Where CRE Fits Into Your Portfolio

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Joe Muratore:

Well, if rents are going up 10% and interest rates are going up 2%, you can see how that might work favorably for us. Also, with inflation costs that inflates construction costs, which means new product doesn't get built, especially on the smaller multi-tenant stuff that we do, which means supply stays tighter, which further leads to more rent growth.

Narrator:

This is Durable Value. Get investing in business insights from industry experts and successful entrepreneurs every week. Like and subscribe now.

Ryan Swehla:

Today, we're here to talk about how real estate private equity fits into a portfolio, and maybe we should start by backing up and saying, what is real estate private equity? What do we do? What is the business that we're in?

Joe Muratore:

Well, real estate private equity is not unlike regular private equity, and that rather than focusing on companies, we focus on commercial real estate. Commercial real estate's an asset class that allows for a reasonable amount of leverage. It's normal and it magnifies. It can magnify returns. What I really like about it is it's pretty straightforward, and that we're growing net operating income, and we generally do that by managing expenses exceptionally well and by driving rent growth. If you do those things and you understand your exit cap rate, same as it might be a multiple of EBITDA or something like that for a regular private equity, you can drive value creation somewhat quickly. The advantage of working with a group like ours is we are very good at taking a commercial real estate portfolio or an asset along a value creation journey. There are other companies or there are other families that might own real estate. Lots of people own real estate. A company like ours is very attuned to our investor's goals, namely internal rate of return, and equity multiple, and creating outcomes that fit those returns.

Ryan Swehla:

Yeah. To speak a little bit about value creation, people often think of real estate as a cash flow investment. I buy a piece of real estate and much like a treasury, every month, I get a rent check and that's my investment in real estate, and then maybe someday I sell, maybe I never sell. Private equity real estate is different. Much like private equity in the company space, we're in the real estate space and we're trained to look for misalignment in value. We're trained to look for, "Huh, every other property in this market is at 93% occupancy, and this one's at 84% occupancy, and it's arguably as good or better than other assets in the market. When I walk in the building, I notice that the frames on the wall are kind of tilted and haven't been cleaned in a while. The paint scheme is old." These are the kind of things that denote potential for value creation, so we're always looking for finding real estate that has built-in value that hasn't been unlocked. That's why we're not as focused on cash flow.

Cash flow is an important measure because that is our margin of safety. We view cash flow as a margin of safety. If cash flow is strong after we create value, then it allows us the option to hold onto the property longer if the market isn't giving us the price that we think the property is worth, but cash flow isn't the driver because our job is to create cash flow. So, we're going into properties. We don't like buying properties that have no cash flow or negative cash flow, but we understand that typically, we're buying properties that have marginal cash flow because the prior owner hadn't been unlocking the value in that property.

Joe Muratore:

We often say that companies reflect their owners. Well, real estate reflects its ownership as well. Just like you talked about walking into a lobby and you've got dusty frames, and maybe vacancies higher than it should be, rents are a little lower than they should be. Well, with regular private equity, they might see companies that are managed in a different style than they could be. Each company and private equity companies have their flavor, and we're on this discussion, and I think that the real estate we buy and the real estate we manage reflects our worldview, so to speak. So, a lot of the value we create comes from leadership. It comes from increasing the appearance of the asset, and then driving rent growth through better operation.

Ryan Swehla:

Yeah. I love that you mentioned that real estate or a company reflects its ownership, and what's interesting about that is every firm is different. So, even though two firms can come into a market and say, "That multi-family property, it's under-market rents. It's poorly amenitized. It hasn't been upgraded in a while," they can both identify those same things, but one company has one flavor and culture of how they do it, and another one has a different one. Arguably, how we approach properties, this kind of gets into the qualitative or the touchy-feely is we approach, I think, the world in kind of an open mind frame. Not a kind of dog eat dog, survival of the fittest sort of thing. And a bit of an abundance mentality, where if I treat people well, good things will happen.

Our company culture is that way, positive, caring, and humble. If I do well for people, good things will happen. That's not necessary in our business, but that just happens to be our flavor of what we do. We go into a property and we do the same business plan, but we have a culture and an ethos of how we do that I think ultimately yields better results, whether that's better results from a psychological standpoint that we treat people well and we respect them, but it also translates to tenants that are happier to properties that have a higher pride of ownership. Ultimately, that does relate to return too.

Joe Muratore:

Yeah. That's a really important point. Some people watching this or certainly as we've gone through the years, we thought like, "Well, do you just go and raise rents on everyone?" Maybe that's apartments or maybe that's industrial, and the answer is yeah, rents do go up, but what's interesting is one key part of our company is we always lead with value. The assets get a lot better. Before we say, "Hey, that costs money," we lead with the property getting better, and there have been times, in fact, more often than not, where we get tenant feedback that's... On the inside, I'm like, "Well, rents just went up 8%. Some people are going to be unhappy," but what's interesting is often, we hear they're really happy that we're there because generally, we buy assets from owners that were sort of checked out or had held it a long time or just didn't care much anymore, and now, whoa, details matter, customer service matters. The asset got prettier, nicer, and... It's a place where they live or it's a place they run their business, but it became a better thing.

Often, when we sell assets, people are like, "Oh, I can't believe you guys are... You're the best owner this building has ever had." We hear things like that and it's surprising, but there is that dimension. Part of it is who's your customer? And the customer of the building that we're buying may not be the customer that we want, once we make the building amazing, but that's a different podcast, I guess.

Ryan Swehla:

Yeah. Well, then how does that relate into what an investment in private equity real estate looks like?

Joe Muratore:

You're investing in an operator. You should be thoughtful to disassociate the asset class with the execution. On the one hand, you should say, "Do I believe in investing in real estate?" That's its own discussion. Beyond that, the question is do I believe in investing in excellent execution in the operator? I think that when you call a firm, real estate private equity, you better be speaking about a firm that's sophisticated, that has a deep process and practices that has an excellent staff that really knows what they're doing. It's the operator that separates just an owner of real estate versus real estate private equity.

Ryan Swehla:

Yeah. Let's transition a little bit to kind of talking about the characteristics of that investment. Real estate private equity is often called private real estate, and what is meant by that is it's not a public market. Right?

Joe Muratore:

Like a REIT.

Ryan Swehla:

Yeah. You can't go on the S&P 500 and buy a real estate investment trust share in private real estate, and that has its pros and its cons. On the pro side, it's a illiquid market, so that means that you've got potential for market nuances that you can take advantage of. The con is also the fact that it's illiquid. When someone invests in private equity real estate, they're sending a check to a company, and when properties are sold, the money is coming back, also quarterly distributions, that sort of thing. So, they're receiving quarterly distributions, but then ultimately, when properties are sold is when they're seeing their biggest return. So, it's out of the investor's control.

Even when they invest, it's a bit out of their control because we have what's called a capital call structure, which is very common in the industry, which is where an investor says, "I'm going to commit a million dollars," and then we as the operators, the manager decide when we're calling that commitment based on when we find good investments that we want to invest in. So, a lot of times, I'll say that think of what we do as money multiplier. That's what we're ultimately focused on. We're not focused on regular quarterly distributions. We do have those, but when we're buying properties, typically they're cash-starved. So, we're buying properties that have modest quarterly income, but our job is to grow that. Our job is to create that value. And then, as we create that value, that's when it's optimal to sell because we've created this value and we want that value to be monetized. So, a person invests a million dollars. They put that money in over periods of a year potentially, and then they're receiving quarterly distributions. And then, over that three to five year period, they're really starting to see that investment come back.

Joe Muratore:

We've had some families over the years that have invested with us and needed to live off of the cash flow like it was a part of their paycheck to paycheck retirement strategy or something like that. And that is probably not the right fit and could be the cause for frustration.

Ryan Swehla:

Well, even if they're thinking of it, "Oh, well, this is a cash flow investment. I'm going to give you a million dollars and you're going to give me back 600 grand every year clockwork," that's not our business. Our business is to receive a million dollars, and over the course of three to five years in lumpy intervals, they receive back $2 million.

Joe Muratore:

Now, the good news is-

Ryan Swehla:

It's to multiply.

Joe Muratore:

... our online platform is incredible, and they can see the activity. Our distributions are quarterly, and we distribute on almost every property quarterly, and certainly statements are quarterly. So, there is that effect, but it can be lumpy, and the happiest customers we have are the ones that have been with us for a long time. When they invest in two or three years, later, four years, they get a big check back and they start-

Ryan Swehla:

Then they get multiples as we sell, and then oftentimes they're, "Okay. Well, what's the next-

Joe Muratore:

So, they're [inaudible 00:13:08] layering in their deals, so that there's closings happening regularly, and money they invested a few years ago is maturing. And then, they might roll that into the next thing or next fund, but those sorts of things.

Ryan Swehla:

Yeah. Another thing about investing in real estate, especially, that we're seeing right now is correlation to stock market, correlation to inflation. These are... Again, when everything's going well, we have low inflation, we have stock market going up, people don't think about correlation to these as much. But now that stock market is having a bit of a resetting and inflation is on the rise, correlation to those becomes important. In real estate, typically, inflation generally is a good thing. I wouldn't say that-

Joe Muratore:

Inflation's great. Interest rate growth is-

Ryan Swehla:

Yeah. That's where it's-

Joe Muratore:

It's lousy.

Ryan Swehla:

With inflation, we often will see that interest rates go up, especially as the Fed tries to combat that. The other thing that we see is expense structures go up, right? Inflation affects our-

Joe Muratore:

Like debt cost.

Ryan Swehla:

It affects our operating expenses. It affects our construction costs. So, certainly on the expense side, inflation is a bad thing, but inflation is a great thing for real estate rental rate growth. So, generally, that offsets those detractions on the expense side. When you're an operating business, if you're manufacturing granola, you have this whole issue of, "I've got to go to the market and try and reprice, but people are already feeling like they're spending too much and they're having to go down to the next product." In real estate, because this is where businesses operate, this is where people live, generally, as inflation grows, we are able to track with inflation on our rental rates.

Joe Muratore:

Ryan Swehla:

Yeah. And then, on the correlation to stock market, this by the way can be good or bad. It's just a fact. Private real estate tends to be fairly uncorrelated to the stock market. So, a year ago or two years ago, when the stock market is doing its rise, real estate has risen as well, but it certainly didn't keep track to the rise that we saw in the stock market. [inaudible 00:16:22] Conversely... Well, because of value creation, right?

Joe Muratore:

Yeah.

Ryan Swehla:

But-

Joe Muratore:

But back to private equity.

Ryan Swehla:

... broad valuation. But conversely, when the stock market has a substantial decline, real estate doesn't directly correspond to that. Generally, real estate values tend to move slower than stock market. Stock market is a daily pricing of value. Real estate, because it's an illiquid asset type, it tends to have a slower up, slower down. And then, as you were kind of alluding too, our job is essentially to accelerate the good, right?

Joe Muratore:

Yeah.

Ryan Swehla:

So, broadly, real estate values might be trending up. They might be trending down. Our job in private equity real estate is always to accentuate the value. So, when the market's going well, that means that typically, private equity returns are outsized. They're exceptional because we've got market growth, plus our ability to create value. But then conversely, on the downside, if broad real estate values are declining, it's private equity real estate that tends to be either declining less or actually growing in the midst of a declining market because we're not in the business of sitting passively and waiting for the market to price our real estate. We're in the business of pricing it by adding value.

Joe Muratore:

What you might say about real estate private equity is you get both a finance company and an operator. And that'd be true with traditional private equity, but think of a hedge fund or a stock investing company. They're having an opinion about what some other company that they don't own or [inaudible 00:18:18] generally control is going to do. Or in a hedge fund, they're taking long and short positions. They're applying leverage in different ways. They're applying finance strategies to a different company.

Now, in our business, there's going to be less of a focus on the finance side. Certainly, there's debt and equity. There are structures there that are important, and we are expert in those, but you also have an activist investor, an activist owner, an operator that's going to steer instead of this company, this property, which is full of lots of smaller companies to its best possible future. So, I think the reason to invest in a group like ours is number one, we better be very competent on the finance side, which I believe we are, but number two is our ability to execute and operate, and I think we're really good at that.

Ryan Swehla:

Yeah.

Joe Muratore:

Ryan, when people invest with us, explain how a fund works. Explain what they're investing in.

Ryan Swehla:

Yeah. Yeah, that's a good point. They're not investing in individual pieces of real estate one by one. Rather, what they're doing is they're investing in a diversified pool of these properties. So, our job is to go out and find what we believe are the properties where we can create the most value, and investors are investing in a fund, so that fund ultimately goes out and buys property by property by property, until we ultimately have kind of a diverse portfolio of properties. But going back to your prior point, these are properties that we control versus buying stock positions in companies that we don't control.

Joe Muratore:

For example, we're in Graceada Partners Fund III right now. There's probably 10 buildings in Fund III. There's some multi-family, some industrial, some office, and they're in various stages of the value creation cycle.

Ryan Swehla:

In various geographies, submarkets, that sort of thing.

Joe Muratore:

What might be interesting to speak to is we have a portfolio manager that thinks about the overall returns and outcomes of that fund. We have an asset manager that thinks about tactically the value creation that's happening in a one-year span. And then, we have property managers that think about collecting their rents and maintaining the assets. We look at the overall fund life, the product we're engineering to create, and also the specific strategies that we're doing on each property, and then the day-to-day.

Ryan Swehla:

Mm-hmm. So, fundamentally, private equity real estate is a piece of a person's portfolio. Like we mentioned earlier, just like in the stock market, there are benefits to dividend stocks versus growth stocks. And ultimately, depending on the investor's appetite, they have varying amounts of each. Private equity real estate is that money multiplier. It is that high growth, high return. It is not focused on regular dividend, although that's a part of what we do, and it has a different risk profile. So, fundamentally, within the broader portfolio construction of a investor, this occupies a space that occupies the space that has that kind of higher return profile and higher risk profile than going out and buying treasuries.

Narrator:

Thank you for listening to Durable Value: An Investor's Podcast, where we demystify commercial real estate with safe and 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, investors' tools, case studies and more. This podcast is hosted by Joe Muratore and Ryan Swehla. It's produced, edited, and mixed by Melodic with intro Music by Ian Post. Thanks again for listening and we'll see you next time.

Summary

With most investors thinking about ways to mitigate tenuous market shifts, some may be reevaluating the makeup of their portfolio. In this episode of Durable Value, Joe and Ryan discuss where Commercial Real Estate might fit.

In this Episode

Real Estate Private Equity defined
Differences between private equity and cash flow investing
Pros and cons of equity investing
How does inflation affect private equity
How does the stock market affect private equity
How does investing in a private equity fund work?

Runtime

22:17

PodcastRyan SwehlaOctober 18, 2022podcast, investing strategy, Commercial Real Estate, asset management, financial crisis, uncertainty