Changing Market Dynamics
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Episode Transcript:
So 15 years ago, if you said self storage is an institutional asset class, people would've laughed at you. Mobile home parks. And yet all of those have been institutionalized. And now data centers, life science, single family rentals, these are all existing asset classes or existing sectors that have become more and more institutionalized.
So now Ryan is gonna come up and speak with us a little bit and he's gonna talk about some of the changing dynamics we're seeing in the market as a firm and, and kind of highlight some of the, the, the good, the bad, the know four I ran come back up 2022.
We used to lament 2020 and want to forget 2020. And I think many of us are starting to wonder if 2022 is one of those as well. There there's a lot of changing market dynamics and I thought what I would start with is long term secular tr trends that affect our business. And then we'll get down to kind of short term cyclical trends that also affect our business.
Everything I'm gonna be talking about is in relation to our investing in our business. I think all of us have heard lots of economists, so I'm not I'm not here to prognosticate, I'm here to tell you about how it affects our business. So first kind of secular trend is migration of people. And we've seen this there was a Wall Street Journal article two days ago I think that said that the average distance that people move today is higher than it has ever been since they've been recording the data.
Average of over 50 miles. Why is this happening? People are, are searching for affordability, they're searching for quality of life, but why is this happening now? Technological advance has allowed people to work remotely. It's allowed people to work as independent contractors. We've also seen businesses that traditionally were in primary markets start to have headquarter or satellite offices in other markets.
And then certainly the pandemic came, came along and it just accelerated that trend. People never really thought about the amount of time that they were spending in their car or in public transit commuting, and all of a sudden that became an important thing and they started to, to reprioritize aspects of their life.
That's a trend that we don't see lighting up. But I would, the, the second secular trend that we want to talk about is capital flow. So this same diagram is representative of capital flows as well. 20, 30 years ago, institutional allocation to real estate and private markets in general. So private markets is venture capital, private equity, real estate.
Institutional allocation to real, to private markets was just a tiny wedge on their, their whole portfolios, the traditional 60 40 equities bonds that over the last decades that that wedge has grown larger and larger and larger. And that trend is continuing going forward. So we've got a case where institutional capital is allocating more and more into the private markets, and particularly into the real estate space.
Then add to that private individuals, non-institutional investors many of us here in the room that, again, traditionally it was a 60 40 split between stocks and bonds. And more and more people are looking for that access to venture capital, to private equity, to private real estate. So what does that mean for us?
When you've got more and more capital allocating somewhere, where does that capital go? Well, what's happened is that more aspects, more sectors of real estate have become institutionalized. So 15 years ago, if you said self storage is an institutional asset class, people would've laughed at you. Mobile home parks.
And yet all of those have been institutionalized and now data centers, life science, single family rentals, these are all existing asset classes or existing sectors that have become more and more institutionalized. We see secondary and tertiary markets as kind of this vast frontier of really trillions of dollars just in the western United States.
There's trillions of dollars of private real estate in secondary and tertiary markets. And who owns that? Right now it's, it's primarily individuals, families. It's non-institutional, and that's what, that's why we focus on bringing an institutional approach into these markets because we see over the.
Next 10, 20 years, it's an inevitability that all of these markets, Boise, Albuquerque, Bakersfield, these will all become more institutional and we're not alone. Groups like Blackstone, Goldman Sachs Goldman Sachs actually looked at doing a, an investment into fund three. They will likely be a fund four investor.
Dow Chemical. Oak Street, Hilton Foundation, these are all groups and, and many others who have really resonated with our strategy because they see not only that market opportunity, but they also see our approach to, to how we're doing it as something that's meaningful. So those are kind of, I'd say the two long-term secular shifts, which is capital and people.
And then let's get into the short term cyclical trends. 'cause these are the ones that I think everybody's thinking about. Nobody's thinking about the two that I'm, I mentioned earlier we're thinking about things like inflation, recession, interest rates all those sort of things. So I think this graph really translates into all of this, or many of the cyclical trends that we're dealing with right now.
This is the fed funds rate. So with the, as the fed interest rate goes up, What what of course happens and probably the biggest impact to real estate right now is, is borrowing costs, interest rates are going up for our existing portfolio. Fortunately we're virtually completely hedged and that's goes back to our like I mentioned earlier, bad debt makes good investors make bad decisions.
So we've always preferred fixed rate debt. We've always preferred balance sheet lenders, and so as we get into an environment like this, Our existing portfolio is unaffected by interest rate changes. Buying new things on the other hand is absolutely affected because debt costs have gone up. And so if debt costs go up, I as an investor, if debt costs went up, the price that I could pay for that just went down.
So we're seeing this across the board. You've, you've probably, you know, read about it in residential as well. But as interest rates go up, values go down. So this is a great time for, for being a buyer in this market. We, we are excited to be a buyer. Being a seller in this market is a little bit more challenging because values have gone down for us because we have a value add strategy.
We're, if you look at our existing portfolio, Our values have gone up because of the work that we do, not because the market, because the market certainly is trending down right now, but because of the work that we do, the value is going up. So we're, we are with, with specific assets, we are still a seller because we've made enough money on that asset that it makes sense to sell.
But I would, I would generally describe our, our position in this market as a cautious buyer. We, we churn through a lot more assets. We do a lot more underwriting. We've also trended up our threshold interest rate, or, I'm sorry internal rate of return i r r. So essentially we, we need a little bit more return to make us comfortable transacting in this market.
So it's, it's certainly not a, a time that we are, you know, out of market. But it is, frankly, it's, it's a little bit more of the opposite. We, we view this particular time as a time more ripe than perhaps six or nine months from now because the other two cyclical trends that I want to talk about are denominator effect and price discovery.
So, denominator effect means institutional capital has an allocation of into real estate, into stocks, into bonds. Stock market drops as it has, and all of a sudden they are over allocated in real estate, not because of anything that real estate has done. So institutional capital generally is more on the sidelines right now.
So there's less buyers in the market. The other thing that's occurring right now is price discovery, which means when the sellers and buyers can't generally agree on what the price is. So. Sellers are wanting to sell at yesterday's price. Buyers are wanting to buy at today's price. And again, that is a time where there's actually a lot of opportunity if you can find the sellers that have, that have accepted this new reality.
Six months from now, we anticipate that to be a lot more, you know, born out. But this time of price discovery is really a, a unique time. I wanna speak a little bit to recession. So I guess what I would say is we are not market timers and we are not market forecasters. What I mean by that is we don't make our investment decisions based on trying to time the market.
We don't make our investment decisions based on future forecast. We make our investment decisions based on what's actually happening right now and what that current asset needs. So that's, I I would frame that a little bit. As we go into talks of recession, we can't be predicting is this gonna be a shallow recession?
Is this gonna be a deep recession? What we can do is we can scenario play. If it is a deep recession, what does that do to our portfolio? And I would say we've been doing that probably for the last five years because we, because of that recessionary mindset. We've, during this trending up market, we have constantly been kind of looking over our shoulders, wondering when the shoe is gonna drop, and I think now we are actually seeing the shoe drop.
So what does that mean for our portfolio? Well, if we're always mindful of a downturn we, as we've mentioned before, we've focused on conservative debt. We focus on adding value quickly because when we add value quickly, that builds margin of safety. So that's why we can be even a seller in this environment because we've added so much value to properties.
And we've generally been low leverage. Our portfolio wide leverages 54% I believe right now. And, and being vertically integrated allows us to quickly react to the environment and allows us to feed to have instant feedback. By vertically integrated, I mean that we have property management staff on the properties that we own.
We have people in the markets where we invest. That allows us to very quickly be able to have that feedback loop as the, as the market changes. So I'm, that's where I'm not predicting the future. We're not attempting to predict the future. Instead, what we do is we prepare for it and we've been preparing our portfolio for it for, for many years now.
So now I wanna switch to some good news on short-term cyclical trends. And one of the things that is good for us is inflation. And that's not good for any of us in the room, in our pocketbooks. But from a real estate standpoint, inflation is a good thing. We're certainly not banking on it.
We're actually hopeful that the Fed's efforts will bring inflation back, you know, to a, a reasonable level. That being said, real estate has the highest correlation to inflation of any asset class. So what that means is as inflation goes up, real estate values tend to go up in, in lockstep with inflation.
And that's because of course rents generally rise with inflation. That's not, that's not always the case. But in our, I wrote an article in Institutional Real Estate Americas recently about our, how our strategy. Is particularly inflation correlated. If you buy a Amazon warehouse with a 10 year lease, that rent only goes up by whatever the contracted increases are within the lease.
It might be 2%, 3%, something like that. So that does not track with inflation. We buy assets that are highly multi-tenant, that have constant leases rolling over. And as you have those con, so think the multi-family, small bay industrial. These leases are constantly rolling over, and so we're able to bring rents to market as, as rents increase.
So it's very inflation correlated. So inflation bad for us individually, good for us inve in our investing. The other cyclical trend that is good for us is housing demand. Housing supply never caught up with housing demand after the great recession. Even, I mean any, I'm sure all of us have read articles about the kind of chronic imbalance between supply and demand for housing.
Well, as interest rates go up, all of a sudden development costs go up debt costs on new development go up. Inflation has made construction costs go up. So new, new development of single family homes of multifamily are getting harder and harder to do for us as a, as an investor in existing multifamily.
This is generally a good thing because it means that rents will continue to rise in a more meaningful way because there isn't new supply coming onto the market. And then I want to speak to the labor market. So we're, we have experienced the tightest labor market. On record. Employers everywhere are having a hard time finding good qualified employees.
I think all of us have had experiences in restaurants where we wonder if the server has ever served people before because they're desperately trying to find people to, to be able to employ. And meanwhile, we just you know, introduced you to some of the stellar people that we have in our company. So why, why is it that during this time of the hardest time to hire people we're able to, to bring on exceptional people?
And fundamentally, that comes down to two things. It comes down to our culture, and it comes down to our, our vision or our purpose. We already spoke to those a little bit. Positive, caring, and humble owns the mission, does the right thing, excellence in execution, and wants to win. As as we said, we, we live and die by these.
We hire and fire by these. And it creates an environment during the tightest labor market ever. It creates an environment where people want to be because it's a dynamic environment that rewards excellence. It's a caring environment. And ultimately you know, groups, as I mentioned, like Goldman Sachs and Blackstone are looking at investing with us.
Our goal ultimately is that we are competing with them. We, we see this market, the secondary, tertiary market strategy. We see this as a highly scalable, very we, we, we see ourselves as being on the, the beginning of a trend. And so the folks in this room and the other members of our team, they see that.
They see not only where we have been and where we are, but they see where we are going, and that, that's been really critical for us. Our purpose, when we really get down to why we're doing this, is we create environments that transform people's lives. Well, what do we mean by that? There's really three areas that, that this transcends.
One is the work environment. Our goal is to create environments that transforms people, lives for our coworkers, for our vendors. It translates into properties. As we move into as we, as we do our value add strategy. That means that we're going into markets, frankly, that are under invested. A lot of the markets that we're going into, institutional capital doesn't re regularly go yet.
And so we're coming in and we're bringing that expertise. We're taking the existing real estate stock in that market and we're elevating it. We reg pretty regularly have residential tenants say, thank you for buying the property, and meanwhile, our job. Is to bring the property to current, you know, amenities and to raise the rent.
Well, why would a residential tenant say, thank you for buying the property and raising my rent? The reason is because we're typically buying from owners who have mismanaged the property, who have been bad landlords, who have not invested in the property the way that it should have been. And so a lot of times our tenants, they now, they have an owner that they can call, that they can actually have a conversation with, that we can develop a relationship with.
They have an owner who like Carson Air, which we'll see to later today, who actually you know, keeps the pool in good condition, who actually updates the landscaping and makes the property something that you're proud of as, as a tenant. This also translates into sustainability. We do energy audits on our properties.
We do sustainability audits and we we're, we don't approach that. We always approach that from an authentic standpoint, so we're always focused on what improvements are going to yield the best return on investment and yield the best outcome for that property. So in, when you're working in primary markets, a lot of the kind of low hanging fruit of energy efficiency, water improve, you know water efficiency, that sort of thing, they've already been done in the markets where we work.
Many of the properties that we're touching, maybe that's the first time that been touched in decades. So it's very easy to find high return investments in the property that also make the property a more sustainable. Contributing property as well. So I just want to touch on the, our, the last point of our mission of improving lives.
We create environments that transform people's lives and that is community. And community again is approach from a very authentic standpoint. We have team members who created a community service committee. Where they figure out which initiatives and endeavors we, we want to pursue. So we've supported Orville Wright Elementary School in Modesto.
We've supported veterans programs, homeless programs, but besides everybody's d n a in our firm, that that makes them want to contribute to the community. We also really program it into what we do. So we have paid volunteer time so that people can actually. Be paid during work hours to go do volunteer work.
We also have this thing called Making Memories, which is Leanne's invention. So I'm sorry she couldn't be here today. But making memories is it's, it is us programming into the budget at a multifamily t family property, a line item that is for the community manager and the other staff to be able to identify when there are tenants that have some sort of a need.
So like an example might be a family's expecting a baby and we provide a welcome package or a care package with, you know, some clothing and other things for the baby. So again, it's not just, hey, do it on your own time, but we actually program it into the dna of the work that we do. And then I, I wanted to speak just briefly about GED scholars, which is something that Joe and I are really excited about.
This is actually modeling after someone, an entrepreneur in Florida who did this in the Orlando area. And what we've decided to do is pay for the full college cost of graduates who are graduating from high school, going on to college from the airport neighborhood. So anyone from the Modesto area knows the airport neighborhood is probably the most socioeconomically disadvantaged neighborhood.
And our goal is ultimately to be able to help fund the cost of every college bound student out of that neighborhood. We started with one, two years ago. We added three more last year. And our hope is to continue to add more. So we're really excited about the work that we're doing and, and the work that we have ahead of us.
I just want to finish by saying that, you know, these are times. These are very trying times, or they're very challenging times. We all wonder exactly how the cards are gonna fall, you know, politically, economically, geopolitically, all sorts of things. And these are the times when experts thrive and when less disciplined firms struggle.
So it sounds strange to say, but we've been looking forward to these times because for the last five years we've really just had this run up, run up, run up in real estate. And it's easy for anyone to look like a genius during that time, but the time that we have ahead of us is really a time when it allows experts to thrive.
Summary
Taken from Graceada Partners' recent investor meeting, Ryan Swehla shares the firm's outlook on market dynamics in 2023, how it affects the firm's strategy going forward, and why Graceada Partners is positioned to weather upheaval.