Owning & Operating Multifamily Real Estate Through COVID-19 with Daniel Shaeffer

Daniel Shaeffer, CEO of Cottonwood Residential, discusses how the outbreak of COVID-19 has impacted multifamily real estate.
Daniel Shaeffer, CEO of Cottonwood Residential, discusses how the outbreak of COVID-19 has impacted multifamily real estate. He also delves into the reasons why the market is relatively stable despite the historically high unemployment the nation is currently facing. Prior to the pandemic, multifamily real estate experienced five years of rent growth and two to three years of development growth. Development growth was worrisome to players in the industry due to the belief that it would dilute supply and put downward pressure on demand.

Shaeffer’s properties are concentrated in the higher end of the sector, attracting white collar millennials who are at less risk of job loss than their less institutionally educated counterparts. This debunks the theory that, in a time of crisis, Class-A tenants will migrate to Class-B properties and Class-B tenants will migrate to Class-C properties because Class B and C assets have been impacted more in the current crisis than Class A assets, just as they were in 2009.

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Ryan Morfin:                    Welcome to NON-BETA ALPHA, I’m Ryan Morfin. On today’s episode we have Daniel Shaeffer, the CEO of Cottonwood. He’s going to share some of his thoughts and insights about owning and operating a large multi-family portfolio due to the Coronavirus crisis. This is NON-BETA ALPHA.

Speaker 2:                        I guess I didn’t know. I guess I didn’t know.

Ryan Morfin:                    Daniel welcome to the show, thanks for joining us.

Daniel Shaeffer:              Glad to be here. Perfect day to talk about real estate.

Ryan Morfin:                    So Cottonwood is a large owner and operator of multi-family across the country. Multi-family has gone through a little bit of a volatile time, but it is a pretty stable asset class. Would you mind sharing a little bit of your thoughts of where you thought the forecast was for 2020 prior to the Coronavirus shock and then how it’s changed and what your outlook looks like going forward?

Daniel Shaeffer:              Yeah, great question. So as we rolled into 2020 the market was very, very strong. It was strong in terms of occupancy, it was strong in terms of rental rates. We really were on the back of five straight years of really, really strong rent growth. Driven mostly by incredible demographics. I mean both the Millennials and the generation following Millennials are the biggest size wise of any generations in the US history, and for a lot of cultural reasons and I think cost reasons, tons of those people are delaying home buying and they have been. They delaying marriage, they’re delaying having kids, so they tend to be apartment renters for much, much longer. That trend has been like this wave that’s been washing over the entire industry over the last five or six years, so all of us have had just unbelievable rent growth.

                                           In our world we typically model a 2% to 3% annualized rent growth, and probably over the last five years we were averaging 4% to 5%. Some years better than others, but it was a very, very strong period in the industry. We’re not like tech companies that have crazy growth, I mean it’s still very stable, but because these numbers are big and they move very slowly, it’s just this wave that’s slowly just washing up over the industry so it was very strong. What had been happening, particularly in the last two or three years though, was a lot of new development was starting underway. So pretty much in any city we operate in, and our business operates in the largest of the Sunbelt cities, so we’re in places like Raleigh, Charlotte, Tampa, Orlando, Atlanta, Nashville, Dallas, Houston, Phoenix, and all great cities but everyone of those cities had cranes in the air building apartment buildings.

                                           There for a few years I was really worried about over supply, but what’s been happening is there’s been so many people in this demographic that all of us have been filling up new units. I think there was some concern that the number of new units going into 2020, and ’21, and ’22 really next few years, was going to be more… It was going to be enough that it was going to start putting some pressure on rent growth. So that was a concern hanging out there, but otherwise, other than that concern financing was cheap, you could get plenty of leverage on deals in the capital markets, and I think all of us felt like 2020 and 2021 were going to be pretty solid years. Maybe not the 4% to 5% rent growth we’ve been seeing but probably still very solid 3%, 3.5%. Even with all the new supply coming online.

                                           COVID threw a wrench in it. However, when the dire forecasts were starting to roll out in early March and everybody started talking about hey who’s going to pay their rent in April? And you heard things about national rent strikes and you heard about all the job losses coming. We were all, as owners and operators, taking bets on what we thought the collections would be. Not only do we own a very large portfolio, we also manage a separate account for a very large institutional partner. Our institutional partner, they were predicting 50% to 60% of the people would pay rent. And we did all sorts of calculus on our own portfolio and we needed about 70%, 65% to 70% of the people to pay rent for us to cover not only our mortgage expenses, but all of our operating expenses and our people.

                                           I felt pretty sure we were going to be in that zip code but you just didn’t know. Low and behold in April we collected 98% of what we collected in the first quarter. That is a little higher probably than the industry average. I want to say the industry average probably ended up at 95% or 96%, but the whole industry did really well. Now nobody wants to be down 4% or 5%, but relative to where we could have been things were much better, much more stable than we expected. And so we didn’t know if it was only going to last a month. Well low and behold in May also we collected 98%, and so far in June, the month isn’t over, today is June 23rd. We’ve collected 96% already for June. Literally I mean with each month has been within a few thousand dollars of the prior month.

                                           I think part of that and when you think about multi-family you have high grade, really high quality stuff, and then you have kind of really, really basic housing. The guys that manage more basic housing stuff have been hurt harder because the people who’ve lost jobs tend to be lower on the wage scale and so they’re renting cheaper apartments. Our apartments are what I would say A, A-, so we’re generally have working professionals, young working professionals in our units, but we’re not the highest end but we’re closer to the high end. I think our demographic of renters has been less impacted by COVID. You see them a lot more, and the things that really worried me and concerned me is virtually every municipality we worked in, we also have a few properties in Boston, we have one in Portland, Oregon. Some cities are more liberal than other cities and were much more aggressive of not allowing us to evict people during the pandemic.

                                           Anybody who came to us and said, “Hey, I lost my job because of COVID,” we have tried to work out payment schedules. Hey pay this much this month and we’ll let you pay us back around three or four months. We’re not charging people late fees, we’re not aggressively pursuing anybody. But then the CARES Act came out and the CARES Act basically said anybody who has mortgages that are financed by Freddie Mac or Fannie Mae you have a moratorium on any evictions. A huge portion of the multi-family market is financed by Freddie Mac and Fannie Mae. I would say probably more than two-thirds of our properties have that kind of financing on them, and that moratorium goes through July 27. I know you’re based in Dallas. Typically in Dallas if somebody doesn’t pay us we can evict them within three or four days for non-payment once we’ve gone through the rent.

                                           Now under the CARES Act you have to give people a 30 day notice, and so realistically if somebody is living in one of our units today and is not paying, for any reason we can’t move to evict them until the end of July and we have to give them a 30 day notice, so they can really live in our apartments through the end of August. And so when all these regulations were being thrown on the industry nationwide, I think we were all pretty nervous. But low and behold our worst fears just haven’t played out. People still pay their rent. People don’t want to get behind on rent, they don’t want to have their credit impacted, and I think the social contract of paying your rent, paying your bills as Americans is still largely intact.

                                           Yes we have properties that you have a few people who’ve wanted to have a rent strike and wanted to make an issue out of it but haven’t, and haven’t been successful. Generally speaking we’re trying to work with people. Where do we go from here? What’s going to happen for the rest of 2020? What’s going to happen in 2021? I’m going to roll the tape back about a year and a half ago. We began thinking about leasing units differently than the rest of the industry. Thinking about leasing units differently than we’d ever done it and different than anybody else had ever done it. So for anybody who’s listening and you’ve gone into a large apartment complex or a high rise and wanted to rent, you typically will meet a leasing agent who’s effectively a sales person who will then take you on a tour of the property and try to get you to sign a lease.

                                           It turns out Millennials don’t really love hands on salespeople. I mean all the studies say that Millennials like to shop on their own, they’re online people, they do virtual tours. Everybody today who’s signing leases or are doing rents they do it on their iPhone. They don’t want to sign paper leases. They’ve already toured your unit, they’ve already toured your complex online, they’ve shopped all the competitors, they know everything about you when they show up to tour your property. We started thinking differently like we probably should change our model on how we lease. Now mind you our industry is old school, it’s very slow moving, and nobody has really done this. We said, “Let’s maybe move away from the old leasing agent sales model, let’s go to more of a hotel, concierge model.”

                                           You walk into one of our properties into the office. We have a concierge who greets you, and the concierge then gives you the information that allows you to tour the property on your own. If it’s a garden style apartment where that’s more spread out we’ll give you a map and we have bread crumbs that show you signs to how to get to the three or four or five units that are vacant and you actually can see the unit you’re going to live in. No more model units where we’re trying to fake you out and this is beautiful, then you rent something that’s totally different and you’re not happy with it. You actually see and tour the unit you’re going to rent.

                                           Low and behold guess what? People like that more. Our closing rates started going up when we allowed people to start touring on their own. And this is important for COVID, and I’ll come back to it in a second. The other thing that it allowed us to do is to rethink about our staffing model, because now we didn’t need so many people in the office because our concierge was there. You didn’t have two or three people out on site constantly touring, and what happens when you have two or three people touring, a new prospect comes into your office. What do they see? They see a little sign on the door that says, “Hey, be back in 10 minutes or be back in 15 minutes,” because the agents are all out on tours and somebody who shows up to tour can’t get a tour. Well nobody in our industry waits around. The Millennials they pick up and they go to the next property, they don’t sit around and wait for your 15 minute clock to go by.

                                           We got rid of those clocks because there’s always now somebody in the office, and it creates more of a sense of urgency if there’s two or three people touring at the same time on their own. And finally, major problem that’s been happening in our industry over the last five years probably has been packages. If you think about the volume of Amazon packages showing up in an apartment complex everyday when you’ve got 300 units. Everybody’s ordering two or three Amazon packages a day, it’s a major shipping center. People in our industry have thrown out their hands. Some have just let people through the properties, the delivery guys. Some have tried package lockers, and we’ve said what we’re going to do, because we’re not spending as much money on payroll to have leasing units on site, we’re going to extend our hours. So instead of being open from 9:00 to 5:00, which most apartment complexes are to keep their employees happy, we’re now open six days a week from 8:00 to 8:00, we’re open Sundays from 10:00 to 6:00.

                                           We did that because the Millennials who want to tour, they want to tour when they’re not working, they want to tour after hours. We want to be open when the customers want to come in, and because of that we can also deal with packages. So now our office just happen to be package centers, and so because we’re open either before your job or after your job, you can get your packages everyday from us, and if you want to ship something you can just leave it in the office because UPS and FedEx are always coming through. And so we solved a whole bunch of problems at once.

                                           But what happened when we rolled into COVID and this is why when I talk about what’s going to happen this year with rents it’s important. When we rolled into COVID we were able to stay open. Our concierge’s put on masks, we sanitize the offices, and people who wanted to tour during COVID, and believe me there actually were people still touring and signing leases, they still came in. All of our competitors closed down. All they could do was do virtual tours and hope people would lease online. And some people do that but most people actually want to see what they’re going to live in before they lease.

                                           And so we were able to continue leasing during March and April and May, but what happened is a lot of our competitors could not, they shut their doors. The old leasing agent, give a tour model didn’t work during COVID like a self-tour did. And so their vacancy started falling, and when our competitors vacancy started falling they started throwing concessions out there. Giveaway, like hey, we’re going to give you a month of free rent. So what’s happening today is a lot of people, a lot of competitors are finally starting to open their doors again, but they’ve lost 5%, 10%, 15% points of occupancy because people slowly have been moving out and they haven’t been leasing and so now they’re throwing concessions on those marginal units trying to lease them back up this summer, and that’s putting pricing pressure on the whole market.

                                           Now luckily for us, because we were leasing that whole time, we maintained our occupancies high. When we’re competing we’re only competing with our marginal units that are vacant because we’re just a lot more full than everybody else, but I predict that for the balance of 2020 rates are going to be lower because people are going to try to lease back up. I would expect to see rates somewhat down to flat for this year for our business. Some markets are going to be worse. New York City, Los Angeles, San Francisco have actually seen pretty sizeable downdrafts in rents. The Sunbelt markets we’re in have been actually pretty flat. I got a list last week from my team looking at every property we manage and own, and probably 50% to 60% of them are flat, probably a third of them we’re going to increase rents 2% to 3% because there’s still plenty of demand, and probably only 5% to 10% actually we worried about the new rents being a little bit lower than the [inaudible 00:14:51] rents.

                                           It’s going to be a soft year and probably 2021’s pretty soft as well from an operating standpoint. What does that mean? That means valuations are probably down a little bit. If you’re looking at a current NAV on your property or on a whole portfolio of properties it’s probably down a little bit because the net operating income likely will be down a little bit for 2020 versus 2019. That all being said, I mean with interest rates falling and now the fed pumping so much liquidity in the market that Freddie and Fannie have come back to the lending world, we think CAP rates might actually go down from here. Even if you have a bit of softening and NOI, you may have CAP rates going down and offsetting some of that value loss. We’re thinking properties are down 5% to 10%. 10 would be high, probably more like 5% is worth settling out.

                                           Two months ago we all were guessing properties were down 10%, but there’s been such a snap back in economic activity and the collections have been so much more stable than I think any of us guessed, that we don’t think it’s going to be that severe long-term. I’ve been talking for a long time, I’ll let you dive in [crosstalk 00:16:00].

Ryan Morfin:                    No this is great. I didn’t want to interrupt you.

Daniel Shaeffer:              [crosstalk 00:16:03] stream of [crosstalk 00:16:03].

Ryan Morfin:                    You kept giving me what we were looking for. I mean so the question is values are down 5% to 10%. Would you attribute most of this… Do you think we’re in a V shaped recovery is the first question? Is that what you’re seeing in the market?

Daniel Shaeffer:              A month ago I would have told you there’s no possible way we’ll have a V shaped recovery. Today I don’t think we’re going to have a V shaped recovery, but I think certain parts of our economy will recover quickly. Other parts are going to be hard. I think there’s been permanent damage done to small businesses. I think you’re going to see a third of the restaurants disappear forever. I think the hotel sector’s going to take a long time to heal itself. So I do think airlines, I mean I’m trying to book flights to go tour some of my assets. The availability of flights schedules is way off, though it’s coming back pretty quickly. Even versus July. July there’s a lot more flights available than there were even in June. And so I was very bearish and I was expecting a very deep and long recession. I’m less so today than I was a month ago. I still don’t think it’s going to be V shaped but I don’t think it’s L, I think it’s a modified U.

Ryan Morfin:                    Yeah, it’s interesting. I’ve been surprised. I think you hit something succinctly though. I think class C markets, class C assets across the country are getting crushed. This really impacted I think the lower income households more than it did the service economy households.

Daniel Shaeffer:              It did for sure. Also the other asset class you’re seeing getting crushed are people that were buying class B deals and overpaying for them in the hopes that they were going to do this massive value add and were going to increase the rents and turn over the rent roll. It’s really hard right now to increase rents in existing place and turn over the rent roll. Because there’s just not enough demand with nicer guys like us now competing for those tenants. However, we’ve done a ton of research on this. If you look back to the Great Recession, and I’ve heard guys out marketing. Hey, in a recession people move from A to B and B’s move down to C’s. People say that because it sounds logical, but it actually doesn’t happen that way.

                                           And if you look at the data it’s all about employment. And so if you look at during the Great Recession, people with college degrees, when we went into the Great Recession the unemployment rate was 2% for people that were college educated. It got all the way up to 5% unemployment for college educated people. For people who didn’t have a college degree and there’s a couple of different categories, people that had just high school, people that had some college. The unemployment rate for people with just high school spiked all the way to 17%, so it was three times as great as the unemployment rate for people who had a college degree. Now it started higher, at 5% or 6%, but the spread was so much wider.

                                           What we learned actually is that people who owned A class apartment properties, their tenants were much more likely to keep their jobs. So people weren’t just looking to save money to move down. If they kept their job they kept their apartment. People did not want to change their lifestyle, so what happened is the B and C properties actually got hit a lot harder during the Great Recession and the exact same thing is happening here. We used to own a bunch of B properties, and that’s why we did this research and over the last decade we basically sold pretty much everyone of those properties and rolled in the newer class A deals because we wanted that demographic, we wanted that college educated higher workforce demographic to protect the portfolio. And that’s kind of what’s been happening I think.

Ryan Morfin:                    Yeah, no I think that is absolutely what’s happened. I think the data about jobs though, I think we had great numbers in May but we dropped a lot of jobs. And so I guess the question is, is your outlook on jobs do you think we’re stable or do you think there’s going to be another wave now that the PPP program rolls off in the summer? Will there be more unemployment? What are you guys thinking? How are you forecasting that?

Daniel Shaeffer:              Well I mean you can call me a cynic but I’ll be very, very surprised if we don’t extend unemployment benefits, at least through the election. This is so political, and I don’t really want to get into politics here because I’m not a political person, but those unemployment benefits, more than even PPP, I think are underpinning economic activity in this country. And so somebody who is one of those B or C renters, they may not of yet had the full transition to unemployment that will happen at some point. And so depending on how we manage that and how much of our fiscal budget we want to throw at that will determine the severity of the recession.

                                           There’s another problem obviously, which is that the more money we print effectively to cover these problems, at some point the pothole we’re filling in gets to a fill and creates inflation. But we all said that in the Great Recession and we never had any inflation, so I don’t know if we’re going to have it this time around either. But I think the fiscal stimulus today is helping us not go into as deep of a hole, and so what I don’t know, we’ve tried to get data but it’s really impossible. What I don’t know is what percent of my own tenants have lost jobs. Now my tenants generally are college educated, they work in higher quality job sectors that haven’t been as hit by COVID, but there’s still companies scaling back. I mean we haven’t laid off anybody in our company because we’ve needed all of our employees, but a lot of people I talked to have used this as an opportunity to cut back anyway.

                                           It’s very, very hard to say what’s really going to happen with jobs. I think the $600 a week per person is masking the true unemployment and the filing. I do think as long as that’s out there those continuing claims are going to stay very high. I do think the worst of it’s behind us, but I don’t know how quickly it rebounds. But you’re seeing more and more calls for a V type recovery, so honestly I don’t know what to tell you. I’m not an economist, I’m just looking at my own business, and I am really surprised at how stable our business has been.

Ryan Morfin:                    Well your former employer and mine, Morgan Stanley, has called for a V shape, Wells Fargo has called for a V shape. I mean it’s interesting and the jury’s going to be out, but I do think yeah, a lot of young people right now are saying, “Please fire me, because I’d rather stay unemployed because I’m getting more money than you were willing to pay me,” which is ludicrous incentive but I think that’ll eventually run out and it’s going to then start to have some ripple effects. Hopefully we can get the economy rebooted. Your comment on inflation’s interesting. I don’t disagree, CPI’s been low, but I think there has been inflation, I just don’t know how we measure it and I don’t know what the real estate community talks about. Hard assets, the stock market, it seems like the central banks have surgically injected steroids into certain hard asset classes. Is that a conversation that you guys are worried about or have you guys had that thoughtful conversation with the V industry is how much of this is central bank tinkering versus real value appreciation?

Daniel Shaeffer:              We do talk about that. I mean if you’re an apartment person inflation’s generally good if you’re properly capitalized. But real inflation, that means rent’s increasing, which they have been. If real inflation is there and you have an accommodative fed, that means your CAP rates are going to stay low, you’re going to make a lot of money. The inflation that is dangerous, of course, is just asset bubble inflation. When you don’t have any real incomes because we could find ourselves in a situation where incomes are not rising so we’re not able to push rents and CAP rates kind of stay flat.

                                           Now if there’s even more inflation you could actually be flat on rents and incomes and still make money if you believe CAP rates are going to continue to go down, and for us CAP rates are effectively they’re a yield on cost. And so if the fed is pushing down interest rates and assets are in a bubble, that means our assets are appreciating, our yields on costs are getting lower and lower and lower, and we’ll still make money in that situation. The trickiest situation is when interest rates rise and you have actual… No inflation or deflation, kind of a stagflation scenario is what is the killer for our industry.

                                           Most people I talk to actually believe that we will have continued pressure, downward pressure on interest rates and continued stimulus from the fed from now through eternity. I mean I say that, I’m 50 years old this year.

Ryan Morfin:                    Infinity QE, yeah.

Daniel Shaeffer:              So I’m saying, “Hey, for the next 20 years of my career, by the time I’m 70 what’s really going to happen?” Nobody I talk to thinks we’re going to have massive spike in interest rates or CAP rates during that time period. We all think yields will stay low, which is going to basically put an anchor on values for us to the downside, which means we’re all probably going to do pretty well. At what expense? At the expense of our children’s generation because they’re going to be loaded with so much fiscal debt? I mean at some point we got to grow the economy to at least have the output equal to GDP at the debt equal to our output. I think it’s going to be tricky because we push through that debt equal to 100% GDP issue. That seems to be a weight on growth for any industrialized economy, so I do worry about that in our country.

Ryan Morfin:                    Yeah, no I’ve been telling people it’s got to be productivity enhancing growth, investments, plus classic core hard assets is a pretty I think sound strategy. As it relates to the Millennials, why do you think people are waiting longer for household formation? What’s driving that trend?

Daniel Shaeffer:              You know I have my own personal theories on it. I don’t totally know, but if you go back to the late 60s, early 70s, it has been a steady increase. I have this chart I show people, I don’t have it in front of me, but it’s right around the year 1970. The average age a man was getting married was 21 and a woman was 19. Maybe that was in the mid 60s, let’s say 1965. Well today the average age now is 27 and 29, and it’s always been this two year difference in age, which is interesting but it’s continued to increase and increase and increase. I think part of it is lifestyle honestly. I think people are playing longer and wanting to enjoy their single years more. I think it’s a lot more difficult today.

                                           If you live in a city, one of the major cities I invest in or one of the coastal cities, it takes a long time to save enough down payment to buy a home, even with rates as low as they are. Home prices are very high. I mean we track home prices to rental rates kind of on a parody. When you look at adjusted mortgage versus rent ratio, and it’s continually been more expensive to own than buy for the last two decades. There was one little blip during the Great Recession where they averaged out for a year or two, but now it’s right back up. I think it takes a long time. I mean I don’t think we’ve had tons of wage growth, so I think because of that it’s hard for people to be in a position where they’re comfortable buying a house.

                                           I also do think there’s a cultural motive to being closer to the cities. I think the Millennials they care more about their lifestyle necessarily than hey I’m going to work super hard and buy that house and start the mortgage. I don’t think they care as much about their parents life as maybe we did, our generation did.

Ryan Morfin:                    Yeah, no and that’s interesting. I mean do you think that… I mean places like New York City you’ve seen a lot of an explosion of interest to move out of the city and less dense environments. Do you think that’s short-term or do you think that some of these mega cities… Now you guys are in the Sunbelt so those development pathways are more spread out and less dense, but do you think some of the highly dense places like San Francisco, LA, Chicago, New York, are they going to see reduction in demand due to the pandemic going forward?

Daniel Shaeffer:              I think the short answer is yes, but I think if there’s a vaccine or the pandemic effectively disappears I do think there will be… I think those people will come back. I think one of the reasons those cities have performed so well… Maybe not Chicago. Chicago’s a bit of an exception to the rule only because of it’s own fiscal problems it’s created that made it hard, and Chicago’s still a great town. I mean I lived in Chicago, I love that place. But it’s own fiscal situation’s made it tough to attract new businesses. You look at the coast, they have done very, very well. They’ve had outsiders return for a long time because people want to be there, and they want to be there because there are great jobs there, there’s great cultural life there, there friends happen to be there.

                                           I think the work from home thing and the get out of the city and have space is nice and it may, even on the short term, you may have family formation happening more rapidly for a while, but I think that unwinds itself once the pandemic goes away. In the assumption that there is a vaccine and this isn’t something we’re living with forever. If this is sort of a new normal and we’re distancing forever I think people are going to think twice about being in crowded spaces. But the youth don’t seem to care. Everyplace I go and I’ve been anybody below 30 no face mask, they’ll hang out with their friends, they don’t even care about COVID. It’s the rest of us and I’m not that worried about it. I’m 49 turning 50, but I think people who are in their 40s, 50s, and 60s seem to be more concerned about it, probably more aware of the risks maybe than the 20 something year olds are.

Ryan Morfin:                    Yeah, no are you guys changing maybe your future CAP X plans given that people are not working more at home, higher speed internet fiber. Are there CAP X decisions that are going to change given people’s work posture?

Daniel Shaeffer:              You know a little bit. I think one of the trends that we were seeing in new developments is a push to a lot of co-working areas in your own complexes where people were [inaudible 00:30:22] work, and I don’t think people want to use those as much anymore. So the whole co-working concept may not be as important for a while. People I think want to be in their own space. I do think having high speed data’s important. We have really high speed data in most of our properties already. That’s something you have to have to keep the Millennials around anyway. Our investment philosophy this year has changed a little bit because it’s really been pushed more by the capital markets.

                                           When the pandemic first started happening there was a complete short-term collapse in the capital markets for real estate funding, and the mortgage REITs who were always the lender of filling in the marginal gap, I would say, totally imploded. I’m sure you guys have followed that pretty closely, and their lenders were basically liquidating their own collateral as fast as they could, so there are all these secondary impacts. Well long story short, that basically caused most construction lenders, traditional banks, to pull back on what they were willing to lend on. They got much more choosy about where they would go, much more choosy about what types of developers they would work with, and then they all pulled back on leverage. A typical lender that would loan you 65% or 70% of the costs of a new development now are saying, “Hey, I’ll give you 55%?” And so we’ve seen a huge hole open up in the capital market for developers and institutions looking to build deals that now have a gap, they have a funding gap somewhere between 55% and 65% to 70% of the capital stack.

                                           And so overnight we started getting phone calls from people who needed to fill that gap. That gap before was never as wide, it was more people would get a construction loan and then they were just trying to fund… They’d maybe split the equity in two pieces. A piece from 70% to 80% of the capital stock or 85% and 85%. 100% would be the common equity. Before people were pricing that preferred equity security, that mezzanine slice, 11% or 12%. And overnight that market went to 15% to 16%. And so when you can put capital in a new development and you’re only 80% of the capital stack so you have a bunch of equity cushion behind you and you can still make a 15% or 16% return, I mean we were pricing developments before, you were only making 18% or 19% on the common equity with a lot more risk. And so we’ve been able to de-risk our investments and increase the yield at the same time, and so we’ve been aggressively pursuing those types of situations.

                                           I don’t know how long that window will be open, maybe a year. After that probably things start tightening back up. There’s just a lot of cash on the sidelines, right? So once people get comfortable investing and the capital markets start healing themselves again, those really sweet opportunities will disappear. I just don’t want to be kicking myself a year or two years saying, “Now why didn’t I buy every one of those I could have?”

Ryan Morfin:                    Yeah, no that is a good risk adjusted return. I think the question I have for you then is how has the pricing on the debt changed? Is is flat? Are credit spreads gapped out a bit for the construction financing?

Daniel Shaeffer:              Credit spreads to construction lending have gapped out a little bit. Before you could borrow LIBOR plus 300 on a construction loan. LIBOR plus 285, that’s probably now LIBOR plus 350, but LIBOR’s basically nothing and so you’re only talking about half of a percentage point increase in rates. It’s really not that dramatic. The rates on the Freddie and Fannie stuff gapped out initially but have tightened right back down, and so it’s more just a willingness for a lender to take risk right now. I’m sure they’re calculating their own books. Hey, what’s going to happen with all these retail centers where the restaurants aren’t paying, what’s going to happen with our hotel clients? They’re trying to reserve capital to deal with. Real estate deals up for certain will be a problem.

Ryan Morfin:                    Yeah, no we’ve talked to some bank CEOs recently on the show and they’ve got their corporate credit books now. It’s not the real estate causing the problems, it’s the tenants so it’s going to be very interesting. Well I know that I was talking to some former colleagues that are at Wells Fargo now and the CMBS program. I guess the multi-family, CMBS programs are going to come back this fall. Is that what you’ve heard as well?

Daniel Shaeffer:              I mean I’m hearing some rumblings about that. I mean CMBS is usually the first thing to go and the last thing to come back. I would say this, people who’ve done CMBS loans and then lived through when the CMBS market has a crisis, probably will opt to never do CMBS loans again. I only say that because in our early days of our business we did CMBS. It was cheap debt and readily available and was easy to get. But the problem is when you’re in a recession and anything you need to deal with at a problem at a property you have to go through… Because the whole thing’s been securitized you end up having these servicers and special servicers, and it’s really complex web of individuals you have to work through to get approvals and everybody wants to charge you a toll through every gate for every response.

                                           Well when you have a single lender or you work with one of the government agencies, Freddie or Fannie if you’re in the multi-family business, obviously if you’re in another business that you can’t use those guys, it’s much easier to service those loans and issues than it is through the CMBS world. We’ve avoided CMBS in the last cycle. Most of the people we know and work with have as well, but there is a place for them. They’ll do higher leverage, riskier deals, and it will come back. There’s a demand for that paper.

Ryan Morfin:                    Yeah, no the servicers are interested in prolonging conversations, not expediting them because they make their ticket every month they charge the trust. That’s a [crosstalk 00:36:24].

Daniel Shaeffer:              Yeah, I mean once the deal goes to special servicing it’s really hard to get it out.

Ryan Morfin:                    Well it seems like there’s not going to be a lot of distressed debt though. You speak about equity gaps in construction financing, but we haven’t seen a lot of people saying to lenders like here’s the keys, we’re done. I don’t think we’re going to see that in this recession.

Daniel Shaeffer:              You’ll see some of that I predict and it’s going to be very localized to hotel operators and to retail operators who can’t stomach it, can’t make it through. There was an article in the Wall Street Journal a couple weeks ago about hotel owners who were largely CMBS were not getting forbearance agreements, were not getting any action. The CMBS guys were taking action and foreclosed, where hotel operators who had traditional banks as lenders, or life insurance companies, were easily getting forbearance agreements. It’s a strange world of haves and have nots in the hotel world. Retail was already struggling because of the Amazon effect, and now you have multiple bankruptcies as all these bankrupt tenants are renegotiating their leases it’s going to have substantial impacts on owners of that retail, both the mall people and even a lot of the strip center guys.

                                           I think guys who are in the grocery anchor are probably in much better shape, but how many of those small businesses in those centers are going to go out of business permanently? I think there’s going to be some pain in those two sectors and there may be some really good buys there. There’s so much money they’re waiting around for it, but I think that stuff’s going to get overbid pretty quickly.

Ryan Morfin:                    Yeah.

Daniel Shaeffer:              If you’re owning office buildings or multi-family or storage, there’s just not going to be any distress most likely. I haven’t seen one deal trade hands in the last quarter. Nobody really knows where the market is and everybody I know is just saying, “Let’s just hit pause, let’s just wait until we have some price discovery.”

Ryan Morfin:                    Yeah, and I think people are going to amend their exit horizon just because they’d rather wait it out versus get liquidity at 5% to 10% below proforma. Any things that you’re reading right now or any books or podcasts you follow or people that are influencers that you’ve been keeping tabs of that not only track your industry but just the markets in general?

Daniel Shaeffer:              I’m a little more of a history reader because I like to think about how things today rhyme with things that happened in the past. I’ve finally, this books been a long time, but I’ve been reading the book about Truman, it’s a pretty big tone and it’s just so interesting to see what was happening back in that time period. You see parallels about what’s happening today, what happened in our Great Recession, what happened now. A book I read during the last recession, which I refer to a lot was a book called The Panic of 1907, and it is an unbelievably well written book on economics. Basically the cause of the panic in 1907. The underlying cause, it was a credit crisis, and it seems like every one of these financial crisis that at least I’ve lived through there is some type of credit crisis. There was a short one now, we’re still living through it. There was a massive one in the Great Recession. There was even a credit crisis during the dot com route. There’s a credit crisis in the late 80s, early 90s.

                                           The panic in 1907 was brought on basically by the great San Francisco earthquake, and when the earthquake happened it caused massive fire, and when the fires didn’t get put out for weeks in some places there was basically a liquidity trap because there was so much gold tied up in the vaults of the banks in San Francisco that they couldn’t settle payment across the United States with the gold, underlying gold because the safes were so hot from the fires it took months for them to be able to open the safes and get the gold out. And so it caused this liquidity crunch and that was before the Federal Reserve was formed and JP Morgan himself had to pump tons of liquidity in. Then there was all sorts of structural issues that caused this cascading liquidity crisis in our country, and really precipitated the founding of the Federal Reserve.

                                           Super fascinating book. I do like economic history as well. There’s a book called Keynes Hayek and it’s about the two different philosophies and they were contemporaries with each other and the book talks a lot about the two of them in World War II on the roof of a church trying to fight the fires as the bombs were being out. Then the book goes into talking about their different economic theories and it’s really fascinating to watch. We live in a Keynesian world, right? Our world has gotten so far away from free market economics, but I think we still have to study economics to understand where we’re headed as an economy and make good decisions. Obviously we all became Keynesian’s the second the COVID thing hit because we wanted the government to start throwing money and resources at every one of our businesses to keep us afloat during a pandemic.

                                           I guarantee it, every decade there’s some crisis that’s going to hit us and like clockwork, if you look back all the way to the early 70s it’s been every decade some new crisis hits us and it’s some new black swan.

Ryan Morfin:                    Well Daniel I won’t tell the folks at Hyde Park or [inaudible 00:42:00] that you’ve become a Keynesian, but I do appreciate you joining in and sharing your insights, it’s been fascinating conversation. Would love to have you back in the months ahead to share more thoughts and thank you so much for joining us.

Daniel Shaeffer:              Yeah, love to give you an update in a few months and thanks for having me on the show. I really appreciate it.

Ryan Morfin:                    Absolutely, enjoyed the conversation. Thank you so much.

Daniel Shaeffer:              You’re welcome.

Ryan Morfin:                    Thank you for watching NON-BETA ALPHA, and before we go please remember to subscribe and leave us a review on Apple Podcast or YouTube channel. This is NON-BETA ALPHA and now you know.

Speaker 4:                        Get busy time. Get busy time. Get busy time.

Speaker 5:                        All price references and market forecasts correspond to the date of this recording. This podcast should not be copied, distributed, published, or reproduced in whole or in part. The information contained in this podcast does not constitute research or recommendation from NON-BETA ALPHA, Inc., Wentworth Management Services LLC, or any of their affiliates to the listener. Neither NON-BETA ALPHA Inc., Wentworth Management Service LLC, nor any of their affiliates make any representation or warranty as to the accuracy or completeness of the statements or any information contained in this podcast, and any liability therefore including in respect of direct, indirect, or consequential loss or damage is expressly disclaimed.

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