In their latest episode of the VALUE: After Hours Podcast Jake Taylor, Tobias Carlisle, Moses Kagan, and Rhett Bennett discuss:
- Beyond Fix and Flip: Embracing Buy & Hold Investing for Sustainable Real Estate Profits
- Real Estate Distress Cycle: A Buying Opportunity for Investors
- The Power of Innovation: How State Farm Grew from a Small Company to a Behemoth
- Real Estate Market Poised for a Return to Rational Underwriting
- Real Estate Has Been This Game of Hot Potato
- Unlevered Yield on Cost: How Real Estate Investors Decide When to Pull the Trigger
- The Downzoning of Los Angeles: How Homeowners Created a Housing Shortage
- Highland Park: A Landlord’s Paradise in Los Angeles’ Hottest Rental Market
- Thorough Due Diligence: A Shield Against Investment Pitfalls
- Inflation and Car Insurance: A Perfect Storm for Insurance Companies
- Real Estate Insurance Costs Have Doubled or More in Some Markets
- The Impact of Current Market Conditions on Single-Family Homes
- Pandemic Disrupted Construction: Delays, Costs, and Refrigerator Headaches
You can find out more about the VALUE: After Hours Podcast here – VALUE: After Hours Podcast. You can also listen to the podcast on your favorite podcast platforms here:
Tobias: This is Value: After Hours. Just make sure we’re actually live.
Jake: I think we are.
Tobias: It still says I’m setting it live. All right. This is Value: After Hours. I’m Tobias Carlisle, joined, as always, by Jake Taylor. Special guest today, we’ve got a foursquare. Is it markets in turmoil? No, we’re talking real estate [Jake laughs] with Rhett Bennett, Moses Kagan about ReSeed Partners. What’s up, fellas? How are you doing?
Rhett: Well, thanks for having us.
Moses: Thanks for having us.
Tobias: Yeah, my pleasure. Usually, this is a stock market value investing podcast, so we’re doing something a little bit different today with the real estate. You’ve got to explain to us a little bit about what you do.
Jake: What is real estate?
Tobias: Yeah. What is property?
Moses: You tell us.
Tobias: I have no idea.
Moses: [laughs] So let me maybe I’ll start out and talk about myself a little bit as I’m prone to do, and then maybe Rhett can give a little background. We’ll talk about ReSeed and what we’re doing there…
Moses Kagan, I’m on Twitter all the time. So, people who are on there probably have run across me. Have been buying, renovating and managing apartment buildings in Los Angeles since 2008. Currently own, depending on what you think of values, roughly like $200 million worth of apartment buildings all in Los Angeles. We also manage another, call it, $300 million worth of buildings for other people on a property manage. So, we manage 1,000 apartments. And have an internal team and everything. Pretty inactive over the last couple of years, as we will talk about, I’m sure, on this episode, and have launched ReSeed with Rhett in part to address that.
Tobias: And Rhett, where are you based?
Rhett: I’m based in Boulder, Colorado.
Tobias: Would you tell us a little bit about your background, your expertise?
Rhett: Yeah. So, I’ve been an investor in both public and private markets, for a little over 20 years. Went to school up in Providence, Rhode Island at Brown. And have recently with Moses and a couple other partners started ReSeed Partners, which is, our goal is to provide capital to emerging operating partners, both operating capital as well as capital to go. Right now, largely focused on multifamily assets. So go buy multifamily assets across the US at this point.
Tobias: Moses, you had one of the more popular podcasts that– When I was doing the interview format podcast, and part of it was that you have an unusual business model, I think, for the real estate industry. Do you want to just talk us through that and then we’ll talk about how you’re working with ReSeed?
Beyond Fix and Flip: Embracing Buy & Hold Investing for Sustainable Real Estate Profits
Moses: Yeah, absolutely. So, I guess maybe to differentiate the way that we’ve done it and the way that ReSeed is doing it from the way most people do it. Let me talk first about how most people do it. So, the normal real estate private equity model is kind of an IRR driven fix and flip model. So, it’s buy things that you can quickly lipstick, use as much debt as you possibly can, do a rip and run type renovation, raise the rents, and then immediately sell it on. And all of that is driven by the economic structure of the deals and crucially, by the fact that at least at an institutional level, the LPs, the capital partners are not paying taxes, either they’re pension funds and endowments. And so, for them, maximizing IRR absolutely makes sense.
What’s weird is that that business model has propagated down through the sub-institutional market, where the capital providers are just like normal rich people in family offices who do pay taxes. And so, operating as if taxes don’t exist is like really crazy. I can’t say that I had that insight when I first started doing real estate deals. We basically bought and renovated a bunch of apartment buildings, sold them, and then I had the very unfortunate experience of looking at the tax returns that we had to file [Tobias laughs] in the year that we sold them.
Jake: Hold on a second.
Moses: Yeah. What the F do we just do? And so that and a couple of other considerations led us to a model where we think more in terms of indefinite or permanent hold investing, where we buy stuff in good locations, in supply constrained areas, we gut renovate the buildings to make them really nice, rent them out to tenants who we’ve selected who are in general pretty high-quality people, manage them ourselves, distribute the capital, and then refinance to pull out some or all the capital you invested, and then just distribute operating free cash flow as that appears each quarter.
So, in some ways, it’s a very simple model. It’s actually like what just like rich families have done for a really long time. But it surprisingly at least is fairly revolutionary for private real estate operators.
Real Estate Has Been This Game of Hot Potato
Tobias: Why is it typically done–? High net worth individual or people who do real estate development for the most part, they want their capital back. Is that the reason for doing it the first way you try to get everything back in one go and then pilot into a bigger–?
Moses: Yeah. Look, the point of real estate or at least the point of good real estate is that it’s like the cash flows are very durable, and they tend to compound. They tend to compound faster than inflation, if you’re in areas that have a lot of demand and have significant supply constraints. So, in almost every town, there’s these families that just buy stuff and then save up some money and then buy more stuff and then save up some money and buy more stuff.
Many of them, like, if you asked them what IRR was or something, they would have no idea what you’re talking about. It’s just like, that’s not how they operate. They’re just thinking about buying good stuff and stewarding it well and that’s it and compounding and buying more. And people have done extremely well doing that for centuries. So, this is not like a revolutionary thing at all.
What’s unusual about it is that the economics of the GP-LP model, the real estate private equity structure, are such that typically the GP can’t get paid, the GP me, the operator, can’t get paid until he or she sells and therefore crystallizes the return and gets to take the money. So, there’s this weird incentive for the GP to always sell, even when it doesn’t really make sense from the LP’s perspective.
Jake: What’s the length of life on a typical LP private equity real estate?
Moses: Yeah. The docs are typically struck for 10 years, but definitely the goal and particularly over the last, whatever it’s been, five or eight years has been like– Let’s get in and out of this thing as quickly as we can, three years, something like that.
Jake: Is that right?
Moses: Yeah. And so, when the result is, if you step back– So that’s the economics on an individual deal basis. But the result of that, if you step back and look at the broader real estate market, has been this game of hot potato. People are just passing these things back and forth–
Jake: Marking it up, asset moving on.
Moses: Yeah, exactly. There’s like a little superficial, “Oh, we’re going to put in new backsplashes and paint an accent wall and spruce up the leasing office and raise rents by $200 and sell it on to the next guy.” And that assets just ping ponging back and forth and obviously that model has– Oh, it was great for the GPS while it lasted, but the music has stopped and people are now reckoning with the fact that they own assets that are depreciating in areas that you wouldn’t want to own things long-term, et cetera.
Tobias: So, with ReSeed, you’re hoping to take the same model and then apply it in different markets? What do you get? [crosstalk] that right?
Moses: Yeah. I think I’m going to– Maybe RET should jump in here, but yeah, take what we’ve learned about how to operate in Los Angeles and apply it in other markets that are interesting.
Rhett: Yeah. And so maybe a little bit of background would be helpful. In my last role, we were trying to build a big real estate portfolio, and we had realized that the sub institutional multifamily space is a place you could generate interesting returns in markets like Moses operates. And so, I got to know Moses. I guess we first met four years ago, and I went to him, and I said, “We want to deploy a lot of capital in your strategy.”
The way that he thinks about unlevered yield on costs and the core of real estate really resonated with me, and the way that I think about it. So, we were trying to deploy significant capital. Moses just said, “Look, A, I don’t need the capital, and B, it’s very capacity constrained.” And so, we took a step back and said, “Okay, how can we take advantage of what we love about his strategy and be able to increase the total amount of capital that we could deploy.” ReSeed is really a result of those conversations.
So, in a lot of ways, we’re trying to take the adaptive model and then take it to a bunch of different cities across the US. And the way that we do that is that a lot of this is through Moses’ brand, we’ve recruited like-minded investors. They have come onto the ReSeed platform. We provided some initial capital to them and then we provide some mentorship and services and then as they find deals, we’ll help them capitalize those assets.
Tobias: Are you looking for experienced operators or are you looking for people who are getting started out?
Rhett: I would say a lot of them are mid-career. So, we launched our first cohort in August. And if you look at the profile, they’re mid-30s. Oftentimes, if you look at the resumes, they came out of maybe a debt private equity business, or they came out of an institutional real estate JV business. And then in a couple of cases, we have a little bit more nontraditional backgrounds as well, because this is our first fund and we’re trying to figure out exactly what the optimal profile for those operating partners will be going forward.
Moses: To be honest, when we launched the business, I was expecting to have more beginners, let’s call them. We were flooded with applications, and we can talk about why that is. And so, I was I think, pleasantly surprised by the caliber of people who were interested in doing this with us. I think to a large extent that derives from the following. People have had now the experience of doing that hot potato business model, and it is actually quite challenging to build an enduring firm based on that model.
The reason is pretty simple. Like, you’re dependent on crystallizing these promotes selling, constantly buying and selling, right? And so, your revenue into the operating company is unpredictable. It’s lumpy. And so how do you staff a business like that? You can’t depend on your AUM being like a slow upward climb. It’s like, sometimes you have a lot of stuff then you sell it. Honestly, it’s pretty stressful to have a bunch of payroll where you don’t have offsetting recurring fees or passive income to cover it. You’re literally hoping that the promote is there, so you’re spending and you’re hoping that out of your savings and hoping that you’ll be able to sell and realize a promote or whatever. That’s all fine, but it forces you to keep doing deals even when maybe you probably shouldn’t do the deals.
Jake: That adverse selection issue where just like an underwriter and insurance company if they’ve got nothing better to do and they think they’re going to get laid off if they’re not bringing float in then they write stupid risk.
Real Estate Distress Cycle: A Buying Opportunity for Investors
Moses: Yeah, exactly. It’s this very weird situation where you’re trying– The whole business exists because the LPs trust you to invest their capital. You’ve got this really screwed up incentive structure where you’re doing stuff because you got to pay your analysts and your asset managers. It’s a crazy model. I think a lot of people having experienced that at other firms are like, “Hey, we are interested in another way of doing this business.”
Tobias: It seems fragile, and it seems to me that at the end of every business cycle, there’s always a whole lot of real estate developers who go bust just at the very beginning. That marks the start of guys who are over levered and they just on that margin start going bust and then everything else seems to follow from that.
Rhett: Yeah, and I think we’re starting to see that now. Unfortunately, obviously, people are suffering, but it’s a classic start of what we think at least distress, maybe a distress cycle where you have people that are undercapitalized, probably didn’t have the operational experience, and they paid a price that really looking back on it just didn’t make any sense. And so, we’re starting to see loan sales and assets start to trade below the debt basis, which is something we haven’t seen a long time.
Moses: Yeah, I want to add to that too. So, the prices paid were not good and the operations were not good, but fundamentally, the assets selected were also not good. [crosstalk]
Jake: Other than that though, it was full.[laughter]
Moses: If you own a 1960s or 1970s apartment complex in Phoenix that has not been re-piped, you are in for a world of pain, if you own that. You will have leaks. If you actually have to eat that cash flow and that’s the source of your returns, you are not going to like the meal that you’re eating. And for so long, that was obscured because you had just lease it up, paint it, release it, send along to the next guy before the repairs and maintenance really started to hurt you. And now people are having to eat.
Tobias: It must be good though if you’ve got a full cycle view and you can see– As some of the weaker hands get shaken out, then clearly, they’re going to be some better prices at some point through this and anybody who’s liquid will be able to make some good deals.
Rhett: Yeah, I think that’s a big part of our thesis. We started this firm March 1st, and we raised an evergreen vehicle to take advantage of some of what you’ve talked about, and then we also have additional investors as well. We haven’t actually purchased an asset in this entity. Obviously, Moses and I have purchased a lot of real estate through the years. But when we were first thinking about this, I had real anxiety about, was this the right time?
And so we were going pretty slow, and then all of a sudden, you started to see the signs of stress. And so now the anxiety flipped from, “Okay, are we going too slow? I mean, are we going slow enough to like, ‘Oh, we really need to get the infrastructure in place,’” because you never know if it’s going to be the opportunity of a lifetime. But it’s very clear there’s enough stress in the market that you should be able to find good assets that you want to own for a very long period of time.
Moses: It’s certainly a better buying environment than it has been over the last couple of years. I haven’t bought one of those rehab deals in probably two and a half years. We bought some core stuff because we could lock in really long-term, very cheap debt like prior to the rates spiking. But yeah, we’ve been really bored around here and inactive because the numbers just didn’t make sense. We’re starting to see stuff where you’re like, “Yeah, that actually might be interesting.”
Unlevered Yield on Cost: How Real Estate Investors Decide When to Pull the Trigger
Jake: How do you know when to pull the trigger?
Moses: It’s a really interesting question. Rhett, we’ve done a whole exercise in creating these buy boxes for each of the operators in different markets. Maybe Rhett, you want to talk about the process we used?
Rhett: Yeah, exactly. So, we think a lot about unlevered yield on cost, and we have, minimum thresholds that we want to hit. [crosstalk]
Moses: Maybe explain that though for people who are what–?
Rhett: Go ahead.
Moses: Yeah. So, it’s just like super, super simple. This is like how I was trained to think about real estate, really, by my first investor. Unlevered yield on cost is very simply annual rent minus annual operating expenses. So net operating income, like, effectively the cash the thing produces divided by the cost to buy and renovate the property, plus any fees. So ignoring mortgage like no leverage. Just think about this. All cash, you put in a certain number of dollars to buy and renovate the asset, and what can you expect on annual basis in terms of cash flow? So super simple. It’s akin to a cap rate, if people are familiar with that.
But the reason we talk about unlevered deal on cost is because you can buy a cap rate. A cap rate is like at a core deal that’s already renovated, stabilized. You buy that and that’s your unlevered yield on costs you have to make. You’re buying a shitty building and turning it into something. Hence the unlevered yield on costs. Anyway, sorry, Rhett for interrupting you, but I just give people some– [crosstalk]
Rhett: No, that’s great. Moses has written quite a bit about unlevered yield on costs, so he is the expert. So, we started with this notion of, we want to have minimum unlevered yield on cost by market. I know you invest in the public markets, like, you may pay one price for Mastercard, but you’re certainly not going to pay the same multiple for a company that doesn’t have that competitive positioning. And so, we then will adjust that unlevered union on cost based on what we think is the quality of the market. So, a lot of that comes down to what’s the long-term demand, but more importantly, what’s the long-term supply picture? And you can see places know LA or San Diego tend not to have the same supply response as places like Dallas or Nashville or Charlotte. And so, we will require a higher level of unlevered yield on cost when we’re going to the markets that are less supply constrained.
It is important to know that in those markets, we’re looking for micro markets. Like, in Dallas, believe it or not, there are markets that are supply constraints. So, we still are looking for supply constraints. And you ask the question like, how do you know when to buy? At the end of the day, we’re not trying to pick a bottom. What we’re trying to do is buy great assets that we can own for a very long period of time that hit our return targets where we think that we’ve conservatively underwritten the asset. And so, we will obviously pay attention to what’s happening in the macro environment. But at the end of the day, the math on the page will drive our decision making at the asset level.
Moses: And crucially, for people who are used to looking at real estate deals, when Rhett says return requirements, it’s not what is the IRR here. In other words, there is no like, “Oh, what are we going to exit this thing at in five years?” Because as all of us know, it’s just complete nonsense. All these people who underwrote an exit three years ago and have now run into the rate buzzsaw, it’s foolish. So, what we want to do is own good stuff at a yield that we can tolerate, and then we’ll put some leverage on there to the extent that that makes sense, and then the idea is just to hold it.
We couldn’t imagine selling stuff. We’re not crazy. There are things that would cause us to sell assets. But the default is, assuming we picked a good building and it’s operating well, just distribute the cash and that’s it. Periodically refinance it as appropriate and just own it.
Tobias: To give a little shoutout, we always have folks let us know where they’re coming in from and then let’s talk a little bit about the peculiarities of the LA market and the other markets where you’re looking at and why they’re attractive. Chapel Hill. What’s up? Brandon, Mississippi. Cupertino. Toronto. Lewes, Delaware. Thanks, Matt. Spell it out for me. Let me know how to say it. Mendocino, What’s up? Scotland. Cincinnati. Alabama, Vestavia (Roll Tide). Kirchheim, Germany. Nashville, Tennessee, what’s up? Petah Tikva, Israel. Good for you. Stay safe out there.
Deadwood, South Dakota. London, UK. San Antonio, Texas. What’s good? Madison. Dubai. Auckland, New Zealand. Are you up early? London town. Yeah. You’re with JT. JT is in of London Town right now. Toronto. Miami. Durham, Quebec. Santo Domingo. kópavogur, Iceland?
Jake: All right, that’s enough.
Tobias: Czech Republic, New York. There we go. Good spread.
Moses: Unreal. What an amazing world we live in?
Jake: That’s so bizarre, isn’t it?
Tobias: That’s why I read it. I think it’s so much fun.
The Downzoning of Los Angeles: How Homeowners Created a Housing Shortage
Tobias: So, LA has this supply constraint. Is that because it’s a big bowl, or is that a regulation issue?
Moses: It’s mostly a regulation issue. There’s some geographic constraints in the sense that we have an ocean, obviously, the Pacific to the West that stops– [crosstalk]
Jake: Keep going.
Moses: Yeah, but it sprawls very far. I’m doing the directions background here, but it sprawls very far to the East. But fundamentally, what’s gone on is that LA used to be zoned for, I think, a capacity of 10 million people. This is back in the 1950s. And the homeowners, basically just came in and were like, “Okay, that’s enough of that,” [laughs] and downzoned the whole city in 1960s and 1970s to a 4 million the population capacity.
And to give you a sense for what that means in real life, we own a building that we bought and renovated. I think we probably bought it like four years ago, where I think it’s a seven-unit apartment building, and it’s surrounded by single family homes, and it is literally illegal to build any more apartment buildings around there. It’s R1 zoning. So, this building was the first one built before the neighborhood was downzoned to the 1960s and then they downzoned it and literally they would take you and put you in jail, if you built another apartment building in the surrounding blocks around our building. It’s pretty difficult to think of a better moat than we will put your competitors in jail if they try, right?
Jake: Yeah. Almost literally a moat.
Tobias: Yeah. Right. And so, it’s like not everything we own, of course, is like that, but just an enormous number of the buildings are. There are some other factors that we can get into that constraint supply, but zoning in all of its various and arguably nefarious forms is really at the heart of it.
Tobias: Because I follow you on Twitter, so I see your– The stuff that you put out about the regulatory environment in Los Angeles is just mind boggling. Makes no sense.
Moses: Well, it’s so bad that– If you want to assume good faith, then you have to assume deep incompetence, or if you’re willing to accept that it might be bad faith, then you’re like, “Oh, this is very devious.”[laughter]
Moses: It’s some combination of those factors.
Jake: There’s nothing flattering that you can take away from it though.
Moses: Well, it’s certainly just not– The whole thing is designed to retard supply growth. And every time the YIMBYs or the yes in my backyard crew attack some constraint, some other crazy one bubbles up over here, it’s like, “Okay, we’re not going to have minimum parking requirements anymore. Oh, low impact development.” Like, “You need to make sure that there’s no stormwater runoff, or you need to put solar panels on your single-family home.”
All of those things obviously sound great in isolation, but the effect is obviously just to drive the price up and therefore on the margin to make a bunch of projects infeasible that otherwise would have been. So, it’s just like this never-ending game of creating these increasingly devious supply constraints.
Tobias: But if you’re a developer, then that’s an advantage too. So, is that what you look for, supply constraints in other markets?
Moses: Yeah, maybe Rhett can chime in about what kind of things we’re looking for. But yeah, basically, what you don’t want to be is the guy with a building next to a bunch of other buildings that are in the process of opening with a bunch of land people can build, because people will just keep building– To the extent that rents go up, people will build more buildings, and those people will need to fill those buildings, so they’ll offer concessions to fill there. You, as the one who owns the now slightly aging building that is trying to compete with the brand-new ones, will never get to really push your rents because the guy next door is always offering some move in discount, basically.
Rhett: Yeah, that’s right. One of the unique features about real estate is that your mode or competitive positioning isn’t nearly as tied to size as it is in public markets. Like, oftentimes, the most dominant players in the public markets, there’s a correlation between quality and scale, and that is not necessarily true in real estate. So, some of these micro markets where you can buy smaller assets that are very well located in environments where Moses used the term YIMBY but NIMBY, the opposite of that is–
In some ways, if you own an asset, you want to be in markets that are characterized as being NIMBY, because the probability that you have pricing power is much higher if you don’t have competing product showing up next door.
Highland Park: A Landlord’s Paradise in Los Angeles’ Hottest Rental Market
Moses: Yeah, let me give you an example. Probably the hottest rental neighborhood in Los Angeles over the last call it 5 or 10 years has been Highland Park, which is this cool neighborhood in northeast LA. It’s like walkably urban. So, there’s a metro that takes you into downtown, and it’s super cool. There were a bunch of apartment buildings built there in the 1980s and early 1990s, there was sort of a boom. A bunch of these buildings got built, but the neighborhood is mostly characterized by single family and duplex apartment buildings that were built in the teens and 20s.
So, in the 1990s, when the neighborhood got really pissed that these buildings were being ripped down and replaced by apartment buildings, they just put a historic preservation zone on. So, it doesn’t even matter what the underlying zoning is. You’re literally not allowed to rip down these dilapidated single-family homes and duplexes to build any more apartment buildings. So imagine what an amazing thing that is to own– Those 1980s and 1990s buildings are non-rent control. In other words, you can raise the rent pretty much with the market. People are desperate to be in the neighborhood and literally it’s illegal to build any more supply. It’s a license to print money, honestly, from the landlord’s perspective.
Tobias: [crosstalk] It’s a little bit outside. It’s not what you guys are doing, but I see them come through Twitter. These office buildings in San Francisco, I think mostly, but other places as well, where it seems like 2015, they’d sell for $200 million.2023, they go for like $65 million or something like that. Is that–? What’s going on there?
Jake: That’s real numbers?
Moses: [chuckles] Look, there’s a number of things going on there. One is obviously work from home and the pandemic. The other thing is, more fundamentally, the office business has for a long time not really been a cash flow business. It’s always been a trading business. Because every time a new tenant moves in, they demand that you spend an enormous amount of money on TSs, on tenant improvements, to make the space beautiful for them, and then you have to pay their broker these huge amounts of money.
I didn’t understand this until like maybe two years ago. When I looked at it and I fell out of my desk chair. When they’re thinking about the NOI, which is the net operating income that they apply a cap rate to price the buildings, they do not take into account those tenant improvements and the leasing commissions. They’re like, “Ah, it’s below the line. Not important.”
Jake: Adjust the EBITDA.
Rhett: Yeah, exactly.
Moses: Yeah. Everyone’s trading, “Oh, I bought an office building that’s a 5K.” It’s like, “No you didn’t. There’s no cash flow coming off this thing at all.” Now that we’re in a market where people are demanding actual cash yield, there’s a price where there’s cash yield. But as we’re seeing, it is way lower than what we’re paying. And so there’s just a massive reckoning going on there.
Rhett: Yeah, one this is going to be fas– As you said, it’s not our area. But one thing that’s going to be fascinating to watch is that, obviously people are resetting their basis. And a big part of your operating costs is the tax base and those assets. Now that you’re obviously buying, it much lower than maybe your competitor in 2015, there’s going to be people that can run buildings at very different economics in terms of top line rent than we’ve seen in years past. So that’s not our business, but people that are stepping in now, it’s probably going to be a really interesting return generator over the next 5, 10 years.
Tobias: I wasn’t sure. It looked like maybe there were trophy assets, and then something new comes along, and it’s where you once the nicest premium price as a result, now you’re third tier or fourth tier and just getting absolutely hosed.
Moses: This part of it will be familiar to your public equities investors. A big part of what was going on in the office business was these assets are so large, just like the amount of capital required to buy them is so large that it’s a very efficient business to be in for capital allocators. There’s not that many assets that can soak up $100 million equity check, but those big trophy office buildings in San Francisco and LA and New York. So there was this game being played of basically just however many of these big operators are just trading these assets back and forth. From the perspective of the institutional capital providers, it was like, “Great, I have to have my office allocation, and I can write a couple of checks a year, and that’s it. That’s my office allocation.”
It’s way harder. In fact, we’re trying to do this with ReSeed is, if you want to actually build a good portfolio of smaller assets, there’s just a lot more diligence, there’s a lot more friction involved in putting a portfolio like that together.
Tobias: So with ReSeed, does it help–? So your partner does the diligence and you guys ultimately decide to go or not, or you give them guidelines for what you’re looking for? How does that all work?
Rhett: Yeah. So we definitely start with guidelines back to our unlevered yield on cost conversation and then we’ve got a quality scorecard that helps our partners understand what we look for in terms of the physical asset as well as the market we’re in. I would say that we ride shotgun, so we’re sitting next to them in the due diligence. Moses and I were on site in an asset, I think a week or two ago, which is probably illustrates the way that we go about it. We have a very clear set of underwriting guidelines of how we look at real estate, and we expect the operating partners to adopt that and incorporate that into the underwriting. And then when they find an asset and we’re going to go and do the diligence, Moses and I and some of our other partners will be on site.
And so we certainly rely on the operators to identify the assets and do the initial underwriting, but our business model requires that we’re also doing our own work outside of their process.
Thorough Due Diligence: A Shield Against Investment Pitfalls
Moses: The diligence process, in my opinion, is like the heart of one of these platforms. I talked about this before, but we have probably a three-page single space, like, eight-point font list of all the different ways we’ve screwed up. Many of those mistakes are applicable across markets. Things like, “Did you go visit the property at night, and are there gangsters hanging out in front of it at night?” That’s applicable across a lot of markets.
There’s also Los Angeles or California specific issues that we have to deal with. So we have this long– Every time we screw something up, it’s rare that we screw something new up because we’ve just screwed up so much that we’ve hit most of the greatest hits. But periodically, we still screw things up, so that gets added to the list. And so what we did is give that list to each of the operators as a starting point, and over time, those lists will evolve in each of their markets to reflect the specific market conditions that they’re dealing with.
But the expectation is that before they and by extension, we commit irrevocably to moving forward with any of these deals that they’re literally going to go through that list and initial next to each of these. Like, yes, I have thought about the gangsters. Yes, you name it. Yes, there is cable TV service can be provided to this building. Yes, I have considered the effect on the views that I value so highly if someone develops across the street, et cetera, et cetera, et cetera. So yeah, the answer is they are responsible for the diligence, but we’re the ones ultimately putting investor money at risk when we capitalize these deals. So we have to be there too.
The Power of Innovation: How State Farm Grew from a Small Company to a Behemoth
Tobias: Yeah, I’ve got one of those lists too. I’m adding to it all the time. JT, do you want to give us your vegetables? Your make glorious learnings make benefit, whatever it is.
Jake: [laughs] Yes, I do. So this week, I was in the Midwest a couple weeks ago, and I often will try to bring a book to read that’s related to that area, if I can. Buffett’s mentioned numerous times how he’s surprised that more people haven’t studied State Farm auto insurance more. He’s mentioned this a few times during the annual meetings.
The company ended 2022 with $131 billion of net worth. And so I’ll just give you a quick quote of Buffett talking about State Farm. “Next to Berkshire, it’s the leader in having net worth. It’s a mutual company, but some guy just figured out that there was a cartel running car insurance. A Farmer from Merna is the name of the book, and he created a system where he took 20 points out or so out of cost. Nobody’s owned stock in State Farm. It’s an insult to capitalism, actually. Everything you learned at the business school says it shouldn’t work because nobody owns it. Nobody’s going public with it.” So I read the book, and I’ll give you some interesting highlights from something that Buffett said we should have done and probably most of us hasn’t.
The book was actually written in 1955. It’s a biography about this founder and his name is George Mecherle, but that’s spelled M-E-C-H-E-R-L-E. He’s German. He was born in Merna, Illinois in 1877 to immigrant parents. He grew up as a farmer. He was actually quite successful. He was an extroverted guy, and he always liked to talk to other farmers about crop prices and new scientific findings about soil management. He lived it. He effectively retired at age 44, and he was leasing out his farm to these tenant farmers. To keep busy, he sold tractors for a while. He discovered that he had a knack for selling to farmers specifically because he was one and he knew what they needed. He believed that city insurance companies were getting over on farmers with higher premiums based upon–
The city driving was just more accident prone. There are fewer cars out to crash into each other in the countryside. He became obsessed with this idea of starting his own insurance company, an honest insurance company is what he always called it. He started this company that was named State Farm the day after his 45th birthday. So I find that actually to be a little bit inspiring. Like, if you’re already getting a few on in age, as some of us are like, “Gosh, this guy started at 45 and–” It’s not quite maybe like, what was the Kentucky Fried Chicken guy when he started.
Tobias: Colonel Sanders.
Jake: Colonel Sanders. Yeah. Anyway–
Tobias: I don’t know, 1970s?
Jake: Yeah, something like that. So farmers had long formed these mutual co-ops for fire insurance to share risk. So by 1890, I think every state in the Midwest had them. And there were these agreements where everyone would pay into a pool. If someone had the bad luck of a fire, let’s say, it would be covered by the group. There were 216 fire mutuals in Illinois alone in 1921, which is the year before they started State Farm. But no one had ever taken that concept of a mutual and applied it to auto insurance. Autos were making the transition at that time from toys to actual necessity of American life. Here’s how the economics worked of what State Farm constructed, $15 was paid as a onetime membership fee. $19 were paid for the first six months of the premium, and then $1 from each renewal premium went to this private company that was owned by Mecherle.
In fact, actually, several years passed before he was ever even close to sufficiently compensated. Like, he practically worked for free for a long time, but then eventually, it proved to be very lucrative for him. But he had this insight of adding a $10 deductible, which, if everybody’s done insurance before, they understand what that means. But it was an ingenious solution, because what it did is it kept a lot of these little petty claims from being filed. And also, the farmers, they probably had to pay for their own minor repairs, so they probably drove a little bit more carefully.
This company was able to operate 40% cheaper than stock company competitors because he had actually figured out a bunch of stuff here. The first thing is that he had this novel idea of collecting premiums every six months instead of annually, and that actually lined up a lot closer with the farmers cycles of when they would have cash, which was important. And also, it allowed them to change rates faster. If you’re too slow to change rates, that’s either you’re overcharging and they find someone else or you’re undercharging and you’re not getting paid for the risk that you’re taking.
They centralized billing and collections at the home office in Illinois, which was previously done out in the field by agents. And those agents would get the money and they’d have it for 45 to 75 days, typically, so they had float on you in a way which obviously not helpful. And the $15 membership fee didn’t require reserves against it, like, traditional premiums that you would write by regulation. So State Farm could actually grow faster than a lot of the other companies. They found a source of capital, basically. The new members paid for their own acquisition costs effectively with that $15 membership and they were very careful about who they selected to underwrite. And that allowed them to discriminate a lot of bad underwriting risks. Like, they wouldn’t cover drunk drivers. They appealed a lot to the high moral farmers. This is how a mutual kind of worked. I don’t know, if you guys have ever seen this before.
But that $19 premium deposit, let’s say, that the share of the cost that year were $10. And so that leaves $9 left over from premiums. There would be a credit that was created of $9 for the user, for the member, and then they would have to add a fresh $10 to restore the premium deposit, and then it would repeat every renewal period. The customers actually felt like this really strong loyalty and they would display the State Farm insurance medallion on their automobiles and people would brag about it, which kind of hard to imagine nowadays, right?
So anyway, let’s just talk a little bit about how well this took off, like, boy, they really caught lightning at a bottle. Started in 1922. After six months, they had 1,300 policies enforce, and that created $29,000 in revenue insurance premiums, which is about $500,000 today, adjusted for inflation. Six years later, they’re at 69,000 policies. That’s like a 94% CAGR for six years. This is like an early hyperscaler for everybody [Tobias laughs] who likes those kinds of businesses.
By 1944, they had over a million policies, which is a 35% CAGR for 22 years. And in 1951, when George Mecherle passed away, it was at 2.2 million policies and $119 million in underwriting revenue. And by the time the book was written in 1955, they were at 3.4 million policies. So wrapping this whole thing up, there’s this beautiful Emerson quote that’s in the book that really sums up State Farm and George Mecherle and it’s, “An institution is the length and shadow of one man.” He was the guy for State Farm. Like, he was totally the driving force to get it going and turned it into this behemoth that defies the laws of capitalism and this mutual system.
Tobias: That’s fascinating, JT. Did they tell you what he did on the asset side?
Jake: There was a guy who was managing that, and I think it was primarily just in bonds. Like, it was pretty generic time period, they weren’t that creative.
Inflation and Car Insurance: A Perfect Storm for Insurance Companies
Jake: Yeah. There’s not a ton of float either in auto insurance because it’s such short tail liability. Like, the money comes in, it typically goes out relatively quickly. It’s only through the growth, the additional policies where you add into the float.
Tobias: All of the inflation for the current car insurance is making car insurance tough for GEICO and so on.
Jake: Yeah. You know what’s interesting? There’s a little bit of analog of this they talk about in the book. It is actually World War II. What happened there was that everybody– Well, one, they couldn’t find enough workers to service the business because you had people off fighting wars. And then everyone came back. And also, all the materials for creating cars were being used to make tanks at that point. So everyone was like running on thread bare tires because all the rubber had been used for World War II, and everyone was back and eager to go drive around. Like, they’re back, they survived. And so there were tons of accidents that were driving shitty cars at that point, like, crashing into each other.
There was a lot of inflation that was happening post World War II because frankly, we ran huge deficits. We printed a bunch of money to fund the war. So they had huge inflation costs and way more than normal accidents. It was like a pretty treacherous time for the business because you ended up with just a perfect storm for an insurance to have issues. COVID might be a little bit of some of the same thing that happened. People are cooped up, and then they’re eager to get out there, and then you have a bunch of inflation from printing for a war on a germ, I think some of the same dynamics take a while to play out.
Real Estate Insurance Costs Have Doubled or More in Some Markets
Moses: At least, speaking not for cars, but for real estate, the real estate insurance market has gone bananas.
Jake: Is that right?
Moses: Oh, yeah, it is. I think if you asked multifamily operators across the country what their single biggest issue right now, I guess the biggest issue for some of them would be the short-term balloon financing. But if you leave the capital stack out of it– [crosstalk]
Jake: If you can survive that, then it’s– [crosstalk]
Moses: The insurance cost, it has gone crazy. Part of it is, lots of development in areas like Florida that are disaster prone anyway. But to a large extent, the cost of fixing stuff has just skyrocketed as a result of deficits of labor, and then there was all these supply chain issues and then those have sort of been hammered out. But the Inflation Reduction Act means that there’s like a ton of concrete and steel and all that stuff going into government infrastructure or energy infrastructure projects instead of into building apartment building. Construction costs have gone crazy. Maybe are softening a little bit. So maybe we’ll start to see this trend reverse. In some markets, insurance has doubled, more than doubled. It’s really hurting operators.
Tobias: Does it help you to have the operating business alongside the fund management business? How do they interact with each other?
Moses: Well, for us, for sure, our property management business basically– not basically does more than cover the cost of the whole platform at this point. So we’re able to continue to employ like my acquisitions guy and finance capacity and whatever that we would not be able to because we’ve been so inactive on the deal side.
The other thing is, and probably more importantly– Well, for better or worse, we feed information from the management side into underwriting for new deals. So I set all the rents in the existing portfolio, I set the renewal prices, I’m seeing the vacancy, I’m seeing the operating expenses. And so all of that data is being fed into how we underwrite new deals. It can be bad because it’s like, sometimes you wish you didn’t know the numbers because it would be easier.[laughter]
Moses: But we do, and so we’re not going to lie to ourselves. And that means it forces a certain conservatism into the underwriting.
Tobias: What’s happened to rents and vacancy as this–? They say that it’s the most unaffordable housing market ever-
Jake: Rent is too damn high.
Tobias: -going against the data. Yeah. [laughs]
Tobias: Going back through the data to wherever it starts like 1960 or 1980 or whatever, how does that show up on the ground?
Moses: Well, this has been market by markets. The response to COVID was to move a whole bunch of people around the country. So some markets went absolutely crazy in Phoenix, Austin went nuts, New York and LA were losing people, particularly in that prime renter age demographic, people went home. So rents got really soft during COVID. Then we had a delayed boom where it got really hot here like a year or so ago, maybe a bit more, but it has now cooled. We’ve kept vacancy under control by reducing rents. I think we’re probably 2% or 3% vacant at this particular moment. So vacancy very low. Everyone’s paying, or almost everyone’s paying, but we’re cutting face rents, for sure, to keep– [crosstalk]
Rhett: Yeah. It’s very different by market too and by submarket because the supply response was largely at the higher end of the quality spectrum. And so if you go to downtown Nashville right now, it’s a great time to be looking for an apartment because they’re given two and three months free rent in order to fill up very nice, well located assets. And as Moses said, there’s a lot of markets that you just didn’t see that supply response. I’d say maybe more than ever, the divergence, you’re really seeing a divergence among markets and submarkets.
The Impact of Current Market Conditions on Single-Family Homes
Tobias: This is, again, a little bit outside your direct area of expertise, but it’s property related. But the single-family residences seem to have been– Sorry, that might be the wrong term for it. There’s this meme or there’s this idea that because everything’s so unaffordable and yet there’s very few transactions going through because people have got the lower mortgage rates, what do you guys think about that?
Rhett: Look, I think there’s a bunch of fascinating second order effects. You’ve obviously seen home builders having to buy down rates in order to drive volume. It’s a much, much smaller pie, but they’re able to take a larger percentage of that pie just because the inventory on the used product is not as available. That’s a fascinating thing.
I think one of the things for me is the build for rent space and the single-family rental space, that’s actually been stronger than maybe I would have originally thought. And a lot of that has to do with just the population and the demographic that are aging out of wanting to live in a certain type of apartment and want to move up to a single-family home. I think folks focused on that business would say that they’ve continued to really enjoy a demand tailwind.
Pandemic Disrupted Construction: Delays, Costs, and Refrigerator Headaches
Tobias: It’s been a wild ride in property with– Lumber is a pretty big input to what you guys do. I’d say, lumber went absolutely bananas through COVID.
Moses: Lumber went crazy. But you name it, it was hard in there. A deal that would have taken us two years pre-COVID, or a little less than two years, because of COVID, those deals took three years. Just you name it. It was getting the labor. You couldn’t source refrigerators because all that stuff was coming from China, and all those supply chains were screwed up. Air conditioners, dishwashers, the list of things that goes into a new apartment, it’s really long. All kinds of stuff that your listeners are not thinking about. Cabinet hardware, the address letters that go on, [Jake laughs] you name it. It was hard to source the stuff.
We had to compromise because we have more or less a standard package of stuff that we want to do in most of our units. And at a certain point, it was just like, “Look, yeah, we can’t get the refrigerators we want. So whatever refrigerators you’ve got, send them over.” We have a long-standing policy of not putting refrigerators with water and ice dispensers into apartments, because it’s like with 100% certainty, those are going to break. It’s just a pain in the ass to fix them. They absolutely do not add a single dollar of rent. So it’s pure downside from your perspective, operational complexity and costs for no reason.
Lo and behold, I have a bunch of apartments with water and ice dispensers in there now because that was the only thing we could buy. It was crazy. From a construction perspective, it was definitely the hardest operating environment in my career.
Jake: What’s just so hard to keep those things running? Ours freezes over anytime it gets below 80 degrees in the house. [laughs]
Moses: You name it. Like, leaks, all that stuff. Obviously, the joke is, meanwhile your grandmother’s refrigerator from 1965– [crosstalk]
Jake: Yeah, it still cruising.
Moses: Yeah, it’s just working still. But yeah, these ones, they last for three years, then they break, and then the technician comes, and they’re like, “Look, we can repair it.” And it’s exactly 50% of the cost of a new one. That’s the life of a property manager is being like, “Well, [laughs] should we repair this or not,” or I don’t know. It’s never ending.
Tobias: Did it change anything about the way that you have done business subsequently? What have you learned from it?
Moses: Well, it pushed us out of the rehab business. This is the case, I think for now, especially– When we started doing those rehabs, the length of time that we had to spend with the building vacant wasn’t a big deal because there was very low opportunity costs from the investor’s perspective. It’s like, “Okay, we’ve been sitting here for two years with no cash flow, but interest rates are zero, so who cares?”
Now if you’re going to do a two-year rental which is now going to get pushed out by some city bureaucracy or supply chains or whatever to three years, there’s a major cost in terms of the foregone, even just like sitting in bonds or whatever. So now, you have to feel like you’re going to move very, very quickly to make rehabs make sense.
Real Estate Market Poised for a Return to Rational Underwriting
Tobias: What are you most looking forward to over the next few years? Is it a good environment or is it a rougher macro environment, which is a better investing environment or how are you thinking about it?
Moses: What do you think, Rhett?
Rhett: I’m most looking forward to a return to rational underwriting. Some of what Moses described early in the call with lipstick on a pig, as we call it, renovations. When we capitalize an asset, we’re going to do that very conservatively and oftentimes, all cash. And as people, they became so focused on IRR, and levered IRR that if you are a person that uses a pretty conservative capital structure, you just become not competitive. There’s all kinds of other places in real estate where people in a lot of ways lie to themselves in terms of what the actual cash flow of the asset is going to be.
Now we should return to an environment, I mean, should return to an environment where people are actually underwriting more conservatively, which allows us to be more competitive and hopefully buy great assets.
Tobias: When did you see the divergence start happening?
Moses: Say again.
Tobias: When did the divergence start happening, between sort of–? [crosstalk]
Rhett: Oh, real craziness?
Moses: The real craziness? I would say things got really nuts in 2020. For me, it was already starting to feel toppy in 2018 and 2019. I think this happened in all asset classes. Like, the COVID Money spigot just extended things into La La Land. What you could see is, if you looked at cap rates, which again is the annual rent minus annual expenses divided by the cost of buying the building. So forget about leverage or whatever. Cap rates reflect a number of things. They reflect investors estimation of both the riskiness of the cash flow they’re embedded like an expectation about growth of rents, and therefore of NOI. The investors expectation about the capital, environment, interest rates, et cetera. So there’s a number of things going on.
But in a healthy real estate market, there is wide divergence in cap rates between different kinds of assets and different markets. Like, a really good, very well-located, well-designed apartment building in a supply constrained market should trade at a very different cap rate from some peripheral property with issues on the edge of a tertiary market. And yet, what happened, particularly in like 2020 and 2021 is there was no spread at all between the cap rates, both across markets, but also asset classes. It’s just like, it’s really operationally intensive to run a hotel, right? Some tertiary market hotel should absolutely not be trading at the same cap rate as a well-located– [crosstalk]
Jake: Storage unit?
Moses: Yeah. It’s just like, “Ah, this is just nuts.” So that was like the signal that things were bonkers, because no one was like– It was all being driven by the availability of cheap debt, which is why the prices all got bit up. People were buying shitty apartment buildings in Phoenix where the rents were already starting to wheeze. It was like, we were getting pitched three caps, like 3% yield on a shitty– That’s with reasonable but not insanely conservative estimates for operating expenses. A three cap for a shitty old complex in a bad part of Phoenix? Are you crazy? That was going on all over the country. And unfortunately, a lot of people bought that stuff with balloon loans and short-term bridge debt and all that stuff. And obviously, that’s coming home to roost now.
Jake: Single-family home, what’s the single best ROI project that you could do for your house?
Moses: For a single-family home?
Moses: I don’t know. Outside my circle of competence.[laughter]
Moses: I’ll tell you, an apartment building.
Jake: Okay, that’s good.
Moses: The apartment building, it’s landscaping.
Jake: Is it trees? Isn’t that what Munger’s guy says is putting trees in?
Moses: Yeah, he’s right. I’m going to repeat myself in a tweet. So the entire business of long-term real estate ownership is basically like this war against entropy. It’s breaking. You fix them, they break again. That’s what it is, except well done landscaping compounds in value.
Jake: Oh, I could see that.
Moses: You plant these trees and they get bigger and nicer over time. I joke with Rhett that like, you could probably pick the neighborhoods we’d like to own real estate in by looking for where the mature trees are.
Jake: [laughs] Yeah. The sun is doing your work of fighting entropy.
Rhett: That’s right.
Moses: Yeah. You get this nice, beautiful– People love trees. It signals a lot about how the neighborhood is being taken care of and whatever. Tenants love it. Anyway, so in my mind, that’s the single best highest ROI.
Tobias: I think that’s good– [crosstalk]
Jake: How quick conveyed some survival advantage at some point in our evolution?
Tobias: That’s a good, high point to end it on. Gents, if folks want to get in contact with you or follow along with what you’re doing, how do they go about doing that?
Rhett: I think the best way is obviously you can follow Moses on Twitter or you can go to reseedpartners.com. If you’re interested investing, there’s a link on our website.
Tobias: Rhett Bennett, Moses Kagan, thanks very much, gents.
Moses: Extremely pleasure.
Rhett: Thank you.
Tobias: See you, folks. We’ll be back next week, same bat time, same bat channel. Billy be back next week.
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