Originally published September 30, 2021.

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Transcription

Welcome to Invest Like a Billionaire Podcast

Ben Fraser: This is the Invest Like a Billionaire podcast where we uncover the alternative investments and strategies that billionaires use to grow wealth. The tools and tactics you’ll learn from this podcast will make you a better investor and help you build legacy wealth. Join us as we dive into the world of alternative investments, uncover strategies of the ultra wealthy, discuss economics, and interview successful investors.

Welcome to the Invest Like a Billionaire podcast. We’re really excited to join you today. We’ve got a fun episode. 

Diving Deep into Passive Real Estate Investing

Ben Fraser: I’m your cohost, Ben Fraser, and I’m joined by cohost Jim Maffuccio and Bob Fraser, and we’ve got a really exciting topic today, which is passive real estate investing. So this is a huge topic.

And, some of our listeners may be familiar with some different ways to invest in real estate. And we really want to just break this down and help create the framework for. that you can invest in real estate passively. Not just in the public markets through REITs, but directly into these types of investments and just take a quick step back.

Understanding the Alternative Investment Continuum

Ben Fraser: So again, the whole concept of this podcast is to invest like a billionaire. And what we want to do is learn from them. The ultra wealthy, the ones that have been very successful investing in what are the strategies that they’re using, what types of investments are they making and what can we do as retail investors to use that term to emulate the best practices and how can we make our portfolios look more like theirs.

And so we have this thing called the investing alternative investing continuum and most retail investors are in the 60-40 portfolio, right? 60% bonds. 

Bob Fraser: Yeah. Stocks and 40% bonds. And zero alts. Zero alts. And that’s the big difference with the ultra wealthy. They’re 40 to 60% into alternative investments.

So we’re going to look at this. And so we have this framework called our alternative investment continuum. And on that, there’s really four different areas. 

Exploring Real Estate Alternatives

Bob Fraser: So this is where we’re going to be looking today at just building a framework for real estate alternatives, which have some huge advantages over other kinds of traditional investing.

So we’re going to dive into what they are, when they work and when you should look out. 

Ben Fraser: Absolutely. 

The Big Three of Alternative Asset Classes

Ben Fraser: And just real quick recap the big three of the alternative asset classes we’re going to be looking at in this podcast are real estate. Venture capital and private equity and hedge funds. And of those three, real estate is the biggest by far.

And the one that ultra wealthy investors are allocating to as a much larger percentage of their portfolios overall. So it’s something that we want to spend a lot of time on. It’s so big, it’s almost hard to do this in one podcast, but we’re going to attempt it. And really just the whole goal here is to create a framework that will help our listeners help you guys.

Understand this world a little bit better so you can make better decisions. We’re going to discuss pros and cons, different strategies that investors use in different structures and really how to evaluate different opportunities. And the cool thing is throughout this podcast, we’re going to be interviewing a lot of experts that are really deep in specific areas of real estate so that we can really learn from them and dive really deep, but that’s not today.

We’re going really high. 

Jim’s Journey in Real Estate Investing

Ben Fraser: And I’m really excited because Jim is a longtime real estate investor. So you want to share a little bit of your background because I think it’s just really cool and ties in a lot to what we’re talking about today. 

Jim Maffuccio: Yeah. So I really got started and I had my first career as an engineer working in the corporate world and that lasted about five and a half years.

And I got the bug. I got the real estate bug and really was mentored by a guy initially who wrote a book. Like actually a written book, not an ebook on syndicating real estate. And I was fascinated by it because this guy would put together people’s money and he’d go and buy it or build an apartment building.

And he taught me, started teaching me that. So then I got involved in small residential infill development projects in Southern California, which is a train wreck as a small player in a big very small fish in a very big pond. But so yeah, and I’ve been in and out of just about every kind of real estate, especially in the residential sector.

I haven’t done as much in the commercial, but I’ve watched people, investors, make really good money. And to be closer to the investment, it’s real estate. It’s actually, so it’s been fun. It’s been a fun three decades. 

Ben Fraser: Probably 10 or 12 years ago, moved to the debt side of residential, which is when you guys started Aspen funds, which, we invest in residential mortgages both performing and non performing and we’ll explore that in another podcast, which it’s a really cool asset class, but you’ve been all over the spectrum of, development to the.

Jim Maffuccio: Built homes, tore down homes, rehabbed homes, lost homes, found homes with just about everything you can do in real estate.

Ben Fraser: Yeah, awesome. We’re going to jump right in. 

Residential vs. Commercial Real Estate: An Overview

Ben Fraser: So before we dive into strategies and types of investing, the two broad categories that we generally see are residential and commercial real estate. These are two very different things. Types of categories and in real estate and residential is pretty self explanatory.

These are either renters or homeowners and single family properties and there’s a lot of them, but there’s not as many ways to invest in them. So there’s really, a few strategies. One would be, rentals, long term rentals, short term rentals like Airbnbs. And like what we do on the debt side.

So there’s hard money lending, there’s distressed mortgages and other things in that kind of vein. But the really interesting thing there in, in contrast to commercial is it’s driven mostly by comparable values, right? So commercials are driven a lot by the income. Yeah. Generates. As a function of the cap rate.

Bob Fraser: The commercial is treated like a business. Yes. The residential is much, much different. So they actually respond very differently to market dynamics, respond very differently to interest rate dynamics, et cetera. So they’re very different asset classes. Yes. Even though you would think they would be very related, they’re highly uncorrelated.

Ben Fraser: Yeah. 

Macro Trends in Residential Real Estate

Ben Fraser: And one of the big macro trends we’ve been looking at more specifically in residential real estate cause that’s the area we’re in in, in Bob’s a side economist, hobby economist, if you want to call it that but it has had a great track record and tracks a lot of these trends in real estate and you want to talk a little bit about just some of what we’re seeing in the residential side of things.

It’s just been a fascinating time and everyone is concerned and worried about, oh, it’s the next bubble, prices are at all time highs again and it feels, are we outside of normal valuations? 

Bob Fraser: Yeah, we’re going to dive into that, in a different podcast, but we’ve been bullish and calling for gains in residential markets since 2013 and in the last, since 2018 have been calling for even a redoubled gain.

So we’ve actually been. Been kind of forecasting this latest push we’ve been seeing and we’re still forecasting. It’s still going up folks. And so we can dive into some of the reasons, but there’s just incredible demand because there’s a huge supply shortage and all the fundamentals, really a 100% of the fundamentals are behind residential real estate at this point as tailwinds.

So that’s going to change at some point, but for now that is the case. And we’ll dive into what those are, in an upcoming podcast. 

Ben Fraser: Yeah, absolutely. And a lot of investors, when they start getting into real estate, residential investing is the easiest entry point for a lot of people because it’s easy to understand.

They usually live at home and that’s where a lot of investors start. 

Commercial Real Estate Investing Deep Dive

Ben Fraser: But, there’s a whole other massive spectrum of commercial real estate investing. And we’ve got a slide here that we’re going to show off some of the most common types of commercial real estate investing, and that includes multi family apartment buildings, retail, industrial, hospitality, self storage, mobile homes, It’s senior housing, student housing, so there’s a lot of ways to invest there.

And each one of those is its own unique animal within this broader category of commercial and. 

Bob Fraser: With the commonality that they’re priced primarily on cap rate and you’re a banker. So what’s a cap rate? 

Ben Fraser: Yeah. Cap rate is a very simple calculation. It’s the net operating income that a property produces divided by the price of the property.

And so that creates this capitalization rate and that’s used as a very simple metric to value the property. And generally the lower the cap rate, the more expensive the property. The higher the cap rate, the less expensive, and different asset classes trade at different cap rate ranges based on riskiness and other kinds of demographic factors as well.

Jim Maffuccio: So it would really be the net cash on your capital invested if you didn’t have debt involved. Exactly. It would be, I could buy the property for 100, 000 and it generates 6, 000 a year. The cap rate for that pro, the net operating was 6, 000. The cap rate would be six. Yep. It’s been interesting in recent years that because of the low interest rate environment, you can actually apply some of the commercial type analysis to residential property.

And it’s actually, I remember, I predicted this about seven years ago, that residential rental housing makes sense again. Because, I’m not talking about the coast. Premium markets, but I have people look at me cross eyed and say, yeah, it’s too, be too tough to manage, be too tough to manage all these properties.

Now it’s like probably the fastest growing asset class is residential rentals. And I’ve heard numbers like 60 or 7%, 70% of the rental properties in the U. S. right now are owned by large institutions. So you, that’s another thing supporting. Real estate, residential real estate increasing in value is that it actually does make economic sense if you take away the cost of the higher speculative markets, their bread and butter markets.

Bob Fraser: But commercial traditionally has been far larger than residential as far as third party investment.

And it is entirely driven by cap rates. And we’ve seen over the last couple decades, massive cap rate compression. So cap rates are coming down with interest rates. Yep. Yep. And so people are seeking yields and to keep driving the cap rates down, which means driving the prices up because cap rates are inverse to, to values.

So you’ve been seeing pretty steep values to a value investor, as I would count myself that Warren Buffett is that, some of the most successful investors are value investors. Is it a good value? We could argue both sides of that, right? 

Ben Fraser: And we will in a future podcast. We’re excited to. 

Bob Fraser: Our cap rates going up or are they going down?

If cap rates are going down, you’re going to see prices continue to climb. If cap rates are going up, you’re going to, you’re going to see, you’re going to see prices drop. And so which are we seeing? It really depends on to a large, to large impact or a large degree, what you think, what you think is going to happen to interest rates in the future is primarily the driving factor.

Jim Maffuccio: It’s all a competition for you, really. Yeah. It’s at the end of the day. One distinction I think we should make, it might be self evident from what you’ve said, but, when we talk about residential versus commercial, residential generally four units or more, but certainly multifamily actually is a commercial class, but it’s a residential use.

Exactly. So the numbers are, I think that’s probably obvious, but I just thought. 

Ben Fraser: That’s a helpful distinction. So one of the things that, you know, as an investor, it’s a passive investor, right? We don’t want to operate these properties ourselves. We want to work with sponsors and other experts in their field to have teams in place to operate these.

But the things we’ve got to look at are what are the macro trends affecting these? We talked about cap rates. That’s a really big one, right? We have inflation as another driver. It’s in tandem with. With interest rates in the monetary policy, and we’ve seen, asset price inflation just massively over the last decade.

And we’re actually gonna be doing a podcast on a kind of inflationary environment and housing in a play a few episodes from here. But it’s really important because these asset classes are all affected a little bit differently, but you want to talk a little bit about just some of those other factors that we pay attention to. 

Bob Fraser: Yeah, and so right now with COVID, and everybody’s mind on my mind is retail and hospitality. 

Ben Fraser: Yeah.

Bob Fraser: They have been creamed. 

Ben Fraser: Yeah. 

Bob Fraser: That’s for a disk for a distressed investor. That’s when you make, you know outsize gains, you know it and so the question is, you know Is it time to invest in?

In retail and hospitality. So we’ll get some experts on and we’ll be talking about those sectors in particular. We’ve seen multifamily. Cap rates just continue to compress and multifamily, it’s primarily cap rate driven. I think you’ve seen a lot of pressure because of the forbearance or the eviction moratoriums, et cetera.

But it’s not been, it’s not been, it’s not damaged these properties. Too much and they’re damaging the industry, self storage is, got its own kind of drivers. I think people as they’re going urban, need and going smaller, square footage is decreasing are looking for storage.

It’s a good option. Yeah. Mobile homes are definitely lower in price, right? And capture this need for lower price housing. That is a big gap in the market. So there’s a lot of us, we’ll get some experts in the mobile home area to talk about that. Senior housing, of course, we know that the world is great.

Jim Maffuccio: Silver tsunami. In my case, it’s a white tsunami.

Bob Fraser: And so that trend is not going away. And it’s interesting because they’ve been massively hit, in, in right now. So the values have been. Dash. So is it a good time? And same with student housing, basically income goes to zero, or, not zero, but, severely crushed.

So these economic factors are something we’ll look at, which each of these asset classes.

Ben Fraser: It’s interesting. I have a subscription to some local multifamily brokers in the town in Kansas city where we’re at. And they were talking about the cap rates per pandemic and post pandemic, and just in the last year cap rates on a class B multifamily property have dropped 1.5%. Yeah. And it’s in there. I think it’s primarily prices going up and a 1. A 5% drop in cap rate is a massive increase in value. And they’re attributing that to all the costs right now with lumber being extremely high right now at this point in time, labor is very difficult to find.

And so it’s driving up all these extra costs for kind of these value add plays and you would think that, hey, we just went through a crisis and, there’s still a lot of things settling out with forbearance and eviction moratoriums that we don’t fully know the impact, but there’s all this money coming.

So there’s. There’s a lot of things you’ve got to be concerned about it and aware of and yeah, and. 

Jim Maffuccio: And stay with us because the journey that we’re on here, we’re going to see changes. As a result of this pandemic, there are going to be some systemic changes. There’s a lot of office space that’s never going to be, that’s never going to come back and be utilized the way it was prepan.

And a lot of people discovered they can actually be. They’re employed. Their employee force can actually work from home, be productive. I think in the multifamily, you’re seeing a lot of people. So you’re seeing demand go up and cap rates down. A lot of those people aren’t necessarily, it wouldn’t be their first choice of where to live.

I actually think a lot of the millennials, for instance, are going to be looking at, wow, we wanted to do the urban thing. We got really close together and everybody’s wearing masks and doing the whole COVID deal. And there’s a lot of fear out there. I think you’re going to see a lot of people that are going to want to move to the suburbs, but guess what?

The cost of lumber, all the things we talked about. The inventory for single family housing right now is down to nothing. And it’ll be interesting to see how these play out. 

Bob Fraser: We’ll see fundamental changes everywhere. Office space is down significantly. I forecast it would come back to 80% pretty rapidly.

But still, that’s a 20% decline in occupancy. Same with senior housing. A lot of people are now exploring. Home options, right? Instead, commercial options. And there’s a whole lot of changes afoot. And so it’s a good time to position yourself to capture those trends or avoid them if you’re not sure. 

Jim Maffuccio: And this is really, you have, by the time your institutional investors get involved, and it trickles down to the retail level REIT investment. It’s the entrepreneurs that go ahead of time and would serve the alternative investment community that find these opportunities, prove them out.

And that’s where really some good money is made. And it’s an exciting place to be an investor because you’re getting in on the front end of something that like I said, now single family housing, rental housing. Is an institutional investment class. There’s still a lot of opportunity on a retail level, but there’s going to be entrepreneurs, there’s entrepreneurs doing short term rental right now.

It’s Airbnb VRBO that is killing it. And it’s all mostly passive investors. It’s private investors that are investing in those business models and they’re doing really well. 

Ben Fraser: Yeah, absolutely. 

Strategies for Real Estate Investment Success

Ben Fraser: So we’re going to move on to the strategy. So these are the categories of types of investments, but there’s I would say these four or five core strategies that can be applied into any of the asset classes.

And so we’re going to break them down. We have a slide here. We’ll show you. And we arranged them on most risk to high in highest return to least risk and lowest return. And some of there’s, some fungible, ways to massage it within that. But first off would be a distressed opportunity.

So you’re buying a property or a piece of debt like we do it at Aspen. And yeah. They’re not performing, they’re not being paid, it’s not being paid. There’s something wrong with it. And so you can usually pick these up at very deep discounts and find. 

Jim Maffuccio: Something that exists. It’s broken and you’re fixing it.

Bob Fraser: Yeah. And so outsize gains. So this is, so not only is a risk scale, it’s also a return scale. Exactly. And also an expertise scale. So I think the way to think about this is, if you’re going to invest in distressed debt, you want to make sure that the operator has skill and experience doing this where it’s less important if it’s just, this is a class, an office space, what we would call core.

And it’s just, this thing is just, you don’t, it doesn’t need to do anything with it. So there’s stress. So expertise really matters. Your gains can definitely be outsized gains and your risk is also greater. But we love distressed debt distress because there’s always distress in the markets and those discrete distresses yield great discounts to people who aren’t equipped to handle those.

And so when you’re equipped to handle those, you can make outsized gains. 

Ben Fraser: And a lot of times when there’s fear in the market, you had a broad level. It’s a lot of times oversold. So a lot of times the discounts aren’t even truly reflective of the actual intrinsic value of an asset. There, there is that opportunity for upside just even intrinsically without even 

Bob Fraser: It’s so true. So we have our underwriting model in our residential distressed debt market. We do model intrinsic value for every note we purchase and we’ve never paid intrinsic value. We’ve always paid a discount to intrinsic value and because the market is so inefficient. And because these things are simply priced based more on emotions and on panic than they are on numbers, right?

And so it’s very true and distrustful, back in 2008, 2009, 2010, you listed properties for sale. There were just no buyers, I remember, my daughter. I was going to buy just a condo, for 64, 000. She was like, how much can I lose?

How bad is it going to be? Of course she sold it two years later and I think doubled her money, tripled her money, something like that. And so it’s, but the fear gets in. And we need to, you’ll make outsized gains when you’re buying, when everybody else is selling and you’re selling when everyone else is buying.

So distress we love distrust. The next one is development. So this is very risky as well, but you can typically get real nice gains there too, as an equity side, they’re very leveraged a lot of times. So you have a lot of debt behind you. 

Ben Fraser: So do you want to explain what development is just for those that may not be familiar with that?

Jim Maffuccio: So development is really, so distressed again, is taking an asset that already exists, but some aspect of it, it’s broken and you’re fixing it. Yeah. Development is. There’s a need out there for an asset and you’re developing it, you’re building it. So in the real estate world, development is, there’s a distinction between development and building and development would be like buying the raw land, for instance, and then taking it through the entitlement process, getting the subdivision approved plan development permit.

Then you move in, usually a developer will build it for you, move into the building, which is actually, so you’re creating an asset. To serve a need that’s out there. So the biggest risk there is market risk because you, and again, speaking from somebody who was doing this in Southern California, you don’t know how long it’s going to take to get a project approved.

So by the time you lift the curtain, no one shows up for your drama. Because nobody’s buying that anymore or the market, the interest rates have gone from 7% to 12%. 

Bob Fraser: Interest rate risk, you have market risk, you have materials risk, and legal risk. Permitting can change or legal challenges, etc.

So there’s a fair amount of risks in there, but also a lot of those things can be solved. And there’s tremendous gain if you do your homework. If you do your homework you have a skilled developer. So again, outsized gains. If you have an appetite for that and you have a great track record. 

Ben Fraser: From a macro view, I view these somewhat, opposite in the sense that distress is a lot of times counter cyclical and development Mostly pro cyclical total, what that means is as the economic cycle is booming and doing well, development projects are going to be doing very well because there’s demand and there’s people that are buying and they need these properties, especially right now, right?

There’s such a shortage and the distress a lot of times there’s always some level of distress. 

Bob Fraser: Like the floods come when there’s a lot of distress. And so that’s a great point. And, it is too. To have a, have part of your portfolio will be both pro cyclical and counter cyclical, to me I think about that having been creamed in the markets several times, right?

As us older gentlemen have been, we’re very sensitive to wanting to position our portfolio for, to both capture the positive in the cycle and capture the negative in the cycle as well. And that’s right. And so it’s, why not build your portfolio to do both. 

Ben Fraser: Yeah, what the next strategy that we look at is opportunistic slash repositioning.

We alluded to this, and this is generally an existing asset class. And as the trends have changed, like we’re seeing in retail and in office and dramatic transformations in a very short period of time, there’s gonna be a lot of opportunity there because there’s other needs that are. Much greater than these could be repurposed into.

And so some of those common ones that we’ve seen are, hotels to multifamily or condo complexes, and then malls, that’s been a big declining trend. And I think especially the last year, it’s You know, but Amazon loves those. Excellent. Nate, to convert them to warehouses, big space. We got to ship all of our boxes.

Bob Fraser: We’ve seen industrial storage, right? So it’s repositioning opportunistic repositioning again, outsize gains if you have a sponsor. Who has a lot of track record and that’s, it’s risky, but if they’re right, boy, can you make a killing. 

Transforming Spaces: The Colorado Springs Project

Jim Maffuccio: Real life example yesterday? Literally a day before yesterday, I was actually in Colorado Springs. I had a meeting with a guy at a coffee shop and they took this, a developer took this typical 1960s built elementary school. That for whatever reason this, that school, that facility wasn’t needed any longer. I’ll just leave it at that. And a big L shaped building, a single, super simple building, and a big parking lot. And they went in and they repurposed this. And now you walk in and there’s like the, the central hallway, just like in a, when you’re walking down classrooms left and right, but they’re all these little reach.

There’s a baker. There’s a microbrewery. There’s a coffee shop. There’s a real estate office, a mortgage office and on. And the place was buzzing. And then they had to use them, you don’t need that much parking as you do. So they had the outdoors. Eating areas on the outside and then inside, it’s like you’re in the school building, but they really did it up cool.

And I looked at it and I said, these are really cheap tenant improvements. This is a moneymaker, and now I’m Whoa. 

Ben Fraser: And then the cool thing with that is it’s already existing assets that you have to build from the ground up. And so there is less risk there, but sometimes there’s permitting issues.

You have to get it re permitted and other things. But some of those very, I think we’re going to see a lot of these opportunities pop up like the ones you’re saying and others like offices and other things. 

Exploring Value-Add Real Estate Strategies

Ben Fraser: The next kind of strategy here, it’s a little bit less risky. 

Bob Fraser: It’s super common. This is a ton of the offerings out there that are value-added. 

Ben Fraser: Yes. You want to hear what value add means? 

Jim Maffuccio: Yeah, I’ll give you a perfect example. I know a guy who recently bought an apartment building, so several hundred units. And in the area that he was in, remember everything with that commercial.

So you’re looking at the net operating income. And when you know that, and when you affect the net operating income, it goes straight to the value of the property. Because the cap rates are pretty. Tightly defined by a market. There’s enough players. So this guy goes in, he looks at, I think he had something like sixty three bedroom units in this apartment building.

And they were all like, they were large three bedroom units. And so they do their marketing studies and they look at what’s in demand and what’s oversupplied, what’s in demand in the area. What turns out, one bedroom, one bath units were in high demand. So this guy went in and took all, not all of them, but like sixty of these large three bedroom units General sense, put a wall down the middle, added a kitchen and a bath, created two one plus ones in place of the three plus one.

Oh, yeah. And so the three plus one might have been rented for 875. But the one bedroom is rented for 600 bucks. So you take that extra and it didn’t cost that much to do the improvements. So that adds to the bottom line of the net operating. He created 2 million of value in this 10 million asset, 20% value just by doing that little change.

And then you have brand new units so you can rent those at the top of the one bedroom market. So it’s a value add. 

Bob Fraser: So other fat common values add plays. So go in and rehab, just update. Yeah. So the doors, so they look better they feel better. They also in, we’ve seen value add in storage.

So you buy the mom and pop storage units and go in, add, the whole digital function. So you automate everything in storage and the same thing in multifamily or you’re automating payment, you’re automating. Requests for maintenance. Yeah. You are automating all this stuff.

And so they’re creating value add there. So it’s all basically making it more efficient. And bringing more revenues and typically raising rents. Yep. And so all of a sudden, as Jim says, that goes to your operating income, any dollar improvement in your operating income produces $5 in value improvement. Yep. So that’s the idea. 

Jim Maffuccio: I know an apartment guy that did, he just added stripes to the parking lot and assigned. Spaces and then said, if you want to, if you want to know you have a parking space, it’s 50 bucks extra a month. Everyone. In fact, one guy rented two spaces, Jake, because he had a brand new car and he parked right in the middle of two of them.

They just created that value out of thin air.

Bob Fraser: Sounds like California. 

Ben Fraser: And really the last strategy here is what we’ll call core. And there’s a few nuances around that, core plus and core. And but really the concept is these are generally going to be very, institutionalized assets. They’re usually very large class a and a large metropolitan, think, Miami beachfront.

And a 400 unit apartment building classic that’s going to trade at a very low cap rate. Generally, they’re going to have pretty low vacancies. It could be, most of the units are rented. So there’s not a lot of improvement, but it’s a stable asset. It’s going to be a much lower return, right?

Bob Fraser: So you may not make a lot of money, but you’re not going to lose any money. Yes capital And not a lot of upside not, lower yields something a bank might own or a pension fund or something else Because they’re not You know, don’t not go for higher yields, but very safe, very low risk.

Ben Fraser: Yeah. When you compare it to a bond or something it’s pretty attractive, even at a lower yield. 

Diving Into Investment Strategies: Debt, Equity, and More

Ben Fraser: When you’re looking at the institutional level, it really is the next kind of piece we wanted to overlay on this, so we have our different categories or different strategies.

And now there’s multiple ways to invest in all of these strategies, right? So this keeps getting exponentially larger as we lay it over. 

Bob Fraser: A five dimension matrix here is what we’re building. 

Ben Fraser: And and really just, to keep it really simple, we’re looking at kind of three ways to invest in these.

There’s debt, there’s preferred equity and then equity. And, very simply, debt is, Senior debt will say is generally a first position in a commercialized assets, generally going to be your bank, your lender. But in our case, in the distressed debt side where we’re actually working with other institutions.

We are working. They’re coming in as a debt position, as a senior lender. And so they’re taking the first position, but they’re getting a lower rate of return for that. And so again, this is a correlation between risk level and return level. And so the. It’s called the capital stack.

If you’ve heard that term, this is what it means. It’s just how your assets are capitalized and debt is going to be the first money out. It’s going to be a lot of times secured and the least amount of risk, but also, banks aren’t getting paid a whole lot right now to lend against multifamily properties.

Bob Fraser: And I find, this also is an investor size scale here too, not only as a risk scale. So typically your larger investors, in my experience, the most sophisticated and the largest investors love debt. Yep. Okay. Because, and banks are, for instance, and so are all a lot of institutional lenders.

They love debt. Debt. Introduction investors love debt because you get paid first, right? So what if the sponsor screws up, I’m still getting my money out. And so it’s that kind of a thing. So the more sophisticated the investor, Typically, and the larger the investor, the more they like debt, generally speaking.

And yeah, and debt, you can think of debt as being low yield, but you can have high yield debt as well. And especially in the distressed state or distressed debt space or in, in other spaces where there’s stress in the market. I remember you could buy it. You could buy debt on oil fields, back when that was in crisis, of course it is again into that but you can buy that debt and they were getting massive discounts.

You can get 80% discounts, but do you want it or not? But I will say, JP Morgan made all of his money buying distressed debt, and he bought distressed defaulted Russian government bonds. They refused to pay the bonds. He bought them all up and then went and convinced them.

Convinced the White House to put pressure on the Russian government to reaffirm the debt and it worked, so there’s a lot of money in debt as well. It isn’t just a low yield play. 

Ben Fraser: And even I was looking at a sponsor the other day where they actually do venture capital debt. So instead of a lot of times venture capital, you’re, you think of something like investing in the upside of the company, but they’re taking a different position of, we’re going to not dilute your equity, capital stack and we’re going to charge, we’re charging 18 to 20%, so they’re making really good returns.

Obviously there’s a higher risk because this is a startup company versus a real estate play, but there’s a lot of ways that can be applied. Still get good yields and minimize risk. The next kind of step up there is what we’ll call preferred equity. There’s also mezzanine debt, which, they, they act very similarly, but the idea is they’re a junior position.

They’re junior to the senior debt holders. But they’re paid before the common equity guys. And a lot of times in, in, in real estate, you’ll see this where a sponsor will offer two types of equity ones, one’s preferred, one’s common and the preferred, obviously they get paid first.

A lot of times it’ll be a higher preferred rate, so you’ll see a eight, nine, 10% preferred return. but no upside. So you don’t get the upside if the property performs very well, but you get a real nice return, get a real nice return. 

Bob Fraser: And you don’t have very little risk. So you have the senior debt in front of you.

If the thing performs at all. You’re still going to get 100% of your capital back and a nice yield. 

Ben Fraser: Yeah, and the final piece of that capital stack is the common equity. And these are the investors. And usually what you’ll see in most of these types of offerings is, you’re playing the upside.

And so you have to believe in the strategy. If it’s a value add, if it’s a distressed play, You’re taking all the risk on the performance of that strategy. 

Bob Fraser: But if it works, you make the money. 

Ben Fraser: But you make the most money. 

Bob Fraser: And but y’all soon lose the most money. 

Ben Fraser: Yes.

Jim Maffuccio: And another point about the equity side, cause it can sound real negative at first wow, I, I’m the last guy getting out or I’m behind this, the senior debt, if you think about it, these senior debt, they’re typically institutional.

They’re not dummies. In a sense, they’ve done the due diligence for you as long as it’s not over leverage. So as an equity investor, if you know an institution came on board and put debt in front, even if it’s in front of you, you know they’ve done some due diligence and they’ve at least vetted the sponsor out pretty well.

Ben Fraser: Yeah. And a lot of times it has to do with scale, right? The institutional partners want to deploy more and a lot of times there’s more, debt in the capital stack than equity and so it’s easier to deploy larger amounts That’s part of the reason as well as risk, but Those are the most common phrases you’ll see and when you’re evaluating an opportunity, those are the things you want to be thinking about is where am I at in the capital stack?

How do I get paid? 

The Pros and Cons of Public REITs

Ben Fraser: It is the final piece we want to touch on in this podcast and I hope this has been super helpful so far. It’s just the general structure, right? So most people, when they think of real estate, if they haven’t been a real estate investor before, are REITs, right? Public REITs. 

Jim Maffuccio: And so what a Real Estate Investment Trust. 

Ben Fraser: Yes, exactly. And so when most people think, oh yeah, I’m invested in real estate, I’m invested in alts and that’s what the advisors will generally put people into. And there, there is some benefit there, but I would say it’s. 5 to 10% of the benefit that you get by going to. 

Bob Fraser: Honestly, yeah, the public rates the way most people invest in real estate with public rates, I think they have so many issues and are super unattractive . In my book one, they’re generally extremely highly leveraged.

So typically, as high as maybe 10 to one. So for every dollar of equity. They’re buying 10 for the real estate. Yeah, so that creates just a massive amount of risk if that property value fluctuates You know you the value of your equity is massively fluctuating Number one number two is volatility so if you look at the I was looking at just a public large public office rate EQ are and and I believe you know, it had something like Eight drawdowns since the year 2000 of 20% or more.

So meaning what was the draw, the stock price where it drops 20%. So you’re getting a small yield of 3% or four or 5% yield, but you lose 20% of your principal. And there were several that were over 60% drawdown. So it’s incredibly volatile because everybody sells all at once. This stuff just goes on sale. And so incredibly volatile. 

Ben Fraser: And one of the things that historically REITs provided. There was some level of diversification and what’s called correlation, right? To the S and P and other kinds of indexes. But we’ve actually seen that, seen several articles. 

Bob Fraser: Correlations have gone to one.

And what that means is they’re all correlated. So if the stock market falls, your REITs fall. And so what’s happened, you, they’re really not diversified anymore. They’re really not. 

Jim Maffuccio: There’s actually even a misalignment of interest, because I’ve been, I’ve watched some guys put together these kinds of investments, from the sponsor developer end, let’s say.

And they’re not incentivized to find the killer deals. They’re incentivized to do deals, because they can’t they’re limited as to what they can take, profit wise, it has to be distributed, and I, more about the structure than I do, but the point is, it’s like we just have to go out and place a lot of capital, as opposed to, we found this really sweet deal, let’s wrap a syndication, a private deal, which I know you’re going to move into next, so it just, I just find it to be, and it’s correlated, so it’s like a stock, it just goes up and down. 

Bob Fraser: It’s really hard to recommend public rates for me, I just, and even though the yields are really low, because the public markets are so liquid, there’s so much liquidity flowing into these things, just drives the price way beyond the true value of these assets.

Ben Fraser: And really a concept that we’re going to be talking a lot about in this podcast is a risk adjusted return. So a lot of people just look at a gross return and that’s the measure of attractiveness or unattractiveness, but it’s really a, you have to. Risk adjusted means you’ve divided it.

Or have applied some level of risk to that return. And something like this where you are, you actually haven’t getting that great of a return, but you have a lot of volatility. So it’s a lot of risk to your capital. It just becomes very unattractive when compared to private real estate.

And that’s really where most of our focus is going to be. In a lot of these podcasts, interviews are about the private real estate market, because this is where the big institutions are investing a big chunk of their capital. And looking at individuals is. 

Bob Fraser: Far more attractive in many ways. And while you’re your financial advisor will tell you, Oh, if you want risk, go private.

You want to avoid risk with the public. I think it’s a 100% the opposite, right? The public markets, you may not forget to invest in a Ponzi scheme, but the chances of losing money are very high or certainly not getting much. For your money. And the private market. Yes.

Yes, there are more at risk because they’re less regulated from regulatory or fraud risk. But that’s not that common either. I’ll point out and then but the gains are. Potentially much, much better. And it really, a lot of it, not just gains, it’s all the advantages of liquidity and other things.

Unlocking the Potential of Private Real Estate Investments

Bob Fraser: So let’s dive into the, to the private. 

Ben Fraser: Yeah. And when you’re going private, you’re, what you’re essentially doing. Investing directly with the operators of this asset and they have a specific strategy and likely a good track record in this space. And so you get all the tax benefits a lot of times that are associated with.

With these assets, which are huge. And especially now with potential changes in the tax code and going up. 

Syndications vs. Funds: Choosing the Right Investment Vehicle

Ben Fraser: So the kind of two most common structures we see, and these are where you probably heard our syndications and funds. So a syndication generally, it’s going to be a single asset.

A lot of times a larger asset is usually commercial, and it’s going to be raising money for that specific. An asset is going to have a specific strategy, a timeline associated with executing that strategy, and then there’s a return of capital and you’re getting paid along the way.

The pros to that are you have visibility with the assets, right? When you’re looking, you know what it is, you know what it is, the market that it’s in, you know what the rental rates are like, you know what the vacancies like the value add needed, et cetera, et cetera.

Bob Fraser: If you’re a kick the tires kind of guy, you can go kick the tires. 

Ben Fraser: Yeah. Yeah. And you can see it. The issue with syndications a lot of times is you lack diversification. And so it’s one deal. It’s one deal. So you have a lot riding on that. 

Bob Fraser: Sponsor risk, geographic risk market risk, lots of different kinds of risk related to that single deal.

Ben Fraser: Yes. Yes. So it’s a very popular structure. It’s very common. And there’s obviously some major benefits of that. But the other side of it is fund investing. And this is something that’s what we do at Aspen, our fund And investors come into a fund and a lot of times it depends on the strategy, but it can be a lot of times what’s called a blind pool fund.

And so you’ll be the sponsor raising the capital for their fund. And you don’t always know exactly what properties you are going to be buying. Sometimes if you come in later at the fundraiser. 

Bob Fraser: There’s more like a box. Here’s the stuff. Generally the PPMs will describe, here’s the box. Here’s our buy box.

Here’s the stuff we’re looking for. And you have to trust that the sponsor, the operator, is going to do that. And that’s, so that’s as much tar kicking as you get. 

Ben Fraser: Yeah. 

Jim Maffuccio: But the fun has more to do with deal flow in a particular defined class that you’re going after, whereas a syndication is.

It’s a single deal. So you’re in a sense, every syndication is a fund, but every fund is in a syndication in a loose way. So it’s just a different way of structuring depending on what your business model is. 

Ben Fraser: So generally a fund is going to have multiple assets, if not hundreds of assets, like in some of the funds that we do.

And you’re going to have less geographic risk, less market risk. You’re going to not be reliant on the performance of one single asset. So you get a lot of advantages there. But sometimes you have less visibility as to what it’s going to be. And you trust, like you’re saying that. The sponsor track record. 

Bob Fraser: Do you want to pay more attention to the sponsor in that way? Because you can’t kick the tires. You have to trust that they are, yeah, kicking the tires and you have to understand their processes and how they underwrite, et cetera, to make sure that you agree, you like what they’re doing.

Ben Fraser: Yeah. 

Understanding Open and Closed End Funds

Ben Fraser: And then just come one, sub note on that is, is in the fund side, there’s two, two primary types of funds. One’s a closed end fund. One’s an open end fund. So closing is the most common type. What that means is its capital is raised, that capital raise is done. 

Bob Fraser: It’s deployed.

Ben Fraser: You deploy it, and then you work out the assets, or you operate the assets, operate the strategy. 

Bob Fraser: And then exit at the. 

Jim Maffuccio: You have a fixed period of time where you raise, that’s why it’s called closed in. Yep. You open it, you subscribe to it, it’s all funded, you close it. And then you go do what that fund is designed to do.

And when it’s done, you distribute, and everybody’s happy, or not. 

Bob Fraser: Yeah. 

Ben Fraser: Exactly. And generally those are going to have lives of, Three to four years, all the way up to 10 years depending on the asset tax. 

Bob Fraser: Yeah. We’ve seen timelines as long as 10 years, which typically a lot of investors don’t like.

No one wants to, even though most investors would probably be on the, in passively invested for 10 years, but you don’t wanna have to be. So that’s the negative. But it just takes time to turn these assets into, to, to do the value add or the development or whatever your, the strategy is.

Jim Maffuccio: So that type of fund might be good for somebody with a retirement account. Cause I don’t really, I can’t really pull that capital. I don’t need it anyway. And I think this thing’s really going to grow. I don’t care if it’s a 10 year horizon. 

Bob Fraser: Yeah, sure. No, I’m all in. Yeah. And the other side, which is actually pretty rare, are open ended funds.

And these are typically funds mostly in the debt space, but it can be also in the. In the residential space, but it’s typically where the assets being invested in are more granular. So like our income fund, we have nearly 700 notes in that fund and we’re buying notes all the time and selling notes all the time.

So we have a lot of it, it’s very granular. Yeah. It’s not three big assets, right? So we can accept a new investment capital on these funds every quarter and we can actually redeem investors if they want their money out every quarter. So we have a liquidity provision that’s built on internal liquidity that’s generated by the fund.

Yeah. So we’ve, it’s a very unique and very rare, but you see the same thing in hard money funds. And, typically there’s some open ended funds. So typically in the debt space, you’ll see open ended funds, which have the advantage of, you can get high yields and asset based investing, real estate based investing, but having a liquidity provision in addition.

Ben Fraser: That’s a lot of information we just covered, but I think that’s really helpful. I, yeah, this is really cool and hopefully you guys got something out of this. Again, this is a high level, right? High level. Just creating the helpful framework and we are going to do a lot of deep diving here and next episode we’re going to cover venture capital and private equity and what those worlds look like.

It’s going to be fun and I’m excited for that. But thanks for joining with us and hopefully you’ll join us for the next episode.