How We View Asset Allocation

In Episode 15 of Durable Value, Joe and Ryan discuss how they use experience in a certain geography to determine which markets and sub-markets will trend to their benefit in asset allocation.

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 Ryan Swehla:
We operate in our geography all the time. And so we can pick up on those nuances and changes in preference, or changes in sub markets. We can start to, it's not even that we can sense, it's almost that we just intuitively know at times that a particular sub market is going to benefit from an abroad theme within a market.

Speaker 2:
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Ryan Swehla:
So today we're going to talk a little bit about asset allocation, and how we look at that through our lens. How do we decide what properties, what product types, what geographies we're pursuing, and just getting a little bit into the mind of what our process is for identifying the right next opportunity.

Joe Muratore:
Yeah, I think when we think about where to invest, some of the key questions we start by asking is, where is the wind at our backs? In other words, which markets and sub markets have population in migration? Have things that are attractive in the current market conditions? That are likely to be that way for the next three to five years.

Joe Muratore:
We also think, okay, but if the wind's at our back, where are our assets also mispriced? So in other words, we see a trend happening, but for some reason, the market hasn't priced that in yet. We see that a lot with the Central Valley versus the Bay area. For some reason, they're only an hour apart, and yet there's a stark difference in values.

Joe Muratore:
We also think a lot about, because most of the deals we buy are off market, where can we be a dominant player that can secure a pipeline of off-market deals? How can we leverage our relationships, our connections with the brokerage community, with the sellers and owners, to make sure that we have a steady deal pipeline of acceptable deals? And tagging on that last point. A key thing we discuss often is where can we be dominant to get that steady pipeline of regular deals that are a good fit for our core competencies? We have to be a major player in the market. We have to be the group that gets the call when the asset is for sale.

Ryan Swehla:
And let's talk about wind on our backs a little bit. Part of the reason that we focus on the Central Valley, or larger northern California geography, is because there is ongoing momentum in that area. It's an area that constantly has population growth. It's an area that has some strong economic drivers like government, ag, healthcare. And through the COVID crisis, we've actually seen an additional wind on our backs that we didn't anticipate, which is kind of a change in preference. People deciding that they no longer wanted to opt for the dense urban environment, or at least some people deciding that. And deciding they wanted to be in an area where they can have a house, a yard, maybe some land, and have a little more space.

Joe Muratore:
Yeah. When we think of, especially office space, we often want to be at 40% of replacement cost or 45% of replacement costs. That tends to be the sweet spot. And one of our core values is, you make your money going in. Versus the Bay area where assets tend to be priced at two to three times replacement costs. So we have a wind at our backs as far as population coming, but we also have maybe mispriced assets in that their half of replacement costs are better.

Ryan Swehla:
And within our geography, we start to drill down into specific markets, specific sub markets and how those sub markets, the dynamics within those sub markets. So take Sacramento for instance, that is a area that probably has the largest population concentration in the Central Valley. It also has the State Capitol, second largest government center in the country. And so that's an area where, when we look at office investing, that's an area that we feel has strong tailwinds.

Joe Muratore:
As we look to asset allocate. We often talk about themes as well. In my mind, I think about almost business lines. So one of the business lines I think about, as we talked about, is office assets in Sacramento in top three or four sub markets. Meaning downtown, South Natomas, Point West.

Ryan Swehla:
Roseville.

Joe Muratore:
And now North Natomas.

Ryan Swehla:
Yeah.

Joe Muratore:
Yeah, certainly Roseville and Fulsome. But assets that are, for some reason, a little bit mispriced or a little bit off market, or we get a lead on that someone didn't know about. Usually they're 70% occupied or 80% occupied, but they fit our model. So that's one business line. Another business line would be apartments. So in this case, they're apartments, they're high four caps, but they're two or $300 below market rents for some reason. This is usually a reflection of ownership. Usually there's a piece of renovation costs we can do to bring them up to market.

Joe Muratore:
That's another piece. In order to keep deal flow going at the right levels, the right piece of pipeline, these things sort of trickle in. So it's like we have an apartment business that we're working on and growing, and we have an office business we're working on and growing. Another thing we've been talking about though, is Bay area. Certainly, the Bay area is getting hammered to some degree right now, because they're getting a lot of bad press and a lot of population is moving our direction, slash out of state. And so the pendulum has swung, 15, 20% of San Francisco office space stands vacant, or looking for sublease. If there was going to be a time to buy a San Francisco office space, now would be a time. And we're not actively investing right this second, but that is a theme we discussed.

Ryan Swehla:
And I think we can also talk about some themes that we are steering away from as well. On the retail side, certainly there are seismic shifts happening in retail right now. We have invested in some large shopping centers in the past. And right now we see that market having a lot of unrest. There are certain types of retail that are strong, grocery services, personal services, that sort of thing. So if the right asset comes across, it's something that we would explore, but the pricing relative to the risk that we see right now, generally doesn't seem to be making sense.

Ryan Swehla:
Another asset type obviously is industrial. This is another asset type that we've invested in, in the past. We actually took a run at a large property recently, but the owner decided that they wanted to solve the vacancy issue rather than going to market and having us as the next buyer solve that vacancy issue. And I think that reflects that market. The industrial market is very hot, arguably overheated. So to find opportunities where we can use our brand of value creation, where we can roll up our sleeves and earn a appropriate return for that value creation, it's very difficult in the industrial market right now.

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Joe Muratore:
One thing we think about too is being agile and adjusting our strategy as we go. One thing I try, is with each asset to be about 15% closer, maybe 10% closer than we were before. When we buy an apartment asset we see how that leasing happens. We see how renovations happen. We see what the market response is. And then we try to be a few neighborhoods closer to where we want to be. And we try that and we learn from that and we triangulate. The same with office assets.

Joe Muratore:
Smaller footprints are leasing better now versus larger. Or this part of this neighborhood is doing better. So with each asset we try to move closer to the expert zone. Closer to that 2%, 3%, 5%, that's at the expert level. And I think one analogy would be Olympic athletes. Often they're only two or three or 4% better than the best amateurs, but there's a big difference between a gold medal and winning an amateur games. And same in investing, it's one thing to do your investment, but to stay at Olympic metal status, you have to keep being in that top two, three, 5%. a little bit better than our competitors.

Ryan Swehla:
Yeah. And if you're not operating in that market every day, you have a very difficult time doing that. Going along with the Olympic athlete analogy, if you're dabbling in different sports, you're going to have a hard time having that clarity of focus that we have. We operate in our geography all the time. So we can pick up on those nuances and changes in preference, or changes in sub markets. We can start to, it's not even that we can sense, it's almost that we just intuitively know at times that a particular sub market is going to benefit from a broad theme within a market. And that you can't have that kind of granular knowledge about thematic changes without being in the market every day.

Joe Muratore:
Yeah. I was in Sacramento last week and I walked through seven buildings. Three or four of them were on our list of prospects or leads, the other ones were surrounding buildings. But I love the Intel when I get, when I walk into adjacent buildings and see what the tenant mix is and what the culture of that building is. Often, it's surprising. Vacancy is a little higher than you expected, or they over-invested here. Or you see something you're like, oh I would've done that lobby a little bit differently. But those little nuances give you the market Intel that it's going to take to make your building shine. And you can't really get that off the internet, and you can't hear it from brokers. You have to build your internal compass of what success looks like, and then go test it out in the market.

Ryan Swehla:
Can you talk a little bit about our apartment buying strategy, and how we're triangulating into particular markets?

Joe Muratore:
Yeah. So we started, we often talk about, if you're going to get down something over the goal line, you start outside the stadium, then you get to the stadium, then you get to the bleachers, then you get to the field, then you get to the goal line. And one of the things we've done recently over this last year is identify the zip codes that we felt were the strongest throughout Central Valley. You know, all the way up to North of Sacramento, down to Bakersfield. But these reflect all sorts of things. Demographics, retail spending, income, marriage rates, you name it. We got it down to zip codes, even census tracks. But we look for the strongest areas, and then we look for mispricing. So, how our rental rates relative to purchase price? How have prices changed and lowered in recent years? From that, we identified a hit list of zip codes. About 75 really, and have been targeting those.

Joe Muratore:
And within that, we find that our best assets are often, we think of them as both location and improvements. A perfect investment for us is sort of a C plus improvements, in a B plus location. So we look for those B plus locations that for some reason, the last owner didn't paint the building. The last owner had sort of that culture that didn't reflect our culture. These are the places where we can lead with capital, we can lead with culture. We can have a fresh vision for that property. And generally, because of the last ownership, rents aren't where they should be. So that's the opportunity we look for and how we dig in.

Ryan Swehla:
So as we go forward, how do we look at themes moving forward? How do we identify and spot those trends going forward?

Joe Muratore:
This comes a little bit to a worldview and investment philosophy. I know we're a little bit similar and a little bit different. I tend to think of the world as a pendulum. And if I want to find opportunity, I look at what's not popular right now. And I try to figure out why, and try to figure out if the reasons why it's not popular at this moment are things that we can impact, or things that will be different.

Joe Muratore:
The market goes up and down, and it's very difficult to time tops, and it's very difficult to time bottoms. So one thing I look for, one thing we talk about, is trends that are happening. Certainly recessions and market cycles, but also COVID, or things like that.

Joe Muratore:
One thing we're talking about is you can't time the bottom, you have to sort of invest into it. So you pick a theme you believe in, and then you start making offers on buildings. You start interacting with the brokers and owners there. You can't just say, now it's time to buy office space in this location and flip that switch. That's a six to nine, to 18 month process to close on something at the right price. So to do that, you have to go engage with that market, even when it's out of favor. Even when it seems like a dumb idea, even when other people might say, you got to be kidding.

Ryan Swehla:
A lot of times when it's a quote unquote dumb idea, that's the time when there is the most uncertainty.

Joe Muratore:
Yeah.

Ryan Swehla:
And something that I think we bring to this a little bit is we're always buying below replacement costs. Sometimes well below replacement costs. We're always buying cash flowing assets. We're buying properties based on conservative future underwriting. So if there's a lot of scariness in a market, our underwriting is going to definitely reflect that scariness because we want to make sure that that asset performs well in a very distressed environment.

Ryan Swehla:
But if we can clear away all the noise of, scary, this is a bad time, that sort of thing. If we can clear away that noise and still fundamentally buy something that is in a great location, it is suffering from distress or poor management. And we're going to be at a cost basis where we can compete even as the market changes, that's our margin of safety. That's how we know we can still clear away. And in the meantime, there are going to be sellers that because of that chaos, because of that uncertainty, they say, this may be the best thing I ever get. And I'm going to hand it over at this price because I don't know what the future holds.

Joe Muratore:
Well, scariness is an emotional term. It's a way of trying to price in a bunch of unknowns. That's scary so I'm going to put a scary factor on it. Sometimes that's reasonable, but great investing requires removing emotion.

Ryan Swehla:
And quantifying that scariness.

Joe Muratore:
Quantifying emotion. Well, what is occupancy? How is occupancy changing? What our rental rates? How is that supply and demand curve changing? What's really going to happen? Not just what's in the news, but if you could fast forward five years from now, come to this neighborhood, come to this building, come to this apartment, what does it look like? How do we get in front of that? How do we get a better price now that lets us profitably execute that play? And that's an enjoyable exercise. I really like doing that.

Ryan Swehla:
And we're not helicoptering in and trying to understand some market that we don't know. We're doing this in markets that we have a long history with as well.

Joe Muratore:
I think that's what our investors, the capital we work with, pays us to do. They pay us to be experts in a subject to think ahead, to see things beyond just what the media is saying. If we just rode the media wave, or we just rode the normal real estate cycle, we haven't done anything. Our job is to see things a little bit differently and to get that right almost all the time.

Ryan Swehla:
And that requires a high degree of proactivity versus reactivity.

Joe Muratore:
Yeah.

Ryan Swehla:
Where we're going in and spotting trends, identifying problems, identifying potential outcomes, rather than sitting back and waiting to see how it all turns out.

Joe Muratore:
Yeah. Luckily we're in the value-add business. So we are not in the business of buying the tops of waves and seeing what the market does. Nope, we don't buy stocks. We're activist investors in that we buy in the middle of waves. We buy buildings with challenges that our company, and we, have deep experience fixing. And so we're able to influence things our direction. We're able to build in a margin of safety that wouldn't otherwise exist, and layer that on top of the wind at our backs, or the belief we have in the market trends. And most of the time it works out.

Speaker 2:
Thank you for listening to Durable Value. An investors podcast, where we demystify commercial real estate with safe sound investment strategies to help you balance your portfolio. If you enjoyed this podcast, be sure to rate it on iTunes, or wherever you get your podcasts. To learn more, visit graceadapartners.com. Where you'll find more information, investors tools, case studies, and more. This podcast is hosted by Joe Muratore and Ryan Swehla. It's produced, edited and mixed by Melodiq, with intro music by Ian Post. Thanks again for listening. And we'll see you next time.