How We Manage Risk
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Episode Transcript:
So today, uh, we've seen a lot of changes in the real estate market. Um, a lot of moving variables. And so we thought we'd just take a moment and talk about what are the risks that we see in the real estate market, or at least in the microcosm that we work in, in the market, and how are we, you know, mitigating around them the best that we can?
Uh, uh, one that comes to mind is, uh, ca cap rate growth. Um, so values are inverse of cap rates. Values have moved, uh, somewhere between 14 and 18% down so far. Cap rates have moved up about a point, um, sometimes a a point and a quarter. Um, it seems like cap rates will still move another half a point, another 70 basis points.
Uh, maybe another point we don't know, nobody knows or Yeah, best we can tell. Um, the challenge on cap rate movement is if, uh, A cap rate goes up a point you have to grow n o i by 17% to offset that. Now, in our normal business plan, when we buy a property, we, um, we often buy things that are 20 or 25% below market on rents.
Um, now there, there is some math in here between rents dropping down to N O I. Yep. Um, point being is you're running in sand with cap rates move moving, and that is a big risk. We think about quite a bit. A mitigator to this would be interest rates went up a lot. Yeah. And cap rates moved quickly. This next round of cap rate movement is likely to be much slower.
Uh, maybe over several years. It may be less than we think. Uh, we don't know. But I, um, from the lens I'm looking through at this moment, uh, cap rates will continue to move. They won't move as dramatically as they did. They will move much more slowly. And, um, it's important that we're buying right now. Uh, we're not that we're buying right now, but that we're buying right now as cap rates are moving.
What, what are our levers, our margins of safety? Right.
Well, we operate in secondary and tertiary markets. We operate in markets that are, uh, predominantly are, are less liquid and are, uh, Dominated by local owners. Mm-hmm. Um, regional owners, not institutional owners. Mm-hmm. Uh, we offer on, for about every 20 buildings that we offer on or underwrite, we buy one.
Um, our sales, our, our purchase cycle, our buy cycle is about six to eight months. So we have lots of offers going out that lead into a few that we underwrite. Which lead into a very few that we buy. And, um, so we have the opportunity of seeing the market, seeing the matrix, seeing the, the boots on the ground perspective in a way that, uh, is not well captured on online data.
Yeah. Um, we're, we're seeing at the ground level, we're also able to pick the very best deals of, of, you know, dozens and dozens of offers. Mm-hmm. Um, so we are able to find motivated sellers. In, uh, markets that we think are stable and stronger and, and going to do well, we are also sort of dollar cost averaging.
Yeah. Um, we are buying a little more slowly this year than we will probably next year. Um, but we are a little bit of ahead of the herd, so to speak. Yeah. There are, uh, way fewer, uh, buyers that are, we're competing with though. Generally we buy off market with low competition. There's just less noise and activity in the market
Um, so we're, we're, we're, we're being cautious. Yeah. And the other thing that I would say is when you work in an inefficient market, there are inefficiencies. And so with that, you have the ability to find opportunities within any market cycle. Um, if you're testing the, the water constantly through offer underwrite.
You evaluate whatever, um, you're able to find those sellers that have adjusted their expectations down meaningfully and sometimes more meaningfully than, than perhaps the market. Um, I know during the last I. Six months or so, we've essentially inched up our threshold on where we're willing to buy. We've, we've increased our I r r that threshold where we wanna buy, and we've done that as kind of an abundance of caution.
It allows, it builds in a little bit more margin and safety because we're transacting in an environment that is, uh, more, uh, you know, uncertain or projected exit cap rates are. Uh, a hundred to 125 basis points higher than they were. Yeah. Um, our loan to value is, uh, 55% versus 65 or 67%. Yeah. Uh, and our projected IRRs are, uh, about a hundred basis points higher than they were before.
So you can see the levers we're pulling there. And generally we've outperformed our un underwriting historically.
So one of the risks that I, I see out there, uh, and that we always have to be thinking about in real estate is new supply, right? Yeah. Supply and demand. Um, we work in two different asset types.
We work in multi-family, we work in multi-tenant industrial, and so there's those each have their own supply demand, uh, drivers. And then market by market has its own supply demand drivers. So if I were to say broadly speaking, um, new supply is always a concern. Mm-hmm. It's something that any value add or existing real estate buyer is, is mindful of.
What we've seen is, uh, on the multifamily side, if I were to just kind of speak broadly across the markets where we operate, we have seen, uh, an uptick in new supply. Uh, we've seen an uptick in new supply over the last, call it three to four years as rents have grown so much that. Uh, more and more developers are entering into the market to, uh, to build.
Mm-hmm. Obviously interest rates going up have had a dampening effect on that, so that's good from our perspective. Um, so that mitigates new supply to a degree, but we are seeing in the markets where we operate, uh, rents starting to taper off, uh, getting back to low single digit growth, sometimes flattening.
Mm-hmm. And that's a mix of a couple things. Number one, we saw this huge run up in rent growth. Um, which, which speaks to an affordability issue. But then, uh, we also have seen, started to see new supply come online. So I, I think, uh, on the multifamily side, uh, macro economically, we are supply constrained. We do not have enough supply of, of housing stock, broadly speaking, but, uh, as new supply comes on the market, that certainly dampens the, the rent growth in the future.
I would say on the multi-tenant industrial side, it's a little bit of a different story. Um, pre great recession, there was a, a influx of new build into that space. And during the great recession, um, certainly we saw supply or we, we saw demand drop off as businesses went out of business, that sort of thing.
Um, where we are with light industrial today is quite different, um, because rents never grew to the point where new, new construction. Could be justified. We have operated it in a perpetual supply constrained environment. Mm-hmm. On the big box distribution warehouse, certainly we've seen a lot of new supply come onto the market, but in that small bay, multi-tenant industrial, we really haven't seen any new supply come on the market.
So new supply will be a problem at some point. It always is. That's, that's the ebb and flow of real estate cycles. But for small bay industrial, light industrial, we just don't see that supply, new supply be becoming an issue probably for years down the road.
Yeah. A big advantage to our strategy being in secondary and tertiary markets is rents do not justify new supply generally.
I. Um, there is some, but it's, it's very limited. Yeah. So rents will still have to grow quite a bit more, be before new supply comes on. Uh, in mass. I talk about tenant affordability too, though. Uh, a disadvantage of being in secondary and tertiary markets is, uh, tenants are generally there, uh, for value in proximity.
And, uh, value has been eroded when over the last few years. Uh, on the multifamily side, we had. In California maxed out 10% rent growth, but generally eight to 10% rent growth. Uh, in, in all the markets we're in, uh, tenants have been pushed on what they can afford and that is limiting on, um, how much rent growth we can do going forward.
So that. That is a bigger risk. We, we, we've always been conservative in our underwriting, uh, in that we would generally, in the high years project, five or 6% written growth. Now we're at three or four, sometimes three flat. Yeah. Um, but, um, that is a challenge to, um, value creation is you've got cap rates moving the wrong direction and you've got rents slowing down.
Yeah. So, and I think one of the ways we mitigate around that, although. It, it is a market-wide issue, is this issue of affordability. Um, but one of the ways we mitigate around that is we do operate in markets where generally tenant rent is 25 to 40% of their income, versus in a lot of primary markets, rent is 40 to 60% of their income.
Yeah. So we're, we're operating in an, in an environment where there's a little more room to give in that affordability, but I think we, we certainly. Uh, we do have a, an issue that'll play out over time, which is we've seen a run up in rent, we've seen affordability, decline. We've also seen home ownership, affordability, decline because interest rates have gone up.
Yeah. And yet the overlay is that we do not have enough housing supply in nationwide. Really? Yeah. So how those dynamics play out, uh, it will be interesting.
In most cases, our going in, uh, rent to income is 25%, uh, of their income. Yeah. And we're, we're careful about that in our, uh, checklist and, and what we buy.
So, yeah. Um, it is safe to say that secondary and tertiary markets, broadly speaking, have, you know, potentially higher peaks and higher troughs through the real estate cycles. Um, pandemic induced cycle, uh, that we've just gone through was different. Uh, primary markets arguably suffered more than secondary and tertiary markets, but as we all know, throughout the long time history, generally primary markets recover faster.
Um, and secondary, tertiary markets recover slower. So there are kind of two postures that one can take with that. Uh, one is to say, well, I just, I won't operate in those markets. Obviously that's not the, the position that we take. It's much like, um, saying I won't buy hotels because I don't want to have to deal with labor and employees.
Well, labor and employees is a fact of hotels and market cycles, and their effect is a fact of secondary and tertiary markets. So our approach is how do we deal with it? Mm-hmm. Rather than, uh, you know, turn a blind eye. And the way that we deal with it is that we, we've, we grew up in tertiary markets. We grew up going, going through the Great recession and the global financial crisis.
And, and with that, what we learned is that our levers are a little different than in primary markets. In primary markets it's very common that you'll see a lot of financial engineering. I. To over lever the property preferred equity and def different tiers of debt and things like that because, um, they're, they're using financial leverage to be able to help yield the return because the, the natural return profile is lower in these primary markets in secondary and tertiary markets.
We operate at a lower leverage and a more conservative debt position. We do that because we've seen what happens when you go through a deep recession with less conservative debt. So our, our general posture on debt is more conservative, fixed rate, lower leverage. Our portfolio wide leverage is about 55%.
Um, the other thing that we do is we focus on, um, certainly we focus on buying well, but we also focus on adding value quickly. Yeah, that's a, a really key. Thing that we learned going through the, the Great Recession is that when, when you have these deep turns, the ability to get in quickly and add value quickly, at least builds that margin of safety.
It doesn't, it doesn't make that downturn a cakewalk. You know when, when cycles are up, absolutely. Everybody makes lots of money. When cycles are down, the people who are uh, prudent are the ones that make money. Well, I think as we close out here, uh, it's important to note that there are real risks to what we do.
Our goal with this podcast is to show that, uh, number one, we're aware of them. Number two, that we're thoughtful about them, and number, uh, three, that they are real and, and do exist, and we are, uh, working to mitigate those. Um, I think that's one thing I really enjoy about our partnership is that, uh, as these issues, uh, come up and as these ideas form our offices are literally, uh, you know, they share a wall and we often, uh, argue through these things.
Talk through these things, yeah. Uh, brainstorm through these things. It helps us make a, uh, a better product. And I, I think I speak for both of us, that we're excited about where we're going. We see these risks, but we see much more opportunity, uh, than risk. Yep.
Summary
Joe and Ryan discuss the current market outlook and how it affects their strategy going forward. They talk about the risks they see in the market, and how supply, tenant affordability, and the sensitivity of secondary and tertiary markets affect their business.