Episode 1: How to Minimize Risk in Commercial Real Estate
In the first ever episode of Durable Value: An Investor's Podcast, hosts Joe Muratore and Ryan Swehla talk about their longtime friendship and business partnership, seizing opportunities, making timely decisions, minimizing risk, and more.
Start Transcript
RYAN: “Oh yeah of course, we all love to find distressed sellers,” and he said it in a way that was kind of like, “Well yeah, of course we’d like that, but you know, how do you find that?” And meanwhile I’m thinking: that’s what we do every day.
We are always in our market, scouring our market, finding those opportunities that people who aren’t living and breathing day to day in our market aren’t able to do.
NARRATOR: From Graceada Partners this is Durable Value: An Investor’s Podcast, where hosts Joe Muratore and Ryan Swehla demystify commercial real estate with safe, sound investment strategies to help you balance your portfolio.
RYAN: On today’s episode, Joe and I speak about seizing opportunities, making timely decisions, minimizing risk, and more.
JOE: Do you remember where we met, like, how we met?
RYAN: I remember it was in Mr. Sutton’s class.
JOE: I remember, you know, you have a twin brother, I remember the two of you had the exact same haircut, wearing the same, you know—
RYAN: No we didn’t.
JOE: --Pacific Sunwear T-Shirt.
RYAN: Turquoise. It was probably a flat top, too.
JOE: Yeah, so we met in third grade. A lot of fun. I remember spending almost every weekend at your—I mean you were at my house plenty too. The fort you had in your backyard.
RYAN: We used to ride bikes back and forth to each other’s houses. Then in junior high we ended up getting in a mild fight together and getting mutually suspended.
JOE: It might have seemed mild to you, but it was serious business to me.
RYAN: And what did we end up doing during the suspension period?
JOE: I remember you at my house, and us throwing a football back and forth.
RYAN: We’ve been hanging out ever since.
JOE: I think that there’s … I don’t know how to say it … but when you find someone you just sort of click with, it just sort of works, I mean we’ve been hanging out for 35 years now. And we’ve been in business for almost 15.
RYAN: Well, and its--
JOE: It’s been an awesome run.
RYAN: It’s kind of a testament that when we get done with work, we still actually enjoy hanging out together. [JOE: Yeah.] Our families hang out together, our kids hang out together, you think at some point you’d get tired of that unless there’s something deeper there than just our business relationship.
JOE: I think we both treat this as … in some ways it’s like we both know this is a great thing and a powerful thing that can serve us for a long-term investing career and a friendship. And that’s a unique thing that a lot of people don’t get to experience, but personally I highly value it, and it’s the essence of what we do, and it works really well.
RYAN: Yeah.
JOE: So, Graceada Partners. You know, it’s been a long story with lots of pivots. We both worked at a different company. We decided to start a company together almost 15 years ago, and started in brokerage, and added … layered in property management, slowly pivoted and then distinctly pivoted fully towards investing. Now we do that full time and that’s wonderful.
Graceada Partners, that’s Grace and Ada. Two little old ladies that donated land for a park in Modesto. That’s a key part of our town, and, our town’s important to us. [RYAN: Yeah.] I think it symbolizes not just a way of life, as well. It’s like a part of who we are, and how we choose to live. It’s a long-term local investment approach.
RYAN: I wake up most days thinking how cool it is we can operate in Modesto and be able to do the things we’re doing. To be able to very comfortably analyze a property that’s worth $40 million and figure out how to add value to it, how to take the expertise and the experience that we’ve done and be able to apply that. And we’re not doing it from downtown San Francisco, we’re not doing it from Manhattan. We’re doing it here in our area, talking about properties in neighborhoods that we know well.
JOE: Yeah. I’m really focused on making sure that we have as much opportunity to pick from as possible. A big part of my job right now is loading the top end of the funnel with properties to analyze and understand. We’ve put in, in the last 2 or 3 weeks, about $120 million worth of offers: multi-family, office buildings, retail. Some of that’s kicking tires, some of that’s very serious offers.
The goal is to uncover hidden opportunity. We don’t know what stresses sellers are under. It’d be pretty easy to sit around during a time like this and say, “Well, you know in a few weeks or in a month, things will start to get going again and I’ll get to work.” But what I know is the seeds we plant now, especially in a time when most others aren’t planting seeds, will pay off then. And in fact, they’re paying off now.
I spend about half my time in the various submarkets—San Francisco, Fresno, Modesto, Stockton—at the buildings. There’s something special about being onsite. You can’t just look at the internet and understand an opportunity; you have to be at the building. You have to see it and touch it and see the neighbors. You have to talk to brokers and talk to sellers. In that I find clues and hints. A lot of times I’ll be looking at one building and someone’ll say, “What about the building next door?” And that’ll just lead me down the rabbit hole. Sometimes those are the best opportunities.
RYAN: Well, we did grow up in this area, so we know it intimately well. We’ve just been very fortunate to grow up in an area that has a tremendous amount of commercial real estate opportunity. California, obviously, is the 5th or 6th largest economy in the world and we operate in this quiet area that people really don’t know about. And yet it has 7.4 million people. It’s the fastest growing geography in California. Has been for decades and it’s projected to be for decades. It’s about the same size as the entire San Francisco Bay Area or the state of Washington (the 13th most populous state.) So, it’s a huge opportunity, and yet there are very few people looking at that market.
The other thing about that market is you look at underlying economic drivers, and why a particular geography will be successful over time or won’t be. And our two underlying economies (the two strongest sectors in our area) are government sector—Sacramento is the second largest government center in the country—and agriculture. And agriculture has continued to grow and flourish in our area. So, we see those as long-term drivers. Also, our area is the most affordable region of California, so we’ll continue to see carry-over from the Bay Area and Los Angeles.
JOE: One thing we think a lot about is asset allocation. Building the best and highest portfolio we can, and choosing where to put our dollars to work. So, government-anchored office buildings are a great place to invest right now, but they might not always be. So, we think a lot about how much should be in multi-family, how much should be in office buildings, and of that, how much professional office, how much government office, how much medical and healthcare. That’s a really important part of our job: seeing where we think the future’s going to be and creating that highest quality portfolio we can.
We started this business in 2008 with effectively no money. As a side note, when we started, I remember telling my wife, it was December, right before Christmas and telling her I had enough money to get through to Valentine’s Day. That’s a special memory because it signals the tough choice it took to start a business and how committed we were, and I certainly was, to getting through somehow. And in those early days, 2008, we’d just begun the Great Recession. It would bottom—property values would bottom in 2011. We saw three years of extremely difficult times before we saw any rays of hope or recovery. Those were powerful, formative times because we were doing a lot of work for banks, we were acting as brokers, we were selling distressed assets … I got to see where borrowers went wrong. I got to see what happens when property values plummet.
RYAN: I felt like during those times we were able to have a front row seat of how to navigate through distress on your asset. And there’s essentially a playbook now that we have of, these are the things we need to ensure on our assets. And also, these are the opportunities that we anticipate seeing coming up, based on that.
JOE: Yeah. A common problem we saw was owners who were trouble making lagging decisions. They were following the pain down and holding on the whole way. They were behind the curve, and one thing I … I think we’ve taken from that is we make decisions quickly and ahead of the curve. So we look at where things are going and we work to make that decision in front of it. And a lot of times that’s a difficult decision. But make it now, or make it later? Better to make it now. [RYAN: Yeah.] And that’s one thing I remember from that time: own your piece of difficulty, get in front of it, make your decision, and move forward. And I think that’s served us well, certainly as we navigated growing a business through dark times and into good times.
RYAN: I think another thing that we learned was the … danger of being overleveraged. Certainly as the property values plummeted owners were in positions where they were at … call it 70-75% leverage and they went to 100% leverage. And one of the things that we’ve been very focused on is being sure that the properties we buy, there is distinct and immediate value that we can create in those properties, because we call that the margin of safety. We only buy properties that are significantly below replacement cost, because that’s a margin of safety that ensures we can compete when new product is developed because we’re at a lower cost basis.
And then the second margin of safety is ensuring that we can add value quickly, so even if a property is already performing well, we don’t buy properties that we simply buy and sit and collect income. We buy properties that we can then add additional new opportunity to as well.
And I think the third part of that margin of safety is ensuring that we have the capital structure that ensures we are able to navigate through. And that’s both on the debt and equity side. On the equity side we’ve structured it as a fund structure so that we have the ability for our same ownership group to be able to work across multiple properties, be able to handle issues, be able to jointly see the benefits of propertis. And then on the debt side, working with lenders who we have personal relationships with.
JOE: I look at the building we’re in now. We bought it at a 9.3% cap rate, we bought it at $123/square foot. This building’s steel and concrete floors and underground parking. It’d be $350/square foot to replace. That’s a measure of safety. And we were at a 9.5 cap on current income. And the building was only 2/3 occupied, and quickly we were able to come in and lease another floor and a half. So that built up a margin of safety. And that’s generally how we approach things.
[Music]
NARRATOR: You’re listening to Durable Value: An Investors Podcast. We understand the realm of commercial real estate can be daunting, but we want to make it as simple as possible for you. Get the free 56-point Checklist for Evaluating Investment Properties that Graceada Partners uses every day at graceadapartners.com/guides
[Music]
JOE: I’d say I spend 1/3 of my week in admin, 1/3 of the week in current escrows and properties that need to move forward, and 1/3 in a very creative space. And that final third, usually about two days a week, is my favorite spot. This is where we’re at the front edge of what we do. This is the finding-opportunity piece, the loading the top end of the funnel. And for me that means being onsite, in the markets, seeing things that you can’t see on the internet, seeing things you can’t see in the listings.
Generally—let’s say I’m going to Sacramento for the day. On the way there I’m calling five or six brokers in that market that I really like. Were friends. When I call them it’s like, “How’s it going?” We both benefit from this relationship. We’re among the most active buyers in the market, and they want to sell properties, and we’re looking for great properties. And we’re not just looking for things on the market; we want the underlying scuttlebutt, the stuff that’s being talked about in the broker’s office. We want the stuff where they know a seller that might be selling, or might be struggling, or might be going through a life change, and a building may be coming to market. So in that casual conversation, I’m picking their brains on what might be coming down the road and how we can have first shot at it. Those are my favorite times.
I also love being in the buildings. Every single day I’m in the market I shop our competition. If I’m in Walnut Creek, if I’m in Sacramento, if I’m in Point West, I go to … every time it’s a different building I haven’t been in before. And when I walk in, it’s always, “How are the bathrooms? How’s the lobby? How high are the ceilings? What sort of lighting do they have? Where did they spend the money for the most impact? Are the hallways lit the same way as the lobby? How’s the exterior landscaping? How are the trash enclosures?” But I love understanding the science of how our competitors work, and further developing our edge.
So, I approach things like a designer would. When we buy a building, I take from those sources and it’s like I build a design tray. I think the hallway should be like this from this building, and I know which address it is, so I can go back there and see it. I feel like the bathroom should be this way. This is the best bathroom I’ve ever seen.
I was in Walnut Creek the other day and saw the best exterior signage of a building I’d ever seen. I came back, I talked to Jim, we’re incorporating it into a build in Sacramento like that [snaps fingers]. I saw it one day, the next day it was moving forward.
A lot of what we do is design. It’s the human element. Without humans, we don’t have buildings. Buildings exist to house humans. They exist to multiply their efforts, to create an environment where humans can do their best work. When we put our hearts into what we’re doing, it’s appreciated. It’s noticed, and in fact, we stand out. When that entry sign is amazing, like they’ve never seen one like that before, that gives that building a uniqueness. And not only is there a joy in building amazing buildings, it’s a margin of safety, that our building stands out. Our building in Sacramento, there’s not another building in Sacramento that looks and feels the way that one does.
I want to make sure the buildings we bring to market are original. They’re an amalgamation of the best practices, but they have our unique touch and flavor.
What about you? Anything else you’d add on how you spend your days?
RYAN: Just like we were talking about a little bit earlier, I think about what we need to accomplish to move our company forward, and what strategic relationships, strategic initiative things we need to be thinking about as we move our company forward.
What we did to get to get us to here will not get us to the next step. So, constantly thinking about what that next step looks like and how we actualize that along the way. That’s the creative space that you mentioned that I enjoy operating in, because our creative space is really where we, as the entrepreneurs, need to be spending most of our time.
JOE: One thing I really enjoy is, we have a team of ten, but the way our accountability chart works, we have moved ourselves to a spot where we can spend about half our time in our expert zone. You more in the capital side, me more on the opportunity side. But Jim and John, who lead finance and construction and property management, are the best around at their jobs. As a company, we’re really good at creating space where people can do their best work.
RYAN: One of the things that our industry has trouble with is high ego and sole operators. You mix those two together and you get a lot of situations where people are making decisions in an echo chamber, convincing themselves it’s the right strategy, and not being open to potential pitfalls.
JOE: Yeah, making great decision is extremely important, but maybe even more important than that is not making bad decisions. And we often say in our office, what got you to here won’t get you to there. The important part about that is keeping your ego low, keeping your ears open, listening, understanding how things are different now than they were before.
The most common pitfall I see in this business is people do well. They have a few hits. They start to think they’re smart. They start to think those little red flags about the investment aren’t that big a deal, they start to think that the market cycle doesn’t quite apply to them. They start to make poor decisions for a bunch of reasons.
And what’s really crucial to what we’re doing is our partnership, our candid 50/50 partnership. And I know when I bring deals to the table, they’re gonna get picked apart by you.
RYAN: Mmhm …
JOE: I know it. I kind of hate it but I know it.
[Laughs]
I respect it because always, every single time I leave our investment committee meetings better off than when I started. I have to defend the pricing we’re going after, the occupancy expectations I think we’ll achieve. The timelines. The rental rates, the positioning of the asset, why this area is growing or not growing. Those decisions you can’t just make them in between your two ears. But if you’re solely running a company, often that’s how decisions are made. But between the two of us they’re verbalized, they’re discussed, sometimes for hours.
But when we go back to the market, we make a call and we make an offer, its well thought through. And that puts us in good stead compared to our competition.
RYAN: Well I think a good example is what we’re dealing right now with this pandemic and its effect on our portfolio. We’ve been able to look at each of our properties, assess the potential risk of each property, and because of the assumptions we’ve made going into the property, we have this margin of safety that allows us to be flexible and entrepreneurial as tenants come to us, as situations arise. Another owner just simply wouldn’t have that flexibility.
JOE: Warren Buffet famously says, “When the tide goes out, you see who’s wearing swimming trunks.” This is the time when the tide’s out, and this is the time when we also test the assumptions we were making two years ago when we were thinking about the next recession.
Now’s the chance we get to see how those are working. And largely, they’ve fared well.
It’s really important in times like this to play offense and defense. We come to work and we deal with issues that are on the table, but we also are very focused on capturing opportunity that exists during these times.
RYAN: So, I think when we started as a company really informed a lot of how we operate. We started in ’08, at the beginning of the Great Recession. We saw the blood in the streets, so to speak. And we’ve seen how people survived through that. We’ve also seen how people thrived through that.
There’s two different skill sets that we bring to that. One is a healthy level of pessimism. And conservatism—I think that’s probably a better word. We use the term “margin of safety” a lot. Everything that we’re investing in, we look at, what’s our margin of safety? What’s our downside risk? Because we always have that in our rearview mirror.
The other thing we bring is an incredible amount of energy and drive and focus. We are incredibly passionate about the work we do, and it feels a bit like we are exploring the new frontier.
JOE: Yeah.
RYAN: And what I mean by that is here we are based in this geography, doing what we do, and we know it arguably better than anybody else in the world. [JOE: Yeah.] Our expertise is arguably better than anyone else in the world for our geography.
I was at a conference recently, and one of the speakers on the panel that I was on said, “Oh yeah of course, we all love to find distressed sellers,” and he said it in a way that was kind of like, “Well yeah, of course we’d like that, but you know, how do you find that?” And meanwhile, I’m thinking: that’s what we do every day.
We are always in our market, scouring our market, finding those opportunities that people who aren’t living and breathing day to day in our market aren’t able to do.
JOE: One trend that excites me is the continued growth of the Bay Area, but the affordability of our area. So as you add high-speed rail and Zoom calls, as you add more ways for people to work remotely it gives people a greater reason to be in the Sacramento area versus the Bay Area—and the Modesto or Stockton area, or Tracy, Manteca, Fresno—than the Bay Area.
You mentioned earlier there are 7.5 million people that live on our side of the mountain range, which is about the same as on the Bay Area side of the mountain range. There’s an incredible population here. We did the math and there’s about $80 billion worth of office buildings between Sacramento and Fresno. $80 billion. That’s a tremendous pool of buildings that we can work on for many years to come.
RYAN: People move to California because of the quality of life that you have in California. People leave California because of the lack of affordability. And here we are in the region of California that has the best shot at affordability. [JOE: Yeah.] Um, it’s certainly not Midwest pricing, but at the same time, compared to just over the hill in the Bay Area, there’s a tremendous amount of affordability in our marketplace. And that’s why, year after year, our region grows faster than any other region in California.
JOE: Who are your heroes, Ryan?
RYAN: Well, the one that comes to mind right away is my dad. He has always been a voice of sound reason throughout our business life and in my personal life as well. He was originally a pastor, and then ultimately became an entrepreneur and he exhibits both of those characteristics. The one of guidance and counsel, and also the one of having been in the trenches, and working through those challenges—cash flow, people, whatever—of starting and running a business.
What about you? Who are your heroes?
JOE: I remember early in my career, getting a book from the library: Warren Buffet, The Making of an American Capitalist. I sat in my backyard with my three-year old twins running around making a lot of noise, and I read those 600 pages in a weekend. I just couldn’t put it down. What I loved about that was seeing a normal-ish guy from Omaha, Nebraska do something incredible.
It reminded me of Modesto. I loved his long-term value investing approach. I loved his commonsense approach, I loved his data-driven, sort of folksy approach. And as I read those pages, I thought, if you set your mind to something amazing you can do it. And when I think of our company and our friendship and our runway and our skillset, I believe we can do incredible things too. I come to work every day det to get important things and to have a great time and to follow my “why.”
It’s wonderful to work in a company where you and I can make any decision. We can make them quickly. A lot of companies would have to go to a committee. There’d be a lot of politics involved. But we have 35 years of friendship and trust, and 15 years of operating a compelling, growing business. And when we look at each other and make a decision, we’re able to make great decisions quickly.
We’re both—I’m 41 you’re about to be 41—but we’re at a stage in our career where we have 15-20 years of work experience, yet we’re pretty young and we’ve got something to prove.
I look at a lot of our competitors and they’re generally a generation ahead of us. And I don’t see them working with the same vigor and enthusiasm that we do. And I think we have a 20-30 year runway ahead of us to do incredible, compelling work. And people of our generation are going to need to step up.
Every building has an owner, and every building is gonna have an owner of our generation. And I believe it’s our job to manage and lead the most important buildings in our region.
And I think we’re best positioned to do that.
[Music]
NARRATOR: Thank you for listening to Durable Value: An Investor’s Podcast, where we demystify commercial real estate with safe, sound investment strategies to help you balance your portfolio. If you enjoyed this podcast, be sure to rate it on iTunes, or wherever you get your podcasts. To learn more, visit graceadapartners.com where you’ll find more information, investor’s tools, case studies, and more.
This podcast is hosted by Joe Muratore and Ryan Swehla. It’s produced, edited and mixed by Melodiq, with intro music by Ian Post. Thanks again for listening, and we’ll see you next time.