September 2023
We have felt confident in our partnership with KCB because of their long-term, disciplined, and patient outlook. They work with operating partners with a strong track record and prefer assets they can hold indefinitely.
Megan emphasizes the need for investors to balance patience with a willingness to adapt to changing conditions, as rising interest rates, widening spreads, and bank failures have been contributing to lower property valuations. The debt maturity wall and national housing shortage may also affect the market in the future. It may be easy to fall into short-term, high-leverage strategies, but a quickly changing market makes it challenging for such approaches to work.
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Hello, everybody, and thank you for joining us for another episode of THE FINANCIAL COMMUTE. I'm your host, Chris Galeski. Joined by Megan Pautler-Gutnikov, Managing Director and Partner of KCB Real Estate. Megan, thank you for joining us.
Thank you for having me.
The real estate environment is sort of in the headlines. You've got, you know, news about Blackstone and all these issues with regards to office. It's an interesting time to be investing in real estate, wouldn't you say?
It is very interesting.
Before we get into that, let's talk a little bit about KCB, because I love this story about your group and what you guys do. Tell us about the location.
So we're a buy and hold control investment firm that's been around for over 30 years now. We were founded as a family office and took our first outside capital in 2003. So we've been investing for a long time, both in direct real estate as well as doing joint ventures with experienced operating partners across the country. And we've invested in all different types of properties, everything from, you know, kind of basic multifamily to senior care, hospitality, other commercial assets.
So we really are looking for finding the right operating partners that really can show a strong track record and in what they've been able to achieve.
Yeah, I've loved the partnership that we've had for over 20 years and the experience that you guys bring to the table, you know, being able to invest in many different types of asset classes, but that only gives us a glimpse of who you guys are. I mean, because you are investing with other partners that you raise money with, you're not quick to just go buy a property just because you have money sitting in the bank account.
Right. You're very patient.
Absolutely. I mean, we're very disciplined because we're long term oriented. We tend to underwrite quite a bit differently than other folks do. So we're looking at, you know, long term trends that have happened over the last 30, 40 years and looking at what we would reasonably expect to see for those assets on a long term basis. And so we can be very patient and we want to make sure that we buy any asset that we would like to hold forever.
Yeah, which is different than what some groups have done in the past. You know, call it four or five, six years in this craze of easy money. Right. When you've got interest rates at zero, how much money you're going to borrow.
Right. You're going to.
Borrow as much as you can. It doesn't cost you anything. And then you throw in COVID and all the stimulus and, you know, the programs that went there. It was interesting to see what happened. And now we're sort of in an economic shift from zero interest rate policy to now you can earn a reasonable rate of return on some really safe assets like government bonds.
Right. So that changes the price dynamic of lots of different investments, especially real estate. So we don't need to get into office. But, you know, now that we're not in a zero interest rate environment and buyers are still saying, hey, I want the price that my property was worth a couple of years ago. Nice price that it may be worth today now that it costs more to borrow money, tell us what's going on in the current real estate market.
Yeah, and I think that the sellers are more reasonable with what their expectations are today versus a year ago. I mean, if they look at their valuations pre-COVID to where they are today, especially in the multifamily side, you know, they're not they're not doing so bad. And other property types, obviously it's it has been a bit more challenging, but when you kind of take a look back over the last year, you had a number of events that really impacted today's valuations.
You had interest rates rising, ah, the Fed rate rising. And then you also had spreads widening too, because people weren't sure of what was going to happen. Was there, you know, a more dramatic recession or a softer landing happening. And so naturally, lenders wanted to create more spread or cushion for themselves. And then on top of that, you started to see bank failures at the beginning of the year.
And actually, if you look at last year, the largest investor in credit was smaller regional banks.
Yeah, that's it's not just bank failures. It's these Silicon Valley Bank, First Republic. I mean, these are banks that, you know, cater to real estate investors and small and medium sized businesses. So.
Right. So when those are wiped out or not, not lending and people can go to private investment funds that are much more expensive, generally the CMBS market really froze for a moment and then spreads widened again there and investors didn't know how to actually price CMBS phones because they didn't know what the market was going to do. So we saw properties that we were looking at at the beginning of the year and a sponsor would go under contract and then have a 100 basis point spread differential happen between, you know, signing of purchase agreement and then we were about to close.
And if you're 1% increase in interest rate, that's about a 10% reduction in long proceeds. Right. So where is the the hole coming from? Sure. Well, it would come from the equity, but at that point the deal probably wouldn't pencil.
Yeah. So, you know, obviously with the how quickly things moved in the market, you know, you were probably looking at a lot of deals that all of a sudden, hey, maybe this doesn't make sense, right?
Yeah. Now, I know your goal for Fund8 is to raise a couple hundred million dollars. Now, that sounds like a lot of money, and that is a lot of money. But in the context of things with, you know, $30 trillion worth of debt and, you know, other really large groups like Blackstone raising $125 billion. $200 million is a real nice, sweet spot.
You can play in an area of real estate that other people can't.
Right. We consider it more of a funding gap. It's kind of a little bit under most institutional investors interest. And it allows us to find deals that we get outsized returns we believe in. And we're typically dealing with operating partners who have raised capital from friends and family for a long period of time or have maybe come out of the corporate space and have a track record.
But they haven't done a deal with an institutional partner themselves. So we're kind of teaching them along the way how to deal with an institutional partner. But they find deals that a lot of times they're buying maybe from groups that aren't institutional capital but don't know how to manage properties professionally. And so we're able to get a little bit more and then maybe going after, say, a $300 million transaction.
Right. And then and that's key. I mean, people that own and operate real estate, they understand the inefficiencies and what they're trying to do, especially the way that you guys invest where you do value add real estate, you buy a piece of real estate, you fix it up, turn it around, and you can increase rents, but you're not just ground up construction.
So when you've got, say, a husband and wife that bought a building that are operating it because it pays them nice cash flow, right? They might have not been operating as efficiently as maybe you can. And so when you find those opportunities to buy, you can really generate a lot of value pretty quickly.
Right. And I think, you know, I heard over the last they call it ten years, you saw a lot of non-institutional people enter the market because it seemed pretty easy to be able to run a property. You had double digit rent growth happening in market. So even if you weren't efficient on the operating expense side, it allowed you to still see some really generous and a Y growth and then appreciation of value.
Right. And right now you're seeing huge increases in your operating expenses. Insurance costs is increasing because of all the different, you know, insurance claims across the board. And then just generally the costs of doing business. Right. And people, which is a big part of your expense line item that you naturally have to pay more because it's a much tighter labor market.
And so with lower rent growth expectations or in some cases negative rent growth, it makes it a lot more challenging then to make sure that your cash flow flowing your property and then lower and increasing debt service payments. You know, people can get in some real trouble.
Yeah, and that's what potentially is happening. I know that, you know, Peter, one of your partners, came out and said, hey, this the next four years could be one of the best times to buy in a decade. But you brought up the example, the last ten years of investing in real estate. It's been pretty easy, right? But for people that weren't paying attention to being long term holders of real estate, they maybe didn't get the right type of debt.
And that debt is adjusting now or the next couple of years to where, you know, they were borrowing it at three and now it's going to be six, right? Well, that extra debt service cost is going to hit the margins and maybe their building’s now less profitable. And I'm not trying to pick on California, but we all know what what's happened here with the fires and the cost of insurance.
Well, that's not just the cost of insurance going up here in California. It's across the country. Right. And so if you're not a great operator, that's not your core business. You probably weren't hedging yourself by increasing rents or adding value to the property to help offset some of those unforeseen costs. And so now we're in a situation where the next couple of years there's something like this debt wall.
Talk to us a little bit about that.
Yeah, depending on the source. Right. It's about 1.5 trillion and in debt maturities that are coming up.
I’m sorry to interrupt. So, a trillion dollars, like let's think about that. I was talking with Jeff, our CEO. If you took the number a trillion and you put it in terms of seconds, how much time would need to go by to reach a trillion seconds?
Oh, my gosh.
31,000 years. Think about that. 31,000 years. Okay. So so back to the debt maturity wall. And depending on who you're talking to, it's about 1.2 trillion that's coming due to refinance in the next couple of years.
Right. You know, and some of those have been more, I would say extend and pretend type loans too right where they came due during COVID. And lenders were forced to extend another year or two to be able to get sponsors the opportune to have their properties recover. Well, in some markets, the recovery really hasn't happened. Right. And then you layer in rising interest rates and it's really taken a toll on a lot of properties and borrowers to a point where they're really seriously considering just letting go of the properties.
And so if their option is to let go of the properties and hand the keys back. Typically, most lenders don't want to be owners of real estate, and so they're going to accelerate the sale of their assets, hoping to get at least face value. But really, I think time is more important for them versus, you know, total increase in profit that they could get potentially from selling the properties.
And so I think that will then naturally have an impact on other property owners who don't necessarily need to sell. Right. But now the new market is a much lower valuation environment. So I think it's going to be challenging also, as we talked about earlier. Right. With higher interest rates, you're going to have lower loan proceeds naturally, unless you were able to offset it by NOI growth.
Rent growth or you know.
Cutting costs.
Right.
Net operating income is basically increasing revenues or decreasing expenses and getting that gap to expand.
Now you guys have the ability to be patient and with this opportunity in the next couple of years, real estate is somewhat interesting because it's somewhat it's somewhat specific to the area or the locale or the type of property. Like even here in Southern California, single family homes have been extremely resilient With all this. You hear, you know, news stories about office in San Francisco or New York, blah, blah, blah, blah, blah.
At the end of the day, you're raising a lot of money. You're allowed to be patient and you guys are going to be patient. But that doesn't mean if you guys came across the right deal today, you wouldn't jump on it, correct?
Right. I mean, we've always looked at long term historical averages. So if we can reasonably believe that over the next ten years, let's say, you know, we should be able to grow rents at one and a half to 3%, depending on the market or if you're doing long term fixed rate leases. You know what your rent escalations are going to be, then you can back into like what would the return be if we're if we're going to move forward with the deal and if the return works for us, then we obviously would be a buyer.
We don't like to ever believe that we know when the bottom is going to take place and don't want to wait for that because it may never happen. And then we’re missing a great opportunity.
Yeah, that's a good point because it's hard. We emotionally want to, you know, think and use our minds on what could happen and is this the right time? But if you don't jump on a good deal and you guys are looking at things from a very long term perspective, it's not like some other operators that are really just trying to make a quick dollar, trying to buy an asset, put some paint on it and turn around and sell it at a higher price, which you can be pretty successful with the last few years.
It's more challenging for those type of folks today to make a deal work, right, Because they're coming into a higher cap rate environment. They're trying to do say, a fix in flat, but the right growth isn't there today. It will be eventually, because we know that there's a national housing shortage, right? Sure. But if you're trying to do a two year or three year hold period and then previously, you know, they're normally underwriting a cap rate that's much more compressed than what they're buying in at.
And we always do expanded cap rates because we assume over time interest rates are going to rise. And so that's really taken a lot of folks out of the market and allowed us to see a lot more deal flow.
Yeah, well, that's a good point, especially in your underwriting. You're finding ways to protect yourself and make sure that your numbers work long term. This has been a really fun conversation. Is there before we kind of wrap it up, is there anything else you'd like to add or you think that we missed? No, in terms of the asset classes, obviously, you guys have senior living to hotels to, you know, retail, some storage, even multifamily.
Is there any asset class that you're really excited about today or is it just looking for those unique opportunities that can that sort of come about?
Yeah, we really like to keep a wide net so that we can look at anything and everything. We don't want to be too specific in what we'll look at and not. But I would say long term trends for us as I mentioned, housing shortage, we know that there's going to be nice rent growth eventually. If you can be patient in certain markets where there is a housing shortage and then also in senior care too, with the baby boomer population, there's a lot of unmet demand and we'll continue to have supply constraints if you don't start to see more supply into the market.
Sure. Well, Megan, thank you so much for joining us and being a great partner at Morton. Thank you. Thank you again.
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