Preston Pysh  1:11  

Let’s just jump right into the interview here. We’re talking about commercial real estate. Give everyone a little bit of background about this asset class and then also give people an idea of the kind of returns an investor should expect out of this kind of investment.

I think what’s really interesting about the history of commercial real estate investing in the United States is that we can actually look to some legislative changes that took place earlier in the 20th century that led to kind of the current, I’d say paradigm of commercial real estate today. Then ironically, some additional legislative changes that is now starting to disrupt that current structure. 

Ian Formigle  1:38  

Let’s start by talking a little bit about real estate syndication because real estate syndication is a practice, which essentially means that multiple private investors come together. They pool their capital and they acquire properties. 

This is actually something that is hundreds of years old. It was actually employed in Europe and even the 1700s or 1600s to acquire properties. 

In the United States during the 20th century, we saw this practice change. It really traces back to the passage of the Securities Act in 1933. This made it really increasingly difficult for smaller investors to access private securities. Commercial real estate consists largely of private securities. 

Now what happened was that private securities became highly inaccessible. You couldn’t talk about them with people you didn’t know and you certainly couldn’t advertise or market them. 

In essence, what we saw was we have a 70-year trend that now begins to take place in which the consolidation of the real estate industry begins. It places the power and the capital into fewer and fewer hands. You even see that trend accelerate in the 1970s. You’ve got things like the rise of ERISA plans that mandated diversification across asset classes. 

The result really of that trend is that today, we have a $15 trillion commercial real estate market. It’s controlled by relatively few players. The types of investors that have come to dominate the serial landscape are predominantly institutional investors. Investors, such as pensions, endowments, large corporations. This could even include real estate investment trusts. 

The accumulation of capital amongst these types of investors combined with a steady appreciation of the asset base over that time has really resulted in a scenario where individual investors had been left behind. 

So what’s interesting to note is that that trend is just now beginning to be disrupted. The catalyst event for it was the passage of the Jumpstart Our Business Startups Act or JOBS Act of 2012. 

When we look at historical returns in real estate, it’s important to begin by considering how leverage is employed. First of all, the amount of debt that is used to finance real estate can range widely as much as 0 to 100% of the asset value. 

Second, the majority of real estate in the United States has some form of debt placed on it. 

Third, the use of this debt can greatly affect returns, but it definitely increases risk.  Therefore, when data sources report out returns on a historical basis, they typically do so on an unlevered basis. 

That’s because by removing debt or leverage from the equation, we can get to an apples-to-apples comparison. 

With that said, looking back to 1986 on an unlevered basis, according to the National Multifamily Housing Council, the mean returns for all major asset classes from 1986 to 2016 were about 7.9%, with multifamily as an asset class delivering about 9% and the other major asset classes such as office, industrial retail, and hospitality delivering somewhere in the low to mid 8% range. 

If we take those returns and we want to contemplate them on a leveraged or levered basis, a good proxy would be to use a typical leverage ratio of about 65%. Today, you’ll pretty much typically see that’s about the median when you think about leverage of commercial real estate in the United States. 

If you layer that on to these returns, and assume a five to seven year holding period, which is also pretty typical for the industry, you would roughly double those returns.

Now to put it back into context, an average of about 16% with multifamily hitting about 18% over that time. But again, once you lever real estate, you are increasing the risk.

Stig Brodersen  5:36  

That sounds amazing. You’re talking about 16% or whatnot. Those are definitely returns that we don’t see too many of these days. What is the benchmark that you’re using here? Like for us stock investors, I would compare my portfolio to say the S&P 500. What is your benchmark as a commercial real estate investor?

Ian Formigle  5:57  

We would look to three benchmarks. The first one I just outlined, the NHMC, National Housing Multifamily Council, produces reliable data on a year-over-year basis. The two other major indices that we will look to would be one, NCREIF. That stands for the National Council of Real Estate Investment Fiduciaries. Then NAREIT, the National Association of Real Estate Investment Trusts. 

Those are going to be three kinds of year-over-year good data sources for investors to understand how to look at real estate returns in comparison to other indices such as the S&P 500.

Preston Pysh  6:33  

Ian, we’re here recording this on the sixth of December. We started to see a lot of volatility in the stock market. More recently, we’ve seen quite a few down days lately. 

For people with a background in stocks, and maybe they’ve seen their portfolio adjusting in that manner, how should she or he think about commercial real estate in their portfolio when compared to equities?

Ian Formigle  6:57  

I think there are three main things to contemplate when considering adding commercial real estate as a component to a portfolio. The first and I think probably one of the main reasons to consider it is that it is a non-correlative asset. 

In general, when we look at a typical market cycle, commercial real estate has really little to no direct correlation to equity markets. In fact, if you go back and look at the correlation coefficient of some of those CR indices that I just mentioned a minute ago, you’ll see that it’s the correlation coefficient is low. In some places it can hit even zero in relation to the S&P 500. 

I would then say that any time that you can add an asset class with historically above equity level returns to an existing portfolio, yet at the same time with negative correlation or zero to low correlation to equities, you’re going to increase total portfolio returns while also decreasing total risk. In other words, dramatically increasing the sharpe ratio of the portfolio. 

The second thing I think to consider is why add CRE to a portfolio? Well, I’d say because it’s how pensions, endowments, and super high net worth investors invest today right now. 

For example, we recently studied portfolio allocations for different types of investors and the results were essentially a rude awakening for the individual investor. So while the typical individual today has a zero or near zero allocation to direct care investments, pensions are allocating on average between 6% and 13% of their portfolio to commercial real estate.

Endowments are going to range their allocation between 10% and 20%, based upon what they see within their own portfolio and where they think they sit within a cycle. 

In super high net worth investors, those with typically speaking networks in excess of $30 million, their allocations are going to jump. You’re going to see those allocations range from 20% to even over 50% for family offices. 

When you think about how commercial real estate delivers solid returns and are not correlated equity markets, it will start to make a lot more sense while sophisticated investors are choosing to invest directly in commercial real estate. 

The third thing I just want to point out is that when you’re adding this as a component to a portfolio, first it should be a company. It can range as I just discussed, and the reason that you want it as a component and to think about it a little bit more holistically within a portfolio is to contemplate what we call the liquidity premium. 

Private money must logically be compensated for its willingness to be tied up for an extended period of time without guaranteed liquidity. If there’s really one weakness or Achilles’ heel of commercial real estate private equity, it’s that when you buy an asset, or you invest in a partnership with an asset with another operator, you don’t exactly know when you’re going to sell. The holding period can range. 

In exchange for this lack of absolute guaranteed liquidity, you must be compensated.  Therefore, what we see is when investors get into a commercial real estate offering, they should know and contemplate that going in, they should plan for five to seven years of illiquidity on average. In addition, if we look at the average holding period across all offerings that we’ve ever put on our marketplace, it’s 5.3 years.

Then you should also understand that in reality, actual holding periods can range from 2 to 10 years. 

I think that’s really, in essence, is that CRE is a good component of a portfolio. It can range from 10% to 30% of a portfolio, depending upon the net worth of the investor and what they’re trying to achieve. 

When you do that, you really don’t look to commercial real estate as the liquidity component of your portfolio, solve for that elsewhere. If you can, and if you can be willing to tie up money in commercial real estate for perhaps an extended period of time, you’re going to earn the benefit of that liquidity premium.

Stig Brodersen  10:31  

Please allow me to play devil’s advocate here because as you said, generally there’s a very, very low correlation, sometimes even close to a zero correlation in some areas of this market. But then what you also saw during the financial crisis was even commercial real estate was really hit hard, together with all other asset classes. What happened back then and what can we expect if we see a new crisis in the housing market?

Ian Formigle  10:56  

When we look back to the downturn, and we really think about it, there’s one thing I think was that when you have a global financial meltdown, when we think about ebb tides and flood tides coming in and out… Well, when the tsunami hits, everything gets hurt. 

First is to understand that when we get to extreme conditions, you’re going to see no matter what the asset class is, you’re either going to see benefits in the extreme upside, or I’d say, assets being hurt in the extreme downside. It’s really when we think about but year-over-year, kind of decade-over-decade is to look at market cycles and look at real estate cycles. Every asset has a cycle. 

Then to think about the fact, as it pertains to commercial real estate is to understand that real estate is local. It has a lot more to do about what’s happening around it, then it has to do with macroeconomic factors. 

Right now I would say is a decent example of that. At a macro level, the United States is contemplating the ramifications of a potential trade war with China. When we look at assets within a commercial real estate portfolio in the United States, you’re far more concerned about what’s happening in the building across the street, what’s happening within your neighborhood, and what’s happening within your city than you are with what’s happening with China. 

I think that is just an illustrative point to say that performance within a commercial real estate asset is really much more tied to specific aspects of the business plan of that particular asset, where it’s located within the United States or around the world, rather than really what’s going on at a macro level, while equity markets are much more sensitive to macroeconomic shocks.

Preston Pysh  12:28  

A little bit earlier you had mentioned that you pay attention to cycles. One of the things that we talk a lot about here on our show is the credit cycle. I know that you mentioned that real estate and stocks don’t really have much of a correlation, but how does commercial real estate perform when you have a systematic risk? Like we saw maybe in the 2008 to 2009 timeframe, where you have these large credit events, and there’s a lot of tightening happening.

Ian Formigle  12:55  

Yeah, it’s fair to say that there is correlation there. And so, I think that can be an interesting case study to look at the last cycle and what’s occurring right now. One of the aspects that I will touch again on is what happened during the financial crisis. It was a crisis of many things. Within the commercial real estate industry, it was a crisis of leverage across the United States. 

What we saw during the run-up was when asset values were appreciating quickly, and you saw a bit of a fervor of the debt markets trying to get access to this heated market, we saw leverage ratios go up. It was very typical for leverage ratios to get into the mid 80s, above 90, and like I said, in some cases, you were seeing leverage up to 100% of the total asset value. So in essence, making major bets on huge upside appreciation with complete disregard for is a kind of downside risk. 

Now when we think about that today, we’re looking at a more sober market. Leverage ratios are now more in this 60-65% range on average, underwriting from commercial real estate lenders, as far more sane rational than it was in the 2007 period. So when we think about liquidity and we think about debt risk going forward, it’s to be contemplated to leverage real estate and then be able to re-leverage it upon maturity. 

It really is going to be dependent upon what is that asset value at the maturity of the debt. If you leverage it at a lower rate today than you did in a previous cycle, even if another downturn happens, if that downturn is not as precipitous as the one that we saw in 2009, well, then you’re probably going to have an opportunity to refinance that asset.

As it pertains to commercial real estate, debt is a really important aspect of the overall market. You’re taking a general market and then you’re taking that market. Then you’re amplifying the returns and you’re also amplifying the risk. So how you put that leverage on the asset is going to have a large effect over what you’re going to either return or potentially lose in that asset years down the road. It’s just really important. 

It drives back to the thesis that commercial real estate is so local. One of the aspects of that locality is that you’re really looking at how much debt is that operator or you as the operator putting on that asset? How do you think that asset will perform in the coming years? 

Contemplate the fact that performance may be different than what you expect it to be and in the downside scenario, if it is worse, what are you left with at the time of the maturity of the debt and what is your ability to refinance the property? Or in the worst case scenario, you have to sell the property in that downturn?

That’s really where a lot of the losses were incurred during 2010. The perfect storm was to buy an asset in 2007, over-lever it, put 80 plus percent leverage on it, and watch that asset drop over 20% in value by 2010. I look at an asset in 2010 now that where the debt has matured. Now, if you leveraged an asset at 80%, it drops 30% in value for example. 

You are now “underwater.” The bank is looking at its position. It’s concerned that it is looking at a potential loss and it will act offensively it’s going to push you out of the deal. It’s going to foreclose and it’s going to seek to maximize as much of the recovery of its money in the asset as possible. 

That’s how investors lost 100% in the downturn. It’s really the lesson of keeping that in mind looking forward, knowing that assets can go down in value, how much your equity goes down, is at some point up to you, depending on how much debt you put on the property. 

Also, that if you think about when your debt matures, then you can almost kind of position yourself to either be able to refinance and move through a cycle or succumb to that cycle in the downside.

Stig Brodersen  16:39  

It was very interesting that you would say that and this is a perfect segue into the next question here. One of the issues we have with the low interest environment is that income investors and investors who are looking to retire soon, they have a hard time finding stable yield. The bonds are just selling 2-3%. It’s hard to get a good deal to live off. 

We already touched upon some of the returns that commercial real estate has. Unlevered, I think you said 8% or 9%. You also mentioned the risk of losing your investment and some of the horror stories you saw during the last financial crisis. 

Could you elaborate more on how to think about that as an investor, if I’m looking for this leveraged or unleveraged return between 8% and 16%? How should my thought process be about that compared to the risk of losing my principal in the investment?

Ian Formigle  17:27  

Let’s talk about a couple of things. The first thing that I think that we see out there is that to your point, we are in a historically low interest rate environment. We’re seeing many bond investors earn negative real returns. 

This realization has made many of them, particularly the largest institutions in the country in the world, as I previously mentioned, look to commercial real estate as a means to earn yield. 

So when we consider yields within commercial real estate, again, it does have correlation to debt. One way to consider this is to consider something called cap rates. A capitalization rate is effectively an unlevered yield on the asset. It is literally the net operating income divided by the value of that asset. That will give you a baseline of kind of a proxy of what it can earn on an annual basis from an unlevered perspective. 

For example, a 7% cap rate is a 7% yield when there’s no leverage employed. So if we now think about putting leverage onto that asset, say, for example, a year or two ago, we could see and a little bit decreasingly so now. However, a 4.5% interest rate, I’d say, was pretty typical in, for example,  a multifamily asset in 2017 to 2018. 

So if you run with the example of a 7% cap rate asset, anytime that you have a 7% yield at the asset level, but then you’re substituting equity for debt that is costing you 4.5%, you have a leverage effect. As you increase the leverage on the asset, you can now see your leverage to go above 10% on an annual basis.  

I would then say that what did that translate to is even in our marketplace, we’ve seen a wide range of yields. They can go as low as zero in a development or redevelopment. They can even go as high as 20% on an annualized basis for something that might be like a limited service hotel in a secondary to tertiary market. 

Typically speaking, when you look at and seek out yields in a CRE investment, you can reasonably target yield ranges in the 4% to 6% range at inception. They can eventually grow to 10% or even greater over time. 

Then when we think about the leverage and kind of adding the risk to the component of that leverage, there’s a couple things to think. One is again, going back to the maturity of that debt, the longer the term that you lock up that debt, the more reliable that you can get to that yield and not succumb or fall prey to a large cyclical shock. 

The other consideration is and this is one of the most attractive scenarios within a commercial real estate investment is to acquire an asset or refinance it at some point during the holding period, which by the way, is a non-taxable event. Receive up to a full return of equity on your original investment. 

Redeploy that original equity into some other investment and then continue to earn an 8% to 10% yield on your original investment in that commercial real estate asset, but which is really now an infinite yield on your residual investment since the denominator is now zero. 

So when we look to diversify risk in a leveraged environment, a smart strategy is to look at the possibility of a refinance at some point in time. If you can invest $1 into an asset, hold it for three years, get $1 back, and still get 10 cents on the dollar on an annual basis, your original risk is now completely off the table. You are now, so to speak, playing with house money. 

You can take that original dollar, you could put it into cash or you could put it into another investment. Now you’re getting yield on what is now zero residual cash. You still have some forward looking equity risk in the deal, but that’s essentially your profit that you’re playing with now. 

That would be the way that, over time, we have seen some investors do tremendously well. You’ll see high net worth investors who take a long term approach with that business strategy and have multiplied their equity basis by multiple hundred fold over 20 to 30 years.

Preston Pysh  21:12  

Ian, let’s talk about some of the key metrics we should be looking at with commercial real estate. If I can make a comparison to stocks, we might be looking at something like the PE, the price to earnings ratio. We know that the lower the ratio, the higher expected return should be. There’s obviously a lot more things that we should be looking at other than just that ratio. 

However, when you mentioned the cap rate, and you say your expected return on leverage should be around 7%. So for me not knowing nearly as much as you do about this asset class, I asked myself, “Why should I settle for 7% here, when I could maybe get 9% next door somewhere else?” So how should we look at those expected rates and what other key metrics should we be paying attention to? I

Ian Formigle  21:52  

A good place to start when contemplating the correlation of risk and reward, in the industry there is a standard, what I’d say 45 degree line chart that you can employ. Consider that running along the x axis of this chart is risk and on the y axis is reward. Along that line chart, we’re going to plot risk profiles within commercial real estate. 

There’s four primary risk profiles to consider their core, core plus, value added, and opportunistic. 

Let’s consider core assets for starters. These are typically well occupied trophy assets. They’re located in downtown’s major metros. You have a core asset, very close to where you live. 

On a leveraged basis, you’re hoping for 8% to 10% annualized returns. On an unleveraged basis, probably 5% to 7%, average annualized returns. The holding periods that are associated with this type of asset are the longest. You’re typically looking at a scenario where an operator will want to hold that asset for 8 to 15 years, perhaps even longer. 

The reason that that holding period is long term is that you’re usually making a strategic bet on a market. You’re not trying to generate any kind of above average return. You’re more or less saying, “I like the downtown of this city for the long term, I’m placing a bet here.”

Let’s move on to core plus. Core plus are assets that are considered riskier than core assets. They’re one step up. They may be a bit older. They may be less occupied than a core asset and or they may reside somewhere just outside main and main locations. 

A good example would be a historic office building on the edge of a central business district on a levered basis. You’re hoping for 11% to 14% on an annualized basis, and you’re looking at holding ranges that can range from 5 to 10 years. 

The next step up on the risk reward spectrum is to move out to value added assets.  Here you take a big step up from core plus. Value added assets generally have a problem that needs fixing, such as significant leasing or major capital expenditures. In essence, the asset is old, it’s tired, we need to fix it. If we can fix it, it will compete far better in the sub market. It will attract the tenants that it cannot currently attract.

Holding periods for this type of asset are shorter than core plus. They’re tied to a specific business plan on average and they can range from three to six years. On a levered basis, you’re hoping for 15% to 20% annualized returns. 

The final thing is opportunistic assets. That’s the top rung of the risk ladder. These deals are generally extreme turnaround situations. They have major problems to overcome. They can be distressed assets and they have a specific business plan as well. 

Holding periods are typically more two to four years on average, and on a levered basis. you’re hoping for greater than 20% annualized returns. There are numerous additional metrics to consider. Looking at risk profiles contemplating holding periods and associated target returns with those risk profiles are a good starting point. 

Stig Brodersen  24:51  

Where would you look right now, you mentioned that risk reward and obviously the riskier place they would have an expected yield or a potential expected yield that is much higher. Where do you see the best value whenever you do compare the risk and the reward for those four classes?

Ian Formigle  25:07  

I would say right now, when we think about a location perspective, we see a lot of opportunity that still exists within secondary markets. There’s an interesting macro play that’s happening within the United States. 

If we look back and we said 30 to 40 years ago, from a kind of desirability of living standpoint, a lot of the best places to live in the United States,  when we think about from an amenity perspective, access to culture, access to food, access to transportation, they were largely centered around major markets: the New York’s the Chicago’s the Los Angeles, San Francisco’s, and Boston’s of the world. 

In recent years, we’ve seen the emergence of the secondary market. I live in one. Portland, Oregon is an example of a secondary market that 20 or 30 years ago really wasn’t measuring up to its surrounding markets, such as San Francisco in terms of livability and accessibility to kind of those best in class amenities, but has taken great strides over the last 15 years to get there.

Other markets that are examples of that are Denver, Austin, and Nashville. These are places that are becoming increasingly attractive to live. 

If we think about what we want, as a consumer, we want to be able to get a good meal, grab a good coffee. We want to be able to get on a flight and go somewhere and not have to connect two times to get there within the United States. That desirability of that metro, at that second tier metro, has really come a long way.

This has led to migration. So we can take it right back up to the macro level and say, “Well look at where people have lived but where are people moving to?” It’s not surprising that people are moving to these secondary markets, because from a cost perspective, they’re attractive. 

The trade off like I said, 30 or 40 years ago, was pretty distinct. That trade off in terms of quality life now is getting far and far narrower, depending upon who you ask, perhaps in a given situation, a secondary market for a particular individual might offer a more attractive quality of life, better accessibility to my job, better accessibility to the types of things I want to do on the weekends, such as go for a hike, go skiing, get on the water. 

Now for that reason, and when you bundle that with, “I’m going to have an easier life that will be less costly and yet more accessible,” the value proposition is compelling and the kind of the clincher of that is can you get a job in that market? Because we have to earn a living. 

Again, if you think about 30-50 years ago, because the primary markets, they held the jobs, they held the population. That trend is now starting to shift. We’re starting to see real job creation occur within secondary markets. 

So now that we have the accessibility, combined with the jobs, with quality of life, you’re seeing this large transformational shift occur at the national level.

When we break that down to commercial real estate, again, commercial real estate, the function of the value of that is really derived in how it will be used? If it’s an apartment building, who will live there and pay rent? How much rent will they pay? If it’s an office, who will headquarter there and how much rent will they pay? 

The better that the secondary market story gets, the more attractive it is to all those people to come in and live there, work there, and play there. I would say that’s why we’re seeing a lot of value in these secondary markets because I don’t think this transformational shift at a national level is over.

Preston Pysh  28:25  

Ian, I’m kind of curious about how efficient some of these secondary markets are. Just to kind of give you an idea where I’m coming from when I look at how the stock market performs, it’s very liquid, especially when you’re dealing with large cap companies. I can sell out of one security and buy something else very easily without really seeing the market price change at all based on the purchase size that I have. But how efficient is the flow of money in the secondary markets when we’re talking about commercial real estate?

Ian Formigle  28:52  

Yeah, this is a great question because this also kind of boils down to one of the essence of commercial real estate. As a market, commercial real estate is highly inefficient. It is so inefficient, even within a top tier market, in which you would theoretically think would be priced super efficiently as San Francisco or New York, for example, that it has competitors within that marketplace from all over the world. Even within that type of market, there are assets being bought and sold every day far below or far in excess of their current value.

There’s an adage within the commercial real estate industry or all real estate is that you make money on the buy, you realize it at the exit. That is, in essence, what when we look at a market perspective, I would say that whenever I’m looking at a commercial real estate investment, I’m looking for the signs in the story that the acquirer is leveraging the inefficiency that is known within the market to its advantage to acquire an asset.

Even so much so that if we want to think about it from a public equities perspective in public equities, if you utilize inside information to your advantage to purchase an equity that you know is mispriced, that is a crime. 

However, now in commercial real estate private equity, if you utilize inside information to your advantage to purchase an equity below, or it’s just a purchase of a property below its current fair market value, that is simply a good deal. There’s no reason why anybody has to make that information available. 

At its essence, it boils down to one seller and one buyer agreeing on a price. When you think about it, from that perspective, is when you can start to realize that when you have one party and on the other side of that transaction, another party arriving at a price, and that’s the price that that thing is going to trade at that, you know, by definition, it’s the wrong price. It’s either too high or too low, depending upon the scenario. 

There are reasons why assets trade at the price they do in the commercial real estate market. Sometimes the overriding factor is not about fair market value. It’s about the motivations of the seller and it’s about the ability of the buyer. 

If a seller is motivated to sell, they will know that they’re probably going to have to give up fair market value to get faster execution. If a buyer is proven, has the liquidity and means to act swiftly and with certainty, they know they can leverage that to their advantage to achieve a relative discount to market price.

Stig Brodersen  31:21  

You would think, everything else equal, that in markets like San Francisco and in New York, you would have more liquidity to meet that motivated seller for instance. Whereas in some rural areas, you would say, “Well, you know, the liquidity, cash is king.” There’s one guy with cash and he can dictate the price. Why do you still see this inefficiency in the bigger markets and where does it come from?

Ian Formigle  31:44  

It is true to say that overall, if we can put a blanket over it and think about generalities, primary markets are far more efficient than secondary markets. 

Secondary markets are more efficient than tertiary markets. That has general consensus belief. 

However, when you look within the market, if we want to look at a primary market, San Francisco, or New York or Washington DC, we’re going to start to look into what is the particular asset. 

If we want to look at the most efficient trade in a primary market, just go all the way up to the top and look at the biggest assets that trade in a market. If any asset trades in one of those markets in excess of a billion dollars, that is the most efficient possible trade that can occur. That asset will be marketed globally. The capital that will run at that market has a cheap cost of its own capital associated with it. 

All the bidders will be leveraged against one another, it will be the seller, the broker in this case. They are going to utilize the visibility of that asset within the city to garner global demand, drive a price and get the exact top dollar for that asset. So that’s the most efficient scenario. 

Now, for example, if we go into a sub market and we look at a smaller asset, it’s the kind of turning over the stones in those primary markets where you can find inefficiencies. It’s also within those markets. 

We’ve actually seen this ona marketplace is to understand that primary markets have sub markets and those sub markets shift. A really good example of that kind of shift within a sub market, look within San Francisco, for example in 2010-2012. Keep in mind that right now, the epicenter of San Francisco is probably where the Salesforce tower is located. That asset is a few blocks South of Market. 

South of Market is the highest, most expensive real estate in all of San Francisco. You only need to go back seven or eight years to find a market in which South of Market real estate in San Francisco is cheaper relative to four or five blocks north into the financial district. 

That was a time in which local players who were prescient could look at that market and say, “I see momentum coming to this location within the market. It’s close to public transportation such as Bart. It’s close to Market which is the main thoroughfare through the CBD. It has great access. It’s flat. I can build on it. It’s going to change and it’s going to improve. I’m more close to Caltrain coming up from the south.” 

These are all the things you have to think about when you’re looking at a particular market. So it’s within those sub markets that even in a primary market where there’s generally like better liquidity, there can be short term mispriced inefficiencies within that market.

Stig Brodersen  34:19  

Ian, I’m very excited about the next question here. This is the one I’ve been looking most forward to, because I am really going to be rude here and put you on the spot. I would like to hear about the best but also the worst investment you have made in commercial real estate. What did you learn from those two investments respectively, that you can pass on to the audience?

Ian Formigle  34:37  

The worst investment that I’ve made probably dates back to my previous experience as a multifamily syndicator, in which we invested in a multifamily housing complex in Oklahoma City. 

The lesson learned there, and I’ll explain the story, is that when you develop an investment thesis about an asset is to really, really look past the first and second layer of the analysis and really go to the third, fourth and fifth layers of the analysis because perhaps the first and second layer look really compelling. 

It’s that aspect of the compelling part of that thesis, which is going to create something in the future, which is going to kind of turn that thesis upside down. It’s the third, fourth and fifth layers of that analysis, which is going to be why you’re going to struggle. 

In this case, it was two apartment complexes that were associated with a specific subset of a market within the city. They were tied to student housing at the FAA Academy. So the Federal Aviation Administration trains air traffic controllers in Oklahoma City at its own airport. These two properties service that market.

Going in, it was a really tightly clustered market, like 10 assets actually service this market and the market was about to expand for FAA stays. We had to train a bunch more air traffic controllers in the United States. It has to do with something dating back to the Reagan era administration when they kind of threw out all the existing ones and recruited a bunch of new ones. Then 25 years later, they could all retire.

In essence, we saw a market to say this is a good market today. It’s a closed off market. It’s a market that we think is going to expand rapidly over the next five to seven years. So we buy the deals.

We were allured and we got drunk on the fact that the market did go how we thought it would go. These properties were a blend of regular apartments and student housing. We went to 100% student housing. We went all in on the thesis.

Then what happens is that the downturn happens. These deals continue to perform well, so well that everybody else wants to get in the market. Because there was more demand, the FAA opened the floodgates, and we saw supply in this market jump 40% in six months. 

Now we’re going from 100% occupied with big rents to now 60% occupied as everybody in Oklahoma City is now in the game. We had invested in that conversion. 

Now we’re rapidly scramble to take short term housing units out of the market, essentially throw away the furniture that we just bought and call capital to get there and then years later, go right back to what we were originally buying, which is about a 50-50 blend of student housing and long term regular apartments. 

Really the lesson there was, if the thesis is so good that you think that you’re going to kill it in a particular asset and location, that if you actually did realize that thesis really contemplate how that market will change, and how those changes in the market might turn your previously brilliant business plan upside down.

We still own the assets today, they’re now more or less stabilized, but I can tell you we had to go through a lot of pain between 2010 and 2014 to get them back into an OK state. 

When we think about the best scenario, while I’d say probably the one the best ones that come to mind was a deal that I invested in located in South Seattle a couple years ago. 

This case study illustrates the point that real estate really is local. If you can understand what’s going on within a sub market, you can leverage that to your advantage and profit immensely.

In this particular case, it was a business park that was located in South Seattle as I mentioned. It was a property that we were going to buy for $10 million, roughly $100 a square foot. So the basis felt really good going in, and there was vacancy in the property. 

However, when we looked at why we thought the vacancy was there, what was really interesting to note is that Seattle has been going through a major transformation of its downtown area. That is building a tunnel that is going to go all the way under downtown. 

It has this giant machine called Big Bertha that is drilling the hole to make the tunnel.In the previous 24 months, this machine was literally shaking the ground next to where this building was located. So as you can imagine, if the walls are shaking, there’s a loud pounding sign noise occurring outside your office every day. It’s probably difficult to office there. It’s difficult to lease. 

The thesis was Big Bertha had moved on and it was out of this sub market. It’s now in the middle of downtown. So in essence, we believe that the asset could now perform and it could now lease. Also, given what has happened in downtown Seattle office rents, this deal being only a few miles south of downtown, just south of the ballpark could now really perform. 

The business plan was to buy it for $10 million, invest some money into improving it, sell it five years later for $15.9 million. In actuality, the business plan played out far better than assumed because that market was now relieved of I would say the short term distress that the infrastructure play was inserting upon it. 

They saw rents spike faster than they thought. They saw demand increase. They did not sell in five years for $15.9. They actually sold it for $17.5 million two years later. That delivered a 2.3 x multiple to investors, which equated to about a roughly 46% annualized rate of return. 

I think that was one of the best deals and I think that just gave an example of when you look at a deal, when you think the real estate is good… It is in a good location and that it has an ability to perform. Perhaps that ability to perform is relatively new, leverage that to your advantage. You can make the bet and then you can be rewarded handsomely.

Stig Brodersen  40:01  

For the next segment here the show, we would like to talk more about entrepreneurship and not only commercial real estate. One of the reasons why we are so excited to bring you on the show is not only because you have raised billions in real estate deals and made millions out of it. You are also a very successful entrepreneur. CrowdStreet, your company just completed a successful Series B round. Let’s go back to 2013. Why did CrowdStreet start in the first place?

Ian Formigle  40:28  

I would say that CrowdStreet started off in 2013, with the underlying belief that markets are stronger when they’re accessible, they’re transparent and they’re efficient. It was a vision of the co-founders that really led to launching the Marketplace in 2014, which means that Marketplace is essentially an online commercial real estate investment platform. Then to evolve into a software company as well by 2015. 

So the two primary solutions at CrowdStreet are really aimed at making commercial real estate more transparent and accessible for individual investors. That was really the kind of the vision on why we did this and why we continue to do it.

Stig Brodersen  41:05  

So let’s continue talking about how to allocate resources. From studying self made billionaires, we’ve found that one of the main struggles that they face, I guess all entrepreneurs face, is how should we allocate our resources? 

You mentioned three different asset classes before for instance. For a successful venture capital fund a company like yours, I can only imagine how many good ideas you have to say no to, only to allocate sufficient resources to the very best one. 

I think it was in the book about Google, where they said that the best companies have too many opportunities, not too few. That’s why they can handle it. 

Now, I’m curious to hear with your background, how did you as an executive think through this decision making process of allocating sufficient resources to the very best idea when you have so many different to choose from?

Ian Formigle  41:55  

It’s a great question because as any startup experiences in the early days, even in the early to mid days, your resources are so far constrained. It is mind boggling. It starts off with literally next to no resources. Then hopefully, if you make a couple of good choices, you begin to have a few resources at your disposal. 

If I were to look back and say, “Well, how did our company take an approach?” It was really I think a combination of kind of it was thoughtful planning. It was taking the opportunity a step at a time and it was thinking and acting strategically, and doing really only what you know you could be the best at. Particularly not falling prey to chasing competitors into arenas where you acknowledge that you lack core competencies. 

That part is tough when you’re in a rapidly evolving market, and you are surrounded by competitors. Then you see those competitors taking actions, you’re inclined to want to copy them for some reason. You’re inclined and particularly, perhaps that competitor is a little bit further ahead of you in the cycle of its own business plan. And so, you’re wondering, do they know something I don’t know?

To bring it back just to keep in mind that they, despite the fact they might be bigger than you, and they might be perceived to be more successful than you right now, they’re just trying to figure it out. 

If you have conviction in your beliefs, stick to your guns. I would say that way, even if you fail, you know you gave it your best shot. I think for CrowdStreet, in particular, this played out as follows. 

In 2014, it was really about launching the Marketplace and sticking to the Marketplace. In 2015, it became a software as a service solution in embarking on becoming a software company alongside the Marketplace in 2016 to 2018. It was really the focus that scaled both of those solutions. 

Then in 2018, when we felt that we had good momentum, and we kind of had proven out to ourselves that those two solutions had long term viability, was then to launch the first of our investor products. We launched two of those in 2018. They were privately managed accounts and our CrowdStreet blended portfolio.

When we look at those products, the blended portfolio is essentially a series of index funds. It’s designed for investors with a single investment. They could invest in 50 separate offerings at a single time. It’s either designed for newer investors or for investors that simply want to kind of buy the platform on a periodic basis. 

The privately managed accounts are really designed for marketplace investors who want CrowdStreet’s advice when constructing a commercial real estate portfolio that can take the form of direct advice or in conjunction with their wealth manager. It’s kind of bringing CrowdStreet in to kind of the more holistic conversation of how they construct a portfolio.

Preston Pysh  44:37  

This was truly a lot of fun to hear some of your responses and we just can’t thank you enough for coming on the show. I think I speak for everyone when I say there was a whole lot of learning going on on today’s show. Before we go, please tell the audience where they can find you and also tell them more about CrowdStreet and what you guys offer.

Ian Formigle  44:57  

If the listeners want to learn a little bit more about us, they can find us at crowdstreet.com. From there investors can go on to browse deals on the Marketplace, we typically have 20 to 40 live at any given time. Also, it’s really important to note that we have ongoing Investor Education. As I always recommend to investors, the best thing they can possibly do is begin to learn, begin to ask questions and take it at their own pace. 

For example, we operate a Marketplace, there’s always a deal. So I always kind of tell investors, don’t be worried about chasing the first thing that you see. Take it at your own pace, ask some really good questions, read some good content out there. 

Urban Land Institute has a tremendous library of information available for readers as well. In particular, they publish a free annual report. It’s called “Emerging trends in real estate.” It’s a fantastic read, it will really touch on some of those market moves and kind of bigger opportunities that we talked about earlier in terms of transitions from secondary markets to or from primary to secondary markets. That’s it. 

You can attend webinars, you can get some good education. You can look at the space as well. There are numerous solid players in the market now. We’re just one of them. I think this market will grow. It gets bigger and there’s going to be a lot of opportunities for a lot of investors and a lot of platforms in the space. 

I guess I really just want to conclude by saying it’s been a real pleasure to be on the podcast today. I really enjoyed the conversation and appreciate the opportunity.

Stig Brodersen  46:23  

We definitely did so too, and really hope we can convince you to come on the podcast again.

Ian Formigle  46:28  

I would absolutely love it anytime.

Stig Brodersen  46:30  

All right, guys. That was all that Preston and I had for this week’s episode of The Investor’s Podcast. We will see each other again next week. 

Outro 46:37  

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