Mike Madsen, of RealSource Equities, joined us to discuss current market fundamentals.
Mike is a Client Services representative since 2005, has participated in workshops around the nation in the National Association of Real Estate Investors, as well as analyzing multi-family properties and doing market due diligence for RealSource.
RealCrowd - All opinions expressed by Adam, Tyler, and podcasts 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 advisors.
Adam Hooper - Hey Tyler.
Tyler Stewart - Hey, Adam, how are you today?
Adam Hooper - I'm doing really well. Listeners, thanks for listening to another episode of the RealCrowd podcast. Tyler, who's here today?
Tyler Stewart - Adam, today we have Mike Madsen in studio.
Adam Hooper - In the studio. Mike, welcome.
Michael Madsen - Hey guys, good to be here. Good to be in town and meet with you guys face-to-face. Glad to be here and get to know you guys a little bit better.
Adam Hooper - Yeah, so we got a little different format today. We've got a live guest in the studio. Mike, you've been on four episodes. We've split your two into two episodes each, so this is now your fifth time on the podcast.
Michael Madsen - Great to be back. We really like the RealCrowd platform, and we want to grow our relationship with you guys and keep things moving along, and hopefully provide your listeners with some good information.
RealCrowd - This podcast is brought to you by RealCrowd, the leader in online real estate investing. Visit realcrowd.com to learn more about how we provide our members with direct access to commercial real estate investments. Don't forget to subscribe to the podcast on iTunes, Google Music, or SoundCloud. RealCrowd, invest smarter.
Adam Hooper - The last time we talked about where we were going to be going as this year starts. We've had a few things since then. The tax plan has been approved and changed. We'll talk about that today. We've seen some of the repatriation that we talked about last time, and we've got a lot to unpack here as we start 2018. Why don't we just kick it off with where we're at?
Michael Madsen - Yeah, no doubt. We've had the tax reform go through. Whether you're a fan of that or not, we're definitely starting to see people talk about that repatriation of funds, which I think last time, we kind of said, why isn't anybody talking about this yet? It's a big deal, and it'll be a big topic for the rest of 2017. You've seen Apple come out and announce that they're going to bring 260 billion back and pay about 38 billion in taxes to do so. Overall, should be good news for the US economy. We're definitely more competitive on a global scale, and you'll see some of these other countries start to try to play catch up a little bit and react to that, and we'll definitely see a lot of changes in the economy out there this year, but overall, we think this tax reform is pretty good for commercial real estate. Little debatable on how well it's going to be for single-family real estate which is pretty unique. Most of the tax cuts or tax reforms in the past have always been good for single-family housing, but you've seen some people come out against it, so it's interesting.
Adam Hooper - Well, and that's one of the things that when we did our first podcast I thought was interesting about how you guys approached the space specifically was looking at how, even at the state and local municipality level, those markets that you guys are looking into, how's that going to affect your ownership position and ultimately, how's that going to affect the investors in these deals? And so, again, I'm sure we'll touch on that here as we dig into taxes a little bit deeper, but overall sentiment from what we've been seeing in the guests that we've had on and conversations we're having, seems like there should be some decent wind in 2018 sales. Are you still feeling fairly optimistic about 2018 or just market commentary, how are things looking now?
Michael Madsen - Yeah, no, if you're in commercial real estate in the right location, I think you got to be feeling pretty good about these changes. There'll be a little bit of wait and see mode on how much it affects average wage boost and job growth over time, but certainly so far, there's definitely a consensus that that's going to happen and that we should start to get a little bit of higher quality jobs. A lot of, at RealSource, we kind of focus on base jobs and ancillary jobs. Usually the base jobs come first, and then the ancillary jobs lag behind and come a little bit later.
Adam Hooper - And so base jobs would be like what?
Michael Madsen - Engineering, financial services, then you've got your candlestick maker, butcher, baker, that type of thing. Those jobs usually follow in secondary, but we think there's going to be a lot of good base jobs that'll be added, then the ancillary jobs will kind of follow up. A lot of the multi-family focus is more on the ancillary jobs primarily, so we're definitely realized that there's going to be certain locations that are winners and losers from what's happening. I think you'll start to see that a little bit more. In the media out there, there's some states that are a little bit more unhappy with the deal. You definitely have that SALT effect which is going to have a big impact on some of the higher-tax states such as New York, California, Illinois, some of those.
Adam Hooper - And let's talk a little bit about that impact. Are you saying impact for individuals as tax payers, individuals as potential home buyers, as tenants, or individuals as investors in real estate deals? Or all of the above?
Michael Madsen - Well, it's all of the above, and there's no doubt that there's certain states that are going to pay a little bit higher taxes now that they've lost the SALT deduction. That's definitely going to have a big impact. In fact, you had Elizabeth Mendenhall with the National Association of Realtors basically come out and say the tax incentives have been baked into the overall values of homes in every state and territory across the country, and when those incentives are nullified with this new tax bill, they're estimating that a lot of home values in most places are going to go down about 10% and even greater in high-cost areas, so some of those states, if you will, that were kind of being subsidized, they're going to lose that subsidy and it's going to have a big effect. We've had a lot of calls come in from California. A lot more people deciding to sell some of those single-family homes and jump into commercial real estate seeing the writing on the wall and understanding what's happening, so we're focused on making sure that we're in the right locations at the right time. This is favorable to our business model. We've kind of studied the migration patterns of jobs and people since 1989, and what makes jobs and people move to a certain location versus another, so we feel like it's a boost for our business model. We feel like our investors are invested in the right places, and so it's definitely favorable to us, favorable to commercial real estate. I don't forecast any major collapse in single-family homes by any means,
Michael Madsen - but there's definitely going to be some changes come through this bill. We've talked about capital gains and how that'll be impacted. I believe it was, you had to be in the home for two of the last five years to qualify for that capital gain exemption, and now they're saying that you need to be there for five out of the last eight, so that's part of the reason why the National Association of Realtors aren't totally pleased with this tax bill, because you could see a little bit less buying and selling. More people staying a little bit longer, which doesn't necessarily benefit real estate, so.
Adam Hooper - Well, we've talked about it before. The, I don't know if it's a paradox, but double-edged sword is as housing affordability becomes less, the opportunities as the owner of multi-family property becomes better, right? And so that's, not trying to be callous to the housing affordability issue out there, but that does present opportunities as owners as multi-family when you come to an environment that makes home ownership maybe a little bit less desirable, that's going to increase your renter pool which, in your case, the case of RealSource and multi-family operators out there, actually might be, you get another benefit for this year.
Michael Madsen - Yeah, absolutely. And most Americans don't itemize their tax returns, and they just use a standard deduction, so that standard deduction going from about 6,000-12,000 for a single-filing households, and about 12,000-24,000, that's a good thing for just the typical American household, so there is a lot of research and consensus that's out there saying this is actually a good for renter which is something we've talked about in the past. That's hopefully what we see from this Tax Cut and Jobs Act is that it's kind of the middle class that's doing better and getting help rather than just the people at the top, so we'll wait and see. There's arguments on whether that's going to happen or not, but certainly, when more of those people are keeping more of their earned money in their pocket, that's going to be good for them.
Adam Hooper - And how long do you think it's going to be before some of these impacts are felt in markets that you guys are tracking?
Michael Madsen - Well, migration patterns for jobs, businesses, and people have already, the trends are already going, if you will, that flow and stream of migration is probably only going to increase, so I don't think we'll see a reversal of those trends. Ee'll just see more migration, so we'll definitely see businesses and people move to those business-friendly states. A lot of this repatriation money will definitely go back into the equities, stock buybacks and things like that, so you'll probably see some of those cities with the Fortune 500 companies who'll benefit a little bit more than the others, but it's definitely going to have a huge effect on our overall economy and should be something that commercial investors are noticing and reacting to a little bit.
Tyler Stewart - You see a positive impact for both urban and suburban markets?
Michael Madsen - Yes. Probably more your big cities will get the initial boost, but if this can create some wage inflation, then that'll ripple out throughout the economy.
Adam Hooper - And then one of the points that was brought up in you guys looking more macro picture at a conference we were recently at was, again, this time is always different, but one of the points that they brought up was the supply and the over-building that we saw in 2005, six, seven, we haven't really seen this time around in the cycle, the over-supply of units, new deliveries, certainly hasn't seemed like that's been as much of a concern as it was, well, looking back, now as it was in last cycle. How are you guys looking at new development activity, new supply coming in line as it compares to demand this time through the cycle versus maybe where we were in '05, six, seven?
Michael Madsen - Sure, yeah, we're way closer to a housing shortage than we are a housing over-supply. We mentioned last year that there's about 10 markets that were basically absorbing about half the new construction, so most markets are far away from being over-built. There's no doubt about that. We're a little bit more worried about it than we were a year ago. We're trying to focus on certain ratios of where average rents versus average cost of construction per square foot are. You look at those ratios in markets across the country, you'll see some big opportunities out there. There's places in North Carolina to where, and other places to where the rents just do not justify new construction. That's a big deal. When you look at the overall supply and demand fundamental side of commercial real estate right now, we are extremely healthy. That's reflected in the national occupancy numbers, and if you look at what's in the pipeline, I think most of the new supply will come online in 2017 and '18. Then we'll actually see that new supply go down in the next couple years, and rising interest rates will only slow that down, so if there's one thing that you can take comfort in, as you see the rates go up as interest rates going up at a moderate pace, is going to be good for commercial real estate owners, and it's also going to help make sure that, it's also going to give the effect that people can build a lot less when interest rates are high brcause these construction guys have got to borrow that capital, so.
Adam Hooper - Well, we've already seen such a huge increase in construction costs. If you're talking about the financing costs in addition going up. We've been relatively stable in historically incredibly low interest rate environment for construction. If you start adding in increased financing costs for construction, that's just going to make it even less economically feasible to build new units, right?
RealCrowd - Yeah, no doubt about it. You'll hear more people talking about the issue of there not being enough housing and rents going up and people wanting to find ways to bring affordable housing the the market, but that's a complicated issue to solve. Somebody's going to pay for that investment and infrastructure, and somebody's got to take a risk, and when enough investors see too much risk and not enough upside, then you're going to see less building, so the supply and demand fundamentals
Michael Madsen - are really healthy on the national scale. They're definitely really healthy in our RealSource target markets. As you guys know, RealSource analyzes a lot of data from both industry fundamentals and outside industry fundamentals, and we basically use our science and use our experience to boil it down to about 10-15 what we call RealSource target markets, and right now, we look at our RealSource target markets, we're very, very healthy on the fundamentals. We're not worried about new supply, and I think one thing we're really focused on and that, you don't hear a lot of people talk about this, but B Class apartment rents are growing at double what the A Class rents are.
Adam Hooper - Well, it's because there's no room for the A Class rents to grow.
Michael Madsen - Exactly.
Adam Hooper - They're almost unaffordable at their base rate just post-construction, so there's not an unlimited room for them to grow, almost, so I guess that kind of makes sense that B and even C Class, there's more room for those rents to grow than there would be at the high end of the new deliveries.
Michael Madsen - Exactly. Historically people have seen B and C Class apartments as a little bit more risk. You've got deferred maintenance and things like that, but there's certainly an argument to make that it's the A Class assets especially in some of these bigger cities that actually carry the most risk, so it's pretty interesting. It's good for us because we're primarily a value-add buyer. We're a picky buyer, but we like to find stuff that we can go in and fix up the interior, fix up the amenities, and get $100-150 rent increase from the marketplace, so it's a good environment for our business model right now. We're definitely trying to play a little bit more defense than offense, being about seven years into this macrocycle, but if you look at the supply and demand fundamentals of the marketplace right now, there's no flashing red signs that say a lot of these markets are going to turn around in the next two to four years. Now there may be markets that we think are a little bit later in the local cycle that we're not going to go buy in right now, but we're trying to focus, play a little bit more defense, buy closer if you will, on the clock on the wall. We're trying to buy closer to that seven o'clock then maybe we were a year or two or three years ago. Three years ago, you could buy at that nine o'clock, have a good growth, and have a nice exit strategy, but what we're trying to talk to our clients about is not necessarily where the market is right now in the cycle. It's where's the market going to be on your exit strategy which could be three to five years down the road.
Adam Hooper - And we got to little peak under the hood earlier today about some of these models that you guys are building, and it's very impressive what goes on there.
Michael Madsen - Fascinating, yeah.
Adam Hooper - And your ability, again, to look at those as it's not necessarily where you're buying today. It's how's your exit looking, right? So, in some of those markets that are getting all the press, and we talked earlier today, Mike, about just human nature of chasing what's hot, right? Once something's hot, there's not much more room for that to go, right? You're inherently taking more risk in buying in a hot market versus buying in that market that's soon to be hot, right? And that's the key to your strategy at RealSource is trying to find those markets that are maybe two or three years before they're at that higher point in the cycle, so that you have that exit baked in and you're not paying somebody else for that value. You're actually creating it and capturing it yourselves.
Michael Madsen - Exactly. We definitely notice there's a lot of people out there chasing momentum, and there's probably a lot of cities that a lot of other multi-family buyers are buying in that we would look at and say, "Man, we would buy there two or three years ago, but we're not going to buy there today," so we're definitely analyzing the risk, and we're trying to play it safe, and even if the macrocycle takes a big lift up for the next five to 10 years, we would rather be early than late when it comes to the exit strategy, and that's one of the things we've learned as a business from being in business since 1989 is we know what the market giveth, the market taketh.
Adam Hooper - And now the inning analogy is always talked about, right? What inning are we in? Does this supply demand dynamic, does that extend our innings? We just talked about it on the last podcast too, of what are some of these tailwinds that we're looking at right now that historically, a couple years ago, we felt like we were getting a little bit late in the cycle? I would argue that today, the sentiment is probably, maybe even we've got more room left today than we thought we had two years ago, right? Are some of these things stacking up to extend what would normally be a little bit later stage in the cycle? Are we seeing an extension of that now?
Michael Madsen - Yeah, no doubt. If we get some growth and some additional job creation, and it's not just part-time jobs, but quality jobs, and that's going to have a big impact. A lot of what we track are how many new jobs came into the market in a certain year versus how much new supply came online, and obviously, the more new jobs you have, the further away you get from having a supply problem, and on the same token, looking at the affordability index, as people start to make more money and get a little bit of average wage increase in the economy, then things are going to become a little bit more affordable, so if those things happen, then that'll certainly extend the innings, or you could say that we're a little in the innings than maybe we were before the jobs act and the tax cut, the Tax Cut and Jobs Act, so there's no doubt that we're definitely on a macro level, I think we're closer to the middle of the innings, but we don't see any signs that say, hey, we're in the eighth or ninth inning. If we were, we would definitely be jumping on here and trying to kind of be the watchmen to give a warning and saying, hey, we see this turning. Be careful. But when it comes to the supply and demand fundamentals, everything is very healthy right now. If you're looking at risk of what could make the market turn, you're probably looking at more of kind of those external forces or unknowns. Certain things that can happen that can make the entire economy change. Those things are a little bit more hard to predict or see, so.
Michael Madsen - One thing a lot of people are talking about is rising interest rates. It's definitely spooked the market just a little bit, but if you go back--
Adam Hooper - They have to come up eventually, right?
Michael Madsen - Yes.
Adam Hooper - We've been saying that for years now. They're going to go up, and they're going to go up, and they're going to go up, but they haven't really appreciably in the last number of years, right? So at some point, they have to.
Michael Madsen - Yeah, and when interest rates go up, it's because people expect inflation, and when people expect inflation, it's because they think there's going to be some additional growth, so interest rates going up are not necessarily as bad for commercial real estate as it is single family. If there was an external force that made the interest rates jump up over night, that's not a good thing. In the past, we've talked about interest rates rising for good reasons or bad reasons, but the more you get into studying commercial real estate and understanding what makes these values go up and down, even if the NOI growth is staying the same, there's no major correlation between cap rates and interest rates which is. A lot of people don't understand. There's definitely that correlation with the single family market. As interest rates go up, the amount of buyers goes away, but commercial real estate just doesn't work that way. It's really the amount of capital flow that's going into those assets.
Adam Hooper - That's contrary to a lot of understanding, right? That the correlation between returns and interest rates, cap rates and interest rates, I would say the general understanding or belief is that those are very tightly correlated, right?
Michael Madsen - That's a little bit of a misnomer out there. Moderate rising interest rates is good for growth, it's good for inflation, which in turn, is good for real estate. The single family market is a little bit more sensitive to that, but if you look historically, it's what made commercial real estate go up and down in value. It's definitely the capital flows. When there's wide-spread fear, the capital markets will no longer have capital. Then there's a plunge in the value, so we're nowhere near that right now. In fact, there's probably a reassuring amount of capital that's entering real estate. We may have had it toned down just a little bit from the year before, but there is a lot of money chasing apartments. Certainly on the underwriting side, we've seen it. We're used to competing against five or 10 other buyers, and now all of the sudden, we're competing against 20 or 25, and that's because people want to buy these assets.
Adam Hooper - Different sources of capital too, right? Not just purely your kind of traditional domestic, either ultra-high net worth or those private equity shops, but the composition of that capital is more unique today than it was before as well, right? New entrants, new buyers, foreign entities, and other new capital coming into the system outside of the traditional sources. Are you guys seeing that in terms of the competition of capital?
Michael Madsen - Yeah, no doubt. It depends on the market you go to, but there is definitely a lot of institutional capital that's chasing these deals. There's a lot of regional, local buyers, shops like RealSource that are pretty active in the market, but that's a good thing. Sometimes you can say, well, there's a little bit of euphoria when you're a the top of the market, but I just don't think we're quite there yet. People will just recognize that it's a good place to make money and preserve capital at the same time, and I expect that the capital flow demand to stay pretty strong. If there's a time to worry about it, you're maybe two or three, four years away. We've talked about this wave of capital coming to the US through the tax reform and basically through turmoil in the markets outside the US. If there's a worry there, it's once that wave of capital starts to retreat back, then that's when people should be more worried about cap rates ticking up a little bit, but overall, we don't see a big change in cap rates coming. I think some of those markets trading at a three cap are a little bit more susceptible to higher interest rates than something trading at a six or a seven cap, and that's always been the case, but overall, there's demand and capital for these assets. The banks are certainly a lot healthier than they were 10 years ago, and I don't think we'll see any major lending taper off in the next two to three years, but maybe three to five years out, you could have a little bit of change in the lending
Michael Madsen - which could create a little bit of fluctuation in cap rates depending on the market, but if you're looking ahead for one or two year, three year window, things are just as healthy right now as they were three years ago.
Adam Hooper - So there's some good fundamentals behind this up move?
Michael Madsen - Absolutely. There's good fundamentals behind the capital flow. There's good fundamentals on the supply and demand, and like we talked about earlier, it's only getting more expensive to build things. You've seen the price of construction go up. You've seen the cost of labor for construction go up, and on that side of the coin, everything is looking really, really well right now.
Tyler Stewart - Yeah, we were talking about earlier, this may have been the most unhappy people have been in an up market since 2013. Everyone's been calling the top, but--
Adam Hooper - We were even talking about animal spirits and such.
Michael Madsen - Absolutely. If you get into the investment world, there's a little thing people call the animal spirits of whatever's inside of you and driving you and getting you excited to invest and make money and make wise decisions out there, and the downturn was so rough, it hit all of us, both the older and younger generations so hard that I think there's been a little bit of a depressed confidence out there in the marketplace, and a lot of people wish they could go back to 2013 and say, hey, this is the time to jump in. Don't have that fear and uncertainty now. This is a cyclical business. Get in now.
Tyler Stewart - Yeah, pessimistic optimism, I guess.
Adam Hooper - Yeah, one of the things we were talking about earlier is the challenge that shorter-term debt might have, right? We'll see some of these maturities that are coming up in later this year, maybe 2019, 20, if the lending world does tighten or if some of those loan-to-value rates, or loan-to-value ratios, or some of the underwriting criteria from the banks change, how might that affect owners that are looking at maybe a loan maturity in the next two to three years?
Michael Madsen - Yeah, there's no doubt that when you get these changes in lending, if there's a little bit of a credit freeze or whatever, or a readjustment of lending, then it's the people that have the maturing debt that get bit by it the worst, so we've been really careful in letting debt mature in 2019. It just seems like a wise move. If you're into a value-add project that you've been into for two or three years, rather than extend it out to the fourth year, it may be a good time to look at the interest rates a little bit and value that into what you're trying to do. It may be a good time to sell the asset now and to jump in and lock in a new healthy loan on something else, so I think it was last year, we said, hey, if you're looking to get out and refi and get into a new project, 2017 is probably better than 2018, so I think we can look back on that and say, yeah, that was probably the case with the change we have had in the interest rates and I would argue the same thing. If you're looking to reposition into a new property, 2018 is going to be better than 2019. No doubt in my mind.
Adam Hooper - Are you guys net sellers or net buyers right now? Or is that market by market?
Michael Madsen - Yeah, just depends on the market. We've been very successful the last several years. We've had a lot of value-add projects that have met its goals after two or three years, and we've exited out a little bit earlier, but we're always buyers, and we're always sellers. We let the data dictate whether we're buyers or sellers or where the market is on the cycle. RealSource has always been kind of an expert on macro and micro real estate cycles and trends, and we're realizing that right now's a good time to probably get back to buying a little bit closer to seven o'clock than 12 o'clock. We definitely see a lot of other buyers that maybe aren't recognizing that or have a little bit more confidence that things are going to go up and up and keep expanding in some of these markets, but we're going to weigh on the side of safety. We'd rather be a little bit early than a little bit too late. By the time everybody figures it out and it's in the newspaper, it's a little bit too late, and the problem that can have is once it hits mainstream, then buyers everywhere and sellers everywhere know that, and you can see a little bit of the value decline or tail off pretty quick there, so we always try to, if you look at the clock, we want to buy at about seven o'clock. We want to sell at about 11 o'clock.
Tyler Stewart - Could you dive into the clock a little bit more and RealSource's philosophy around the clock? A cyclical market. What does the clock really mean to RealSource?
Michael Madsen - Yeah, sure, so it's been one of those easy analogies or whatever, to explain to people, if you look at the clock on the wall with 12 being the peak of the market and six o'clock being the bottom, we really have kind of recognized, and our founder, Michael Anderson, who has been studying this and built our company over the last several decades, what he calls the decline market is probably about two o'clock to six o'clock. Then, about six o'clock, it turns to what we call the absorption phase, and we really try to wait and let the evidence show us that it's bottomed and so we feel confident of getting in at seven or eight, and right now, we're focused on understanding that the expansion phase of that, which really goes from about 10 o'clock to two o'clock. The expansion phase is when you kind of get a lot of rent growth, a lot of building. Things haven't necessarily peaked, but the tides turned a little bit, so we want to really focus on those indicators and make sure that we are being conservative and make sure that we're getting out of the market soon enough, and I think there's a lot of markets that you see out there on people's top 20 places to own real estate or apartments this year. It's surprising. You look at a lot of those lists, and you go, man, that might be the best market for 2018, but is that going to be the best market from 2018 through 2023? Again, you got to focus on your exit strategy and where you think the market's going to be in the cycle at that point.
Tyler Stewart - Got it. So buy at seven or eight o'clock. Your downside is six o'clock, and seven or eight gives you the room to run to 12? Is that how that works?
Michael Madsen - Yeah, we usually try to get out at about 11 o'clock. As soon as we see those key signs of the market turning from absorption to expansion, being if it was early in this macro run, we were a little bit more focused on trying to identify the markets that were turning from decline to absorption, but now that we're a little bit later into this, that focus switches. Okay, well, when is this market going from absorption to expansion, so we've really drilled down on that. We've really enhanced our models. We've really tried to focus on making sure that we're eliminating any of those markets that are showing to be an expansion, eliminating them from our target list right up front. It's a wise, smart, defensive maneuver, and we hope the investors and clients and listeners think about that and realize that we're doing that for good reasons, and it's better to be a little bit safe than be sorry later, so we think a lot of people will actually value that, and you may see the cities we're buying in, and they may not be on everybody else's top 10 list, but wait a couple years, and it will be.
RealCrowd - Thanks again for listening to the RealCrowd podcast. If you like what you're hearing, please visit realcrowd.com to learn more and subscribe on iTunes, Google Music, and SoundCloud. RealCrowd, invest smarter.
RealCrowd (Real User Testimonial) - My name is Jack and I've been in the financial services industry for over 30 years. I've done six different deals. When I first started doing these deals, I was looking for core real estate cash flow. I wasn't looking for a lot of upside return. I wanted more immediate yield. And so I went conservative to start, and then as I've gone through, I've just looked really at the quality of the sponsors first and foremost and their level of experience. Now I'm trying to mix in different types of properties, different geographies. I wanted some core-plus and a little bit of development, so it's still pretty, in my view, a conservative portfolio. It's mostly focused on sponsors and then looking at the projections as far as how much of the return would come from current income and yield and how much of it would be based on appreciation and thinking through whether or not, how much risk there is in the appreciation being realized. So it's really a portfolio approach for me. Looking at different sponsors, different geographies, different property types, and even different types of properties as far as core or core-plus or development. I'm looking for, I guess I would start with a certain level of return, because my investments are primarily in equities, and I look at the direct real estate investing through RealCrowd as being a diversification play, but I also want a pretty substantial return, so I typically look for properties that have a yield of 7, 8, 9% current income, and then an IRR that's in the mid to upper-teens, low 20s in some cases.
RealCrowd (Real User Testimonial) - So I start with returns. I focus on sponsor. I look for property types that I don't have already invested in the portfolio, and then I guess, finally, look at geography. Well, I think that diversification's important to any portfolio. I looked at a number of different crowdfunding portals. I chose RealCrowd because I like the transparency. I like the fact that the sponsors pay a fee to be on the portal, and that there's not built-in fees for RealCrowd in the compensation structure, the deal. 'Cause these deals are fairly complicated to understand anyway because you've got to pay a management fee and incentive fee and things like that, and if there are embedded fees from the portal provider, it just makes the complexity so much higher, so I think the key for me is the transparency, and I just think that direct real estate is a great compliment to a lot of other stock and bond portfolios. I think it provides inflation protection, current income, and appreciation potential, and for me, direct real estate is better than REITs which are more subject to market fluctuation in price, and I just think with the minimums that are out there now, and the quality of the sponsors, it's a really good way for a lot of investors to access direct real estate without the hassles of property management on your own, so I think it's an important advancement for a lot of investors to diversify their portfolio.
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Adam Hooper - And so you guys are tracking this across what, 250 markets?
Michael Madsen - Yeah, we cut our list down to about 275-225. At the end of the day, there's probably about 150 markets that we would ever buy in due to population. Some of this smaller metro areas can be too impacted by a single employment sector or a single business, so we try to stay away from that, but at the same time, we really like to get a pulse on what's happening everywhere, so we felt like tracking 225 gives us a better indication of what's happening regionally or by a state level.
Adam Hooper - And then at any given time, the macro look on real estate might be at some hour on that clock, but at any point in time, individual markets are going to be at different points on that clock, right? And again, we said Miami was one that's getting toward the top of that expansion phase. That's a hot market right now. That's not one that you guys are going to chase. So just because the macrocycle might be at some point of this expansion, absorption, decline, the individual markets might be at different times on that clock based on the modeling that you guys are doing.
Michael Madsen - Yeah, absolutely. And if the next 10 years and the '20s are the roaring '20s again, then maybe the guy who buys in Miami does a little bit better than we do, but if you're going to diversify and buy three different properties, and one of them goes south, then you better look at the average, and we think that we have a great track record. A lot of the businesses that do what RealSource did, went out of business during the downturn in 2007 through 2010. RealSource was able to survive that, and we really think that a lot of that was one, we got good people, we got good connections. But probably more than anything was our ability to stick to the fundamentals, to buy right, let the data tell us where to buy, and we were in places that had a lower risk in 2007, 2008, that we were able to survive and come back, so the later in the macrocycle that we think we get, the more we stick to our fundamentals, the more we really try to focus on not necessarily hitting a home run, but just hitting a nice solid investment. Not that we think we're to the end of the innings. We're just recognizing that this is the time to start focusing on your transition of absorption to expansion markets, and it's very different than where we've been the last several years, but we think it's the right move. It's a good maneuver for the company, and it's why we've been in business for many cycles, since 1989.
Adam Hooper - And now you guys recently refreshed and updated those models with new data, right? Did you guys have any surprises there? Is that what started this shift of looking at where you're identifying the cycles, or how did that impact our conversation from this time last year?
Michael Madsen - Yeah, we've definitely made some of those maneuvers for sure. A lot of it comes from our founder, Michael Anderson, and his experience. And he's mentored me along, and eventually, we kind of sat down and said, "Hey, this is what you need to be focusing on at this point in the macrocycle," and he's done a really good job of making sure that we're focusing on the right things and we're not chasing momentum. And this is the time in the cycle where people will chase momentum, and a market may have 6% rent growth like a Reno, Nevada doing really well. 2018 or '19's going to be awesome, but again, we don't want to buy too late in that cycle, so if it's trending the wrong direction, that's one thing we'll focus on once we break it down. Okay, here's our top 30. How do we get down to our top 10. We're really focusing on the trends. Is the trend getting stronger? Is it declining? Things like that, and by the time we're done taking this through our whole process, selecting target markets is both an art and a science, and by the time we get down to about our 10-12 cities, we feel really confident in those, and it's been our business model for a long time, and we're proud of that.
Tyler Stewart - On the momentum chasing side, how do you keep from letting the emotion of seeing some markets take off that you're not currently in, how do you have these hard set rules, or do you have hard set rules where you just say, that's a no-go zone. We're not going to jump into this market because it's too late?
Michael Madsen - Yeah, some of our most seasoned guys at RealSource really have that experience to step in and make sure that there's no emotional input to any of this. This is science. This is data. Sometimes your experience and knowledge can help you see a turn where the data can't. For example, if you're looking at Reno and all of a sudden you're looking at the science and the data and it says, "Oh you're getting close to expansion," but you know that Amazon's headquarters are moving to Reno, the science isn't going to pick that up, so. There are a few exceptions. If you look at Huston with what happened with that flood and energy rebounding back, there's definitely a few of those anomalies that say, the data says this, but due to XYZ factor, this really is in the absorption phase. So over time, our economic team is really good at studying that and finding consensus as a group, and we make those adjustments when we need to.
Tyler Stewart - What does that meeting look like when you're taking the data and you're deciding there's 10 or 15 markets we really like. What's the RealSource meeting look like? How do you guys discuss the data? How much of that is art? How much of that is science? Could you dive into that a little bit? Is that too secret saucy?
Michael Madsen - No, absolutely not. It brings up a lot of emotions just thinking about that because the last six months I've spent 50, 60 hours a week answering that exact questioning, leading the team in doing that, and there's no doubt first of all, you let the data indicate where you go, but at the same time, there needs to be some human input and some decisions made, and sometimes it comes down to okay, well, we have these 30 markets that we're comfortable with, and we feel good about where they're at on the microcycle, but then it comes down to, "Okay, well, which one of these is going to be the best metro to go to and why," and which one has more risk and which one has more diversity in employment. You wouldn't believe the different analysis and models that we churn through and burn through on a daily basis. We eat and breathe this stuff daily, and we take a lot of pride in selecting those markets, and at the end of the day, we have what's called our data-only RealSource rankings which is all just pure data, and then from there, we have our data-only with the weighting to where we'll change these weights on different key indicators from year to year depending on the landscape and environment and risk and opportunities out there, so we'll break it down, we'll take a small group of about five of us who will really break down and debate and talk about and analyze where the weight should be and why they should change, and then from there, we get into a larger meeting with some of our more seasoned people that have been heavily involved in the acquisition process
Michael Madsen - and the property management process, and once we've narrowed it down to that top 30, then it's really a group consensus of working things out and really just dotting our Is and crossing our Ts to make sure that when we get down to our 10 or 15 markets, we're all really comfortable with them, and some years that may be 10 markets. Some years that may be 15 or somewhere in between.
Adam Hooper - But it's an annual thing? So every year, you'll go through and decide which markets you like?
Michael Madsen - We'll do that twice a year. Every six months. A lot of these markets don't turn like a speedboat. It's more like turning like the oil tanker, so we want to keep a pulse, but we feel like there's a couple data inputs that we update quarterly and track and monitor, but we really break this down, make our key adjustments about every February and about every August.
Adam Hooper - Any surprises around this last time? Anything that you were tracking that was just now completely off limits or anything that what was like, yeah, I would never go there, but now it's bubbled up to the top?
Michael Madsen - Yeah, there's definitely a few of those markets that have been good to us, are in good, favorable states. The state'll have a healthy state GDP versus state debt ratio, and we feel really good about, but at the same time, it comes to that discipline and really sit down and say, "Okay, well, we think this market may be too close to expansion. We got to cross it off the list," and that's tough to do when it's in a market that you've done so well in for--
Adam Hooper - Made a bunch of money in, and yeah, you got to get off the horse.
Michael Madsen - Yeah, absolutely. But that's what we do. That's what we do all day long, and we make those big decisions, and these are properties that we're investing our personal money in as well as for our clients, so it's our whole world, and we're very safe and very cautious and do the very best job we can, and like I said earlier, we'd rather be a little bit early than a little bit late.
Adam Hooper - Yeah, and one of the themes, again, running themes that we've been talking about internally and with a lot of our guests on the podcast is, and Paul Kaseburg brought it up a couple episodes ago, this concept of vintage, right? Of when you're actually deploying that capital and spreading that over time, and one of the things that we're seeing is the market is changing, right? We are getting further in the cycle, and so the deals that we were seeing back in 2013, '14, '15, those return profiles just aren't there anymore, right? And we even talked about this on the prior podcast, right? So part of what we're trying to do and through education and through awareness, is helping investors look at today's current return spectrum and how underwriting might look different today than it looked in 2013, '14 when a lot of our listeners, this is maybe their first access to this asset class. Can you kind of walk us through how underwriting has changed or evolved or where in that cycle things look a little bit different today than they might have looked in 2014, 15?
Michael Madsen - That's why we like RealCrowd is because nobody else in the crowdfunding world is doing that much due-diligence and that much watching out for what their clients are investing into, and that's why RealSource and RealCrowd has been a good fit. Everywhere we go and any market we go into, we want to find the best of the best service providers whether that's property management, contractors, sub-contractors, attorneys, title agents, and so that's what we do, and there's no doubt that our underwriting has changed these last few years. We had rent growth on a national average of somewhere near 5% there for a couple years, and that's slowed down a little bit, so naturally those gangbuster returns on an operational standpoint aren't quite there, but again, as we've talked about in the past, how those values change in regards to cap rates and inflation is a little bit harder to predict and see five years out than, say, the supply and demand fundamentals. We're being conservative, and that's going to kick out that IRR of somewhere between 15 and 22%. The market's done a good job of adapting to that, and that is kind of the challenge is how many deals can we do if our IRR is between 15, 16, and 17, but if I'm an investor, I'm really, really focused on the risk aspect, especially with capital flows and interest rates changing the way they are. There's no doubt that if interest rates just shot up too fast, too strong that it's going to change the economy overnight, and so I think it's wise to be focused on risk, safe debt structure.
Michael Madsen - Yeah, you can a little bit on your operations and get a little more cash flow if you're on a floater loan, but what's the extra risk? And you guys do a great job of trying to identify that, so my hat's off to you, and I think people appreciate that, and I think people are listening and they're not signing up for too risky of deals which I see on other crowdfunding sites. We often go to other platforms and see what the underwriting is and see the way other people are doing business, and it's a little worrisome, and it's not somebody that we want to work with, so there's no doubt about it that you guys are doing your due diligence. You're helping your client investors, and I think it'll pay off. About 70% of RealSource investors are repeat investors. I think that that's key for building longevity of a business is making sure that your customers are happy and your customers are getting what they expected and that they're doing well, so keep it up.
Adam Hooper - Thank you. And we didn't even have to pay him for that plug.
Tyler Stewart - No, no. But we might take him out to dinner.
Adam Hooper - Yeah. You mentioned the rent growth. You're seeing national average rent growth in 5ish% range? The standard underwriting model was just you put in 3% rent growth, and that's just your constant. Forever, in any market, you're going to see 3% rent growth. Are you guys seeing rent growth slow, are you seeing it increase? Is that still just completely a market by market thing?
Michael Madsen - Yeah, it's totally market by market, maybe now so maybe even then two or three years ago. There's no doubt there's a lot of markets that are kicking out over 3%, and there's some that are going to be in the 2%, but on a general feel, I think that if you ever see an inflationary rent growth number over 4%, then that's probably a little bit of red flag. We're probably speculating a little bit more. Now if we keep getting 3% GDP growth and that turns to four or turns to five, then that's going to lag and reflect in rent growth and inflation which is good. That's what happens in a growing economy, but it's just not warranted at this time, so I would be cautious whenever I look at underwriting and I see inflationary rent growth at 4%. I really ought to question that, to be honest.
Adam Hooper - Maybe we can spend a little bit of time on that. As investors are out there looking at underwriting on some of these deals, what are some of those key points to try to pick through, right? The most obvious ones are, I would think, rent growth, what's your exit cap compared to your going in cap, is there justification if you're trying to buy an asset at a seven cap and you're going to exit in three years at a five cap? That's probably a little bit suspicious. Are there some other big things that you can maybe guide or help investors understand as they're looking at these underwriting methodologies, some of those hot points?
Michael Madsen - On the risk side, it's definitely about the debt that we've talked about, but other aspects of it, if you look at the value-add, how much of that value-add is deferred maintenance? Deferred maintenance is not going to get you an increased rent. You're not going to earn that from the marketplace, but if it's more of an interior upgrade or amenity upgrade, then you can probably get $100-200 rent bump depending on the market, but if I were people, I would really focus in on not just the rent growth but the expenses. A lot of people don't quite underwrite property taxes like we do. Or not most people, but many don't do that, and if there's one thing that'll burn investors or property owners in multi-family or commercial real estate in general, is you're going to see property taxes increase in a lot of these states as we maybe have some municipal or state-level debt obligations. There's a debt issue that's going around the whole world right now that a lot of people are talking about, and I would really drill down on the property taxes and maybe get a second opinion. If there's one key operational cost to really scrutinize, it's that property tax. A lot of people can look at the expense ratios and make sure that those are in line, maybe get some third-party data or some third-party second opinions on kind of those expense ratios. If people are underwriting their expenses to be too light, it may reflect well on a proforma, but may not be able to achieve that. The good sponsors are under-promising
Michael Madsen - and over-delivering, trying to get repeat earned business and being cautious, but there's definitely some of that underwriting where we've seen the property taxes and just go, oh my goodness. What are they doing? And in fact, a lot of the times when we're out trying to get traction in deals or underwriting deals, we'll get into a market and find out that somebody has a different way of underwriting property taxes or maybe they're local or regional and they have a certain creative way to go in and make sure the property taxes are a little bit lower. We don't play in that game and there's a few target markets to where we've gotten in, and we've said, this property tax issue is a problem because if the guy's you're competing against to get awarded that property are underwriting low property tax, and they're going to come up with a higher value than you, and that's going to put you at a disadvantage, so there's definitely been times to where that has affected where we go and what we do, and property taxes is going to be a big issue going forward on a state and city level.
Adam Hooper - And one of the things, since we're talking underwriting with this new tax bill, is the increase in depreciation timing for commercial properties. They dropped that down to be concurrent with the residential depreciation schedules. Does that play into your methodology at all?
Michael Madsen - Not a lot. It's something we'll pay attention to to make sure we're accounting for it correctly, but I don't see that being a big change. It's really just a minor
Adam Hooper - That's not going to affect the value that you guys can pay for deals or anything like that.
Michael Madsen - Yeah.
Adam Hooper - Yeah. And are you having the cost segregation analysis side of the world, or is that not a avenue you guys explore too much?
Michael Madsen - Yeah, we do. We have a couple people on our underwriting and due diligence team... There's a couple guys that once we've identified a property or we go into a best and final type of situation or we've got the contract we've been awarded, and we're really doing our due diligence, then that gets analyzed by a certain department or office.
Adam Hooper - And that's an after-tax cashflow, right? That's not necessarily affecting the value that you can pay for the asset. That's more of how that depreciation gets passed through down to the limited partners in the partnership versus the underlying value of the asset, right?
Michael Madsen - Correct.
Adam Hooper - Yeah. What else do we got?
Tyler Stewart - Well, Mike, could we put you in the investor's shoes for a second? And say there's a sponsor you're comfortable with. They have a new deal. They unload all the due diligence material on you, the PPM, the financials, executive summary. What's the first document you open, and what section do you go into, and what are you looking for?
Adam Hooper - Oh, that is a good question.
Michael Madsen - Definitely, I'd go right to the debt structure if it were me. If it's not a value-add property, and it has less than a seven year term on it, then that's the first place I would look and would be aware of, and I know a lot of people have talked about defeasance and defeasance being an issue, but that's because we've been in such a low interest rate environment. You got to remember that defeasance is less of an issue if and when rates do rise.
Adam Hooper - And for non-real estaters out there, can you give a quick overview of what defeasance is? That's a big word that non-real estate people might not know about too much.
Michael Madsen - Yeah, no problem. Say you lock in a 10-year or a seven-year loan, and you decide you want to sell the property and pay off the loan early depending on the parameters of that loan, there can be a huge penalty for paying off that loan early. I guess maybe a better word is a pre-payment penalty, but it is subject to whatever the interest rates are and the terms are on that outline of defeasance. When a sponsor or an investor goes and looks at whether to put really long-term debt or short-term debt, the only thing that keeps them from even considering the short term is the defeasance issue, and that's why in a value-add property, the short-term loans can make sense because you know that you're going to get in, do the work, re-position the property, rebrand it, earn a new tenant base and then get out, so that's where a short-term loan makes sense, but there's no doubt. If I was the investor and I didn't have the experience I do of underwriting these things every week, I would definitely, the first thing I would turn to is the debt structure. The next thing I would turn to is the expense ratios. Are they underwriting cutting cost? Are those cost-cutting goals achievable or not? It's easy to pencil lower expenses.
Adam Hooper - Well, that's all there is to real estate, right? Raise rents and reduce expenses, and you're golden. Just that easy.
Michael Madsen - Yeah, easier said than done sometimes, for sure.
Adam Hooper - And so I guess to continue on that line, you guys, RealSource, you've been very responsive to investor questions and that's why we enjoy working with you guys so much is you take really good care of our listeners out there and the investors. As an investor, or I guess, reflecting as the sponsor, what are some of the better questions that you get asked, and conversely, what are some of the questions that you wish you would get asked?
Michael Madsen - We like to hear people ask about exit strategy. That's usually a sign that somebody's done this before, that they're pretty seasoned investor. A lot of people ask about that, but probably not enough. I would get into the exit strategy. The other questions that people should ask a little bit more would come down to what is it about this specific sub-market or this specific location within the market that you think is going to drive the values up? And I'd scrutinize not just the city, but is it on the right side of the train tracks? What's the school district like? Some of those basic things that maybe even if you were going and looking at buying a home that you'd be looking for. Workforce housing or B-, C+ apartments don't always come in the very best school district, but you don't want it to be in the very worst school district either, so I would scrutinize some of those common sense aspects. Make sure that you're not just in the right city, but you're also in the right sub-market and location, and again, that comes down to our relationships in these markets. We have some markets that we've taken investors to 10 years ago. We've bought there for three years, we held there for a few. We've been away from the market for several years. We go back and we find it's the same key guys that are still working that market, and that's how it works in commercial real estate. The best five brokers in any city are going to do 80% of the business, and so we've really learned to value those relationships and value having that local knowledge
Michael Madsen - and knowing that it's somebody that we can trust and somebody that's lived there and knows the market inside and out. That's absolutely key. I'd probably also just remind people to stick to the fundamentals and, as we've highlighted a lot in this podcast already, is the later in the macrocycle or the later in the microcycle you get, the more you need to stick to those fundamentals. And you can almost hear your teacher or mentor or parent telling you that same thing of, "Hey, I know you're doing great. I know you're awesome, but stick to the fundamentals." You don't want to get away from those key fundamentals and those key ingredients for success that got you to be where you're at. That's one think I would just remind everybody. If you're worried about interest rate risk, if you're worried about unknowns or any uncertainties out there, just stick to the fundamentals, make sure you're finding a sponsor that knows how to do that, make sure they have a business model that has a fundamentals to the business model, and really try to find the right sponsor and the right property that just sticks to those safe fundamentals.
Tyler Stewart - Yeah, and top three safe fundamentals?
Adam Hooper - I'll jump in with a little golf analogy.
Michael Madsen - Okay.
Adam Hooper - That was my world before real estate, 13, 14 years ago, PGA teaching pro, no matter how good of a student you have in there, it gets back to grip, aim, and posture. That's your freebie golf tip for the day, too. Grip, aim, and posture.
Tyler Stewart - I like that.
Adam Hooper - Those are the fundamentals. I think sticking to the guns on those fundamentals are definitely the key, and again, as you said, certainly getting to this later stage in this cycle, we've certainly seen a really good market can cover up a lot of suspect underwriting. Keeping the fundamentals is certainly, that's going to help you protect the downside big time.
Michael Madsen - Yeah, I think one of the key fundamentals is buy low and sell high.
Adam Hooper - Which again, sounds easy. But human nature makes that tough sometimes.
Tyler Stewart - That's what you pay the sponsor for, right?
Michael Madsen - I think so. That's what separates a good sponsor from another. History of our clients at RealSource, as I'm sure many of yours are, are people that have bought and managed properties a lot on their own and done pretty well, but then they've realized there's kind of this power of the group and economies of skill and I can't tell you how many investors I've been talking to on the phone, and they've said, "Man, if I just would have realized that investing in your group deals, investing in a RealSource property was going to make me more money than owning it on my own, I would have started doing it a lot earlier," but I think a lot of people assume that if you go with a sponsor or let somebody else manage that asset that you're going to maybe make a little bit less, but in reality, you're probably going to make a little bit more, and we'll back that up with our track record. It's been amazing how many deals we've been able to double someone's money in in less than three years, and we have a lot of investors that have done it over and over and over, so I would definitely stick to those fundamentals. Buy low, sell high. Location, location, location. And just make sure you're not trying to reinvent the wheel. I've heard a lot of people have these out-of-the-box ideas of things they can do to raise rents, but if it hasn't been done before, be skeptical of it.
Adam Hooper - Good. Well, I think fundamentals, that's a good place to wrap up our first live in-studio podcast.
Michael Madsen - Yes, thanks for having me in town. It's been really good to get to know you guys more and check out what you guys have going here and learn more about your business and where you guys are going down the road. And these guys have a good shop. They've got good leadership. The more I get to know RealCrowd, the more confident I've become in your guys' services, and I definitely tell people out there that if you like what you've found, then tell a friend because now's the time when more and more people need to learn to take control of their own financial future, and there's a lot of people out there that have got involved in this business because somebody that cared about them cared enough to say something and tell them what's going on. Sometimes that's a tough thing to do. Sometimes it's maybe more uncomfortable, but if you feel like you've found something good and it's working for you, and it's helping you in your household, then tell a friend. Send them an email, send them a link. Tell 'em what you've found, because this industry's about people and knowledge, and the more good people we have in the network and the more savvy investors we have in the group, the better everyone's going to do, so I definitely just encourage people out there to spread the word a little bit. This is how people create wealth and preserve capital, and the trend's going to continue. Help somebody you care about get in the game at seven o'clock instead of 12 o'clock.
Adam Hooper - There you go. Bring it to full circle. Well, Mike, we really appreciate another great episode here. The podcast listeners, thanks as always for listening, and if you have any comments or what you want to hear Mike talk about next time, send us an email to firstname.lastname@example.org, and with that, we'll catch you next time.
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