Phase 2 - Real Estate 101 (How to or one big idea)

Podcast - Forecasting the 2020 Real Estate Market

Tyler Stewert
August 29, 2021
Podcast - Forecasting the 2020 Real Estate Market

Mike Madsen, Economics Director at RealSource, joined us to discuss his outlook for the real estate market in 2020.

Mike started with RealSource in 2005, participating in investor workshops around the nation with the National Association of Real Estate Investors, as well as analyzing multifamily properties and doing economic due diligence for RealSource.

He has lead negotiations on over $200M in multifamily transactions in over 6 states. He specializes in macroeconomics, multifamily fundamentals, capital markets, real estate cycles, and applying econometrics to track data and trends for 225 MSA’s across the U.S. Mike is passionate about real estate investing and understanding what key indicators will drive local real estate cycles in the years ahead to help identify target markets for acquisitions.

He graduated from Westminster College in Salt Lake City and where he studied Economics and Business Administration. He previously attended University of Utah and is active in the local CCIM chapter. He holds a real estate license in Utah.

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RealCrowd - All opinions expressed by Adam Tyler and podcast guests are solely their own opinions and do not reflect the opinion of RealCrowd. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. To gain a better understanding of the risks associated with commercial real estate investing, please consult your advisers.

Michael Madsen - If anything we need to start building a lot more and get a little bit ahead of it and realize that we have a housing shortage and if the cost of constructions going up maybe we need to start building more now. I think there's been a little bit of the fear factor in the development world so that fear factor has caused a lot of hesitation from the development communities.

Adam Hooper - Hey Tyler.

Tyler Stewart - Hey Adam, how are you today?

Adam Hooper - Fall is in the air.

Tyler Stewart - Yes, it is.

Adam Hooper - Fall is in the air here in Portland, Oregon.

Tyler Stewart - Nice crisp, cool day here in Portland.

Adam Hooper - It is a crisp, cool day and it was a wonderful day to have a guest in the studio.

Tyler Stewart - Yes, we had Mike Madsen, came all the way from Utah to hang out with us in the studio.

Adam Hooper - Mike heads, up RealSource's econometrics team and their acquisitions initiatives, had him on the show a few times also here in the studio. It was great to see Mike again and come have him share their knowledge and kind of current outlook on where we're at with a whole bunch of different factors that we talked about today.

Tyler Stewart - Absolutely. Speaking of factors Mike and RealSource they look at 35 different factors and they gave us an update on what they're seeing in the market and what regions of the US they are currently looking at.

Adam Hooper - They've got a really interesting model, trying to identify those markets again that are of the most interest to them based on some really cool, cool metrics that we'll talk about in the show. Mike's also not a stranger to making some bold claims, so we checked in on some of those claims he's made on prior shows. We've seen how those have played out. Made a few claims as we look at 2020 and beyond here as well today didn't he?

Tyler Stewart - Not only did he make those claims, but he's asking listeners to call him out. If he's right or wrong, he wants to hear from you.

Adam Hooper - Yes, so you'll hear in this episode a call to action if you will, if you're going to take a contrarian view to Mike here, send us a note to so we can keep track of that, but you're going to have to listen the episode to see what it is that we're talking about.

Tyler Stewart - Exactly. Anytime you get Mike on the podcast it's always an episode where you want to maybe take a couple listens, definitely take some notes. He goes over a lot of information. Things investors should look at when they're looking at, more the economic side of real estate, so definitely a great episode.

Adam Hooper - Absolutely. Well again, pay attention, see what we're talking about for this prediction. Let us know if you agree or disagree. Send us a note to Again as always, we appreciate your reviews, ratings, iTunes, every time you go and leave a review and a rating that helps us get in front of a bigger audience that enjoys this content as well. We appreciate you heading over there to do that for us. Well Tyler, I think that's enough of us. With that let's get to it. Mike thanks for joining us again here in the studio live in Portland.

Michael Madsen - Yes, it's great to be here. Love the city, love your guy's office and it's good to be in here with you guys in the studio.

Adam Hooper - This is third time on the show. We had a couple, third time?

Michael Madsen - Yeah, I think this the third time maybe fifth or sixth episode--

Adam Hooper - Yeah, we cut a couple in the two parters, but you got a lot of really good stuff to talk about. We talked about last night we were having dinner, some of the more bold calls that you made on the earlier shows. How have those turned out? I think they've turned out reasonably well.

Michael Madsen - We feel really good about the calls we've made and our economics team at RealSource has done a really good job at staying focused on the data and letting the data and numbers kind of tell us where the markets going and show us where some of the threats and opportunities are, so we're feeling good. The markets doing well. We've been right about a couple things. We were a little bit against the grain, but where we want to go out on a limb and show our knowledge and what our expertise is in the market and hoping that investors value people to have a track record of kind of knowing what's going on and what's next in the marketplace for commercial real estate.

Adam Hooper - One of the early ones we talked about a few years ago, you talked about how we were going to see rising interest rates. I think that was again a bit contrarian at the time. What did we see there?

Michael Madsen - Obviously the trend 2016, 17, we saw interest rates moving up on the T bills and then 2018 we saw them move up quite a bit and in the past we'd kind of listed that rising interest rates going up too fast was probably the biggest threat to the industry. We weren't overly concerned with it, but in 2018 if you talk to the people that are really on the inside of the game on the lending side there were some signs of worry and crack and red flags in the market and people were worried that values were going to dip a little bit, but we also came out in early this year and said that interest rates will probably be pretty flat in 2019, 2020. Obviously there's been a lot of money coming in from Europe which has pushed down those rates but it's also been interesting because we believe that, kind of our house view at RealSource is that the Federal Reserve has a big influence over interest rates, but they don't just have a magic button to control everything and they're debating it and they're trying to figure out what's best for the market, but we believe that a lot of the interest rate movement is driven by the marketplace and if you go back and you look at the movement and the 10 year rate, we really kind of drop down from that three, five level kind of down below two before the Federal Reserve even announced that they were going to do interest rate cuts. I mean if you go back to a year ago from today, most of the big banks and big firms on Wall Street were forecasting three to four rate increases in 2019. So it was the market that that moved

Michael Madsen - and they made an adjustment and we stand by that call and we think that interest rates are not going to be a huge threat to commercial real estate over the next foreseeable two years. I think if we're looking long-term, I think it's it's debatable and there's some people on our team that think that the rates will stay fairly flat, they'll go up a little bit but would be a big disrupter, but there's some of us I think if you're looking over a longer period of time that interest rates will naturally rise over the next decade.

Adam Hooper - We're just off the heels of another reduction by Fed recently again when we're recording this episode. Where do you guys see that going? Do you see that continuing? I mean based on where yields are around the globe. zero or negative interest rate environment, how far do we think this is going to continue to go? Who's driving that? Is it more market forces? Is it going to be from policy? Where does that rate go in the next 18, 24 months?

Michael Madsen - They're working hard to get inflation up if you look at the kind of the general CPI inflation they're trying to get to 2%, it's not there. If you look in real estate and the cost of living, cost of living is going up way more than 2% a year. We think that it will be market driven, but right now the trend is that there's a wave of capital coming to the US. A lot of it's coming from Europe, looking for safe haven place to park, going to equities, going into the bond market, and the more money that comes into the bond market the lower that that rates going to go so--

Adam Hooper - That was something again, we were talking about that, we've talked about a bit on the show, but I don't know how well understood that dynamic is. You've got a foreign investment in US real estate and we just had Mitt Rochelle on another episode was talking about how some of the known players, again China was maybe cooling off a little bit, some of like new UK, Britain, Western Europe, was kind of cooling off a little bit, but other areas are picking up. So Japan, interest in US real estate definitely picking up. Other areas of Europe interest in US real estate definitely picking up. When you have the US real estate even on the most core side, delivering mid-single digit returns, that's really, really attractive when your options are zero to negative interest rate on other debt yielding products, right?

Michael Madsen - Right.

Adam Hooper - How much of an impact will that dynamic have for say a retail investor? Someone that might be listening this show. Someone that's looking at investing in syndicated deals, maybe not competing with foreign capital directly, but what kind of an impact will that continued attraction to US real estate from big international capital players have on the more kind of retail focused investors?

Michael Madsen - Well if you look at the trends in place right now it's driving up values and it's driving up prices and we don't see any signs that showed the word to the end of that trend going on right now. In fact you could probably say that things are getting a little bit worse or a little bit more chaotic in the global bond markets that's really forcing this trend to continue for at least three more years. So I would look at it as an opportunity to make money and take advantage of it. I think it's going to push values much higher in the next two to three years and people want to take advantage of that and be a part of it and at the same time interest rates are so low because other areas of inflation outside the cost of living are low or getting some low rates to invest with, so you're kind of getting the best of both worlds. You're getting values driving up and you having the ability to lock in low costs of debt.

Adam Hooper - On your show that we're on, I think it was in early 2018, so almost two years ago now, you had made a call that in the next four years we're going to be as good as the last four years. We're now two years into that and again, I think that was a pretty contrarian view at the time. I think everyone was still in that, are we got the peak, are we at the top, we're super late in this recovery, at some point it's got to have a correction. We haven't seen that yet. So where were two years into that four year period. How have things looked and what is the rest of this next two years look like in your mind?

Michael Madsen - Obviously the last two years have been really good for commercial real estate, especially if you're in the multifamily sector. We saw it coming, we looked at the numbers, and we saw how healthy the fundamentals were in the industry and we saw a lot of people kind of calling for the top there. They were a little confused on where cap rates could go, but it's been interesting because a lot of the industry experts have kind of changed their views and come around. CBRE is the biggest real estate firm in the country and they've done a really good job of figuring out how global capital flows are affecting US real estate and we feel like we've obviously the last two years have been good and we feel the next two years look very favorable and there's no evidence or signs that the markets going to have a dip in capital demand or the fundamentals inside of the industry to cause NOI or occupancy NOI to go down or occupancy to go down so we feel good about it.

Adam Hooper - Cautious optimism is a word that we've used a whole bunch or I guess that's two words, isn't it? That's two words. Yeah. We've used that a bunch on the show. I think that's a general sentiment throughout the industry is cautious optimism. How cautious is your optimism? Like where is the caution in that optimism of the next couple years are still looking to be pretty good fundamentally for the asset class?

Michael Madsen - We're definitely very cautious. We don't believe the market just always goes up and up and up and we're all about timing macro and local real estate cycles to understand when the time is to buy and when the time is to get out and I think over the next five years it's going to be really important to be with a firm that is ahead of the curve and knows when it's time to sell or when it's time to go to a new market. I think there's a little bit of a misnomer out there that all commercial real estate markets across the country are going to peak at the same time and we've tried to talk a lot about that, about how every markets different, states are very different. There's a lot of tax reform and a lot of things causing migration volume to pick up, which is kind of making, it's having a bad impact on certain states and it's having a good impact on other pro-business states, so we're focused on that and our motto since 1989 has been live where you want, invest where it makes the most sense and we're all about investing in the right place at the right time and and staying ahead of the changing trends.

Tyler Stewart - When you look at cautious optimism, obviously you're trying to put yourself in the best position to gain the most reward, but when you look at the cautious part of that optimism what do you do during this time to also hedge your bets?

Michael Madsen - Yeah, I mean it's a time to change how you're investing, you might want to be a little less aggressive. Not a good time to do variable rate down on a stabilized asset. So it's really about looking at how you can lower risk and where the risk and threats are in the industry right now and changing a little bit of your strategy of how you invest and where you invest, but it's still a great time to buy. There's a lot of money to be made out there and the markets beating people's expectations. So we're seeing great returns out there and the healthy debt environment has made that even better.

Adam Hooper - And what are some of the factors or metrics or statistics that listeners of the show can be keeping an eye on or keeping track of when we start to get into a position where maybe some of these factors are changing or when we look at, as you said, the timing of markets is different across the country. Not not every market is going to peak at the same time, so there is variability in where a market might be towards the top of that cycle. What are some of those statistics or factors that you guys look at that maybe some of our listeners could start paying attention to, to be a little bit more informed about maybe where that stage of the cycle is?

Michael Madsen - Affordability has been a big issue. We've been been talking quite a bit about affordability, not just on the threat side, but on the upside. A lot of the best rent growth markets have been where if you look at the wallet share of how much someone spends on their wallet every month on their rent I mean there are markets that are a little bit less robust in job and population growth, but because their rent is so affordable compared to incomes and there 95% full everywhere you're seeing rents jump five, six, 7% in places like Tucson, Arizona or Colorado Springs. areas that maybe you wouldn't expect to be leading the country in rent growth, but the fundamentals are there and that's what we do is we try to find markets that are healthy on the affordability index. Obviously we want to track and see what's the volume of stuff trading in a market. we want to see what type of tier people are investing into, is there a drop-off an A Class, B Class, C Class? We've seen a lot of money go into kind of the B, C markets chasing yield. We want to be really careful if that capital kind of backs away from those asset classes. We want to know before that happens so we're tracking that quite a bit. Rent control is a big issue, kind of on a state level. It's affected California and New York and Oregon, it's had a little bit of an effect on cap rates, so we're really watching to see is that is that a bounce from this change or is that trend going to continue? So we're watching cap rate movement on the local level, we're watching the housing supply levels

Michael Madsen - and we're also kind of watching the natural population as well as the domestic migration into the market. Obviously cap rates are a little bit low and we think the markets that have potential to see rent growth of four or 5%, the next five years, those cap rates are much more warranted than maybe a market that's has yield opportunities. People have come in there and push the cap rates down maybe a little lower than what we think is warranted because the growth isn't quite there.

Adam Hooper - We also spoke a while back about the days of that four or 5% rent growth underwriting, we're probably getting most of the assumptions out there whether those days had passed that this was 2016, 17 had seen a lot of really strong rent growth. We were seeing some of the pullback in like the San Francisco markets, Seattle, some of those areas that were having extreme rent growth, were pulling back a little bit and the assumption was maybe that was going to reflect across all the asset class, all the markets in the multifamily space. Have you seen rent growth? It sounds like you're still seeing some markets that are growing at that four or 5% range? Is that more of the smaller pockets that are seeing that or has rent growth sustained at a higher level than maybe we anticipated a couple years back?

Michael Madsen - I know a lot of people talk about inflation not being at the levels that people are hoping for and policies are being steered to pick up inflation, but if we look at the cost-of-living inflation I mean it's growing quite a bit and I think a few years ago we said, "Hey, we're not going to underwrite 4% rent growth. We're going to be conservative and be responsible." And most of the industry has kind of done the same thing and underwritten about maybe two and a half percent growth on kind of an average number, but in 2019 Yardi reports that already they expect for 2019 that over 20 markets will have grown over 4% in rent growth and those are those are a lot of big cities, there's not as many of the big coastal gateway cities as you'd expect but there are some pretty big cities in the right area and 4% rent growth, I mean when you're leveraged and you're buying real estate and your income is going up 4%, I mean, you're making money.

Adam Hooper - That's one thing that we've seen, again we talked about on the show is kind of helping investor expectations stay in line with where market returns are. Where realistic opportunities in the market are. The 20 plus IRRs harder and harder to come by now, so that mid teen, kind of high teen-ish underwriting is where we've seen it come down to. Do you see yields given the current debt environment where we see interest rates going, do you see those yields kind of holding to that mid-teen level for your kind of down the fairway real estate or do you see that going up or down in the next, again, 18, 24 months, 12 months?

Michael Madsen - Well in 2018 we were forced to underwrite deals at a 65% LTV because of the change in interest rates and the debt ratio qualification. When you're going in at a 65% loan to value ratio, your returns are going to be lower than if you can go in at a 75 or 80% loan to value. Now that the rates have changed, we're back to being able to underwrite stuff at about a 75% LTV and so returns have naturally gone up a little bit. I would say in 2018 our returns are probably 13, 14, 15% depending on the asset class and location, but I would say we're starting to see stuff in the 16, 17, 18s. But again, on a pro forma, the industry is so conservative because there's so much of the fear factor from 2008, which was obviously a recession caused by the downturn in real estate that people have been cautious and so there's a lot of these products that I think will show a 15 IRR on a pro forma, but will end up producing a 20 IRR.

Adam Hooper - And that would be because again, you're more conservative on the underwriting side for that rent growth assumption, but in reality that market might have a little bit more juice in it than what your underwriting conservatively?

Michael Madsen - Absolutely. If you look at all the biggest third parties forecasts for rent growth I mean, they've missed the mark pretty consistently. I don't know if that's just people trying to be conservative or why it is they've missed that. I've tried to get on the phone with their economists and the people that do that and find out why. They've said a lot of it is the single-family housing markets is so hot in some of these areas that people that want to move from a apartment to a home have a hard time doing so

RealCrowd - because they go and put an offer in on a house and have to compete against so many other offers and so they'll end up renting for another six months, 12 months and there's so much demand for apartments and some of these RealSource target markets that are already 93, 94% full that operators are going to increase their rents a lot more when the property is 95% full than if it's 89% full.

Adam Hooper - Overall it sounds like pretty bullish on the market still, as an asset class multi-family real estate still pretty bullish on the market. Have you shifted any of the indicators that you're looking at in the last couple years or fundamentals of analysis still pretty consistent with all the different factors that we talked about last time?

Michael Madsen - Every year we kind of change our weighting and what we call our RealSource target market econometrics model, which we take about 35 different metrics, we cut those down to maybe the key 15, we look at the other 35, but we take the key 15, plug it into a scientific data only model and each one of those key 15 metrics, we put a weight on it and that's adjusting for what the different threats are and the change in the environment where we may be in kind of a macro cycle. So yeah, we're definitely making those changes year to year. We're a little bit more focused on kind of migration patterns now that the volume of migration across the country has picked up. Kind of on the defensive side, we're really putting a lot of consideration into local cap rate risk and new supply threats, which most markets besides maybe eight of them have a housing shortage and oversupply, but we're also looking at the potential impacts on property taxes as state obligations are rising. We want to be in states and cities to where we don't think property taxes are going to ding us too hard and then obviously we're focused on the affordability of the single-family housing markets, those prices have risen up, and if a single-family housing market has a little bit of a bubble and declines 20% that's usually not good for multifamily in the area. So we're focused on those defensive weighting a little bit more this year.

Adam Hooper - In the migration trends are there anything, are there any trends that were surprising or anything that you've seen shift in the last couple years? Well the JOBS Act and tax reform bill kind of increased the volume of migration. Some states lost their SALT tax deduction and they're already stressed about how unaffordable it is to be there. A lot of people have talked about the migration coming out of California. I think the biggest winners as far as state inward migration are Arizona, Texas, Oregon, Washington,

Michael Madsen - Well the JOBS Act and tax reform bill kind of increased the volume of migration. Some states lost their SALT tax deduction and they're already stressed about how unaffordable it is to be there. A lot of people have talked about the migration coming out of California. I think the biggest winners as far as state inward migration are Arizona, Texas, Oregon, Washington, and so we've kind of seen the migration patterns pick up. A lot of that as due to affordability issues as rents and cost of homes have risen, It's made more people consider relocating and also with the unemployment level so low there's six million job openings out there. Those are type of conditions too that cause migration patterns to increase, which is good for us because that's what we study and we believe in being ahead of that so when we see that volume of migration pick up, it's good for our business.

Adam Hooper - On the supply side, again we've talked about this a fair bit. Pretty much impossible to build new supply outside of class A premium type product. Have you seen anything that would impact kind of Class B workforce supply or do you see new construction of class A luxury having an impact downstream in terms of product class?

Michael Madsen - Depends on the market, but according to the National Multifamily Council and the National Apartment Association they're saying that developers need to complete approximately 325,000 units annually between 2017 and 2030. So we do, we have a housing shortage problem. It's one of the things that's actually driving up rents. RealSource is getting into development in the right target markets, which we are really excited about because now you'll see some IRRs go over 20 for those development projects, but overall it depends on the market, but obviously total housing still lags demand and we're focused on that and we think that it's going to open up some development opportunities.

Adam Hooper - And then in the again, kind of downstream Class B, a lot of the value-add kind of strategies that we see in our marketplace, in our space, what's being done? What is the supply demand dynamic for that type of product? Again, you can't can't build it new. Are you going to see just the gap I guess between better Class B and luxury Class A continue to tighten or what happens to Class B multi-family if there's such a demand for affordable non luxury housing stock, what gives there?

Michael Madsen - Right and that's why if you look at the last two to three years B Class rents have grown almost double what A class has, which is why one of the reasons we've been focused on being a B class buyer and operator, the biggest thing that's affecting that is the cost of construction is up 10% in the last year so--

Adam Hooper - Which is slowed from what it was. I remember, gosh, that must have been 2015 or 16, there was a conference down the Florida and they were saying it had been up either they're hard construction costs, materials costs, were up almost 50% year-over-year. So that seems like that's still a substantial amount, but has that pace of raw supply cost to that--

Michael Madsen - Yeah, it's slowed down builders that have been worried about having a rents that justify the cost of construction, but it's going to be a big, big issue over the next 10 years. I mean, a lot of the times to replace an apartment you're talking 200 to 225 thousand or in some cities much more to replace that unit, so how are we going to get affordable rents off something that's costing us that much? It's a big issue and how we solve the affordability issue and develop affordable B class units, I mean, it's pretty tough to do out there when the cost of construction is going up and only expected to go up. I mean, I don't know about you guys, but I don't expect the cost of construction to be lower than it is in five years or 10 years and if anything we need to start building a lot more and get a little bit ahead of it and realize that we have a housing shortage and if the cost of construction is going up maybe we need to start building more now. I think there's been a little bit of the fear factor in the development world. A lot of developers got burned or bankrupt or went out of business in 2008 so that fear factor has caused a lot of hesitation from the development community. So hopefully we can develop more stuff and find a way to not do to high-end of luxury and try to make it as affordable as possible, but one of the things that's driving up rents is that there's not enough supply. So when there's not enough supply like we talked about people are going to naturally raise the rents,

Adam Hooper - Right, it's interesting approach of if you build, I guess it would be hard to over build today given the shortage, pent-up demand, but if you pull the trigger and build today and can hold you're going to be in at a discount to what new product would cost in a handful of years assuming even at a 10% increase in those construction costs, right? So you're building into a discount today based on where construction costs could go.

Michael Madsen - Exactly.

Adam Hooper - It's interesting.

Michael Madsen - Exactly.

Tyler Stewart - One thing I haven't heard you mentioned is the yield curve inversion. As a real estate economics expert what are your thoughts on the yield curve? We got a little taste last night. I know there's some passion behind your thoughts on the yield curve but could you go into whether or not you think that's an important factor for real estate and why or why not?

Michael Madsen - Yeah, I mean the yield curve has inverted a couple times, it inverted this summer, and it was about this time last year to where a lot of people were starting to say a recession, the yield curve is going to cause the recession, but we think that this time is different and we think what pushed the yield curve down was money coming from Europe. The indicator of the yield curve inverting and people parking in a safe haven. if you look at that domestically. if it's domestic money that's parking in the treasuries is very different than if it's international money. So far I think we saw the first red flags of the yield curve adverting about a year ago, there's no recession. We have seen no evidence and we do not expect a recession in 2020. So we think this time is different and we think that a lot of people missed that, but you really have to analyze what's happening on a global level. I mean it's kind of like fishbowl economics. If you're focused on just what's happening in the US and you're not looking at the other factors you're going to miss some of these things.

Adam Hooper - Back to the factors that you guys are looking at. Obviously you have a proprietary model, but as the market continues to mature or the cycle continues to mature, the strategy changes to looking at more, and we've talked about this. kind of longer-term more conservative fixed rate debt. Are there any other strategy shifts that you'll see? Are there other factors that you guys will look at having more importance given the extended nature of the cycle or does your fundamental look at those indicators and those trends remain consistent throughout whatever part of the cycle we're in?

Michael Madsen - No, it definitely, definitely changes year to year and right now one of the biggest things we're watching, what you talked about, is just the capital demand for real estate. The volume of closed-end private real estate funds is more than it's ever been in the last 10 years and the trend is that that's increasing. So we're really focused on the demand of people that want to get into these assets. I mean we've talked about that in the past about we used to go and we'd put in an offer on a product and there would be 10 other offers and then we've noticed that it's gone to 20. And just last week I spoke with a broker on a nice product in Cincinnati and he basically said, "Hey, we have 30 other offers and we've got multiple offers with non-refundable seven-figure money. This is you this is going to be very, very tough." That's one of the reasons I like being involved in acquisitions on the economic side is because I get to experience just how frothy this market is and so far it's more frothy, not less frothy, than last year and obviously there's the feel of it and then there's the data and looking at the numbers of those key indicators, but right now demand is increasing, demand's not decreasing so let's pay attention to that. it's probably going to push cap rates lower, not higher over the next two to three years.

Adam Hooper - Is that another, that's another big call right there?

Michael Madsen - Yeah, I think that you're going to see cap rates decline more in 2020 then you did in 2019 and that's saying a lot. I mean one other key thing to remember out there is for the last three years 100 basis point rise in cap rates has been baked into the prices. When you underwriting off to multiple lenders they're going to want to see that your exit cap is 50 to 100 basis points higher than your entrance cap, which is really baked into the prices. And now even CBRE when they came out and said, "Hey, we don't see a recession until at least 2024." That's their house view and they also advised people to think about that. I mean there's caution about that, but then there's also accuracy. So we want to be cautious and we want to be accurate so a lot of these bigger firms are encouraging people to lower the increase in their exit cap from their entrance cap. And just to mention on cap rates a little bit, I think it's a little bit over harped in this environment. We're in an inflationary market for cost of living. Someone may pay a 4% cap rate looking backwards on the asset knowing or expecting that they're going to be getting a 10% return on that asset in two years because of the value add they see or where the market's going or where different things they can do to get that NOI up. So cap rates are talked about quite a bit, but let's talk about them a little bit less in a market to where rents are growing three to 5%, than a market they're growing one two.

Adam Hooper - Yeah and the lens through which you look at a cap rate, like you just suggested is maybe a little bit different, right, rather than looking at the cap rate as this is my return, I'm overpaying for this because it's got a four on it. That is a look back on current rents. If you're in a market that you have confidence that you're going to see some substantial rent growth, if the trends are there, if the demand is there, the supply is still limited that can reasonably grow into a far greater than 4% return, whether it's through value add, whether it's through writing, some of these trends, that make that four or five cap going in more tolerable from an overall financial picture than just that look back on the trailing 12 income.

Michael Madsen - I remember people buying in Atlanta and saying why are we buying in Atlanta at a five-and-a-half cap? Is that warranted? Well now today cap rates in Atlanta are four and a half percent and yeah, I think people over focus a little bit on it and I think it's also critical to have a sponsor that knows the markets, that knows how to identify which markets are those cap rates justifiable and warranted and which ones are they not. And I do think there are markets out there to where the future growth does not warrant the cap rate and I'm not going to name names, but I think there's a lot of areas out there so I think this is a good time to focus on sponsors that realize that every market's different, every markets going to see different job population and income growth. We've had a lot of yield chasing into these secondary markets, but maybe they've chased a little too far into some of--

Adam Hooper - Maybe we need to do an insider's podcast. That seems to be a trend now, so maybe we'll do an insider podcast Mike and you can come name some names.

Michael Madsen - Okay, I'll do it.

Adam Hooper - Maybe taking that to a more positive spin, what are the markets that you guys do like right now? We talked a little bit about some of them last night. Maybe some of the markets that you guys are focused on right now that have some good looking trends and then looking a little bit forward, are there any surprises without giving away too much secret sauce, kind of contrarian picks for markets that people might not think of as top of mind that have some of these good flavors going.

Michael Madsen - We're focused on about 20 different markets and RealSource feels like this is the appropriate time to start doing development. So we do kind of focus on okay, which market is the best for kind of the build to rent single family style developments? Which markets and which indicators do we need to see for multi-family vertical development? Then we're also doing a storage units, which will maybe talk a little bit more about down the road but there's some good opportunity in that sector as well. There hasn't been a lot of things in the last 24 months, there hasn't been any major big economic changes that have caused a big shift as you'll see in other years, so I would say that a lot of our markets are pretty consistent from where they were 12 or 24 months ago. I mean obviously everybody knows that Texas and Florida, major metros maybe outside of Miami are a very, very attractive place to park capital. There's a lot of natural growth going in there. There's no state income tax which helps the performance of people's ability to move into an apartment or form a new household. So we don't want to give away what all of our target markets are. I mean they can call and ask us if you're a RealCrowd investor, call us and talk to us about it, but yeah, I mean there's a lot of markets out there that were really excited about. We're trying to get into and and there's also some markets that we really want to be into, but the competition is so steep that we want to focus on places where we're going to get traction and get deals done.

Adam Hooper - And are there any surprising common threads between those markets that you guys have found? Obviously the fundamentals, right, job growth, population growth, affordability, desirability for a place to live, education, those are you know table stakes if you will. Are there any interesting factors that you've seen that are maybe a little less than obvious of a common thread amongst markets that you guys are excited about?

Michael Madsen - Millennials are fueling renter demand. There's about 67 million young adults between the ages of 20 and 34 in the US expected to find jobs over the next decade so we are kind of focused on those type of demographic analysis. A lot of the student loan debt is causing Millennials to rent longer, delay home ownership unfortunately. Then the kind of the type of jobs, the high paying jobs, markets like Colorado Springs to where there's a lot of young people. It's a very highly educated metro. A lot of defense sector jobs, cyber security jobs, so we're really focused on kind of where the median income is. Obviously the markets with a higher level of education attainment is probably growing a little bit quicker, but one other interesting indicator to follow is where is income growth by age? I mean if you look at some of these studies coming out of the Atlanta Fed data. I mean people between 24 and 54 are seeing a big increase in their income growth and a lot of people talk about wage growth being stagnant, but a lot of that unfortunately is people that are usually older than the prime renting age. So we do focus on a little bit of those age and income demographics, a little more of this year.

Adam Hooper - And concerns about those markets? Are there different areas of concern that you would see and I guess just I'm kind of thinking with job growth if you've got a younger workforce coming in, maybe that job environment's a little bit more volatile, than a more stable market? So would you prioritize a more slow and steady growth of an economy or job growth for a market versus maybe more lumpy, more volatile growth?

Michael Madsen - That's a good point because if you go back to kind of the dot-com bubble. The tech jobs and the tech cities were the ones that got hit pretty hard. A lot of those people in a downturn, their departments can get cut and it can be a problem. So yeah, I mean we don't want to see any target market that has too much of anything. An example would be like a military town, which are usually small enough that we don't consider those. But yeah, I mean definitely we look at those factors and worry about if there's too many tech jobs in a market for sure.

Adam Hooper - And then I just remember back to, again this was pre-08, but I was in Bend, Oregon, which was super volatile, right? It was one of the fastest growing cities in the country. A lot of, not like core employment there. A lot of it was transplants. It was telecommute workers, it was kind of again a very more volatile employment kind of environment and then once that turned off, man, it turned off. So I think it's interesting to kind of get your take on prioritizing again over those more volatile employment markets and how maybe that changes throughout the stages of the cycle, I don't know. I mean, is that something you guys have tracked?

Michael Madsen - The population of the city is key. I think some of these secondary and tertiary markets have seen cap rates come down and there are a threat of some of those, of that bouncing back the other way. So we do want to shift a little bit more towards heavier population metros, but also at the same time stay away from the ones have affordability issues and like a Miami or Los Angeles is not a place we're going to go, but we'd love to be in Dallas, we love Atlanta, we've got some deals we're working on getting close to contract on right now in Atlanta and so we do want to shift to, usually we want to stay in a market that's above 500,000. We're probably going to put a little bit more weight into those bigger markets that have all the other fundamentals.

Tyler Stewart - Could you walk me through the funnel? So it sounds like you're top of the funnel, there's 35 metrics you look at. You decide we're going to focus on these 15 keys and then you came up with the 20 markets you're looking at. Can you take me through that middle part when you go from identifying those 20 markets to before you purchase a property? Once you have those 20 markets what data are you looking at in those markets? Are you doing it on the relationship side? Are you talking to brokers to start to identify some opportunities? What's the hand-to-hand fighting before you actually decide to purchase a property?

Michael Madsen - Yeah, that's a good question and I'm glad you ask it because we kind of think that that's a little bit of our niche and what makes us a little bit different, is we spend a lot of time and a lot of money in collecting data from all over the place. So we do focus on those 35 key metrics because it helps us with our underwriting. We can see if this key factor is in the bottom 25 percentile or the top 25 percentile, so it kind of highlights some kind of risk and opportunity on our target markets and helps us with our underwriting and how to plan for even things like budgets, but yeah, we do track over 35 key metrics in 175 markets and then we take those key 15 to 20 variables that can change year by year and then it kicks out what we call our data only rankings. No human input, here's the numbers, here say your top 30 markets, and so we're going to take that top 30, but then we're going to apply our experience. We've got people like Steve Marrero in Florida who's been in this business developing relationships for 40 years and has a lot of insight on how things work or maybe it's tougher for an out-of-state buyer to buy in this city or lots of different things. So once we kind of let the science narrow it down to our top 30 markets, we're going to sit down as a group and we're going to take in some kind of human input and use our experience and kind of, a lot of it comes down to where do we have a presence already that can help a little bit, where we like to operate on economies of scale. So if we can get into a market

Michael Madsen - to where we have existing product that may push a market from 20 to 15. If it's an area we've never done business or we're a little bit more unknown, we might want to see how it reports the next year before we make it a top 20 market, but we do have what we call our RealSource economic team. There's five of us and we each have our role and our part and we hash through it and we talk through it and we narrow it down and get down to about 15 to 20, sometimes 12 markets, depending on what's going on and then we focus there.

Adam Hooper - And it's an interesting and we'll talk later today about what we're doing on the risk underwriting side, is balancing the science and the art, right? I think there's there's been a lot of groups that have tried to approach it from purely the data side, purely the analytical side and just trusting 100% the numbers, but removing or trying to remove the human component of underwriting and kind of that art piece. Our thinking on that is the science can get you to a place where you can make a better decision with the art. Not replacing the human component entirely, but how can we use this data, how can we use this understanding to come at it from a better perspective where we can use our skills as humans and our experience to be able to make a better decision. So I'm curious, it sounds like you let the science get you to a point and then you use the art form and the experience there to get you to those finals. Do you see that becoming more or less skewed to one of those factors or I guess how has that changed over time you know as data has become more robust, and you have that access to more data, how is that balance of science and art shifted throughout your underwriting model of methodology and how do you see that going forward?

Michael Madsen - The art comes into play a little bit later in a long macro cycle and just understanding some things outside just the numbers for sure and especially on the underwriting side. I mean it's going to be a long time till you see a computer model start doing your underwriting. I mean there are so many little things to catch, there are people that try to put stuff below their NOI line and say this is a one-time cost when it's a regular cost. I mean underwriting especially is something that takes years and years and years to get very good at. Not just to be able to pick up risk, but pick up opportunity and really see through the numbers, so we really believe on seasoned underwriting, reviewing it as a group, getting multiple eyes on it, getting people from operations side, getting local knowledge. getting our property management input. I mean all of those types of things are very important and I'd say as soon as you pick a market it really becomes about art and relationships and gathering intel and getting brokers to tell you when you need to back away from a deal or when you need to send an extra guy to lock down the deal and it's definitely still a relationship business when it comes to executing and getting good deals.

Tyler Stewart - How's that handled internally? So if you have your econometrics team who's more data focused, is that handoff to a team member who's more of the arts and the relationships, is it hard to transition from the data to okay, here's my experience, we'll take that data, and I'll use my arts to finalize the deal? Is that a difficult conversation?

Michael Madsen - Well we've learned to be disciplined and stay in our target markets. I mean what we've done on focusing on RealSource target markets has paid off so well and especially in years like this to where you have a lot of market softening and a lot of markets just earlier in their growth cycle. So a lot of the times it's about giving the person, the acquisition team that's in charge of that market all the tools and resources and data, which we spend a lot of money to gather so we can know okay, well what's the best performing submarkets, what does the crime map look like, where is the growth migrating to, which sub market had the most homes developed in the last two years? So we really try to provide those tools and analytics, but at the end of the day they need to go there, they need to get to know the market, they need to get to know the ins and outs that you're not going to see from the 30,000 foot level. Use us as a resource, but once we've targeted a market it's about local knowledge and somebody really getting to know the ins and the outs of the market.

Adam Hooper - Good. Now I guess more on the the deal side or the investment side. How would an ideal property today look different than an ideal property maybe a couple years ago? I guess the the line of questioning is for a lot of investors they use a platform like RealCrowd, they're not daily in the deal flow like you guys are and so their view on what's kind of expected or what those metrics are or maybe what some of those different factors that they're reviewing are is seen through the lens of what's available in the market that time. Or they don't see all the deals that don't get done or they don't see the deals that are passed on. So how has the ideal property profile changed over the last couple years or has that remained largely the same? And you said you're looking at now doing even some development, which I think again, would be a bit of a contrarian play at this stage of the cycle. How has that ideal deal investment profile changed over the years or has it not?

Michael Madsen - No, it definitely is always changing. I mean we focused on B class value-add, because our investors like returns. They like low risk, high returns, and we do our best to deliver that and I remember talking to a lot of other groups the last five years that just thought they were hitting home runs buying A cost product. And then they've probably done okay, but not as good as the guys that have bought the B class product. It's a market by market thing, but I think over the next five years as inflation and the cost of repairs go up, there's going to be a time to where if we do get into a more inflationary environment to where people are a little bit more stretched on what they can afford that it'll make sense to be in kind of a B plus, A minus. I don't know they ever want to be the exact top of the market. But as the cost of repairs go up, I mean we don't like to see stuff that has heavy deferred maintenance anymore. We can live with everything's right, but it needs a new roof type of thing. But if the property has just been ignored, somebody bought it and hasn't injected capital under the property to maximize it, there's a point to where there's too much deferred maintenance. But another kind of interesting little niche for us is we're focusing on properties expense ratios. So if general inflation is starting to rise that means the cost of labor, the cost of turnover, replacing the counters, cabinets, even things like painting are going to also, those costs are going to increase with inflation. So if you're buying a property that has a 35% expense ratio,

Michael Madsen - general inflation is is going to treat you much better because that inflation is lifting your rents and lifting your expenses but your expense ratio is low. Compared to if you go to a property that's a 55% expense ratio, now inflation isn't really helping you get anywhere especially if the cap rates are still. So RealSources, a lot of our roots the company is like-minded real estate investors coming together and doing well but realizing like holy cow, if we all went in on this together and we all bought this 400 unit apartment complex to where our expense ratios 30% and a market to where property taxes are not expected to run away, they realized they could make a lot more money so we're probably focused a little bit more on kind of larger product as much as we can. We may need some different strategies on the equity side to execute that quickly, but I don't think you'll see a lot of other people talk about that, but let's watch and see what happens and let's see how the properties with the lower expense ratios perform and kind of a general increasing inflationary environment.

Adam Hooper - There's a general sentiment that a lot of the easier value-add low-hanging fruit, if it hasn't been done by this stage in the cycle then there's probably a reason that it hasn't been done. It might never be done or it's just too much of a lift financially for it to pencil to do that work. Right, like you were talking about. It's something is just so far behind in deferred maintenance. If at this stage of the game that hasn't been solved, it's going to be difficult for somebody to maybe come in and solve that. Are you seeing that out there or are there properties that by this stage in the recovery, the opportunity for a responsible value added strategy has kind of passed by or is there still an opportunity for those ones that maybe haven't seen that strategy yet?

Michael Madsen - There's still an opportunity. They're harder to win. It's not necessarily that people are running away on the price. I mean the price is going up, but usually what separates a winning buyer from a losing buyer is the terms. But overall the value add deals are still very strong. We like to find stuff to where somebody's come in and their plan was to renovate the exterior, to do the new roofs, to do the new siding, upgrade the landscaping, renovate at the clubhouse, as to where we think that the biggest bang for your buck in general for value out is on the interiors. I mean to me--

Adam Hooper - That's where people actually live.

Michael Madsen - Yeah, exactly.

Adam Hooper - I mean the clubhouse is cool and it's a selling point when you're leasing it--

Michael Madsen - I don't care how nice my pool is, if I got a rundown interior that's not going to be too happy. I've been in a lot of empty remodeled club houses to where I don't know. So we've focused on that and we know that there are amenities that definitely make sense, but ideal for us is a lighter interior value add play. Maybe something like mid 90s, there's a lot of product built around 99, 2001-02 period to where they did very vanilla finishes as the market turned on them a little bit. And then obviously as housing adjusts there's going to be an awesome opportunity in storage units, which some people say will trade more like a commodity than real estate and so we're really excited about getting into that and doing some more creative things, which I think we'll talk about next time in that space. So it's changing, there's value add out there, it's tougher to get your hands around it and win it, but we're still finding ways to do it.

Adam Hooper - What you mentioned last night and Ivy Zelman when she was on mentioned this, the kind of build to rent single family strategy, which we're seeing more that we haven't gotten into that space at all on the marketplace. But seems to be super interesting, right? It's you get the benefits of both really. You get the kind of the amenities of a multi-family community apartment complex but you still can deliver that a single-family experience for either the young family or someone that wants to of home rather than an apartment. That's an interesting strategy, so I think again we'll hopefully, once you guys get your hands around that a little bit more we'll get you back on and talk more about that space.

Michael Madsen - Yeah, they call it build to rent or B2R, but it's very exciting. It's a good product. I mean you go inside these things and it looks like a new home. You go into the bathrooms and they look like a brand new home, but yeah people don't always need as much living space these days, so yeah it's basically taking multifamily and going horizontal instead of vertical. It's really about pinpointing where that demographics and where it pencils is really important. It's not something that's going to work in big infill areas or even every state but there are certain cities to where it's going to be a big new trend and they're big buyers that want to buy it. So we will be developing that in the next two years and we're excited about it.

Adam Hooper - As we start to round the corner to 2020, what is top of mind for you guys? What should investors that aren't full-time professional real estate folks be looking at in the space and just kind of generally what would your top points or top factors that listeners of the show should be thinking about as we turn the corner into 2020?

Michael Madsen - A lot of it is just getting over the fear factor. There's a lot of people talking about a recession. Obviously the inverted yield curve. There was no recession in 2019, which we did forecast to our clients. We don't think there's going to be a recession in 2020. Eventually is there going to be another recession? Absolutely, we know that too. We think we're definitely a couple years out. It's easier to forecast the next 24 to 36 months than it is five, six, seven years down the road, but we try to highlight to people that not every recession hurts equally. If you look back at the last five US recessions, only twice did commercial real estate returns go negative. So let's say that again, think about this. Even if there is a recession only twice in the last five US recessions has commercial real estate returns gone negative and the last one was so deep that that's usually the big ones don't just hit right after another, usually you get a couple minor recessions then maybe about once every 25, 30 years you get big cyclical macro downturn in real estate, but there's a way to keep investing and keep buying and not miss out. I think there's going to be a lot of people and we've said this before that choose not to buy, get a little worried, and then they have that lost opportunity cost. But we're focused on watching recession indicators and if it'll slow down, but personally I'm not going to be surprised at all if during the next US recession if it has a very, very little impact on long term returns in commercial real estate.

Adam Hooper - Is that your bold claim for 2020?

Michael Madsen - Yeah, that's definitely one of my bold claims. I mean the market rents, does anybody in here think rents are going to be lower in five years or 10 years from now?

Adam Hooper - Unlikely.

Michael Madsen - Does anybody think that the cost replacement, cost of apartments is going down? I mean this is a business that generations have built wealth on and it's a good place to be long term and everybody's situations different. Some people may already be 80% of their portfolio in multifamily or commercial real estate. Some people may be just dipping in, so it's different for everybody, but don't be overwhelmed by the fear factor. If you're worried about where cap rates could have a year to a volatility or the lending market could have a year or two volatility, if you have 10 year debt you're going to ride right through it.

Adam Hooper - What you just mentioned there is for real estate folks is a given, right? This is a long game. The ability to look at things on five, 10, 15 year horizons, looking at costs, looking at just general demand factors, looking at economic factors, looking at it on such a long term horizon is more typical for how the real estate mind approaches the space as an investment class. Whereas they think a lot of what we've seen, in our space particularly, for people that are new to investing in real estate they're still used to the liquidity of an equity markets. They're used to even in our space shorter term, two, three year, quick value add, get in, get out kind of strategies. They haven't really been exposed necessarily to the more traditional seven to 10 year plus time horizons that historically most real estate managers have looked at through that lens of a longer term wealth creation, wealth generation strategy. So I think that's something we've talked about a bit on the show and I think is a general trend that hopefully investors are starting to look at this asset class as a longer term horizon. Because exactly as you said, I'd be curious how many people out there and I guess if you're listening the show and you think that that rents are going to be less in five years send us an email and we'll we'll check back in a couple years, right? That's probably a fairly unlikely scenario where your income in five years is going to be less than it is today. Especially in a inflationary environment.

Adam Hooper - Just switching that mentality of these more short-term, get in, get out strategies, to that more conservative, more longer-term approach, to investing this asset class I think is generally a healthier mindset to look at this as an investment through.

Michael Madsen - We're all about market timing. We're all about buy low, sell high, move to the next market. So we're going to be doing some selling in the next five years and going to different markets. We're going to do some selling and going to different asset classes. So I don't want to sound like we're saying the market's always going up and up and up, but we're saying hey listen, we're the guys that have been saying the last three years, when everybody else, most people were saying we're in the ninth inning, saying hey, we've got a long ways to go and here's why. So we are about buy low, sell high, but I mean even think on a public read. I mean go look at some of these biggest public reads, see what their price for per share was two or three years ago and what it is today. That fear factor can go against you too, because when everybody gets fearful and everybody wants to sell, well guess what? You're selling at a discount, a big discount often. So I mean we are all about you owning a piece of an asset, you have some impact, you can ask questions as way better than just owning a basket of real estate and a big public company to where you don't know what type of discount you're selling when you want to get out and if everybody gets fearful at the same time and everybody wants to sell that thing at the same time, they're going to start selling for 20-30% less than it's worth.

Adam Hooper - Yeah, big volatility in that space for sure.

Michael Madsen - Yeah, absolutely.

Adam Hooper - Any other big bold claims for 2020 before we wrap it up here?

Michael Madsen - 2020 is a good time to be in the right strategic markets. I think you're going to see, it's going to be interesting to watch to see what happens in California. Some of this rent control stuff is kind of spooked buyers a little bit. We've seen cap rates bump up in some of the bigger California cities, so we could see a couple years to where California real estate kind of slows or plateaus depending on the area to where outside of California and New York, the rest of the country is kind of thriving in the real estate market, especially where it's affordable. But I would go out there and I would say that once again, we had Yardi report 20 markets were above 4% rent growth. With the the data we're looking at and the affordability that's out there and the income and job growth we're at right now, I would say there's going to be 25 MSAs with over 4% rent growth across the market.

Adam Hooper - Well, we will hold you to that. We'll get you back on the show of course. Check in and see where we go. Mike again, as always, just a ton of really good information today. How can listeners out there learn more about what you and the folks at RealSource are up to?

Michael Madsen - Yeah, go to our website Check out out team, check out kind of what we're doing and what we're up to. And if you want to receive our quarterly economic updates, send me an email. If you are a RealCrowd client of course, we'll have to make sure that that's the case. But if you are a RealCrowd investor, send me an email at That's M-A-D-S-E-N and we'd be happy to hear from you. We'd be happy to talk to you about maybe some of your markets that you want to know about. We track a 175 of these markets. So if you're invested in Tampa, Florida or Toledo, Ohio, wherever it is, go ahead and check in with us and we're happy to talk to you. We got a team of people, if you want to talk investment strategies, what other people are doing. If you want to talk economics, markets, development versus existing assets, that's what the roots of our company is is talking with investors and so reach out to us, let us know who you are, get on our email blasts, that keeps you aware of what's going on and what we're doing.

Adam Hooper - Perfect, well again, thank you for for coming to Portland, sharing the knowledge with us today. Thank you for the RealSource team letting me sneak out of the office here for a couple days. Great to have you here in the studio. Always fun to have guests.

Michael Madsen - Yes.

Adam Hooper - Live in the studio here in Portland.

Michael Madsen - No and thanks to you guys. I mean oh we're very appreciative of the chance to do business with you guys and get to know you and we really like these podcasts. We listen to them, we keep up on them, and we learn a lot and enjoy it, so thanks to you guys, keep up the good work. Your integrity and your care for your clients and their investments is second to none in your industry and that's why we like you guys and why we keep coming back.

Adam Hooper - Perfect, you didn't have to read that off the script.

Michael Madsen - No.

Tyler Stewart - It was perfect.

Adam Hooper - No, but I will slip in five bucks. Well thank you listeners for another episode. As always if you have any comments or feedback or if you're going to make the call that rents will be less in five years than they are today, send us a note to or you could even leave that in review. You could go rate us on iTunes and leave us a review.

Michael Madsen - Yeah or cost of construction. If anybody out there thinks the cost a construction is going to be lower in five or 10 years and I'd love to hear why if there's people out there that really see that I'd love see that dialogue.

Adam Hooper - Perfect, again And with that we'll catch you in the next one.

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