Essential Framework for Real Estate Investing: Durable Value Ep 76
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Ryan Swehla: So today we're gonna talk a little bit about the essential framework for real estate investing. And in some senses, you could say this is the essential framework for investing in general. And like I've heard you say before, it's, it's a three-legged stool. It's mastering that strategic vision, it's balancing risk and reward, and it's excelling through execution.
And without any of those legs, uh, investing becomes challenging. So maybe you could speak a little bit about mastering strategic vision and what that means and why that's important.
Joe Muratore: I'd add on to the, the first thing you said, which is that when you think of a three-legged stool, it's a, it's an important analogy.
Obviously, you can't stand with two legs or one leg, and it's like why not four legs or six legs? Like w- how many legs are on this stool? But the things we're solving for really are balance, uh, stability, and purpose. Balance being like diversification, all your eggs are not in one basket. Like, you have a plan.
Uh, stability being like there's, uh, y- the ship can support itself, the stool can support itself. There's guardrails. This is really risk management. And purpose, it like w- you know, where are we going, why are we doing this, and, uh, how are we doing this? So let's talk first about the idea of, uh, managing str- strategic vision.
The first thing in doing this is seeing beyond the deal. Like, investing is, uh, so easily one deal, a deal, the deal, but strategic vision is seeing beyond the deal to see the context. Like, what ocean is this boat floating in and what are the seas ahead and behind and why is this particular boat, uh, going to float well in this particular ocean?
Ryan Swehla: And l- being able to look at the broader context, uh, look at more macroeconomic factors and the broader market dynamics, because those create that framework that allow you to then execute or, or identify a particular investment. So it's almost like the, uh, the guardrails or rather the lens through which we view the world.
Joe Muratore: Mm-hmm.
Ryan Swehla: It's like, uh, the, the strategic framework is the binoculars that allow you to then zoom in on the individual opportunity because you're looking through a particular set of lenses.
Joe Muratore: Someone said it's the, um, the art of long-term thinking in a short-term world. Like, we're, we're all driven by our, you know, need for short-term this or that or there's an immediate need all the time, but h- and that won't go away, but how do you place that in the context of a long-term world?
How do you see the long and the short and the middle? Another way to say it is how do you see sort of patterns in chaos, and, and how do you see the patterns that have held true for you based on a career of investing? You know, I, I throw that back to you. But how, how do you particularly, Ryan, see patterns in chaos, and how do you, you do that based on your career and experience?
Ryan Swehla: Patterns in chaos are almost like looking at a river where there are all these eddies on the side, but you're trying to focus on where is the river going. And I usually, uh, rely heavily on my experience and my intuition w- that has been developed over time because that experience and intuition, using the, the river example, that's the fisherman that understands based on this flow, based on this marker, I know what's going to happen next, or I know where, where this will evolve.
So I think, uh, the, the anchor to identifying patterns in the chaos is experience and, uh, the conviction that we've developed over time. So how do you see patterns in chaos?
Joe Muratore: I, I really, uh, enjoy the idea of Warren Buffett saying that the, the optimal time period in- for investment is an infinite time period, the idea of compound interest.
And in real estate, uh, there's a lot of opportunity for compound interest. When you make a decision, um, you have a chance every year to grow NOI in certain ways. You have a chance every year to see the market and develop in certain ways. You have a chance to build new information into your existing framework year over year over year over year.
If you need to, you can move on from an investment, but, um, when you start, you, you aren't setting something in motion forever. You are starting with something, and then you are gonna be able to add in new information to try to move that NOI higher- Mm-hmm ... to try to move that, uh, return, uh, higher. Especially for us, we tend to invest in unflashy markets.
Like, we're, we're not, uh, buying this hot stock or doing this thing. It's like, no, we're buying a- 2006 vintage, uh, apartments, townhomes with garages in this secondary market where there hasn't been any new supply in three years, and it, it doesn't warrant building any new supply. It's like we, we pick our pieces of conviction.
They're unflashy, but they're stable, and we map out what we believe the growth to be, and then year over year, we get new pieces of data to, um, help bolster our conviction and, uh, the opportunity there.
Ryan Swehla: Well, and I, I think we've been rewarded with that particular piece of vision, which is this idea that these markets, broadly speaking, are overlooked.
Yeah. They're underinvested, which also means there's more limited competition, which also means it's lower risk to be investing in the market because you don't have as much competition in the market. So in, in many ways, the strategic vision also helps create safety in investing because it's around a broader framework or a broader thesis, uh, than a, an individual investment.
Joe Muratore: In many ways with real estate, patience is the, the killer instinct. Real estate's not a short-term business. Real estate cycles take a very long time, sometimes over a decade, often over a decade. Mm. The point being is that there's not gonna be specific up moves or down moves. If you have a piece of conviction about a specific market, you have to have the patience to wait until the right asset aligns with the right time in the market, which aligns with the right part of the market cycle.
So when it talks about mastering vision, vision really speaks to seeing what's next and what's, what the long-term piece is. And so the first leg of the stool, uh, mastering vision, is about having the ability to see long term based on data and experience and have the patient, the patience to, uh, to, to buy and to sell, uh, based on a long-term vision.
What, what about, um, risk and reward? How would you speak to the second leg of the s- of the stool?
Ryan Swehla: Yeah. That is the perennial balance is, uh, as we've spoken about before, risk is inherent in investing. Uh, the reason that one earns a return is because they are taking risks or perceived risks associated with that.
And so there is always this balance and this push/pull between risk and reward. I think going back to the, the, the idea that our experiences inform spotting patterns in chaos, our experiences also inform how we view risk and reward. I look at the, the fact that we were founded in December of 2008, about three months after Lehman Brothers collapsed, and so we, in retrospect, had this wonderful learning experience of going through this incredibly traumatic time in the market.
But it gave us a, uh, a maybe a different risk tolerance when it comes to debt. Uh, we saw that, you know, bad debt makes good borrowers make bad decisions. And so we learned from that that we just don't have the same risk appetite as others do when it comes to debt, and that has become a, a, a important part of our strategy as a result.
So I think experience informs that balance between risk and reward as well.
Joe Muratore: I think we've, uh, we're great in managing predictable risks. I think where people get into trouble is that most risks, uh, are sort of unpredictable. Uh, the 2008 financial crisis, uh, COVID, uh, office, uh, you know, demand changing based on work from home strategies.
Recessions are, are usually poorly predicted. I mean, at this point we've been waiting for the, uh, recession that hasn't come for five years. I mean, there was the COVID recession, but then there's supposed to be this other recession, then there's not. It's like-
Ryan Swehla: Yeah ...
Joe Muratore: i- i- it's really important in building a resilient portfolio to have a portfolio that's built, that's diversified in the right way amongst the right assets, that's capitalized with the right amount of safety- Mm-hmm
and cashflow and upside- Mm-hmm ... to deliver on, on the promise without needing five things to go exactly right. And, uh, it- in real estate, there's, uh, often, uh, many slow cuts to death where, uh, yeah, your basis was great, but your asset was a little obsolete. Mm-hmm. Yeah, that market was a little off, you know- Yeah
but it was good this time, but then it wasn't. Yeah. Uh, that recession you weren't planning on started to happen. Yeah. That unpredictable event, I mean, as we speak- Yeah ... half of Los Angeles is on fire. Yeah. Uh, insurance costs changed. You know, like-
Ryan Swehla: Yeah ...
Joe Muratore: we live in a dynamic, unpredictable, uh, you know, world, and- Yeah
you must build, uh, portfolios for upside, but also safety.
Ryan Swehla: Another word for reward is opportunity. Risk is the, the fact that losses can occur, the fact that bad things can happen, and opportunity represents the ability to, uh, take advantage of, of some unique aspect of the market. And really, as an investor, our job is to Double down on or, uh, particularly exploit the areas that we have high conviction around, and that we have a high level of experience and control.
Joe Muratore: Mm-hmm.
Ryan Swehla: Where we start to get more uncomfortable is where we're doubling down on some aspect that we can't control or something that we don't have a, a particularly high experience level or conviction around. That's where we get more cautious. And so I think as an investor, part of that balance of risk and reward is being able to recognize where y- you as an investor are well-suited.
Mm-hmm. Because where you're well-suited, those are areas where just by definition you're reducing risk, and you're able to take advantage of that opportunity. And on the, uh, the flip side, recognizing where your unique strengths or capabilities or experience are not well-suited and, and the risk that inherently comes with that.
Joe Muratore: I think it's really important to know who your customer is. Real estate exists because humans have a, a need for shelter or dis- distribute products or to... They exist to serve humans. Mm-hmm. On the other side of real estate, maybe with the exception of data centers, although those exist to serve humans too.
But on the other side of real estate are humans, humans who have a need that the real estate serves, and it's this capital intensive, large, immobile, uh, property that serves a human need. And I, I, you know, I, I would add that I think it's important to see how your- the humans you are serving, how their needs are changing, how technology is influencing what they want, how their lifestyles are changing, how work trends are changing, how family dynamics are changing, and to both, uh, understand what their needs are now and to understand where their needs are headed in the future, and to be in front of that with the structures that serve those needs.
And it's easy to look at what worked, say tall office buildings or- ... it's easy to see what did work and, and assume that the, the product is the building. But y- you can get out of line with understanding that the, the building exists to serve the customer, and if the customer changes, the building won't be needed in that way anymore.
Ryan Swehla: You mean like, uh, indoor malls. Another great example. Or
Joe Muratore: outdoor mall- Yeah ... or, you know.
Ryan Swehla: Yeah. Yeah, name it So we've talked a little bit about r- balancing risk and reward as one leg, having that strategic vision as the second leg. And the third leg that we wanted to talk about is execution. Mm-hmm. And being able to use execution to your advantage.
And I think, you know, we're fortunate to be working in the real estate space. Uh, it's our particular part of real estate is often called real estate private equity. And when I think of that, what I think of is operating business. Mm-hmm. And private equity invests in operating business, and what I think about is control.
The, the beauty of the investing that we're doing is we are working with a physical asset and a thing that we can distinctly change the outcome of. Uh, very different than stock market investing, where it's much more focused on making the right decision on investing in a particular company than it is on any ability to influence that outcome.
So when you think execution, what do you think about?
Joe Muratore: Creating value in real estate, uh, normally has a couple of traditional hinges. Uh, NOI and exit cap rate are your two big ones. So you're working to grow NOI, and you're working to sell at a time when cap rates are either similar today or better than today.
Mm-hmm. But you, you're having to call o- out five years in advance what multiple or what cap rate this real estate will sell at. And So yes, that's, that's known, and that is execution. But one thing to say here too is there are these hidden drivers of value. Mm-hmm. E- everyone knows those hinges, but as you look at, like, why did that company do well and why did that company struggle, or why did that, that seller not execute well- Mm-hmm
so much of this comes down to things we've, other things we've been talking about, like the psychologies of risk and reward- Mm-hmm ... the ability to, uh, lead a property. It's-
Ryan Swehla: Culture.
Joe Muratore: Culture. Like, did, did the property, uh, become a better place? Like, a property serves humans, but if you're a jerk and you're hard to work with and you don't i- invest in, in serving the humans, the humans will go somewhere else.
Mm-hmm. They have other options. Your NOI, uh, will struggle. So, um, leadership is one of the biggest hidden drivers. A- another might be capital structure. Yeah. Um, managing your, your debt and equity in such a way that your, uh, hard stops on buying and selling are aligned well with the market. Yeah. Um, also having the right amount of margin.
There's always pushes and pulls in real estate, where there's always debt that's coming due or tenant, uh, tenants that are coming due, um, on their leases. There's always these pushes and pulls trying to... It's easy to land in a spot where you can, where you have to make suboptimal decisions. The challenge, uh, for all of us is to, in execution, is to have the right amount of margin to maximize return and safety at the same time.
Ryan Swehla: Yeah, and I think a big part of that goes back to what we were talking about before, this idea that you're pursuing opportunities that are most in line with your core competency, with your expertise, with your strength. Because that is the area where execution in some ways becomes natural or it becomes self-evident When we, uh, uh, deviate from those core competencies, that's when execution struggles because we're now trying to learn a new thing.
We, as investors at times, will in- intentionally move a little bit out of our core competency, but part of that risk and re- reward balance is recognizing that, hey, we're executing here, and it's not quite what we normally do, and so I'm going to in- I'm going to factor in a greater, you know, risk exposure here, and I'm going to maybe minimize some other aspects of that investment.
I think of a, a couple investments recently where, uh, maybe there was a little bit of a self-storage component, or maybe there was a little bit of an excess land component, and areas where they're adjacent, you know, they, they, they're adjacent to what we do, but we also recognize that they're a little bit outside of our, uh, core competency, and so we, we factor that in as we go to execute on those investments.
Joe Muratore: I'd add, too, that there's sort of a Disneyland effect, and the, the Disneyland effect is, you know, Dis- Disneyland, you know, in Southern California was built in the 1960s, but when you go there, the attention to detail is tremendous. Those old fence railings are, seem to always be newly painted. The landscaping's always excellent.
Like, every detail is well thought through, and there's some intangibles to that. Like, you might not notice exactly what happened, but you feel the quality. Uh, and so to... So execution optimally looks like, uh, extreme attention to details, both big and small, both in front of the scenes and behind the scenes.
It's not just how the property is, but how your organization is run. Are the people who are answering the phones, number one, when people call the organization, does someone answer the phone? And number two- Yeah ... are they happy to talk to you? Uh, are, are, are things well logged? Are, you know, complaints and challenges dealt with quickly?
Is there love and compassion be- behind what happens? All of these, uh, have a, an additive effect or a, you know, a negative effect. Yeah. And, um, so the details matter.
Ryan Swehla: Yeah, and in real estate, uh, let's be honest for a moment, property management is not a sexy business. No. It's not a business that people are dying to enter.
Uh, but we have built that core competency over time, and we have seen such great value in our ability to execute as a result of that, that we wouldn't trade it, and we're, we're willing to take the kind of challenges and unsexiness associated with property management because we know that, how that influences our ability to execute.
Joe Muratore: Adding onto that, there's, like, per- perspective and position And what do I mean by that? I mean, position is, "Hey, we run an operating, uh, a property management business. This is how we do it. You know, if there's an issue, this is our standard response." Uh, and then there's perspective. Like, "All right, Mr. and Mrs.
Tenant," or whoever, "tell me what... Help me understand what's going on." And remember, there's a bunch of psychology there, too. Yeah. They might just be frustrated and need to be heard. Yeah. That's probably half of it.
Ryan Swehla: Yeah.
Joe Muratore: Um, but it's the right amount, especially as you scale an organization, of having the right people who can both have position and pers- perspective.
They can- Yeah ... they have a standard way of approaching things. Yeah. But they also, number one, can, uh, cover that with care and love, and number n- two, know when to stand up and say, "Well, you know, normally we do it this way, but this is a time to do it this way." And, uh-
Ryan Swehla: Yeah ...
Joe Muratore: that's a fine balance.
Ryan Swehla: Yeah. Well, this has been a, a great discussion, and, and just to kind of recap again, the, the three legs of the real estate investing, or arguably the investing stool for us, are having that strategic vision, being able to balance risk and reward, and being able to, uh, execute successfully on the investment.
In Episode 76 of Durable Value, hosts Ryan Swehla and Joe Muratore talk about the essential framework for real estate investing, drawing on their experience to provide invaluable insights. They break down the three key legs that support successful investing: mastering strategic vision, balancing risk and reward, and excelling through execution. With real-world examples and practical advice, this episode is a must-listen for anyone serious about real estate investment.
00:00 Introduction
00:30 Mastering Strategic Vision
06:46 Balancing Risk and Reward
12:31 Excelling Through Execution
19:29 Conclusion