get what we believe to be maybe a 5 to 15% discount on our purchase price, which is obviously meaningful, especially in a market like we're in. And the other thing that we've done is equity recapitalizations where a lot of times there's an operating partner and there's the money partner. Sometimes the money partner is ready to get out, but the operating partner wants to stay in. We'll go in and buy out the money partner. The LPs come in, we still control the deal, but in doing so we a lot of times believe we can get that same kind of 5 to 15% discount.

Wow, okay, so you guys are utilizing multiple strategies to be able to do that. Like what are the size, just so people gives people some perspective. Like what are the size of some of these deals in terms of units of apartment buildings versus, you know, like the loan size or the purchase price? Like what kind of size deals are we looking at?

Yeah, we like to see over 200 units. We think there's some operational efficiencies that come with that. So you'll see us buying deals anywhere. Two to call it 600 units. Usually apartment complexes are much bigger than that. And then purchase price, we'll see anywhere from 20 to 80 million. Just kind of depends on the deal and certainly on the market as well.

So do you think those strategies are like, again, sustainable strategies, whether the market kind of goes up or down or whatever, all the volatility that might happen in the next couple of years?

Yeah, we think so. And the main reason is, is because we believe we're getting into these properties at a price point that's beneath where market pricing is today. And that always in our mind is a good thing. And certainly in the debt assumption strategy, you're, you're assuming some fixed rate financing, so you're avoiding some interest rate risk there. But the key is just being really conscious of basis. And you know, the nice thing about buying these properties is we believe there's some inherent value just by assuming the deb, let's say, and holding out for the rest of the term of the loan until that prepayment penalty goes away. And just by owning it, we've created some value.

All right, so let's say I'm an investor right now, and my money is maybe sitting in a savings account, probably not getting too much. And I'm worried about, like, hey, there's volatility coming, and I'm not sure how my money. I want my money to be safe, but I want to get more than I'm getting out of a savings account. How can investors, or how should investors be looking to invest their money so that they can kind of really spread out that risk? Like, what are you guys seeing in terms of that? Or opportunities for people to feel like, hey, I've got multiple options or I've got diversification of my funds.

Yeah, I mean, there's certainly a million different places you can put money and certainly different. A million different real estate groups out there that are, you know, looking for investors. I think the thing that you just mentioned, though, diversification is super important At a time like this where, you know, there's a. There's a lot of skepticism in the market, it's really good to make sure you're not putting all your eggs in one basket or all your money into one property. And so I think it's important to look for that. I also think it's really important that as you look at deals, regardless of how many you're doing, it's important that you're focused on not being too highly levered. Like I mentioned earlier, it's a quick way to get yourself in trouble. For example, MLG likes to be 60 to 65% leverage in our deals, and you can generate higher returns by taking on more debt and taking on more risk. In our mind, it's just not worth it for to squeeze out a little bit of extra return to increase the risk in the deal so significantly. And then maybe the last thing I'd say is we're entering a time period where there's likely to be some increase in interest rates. It seems to be the direction that the market indicators are heading. And so when you're talking to sponsors, you need to be making sure that the exit cap rate that they're underwriting in their model has some real cushion in it for cap rates and interest rates to increase. We like to underwrite 50 to 75 basis points of increase, so 0.5 to 0.75% and we feel like that covers us pretty well. A lot of groups aren't doing that. And so that'll be an important question to ask as you consider different investment opportunities.

Yeah. So if I have that right, what you're saying is like in your underwriting model, you're expecting the market to essentially not be as good as it is today, is that what you're saying?

Exactly right. If someone's willing to pay a 5% cap rate today, and that's the amount they're willing to pay for that cash flow today, we have to assume that five years from now, they're going to only want to pay a 5 1/2% cap rate or pay a little bit less of a purchase price for the same amount of cash flow. So our pro forma is very much important that we have a strategy when we're buying the asset to increase the operating income, such that even if someone is less willing to pay the same price for the cash flow five years from now, the value is still there when we go to sell.

Can you explain for people what that means, just again, for the sake of education, what does it mean to increase value or to increase the operating income? What kind of things are you doing as a company or to actually really drive that?

Yeah, well, what it really all comes down to is increasing your operating income. And that's defined as revenues minus expenses. Right. And so the buzzword that's thrown around in the industry is value add. Everyone's looking for a value add opportunity. But when you start breaking down the math, let's just say you're talking about a hundred unit apartment complex. I know I said those aren't the efficient ones, but making math easy for myself here. And let's say you can take all 100 units and raise rents by a hundred dollars a month. Okay. So maybe you invest a little bit of money into the property and you can increase rents by a hundred dollars a month. That's twelve hundred dollars a year on your hundred units. That's twelve thousand dollars a year. Did I do that right? $120,000. Yeah, yeah, there it is. But when you start talking about the you've grown your operating income, it trades on a multiple of 20, let's say a 5% cap rate, 20 times your $120,000 of value growth. That's $2.4 million that you created in value growth. That's where we're really going. We're really looking to perform for our investors. If you're relying completely on the cap rate or the multiple to Go from a five to a four and you're going to keep your operating income the same. Then you're really at risk of losing money or getting yourself in a pickle if the market isn't as good five years from now as it is today.

Just so people are aware. And I'm just curious, when you talk about you and company as an MLG and people that are operating and running this, what is the whole team? Who are the key players in this team that are involved in making this happen? Because I know when I, you know, when I own my own properties, I know some of the people that are involved and what I have to do to make sure that happens. But from you guys, I'm wondering what that team looks like.

Yeah, I think actually MLC MLG is a more built out team than a lot of groups. You know, it starts with our investment committee. There are six owners of the company that sit in on the investment committee along with a couple of our VPs. They're the ones making the decisions about the opportunities that we're going to pursue and ultimately invest in. And they're the ones that are the ones signing on the deal at the end of the day. But then beneath the owners, there's a group of VPs and then an entire host of our team beneath them. I mentioned I'm an avp, we have several different other people on the team who work in different regions. We have analysts beneath us and all stuff like that. Excuse me. We also have a whole built out team of attorneys. We have five attorneys on staff, we have nine CPAs, we have a bunch of other staff accountants that work on all of the back end stuff for our investors. So. And then we have an entire investor relations team who deal with a lot of the kind of post close investor issues. So for us that team is pretty well built out. You might see a lot of other groups that are newer that don't have quite a significant bench. But we think it's important to make sure we're providing as top of the line service as we can.

Yeah, I mean one of the things that I hear a lot about also is inflation. And obviously right now it's in the news quite a bit. It's raging right now. How is real estate investing in terms of. You always hear that's a hedge against inflation, but is that what you guys think is going to happen in terms of real estate investing? It's a great opportunity in times of inflation or are you worried about that or how does that play into a lot of your decision Making. And how should investors think about that?

Yeah, it certainly does. Inflation certainly impacts your investment decisions. And we are certainly in a period of inflation right now. A lot of times what inflation means is there's more money flowing through the economy, means people are paying more for rent, there's less vacancy, there's less concessions. And ultimately going back to our conversation about operating income, higher operating incomes. Right. So real estate, especially multifamily, is a beautiful hedge against inflation because as that rises, we're able to move rents along with it. People generally are signing relatively short term leases, typically 12 to 13 months, and those expire somewhat evenly throughout the year. So there's always an opportunity to continue to raise rent and bring them to where market is at a given time. The downside of inflation is that we may start to see some rise in interest rates over time. Our belief is that the rise in interest rates and inflation go hand in hand. And typically the revenue growth that we tend to see as a result of inflation offset any value loss as a, as a result of rising interest rates.

Got it. Okay.

No, no. It's good to know what to expect when it comes to inflation. I know a lot of people are worried about it and they're concerned. And I know that you guys as a company have been through multiple ups and downs and different cycles. How are you guys expecting and preparing for this upcoming cycle based on like kind of some of the other stuff that you've seen in the past? Because I think that's. That that matters, right? That experience matters. And how are you actually preparing yourself for that?

Yeah, that's, that's a great question. I think I would go all the way back to 2008 and 2009. We came out of that cycle and we made some pretty strategic shifts as a company overall. And the first might sound familiar, but we got diversified, we started doing fund deals instead of just individual syndications where, you know, one market could be hit disproportionately badly and if your deal is there, you could be sunk. So we're getting our investors diversified across different markets, different asset classes, and we're staying lower leverage. There is, like I said, there's availability to get higher leverage, riskier debt in the marketplace. Today, in our mind, it's not worth it. The first and foremost goal for us is protecting our investors capital. If we can grow that money in a responsible, risk adjusted, attractive way, then that's great to be on top of it. Right. So we haven't made a strategic shift in the last year or two because of the way pricing has, we made an entire philosophical shift about 10 years ago and we're sticking with that as we go into whatever market we find ourselves in.

All right, so to lay things out a little bit, because I think ultimately what people care about is how is it going to affect them in terms of an investment? What's that going to look like for them? And something we talk about all the time, especially in this group, and I think I'm a big believer in, is using these investments to create cash flow essentially, as in ways like, kind of like income replacement. So it's nice for people to understand what like an investment if they make like looks like as it goes down the road. So if somebody makes like investment. Well, first of all, what is the minimum for your fund? 5.

You're investing taxable dollars. Minimum is 50,000. If you're investing from your retirement account, the minimum is 100,000.

Okay, so that 50,000. Just to break it down for people when they invest 50,000, like what is that? What can they expect in terms of the. I mean, obviously there's no guarantees, but what does it look like from an investment standpoint moving forward in terms of the timeline, how long does that money get in the deal? Like, does cash flow come back to them immediately? What does that typically look like?

Yeah, great question. So we target all in returns net to the investor of 11 to 15%. That's comprised of three distinct tiers over a 10 year expected life cycle. Okay. So when you make your first investment, you're into the fund, you can expect the first tier to begin, which is an 8% preferred rate of return distributed to you quarterly. Now I say 8%. That's what you're accruing, that's the return you're earning. What's actually distributed to you might end up being more in the 4 to 6% range. And that's because like we've talked about, we are buying these assets with a strategy to grow the operating income and we're going to grow into that 8% over time. That said, if we pay out a 5%, let's say that 3% difference between the 5 and the 8 is still owed to you. It accrues and it compounds earning 8% interest until we make you whole. So when you first come into the fund, you can expect the quarterly distributions in the 4 to 6 to 4 to 6% annualized range. But we're going to make you whole on 8% over time. Hopefully get caught up in that in the first few years. And then we go into phase two, once your 8% rate of return has been accomplished, phase two is targeting to return all of your original capital in six to eight years from when the fund begins. So we'll start selling deals. Years 4, 5, 6, 7, we'll start returning capital to investors. And what's powerful about that is MLG is not reaching in and pulling out our share of the profits on any of these early sales. Investors get 100% of the cash flow back to them until they have their 8% annualized and all of their money back. So really in the first two bites at the apple, from there, we typically say the remaining cash flow is split 70% to the investor and MLG gets 30% above and beyond an 8. At that point, we have a special deal with the passive income MD group where we amend that and the investor gets 75% and we reduce ours to 25% because the group has invested greater than 5 million into fund 5. So that should be a nice reference for. Well, first of all, it's a good financial perk, but it's also a nice reference that a lot of the PIMD folks are trusting MLG and we're delivering results for them.

Yeah, I think there's a key thing to note, Nathan. I think we've had a great relationship with mlg. First started with me as an investor and then me kind of talking about mlg. And I know so many of our group members have had a great experience with you guys. And so for people that are interested, just letting you know, we get, you know, PND gets nothing out of that. It's just they've created a nice relationship where they give an extra 5% to passive income MD investors. All you have to say is mention the word you're part of the passive income MD group, and they'll, you know, they actually get a special letter for you, downline those things. And so they've always been great partners of ours and created great opportunities for people. I mean, Nathan, I think you've done a great job of just explaining where the market's at. People know where to invest in. What are the. Some of the strategies that people and companies can use to increase value outside of just the market going up or down. I think that's been powerful. What inflation looks like, how people can think about inflation and in terms of how rental properties and all that stuff are a great hedge against it. You got your light, my lighting going on. Uh, and otherwise, honestly, you just shared so much information about how to, you know, think about real estate investments in general in Terms of diversifying your portfolio, I think we covered a lot, don't you think?

Yeah, we sure did. We dove into some. Some more technical stuff today. Happy to talk more if people have more questions. We have a ton of content that I can provide and, and on our website as well. Um, but it, it's definitely good, you know, especially in a. In a time in the market like this, you have to do a little bit more homework and, and understand what's going on because, you know, there's definitely risk involved in understanding that is important.

All right, Nathan. So people have questions, even like the most granular or maybe like the simpler questions is that should they hesitate to reach out to you or reach out to somebody on your team about that? Because I know a lot of people sometimes worry that, hey, I don't know what to ask or say the right words or this kind of thing. They have some questions for you. Is that something that it's okay for people to reach out to you with?

Yes, please. Please do. I'll see if we can provide my email address with the video. But if you reach out on our website, too, it goes out regionally, so if you're in the Midwest or in Texas or Oklahoma, I'll be talking to you. But if you're in a different region, it'll be a different team member. But we're really, we're eager to answer any detailed questions you have. We want to get grilled, and we believe we have the right answers for your questions. So, so please do reach out.

Awesome. If anyone's interested, we'll leave his information and MLG's information below. Again, they've been a, you know, 30 plus years in the industry. It's a fantastic track record. Please make sure, I always recommend for everybody, whenever they're vetting out, doing due diligence on a company, ask for the track record. You know, you'll find the good ones are more like they're not hesitant at all. The fact they're proud to show you their track record, make sure you ask for that. And there's always a red flag if a company always holds that back from you. So make sure you ask for that for mlg. Nathan, I want to appreciate you. I'll tell you, I appreciate you. Thanks for your time. And as always, you know, this has always been a good time and it's definitely learned a lot from you. So thanks so much. Let's talk again soon.

Yeah. Thanks, Peter. Thanks, everybody for listening in.

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