Failure Science, Why Good Companies Drift and How to Avoid Catastrophe | Durable Value Ep 79
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Joe Muratore: Today we're gonna talk about failure science, uh, why good companies and properties stall, the erosion of why things go wrong. Most people think that failure is a catastrophe. It's a giant blowup. There's that old quote of thing- things went sl- uh, slowly and then suddenly. But most, uh, things happen in a drift.
People get off track, properties get off track, companies get off track, and little problems begin to fester, and then turn into bigger problems. Small misalignments begin to stack up while on the surface things look fine. Today, we're gonna talk about that, and we've talked in the past about the idea of, uh...
Think of it this way, w- to set the stage. Like in Olympic archery, the target is three quarters of a football field away, and it's, you know, a few feet by a few feet The point is, as you're aiming an arrow at that, a few millimeters one direction or another is a miss. Just like, the point is there's tons of information out there on success.
Today we're gonna talk about what's not success. The actual easiest point of improvement is to move from everything that's not the target to move towards the target. Today we're gonna talk about all the things that aren't the target.
Ryan Swehla: Yeah, and one of the key areas is, especially in investing, misconfusing luck or market timing with skill.
We've seen this play out, uh, pretty manifestly over the last, you know, last up cycle and down cycle. It's funny, our historical returns are phenomenal. But I usually don't lead with our historical returns because then when we talk about them, we have to say, "Yes, but..." And the yes but is we had this incredible tailwind environment that helped us- Yeah
yield those results. And, and to think that the results that we got during the last up cycle are indicative of all results at all times is, is one of the, the biggest fallacies that we have. We recognize that in each market environment, there is an appropriate range of returns that can occur, and if we think that, "Well, I got that two years ago, and therefore I'm gonna, you know, maintain that same track record going forward" is, uh, false.
Joe Muratore: Yeah. It's sort of like seeing our company and ourselves as information machines. Like, we're gathering information all the time, and it works great, but at some point, like, signal gets divorced from reality. And where are, where's that subtle shift where truth a- reality and, and not reality begin to part?
This is where our, uh, biases come in. This is where signals begin to get filtered. This is where we begin to believe our own hype. And this is the, the biggest problem in investing, is, uh, we all have egos, and especially, you know, in the investment business, we're responsible for many tens and hundreds of millions of dollars.
We think that we're smart. We got to here. Mm-hmm. Uh, we built an organization around this, and it's really important to see that it's really important to not let your ego get involved in seeing luck as skill. Mm-hmm. Otherwise, you can have win... You're, you're like a genius, genius, genius, idiot. It's like, what happened?
The market changed. You began to see things differently than they actually were. The, the playing field distorted.
Ryan Swehla: That is the beauty of, uh, real estate market cycles. Real estate market cycles are the ultimate leveling field because when markets are rich or when we're in an up market, even at the beginning of the up market, when we start making invest- investments then, they go well, they go well, they go well, and the market cycle is really the best, uh, leveler of that.
It's, it's what kind of clears out the novices from the professionals.
Joe Muratore: I mean, one way we guard against that is, uh, being an execution engine. Our job is not to buy assets and ride the market. We're not buying stocks and believing they're gonna go up or down. We're buying a, a business plan. We're buying assets that have the right things wrong with them, that have rents that are currently below market, that are missing paint or landscaping or roofs or leadership.
They need the things we have, and our job is to apply the, the tools we have against the assets we have. Now, it happens that we're in a 3D environment. Our 62 people and our skill set are applicable to a problem set, and we're looking to marry those up And then buy it at the right price to reflect the current environment.
Ryan Swehla: You know, one of the other ways that we can lull ourselves into problems is, uh, this idea of buying a trophy asset. Like- Mm-hmm ... oh, my gosh, I have to have that asset. As I say it that way, it sounds pretty silly. You know, "Oh, I have to have that asset." But we as seasoned investors still do this. We just say it differently.
We say, "Oh, man, that asset is, has attributes that are stronger than any other asset." Oh, yeah. And, uh, it's a great long-term investment or, you know, the, market cycles don't affect that asset as much. All of these may be true, but it still may be the wrong asset to buy at that price at that time. How do we defend against that?
Joe Muratore: Well, first off, it's really tempting in this business to look, to want to look sophisticated, to want to sound sophisticated, when you may be masking a, a lack of sophistication in your underwriting. Your cap rate may be too low, your rent growth may be too high, and you may tell yourself a story, you may tell your team a story, you may tell your investors and everyone who will listen the narrative of why it's not, and you may be missing the true fundamentals of why you should or shouldn't buy those assets.
I mean, trophy assets do have attributes. They usually are newer. They usually are in great locations. They usually have, uh, inherent demand. And usually the sellers try to get paid for that. At the end of the day, we are still trying to have a distortion between where the market currently is and the upside that we can create there.
There has to be a delta. If you pitch one that's not, you're going to get into trouble. We have to always remember b- that we're being advertised to. Every OM that we get on a property has a perfect deck, has great tables, is well thought out. But it is a sales pitch, and it's crucial that we apply the experience we've had over the last 17 years and almost 50 assets in our pitch.
And, you know, we deal with this all the time, but sellers and brokers and the people involved are all lovely people. They all are. You wanna treat them like they're your friends or like you're at a country club or something, but they're not. Their job is to achieve the highest price possible, and we have to ruthlessly focus on the buy side, on achieving the lowest price possible, and that's usually, for a fact, it's always a grind.
It's always a polite hand of poker, and it, it's always played out during the escrow
Ryan Swehla: You know, one of the other ways that we have the fortune of navigating around that is that we work in geographies that are generally less sexy or less desirable. In many senses, we're contrarian in that regard because we see opportunity where others don't.
And so I would say that, you know, even as it gets to that idea of the trophy asset and, you know, this is a intrinsic asset that, you know, we should own because it's, you know, it's great, it'll always perform well, we do have, like, this natural intuition, uh, that says, "Okay But, you know, if everybody else feels like this is the best thing that we should be buying, you know, what's wrong with that?
Joe Muratore: Of course, buying in, uh, other cities and other states, we have the ability to bring, um, a macro understanding because we have assets in a lot of places to see things that local buyers and sellers can't see because they're so entrenched in their markets. And done right, that's a tremendous advantage. Done wrong, you can get hometowned.
You, you can buy the wrong thing that the local person sees as a problem a- and that you don't. But it's our opportunity to see what's happening in the adjacent markets and ac- in the state, in the macro environment, and see something in a, in an individual city that the locals might not see.
Ryan Swehla: Let's talk about one of the other areas of failure science wh- that we can get caught up in, and this is the idea of the amount of time we've invested in something.
Joe Muratore: I'm living through that in an asset right now. It's a, it's a big challenge because a lot of the deals we do we've been working on for 18 months. I mean, it, it takes a y- they come to the market, it's a really high price. You offer or you wait, it doesn't achieve the price. You come in at a lower price. The seller doesn't wanna have it, but then a few months go by, now they're willing to talk.
You finally get to a price, you go into escrow, you find problems, you re-trade, they get cold feet. They come back to the table. You're potentially able to move forward, and it... By the time you're, you're six, nine, 12, 18 months down the road, all parties have a lot invested. And number one, that's a tool for us to use, two, because the seller's like, "I'm done with this thing.
Just buy it." So we have to have the... We have to be agnostic sometimes to outcomes and be working on enough deals that there's never a deal we need. We're always just playing the hand we need to play to serve our customers, to serve our investors.
Ryan Swehla: Yeah, I agree. I think one of the pieces of safety that, um, helps prevent this idea of I've spent so much, we've spent so much internal energy and resource that, you know, we just gotta get it over the line, is this idea of having multiple options.
Mm-hmm. And one of the things that we stress is that with every deal, every opportunity, every situation, we try to have multiple options because it brings a calm that helps reduce the frenzy of the idea that, "Oh my gosh, we've spent so much time and effort into this deal. We, we need to make it work."
Joe Muratore: It's really a case of short-term and long-term thinking.
Short-term says, "We're so invested, just buy it." Well, that works great-
Ryan Swehla: Until it doesn't.
Joe Muratore: On the day of close, it's, it's fine. It makes sense. And then the next three to seven years, you battle with this asset 'cause you paid too much for it, and it's a constant pain. So it's really important to invest for the long term, to see the long-term upside and opportunity and downside, and not say, "Well, we're so in it right now."
So th- those are always the trade-offs, but this is a big Reason that properties fail and companies fail, they make short-term decisions. Here's a big one I'll pitch to you, but capital pressure late in the cycle.
Ryan Swehla: We've alluded to this a little bit earlier with the, uh, the market timing, but there is this push during the market cycles, or I should say it's a tailwind during certain parts of the market cycles.
It's a headwind during other parts, and of course, it's a tailwind when you don't need it many times, and it's a headwind when you could use it as a tailwind. So what do I mean by that? When the market, during the, the upcycle, it's kind of like this early phase of capital kind of re-entering the market and feeling comfortable and there being transactions to validate values, and then there's this slow upward momentum, and then you get late in the market cycle, and you get FOMO, and capital wants to push every dollar out possible.
Uh, we actually saw this in some of the research that we've done around primary and secondary markets. In primary markets, which have a higher prevalence of institutional capital, in primary markets, you actually have greater volatility. You have bigger peaks and troughs, and the reason for that is because there's more availability of capital.
And more availability of capital always, uh, exacerbates the problems. It makes the highs higher, and it makes the lows, uh, lower.
Joe Muratore: I guess people, investors don't tolerate risk well in that when... Like right now we're, we're seemingly at the bottom of a market cycle. We're doing well in capital raising, but it, it, th- this is the time when it's hardest to raise capital.
Ryan Swehla: Absolutely.
Joe Muratore: And in 2028 or '29 when the market has experienced some level of recovery and, or, or it's getting hot again, or it's very hot, there will be capital pressure on us to buy, and it'll be important for us to say, "Whoa, moderate. Now's a good time to buy, these next couple of years, and it, it's-" Yeah
gonna get more challenging from there. I'll talk n- next about a really common one, which is narrative reinforcement loops. Like, we all have a story. We have a story for what our life's about, what our company's about, what our investing strategy's about. This reminds us of, of our old podcast, the map not being the terrain.
The point is, the story works. Everyone believes it. We keep saying it. And what if it's not the right story? What if our own personal biases, our company history, our personal history, our, what we've said to our investors is biasing our decisions and distorting, uh, reality from what we should actually be doing?
So these, uh, narrative we tell ourselves are not always true. The loop is the compounding. We say it, we hear it. We retell it, it distorts a little bit, we say it again. After a while, it's like a game of telephone where the thing being said can be quite different than what's really happening, and what's really happening doesn't really care about your game of telephone.
It's really happening
Ryan Swehla: I, I can give a real-time example of this, uh, which is in our multi-tenant industrial. We have, uh, seen over the last many years this incredibly tight vacancy in multi-tenant industrial. Mm. Even as big box industrial more recently has started to see pretty significant vacancies, even up into the double digits in cer- certain markets, multi-tenant industrial has managed to stay tight, and there are a lot of reasons for that: supply, uh, lack of new construction, you know, rents not justifying new construction, blah, blah, blah.
And the reason I say blah, blah, blah is because that is also the narrative we tell ourselves. It's a truth until it's not a truth, and what we've seen more recently is we have seen some softening in demand for industrial, uh, tenants. Mm-hmm. Uh, that comes from things like rents having grown so much that the underlying businesses just can't support that much rent.
Mm-hmm. It comes from things like the economic environment becoming more volatile or less certain. And if we keep telling ourselves that, "Oh, yeah, multi-tenant industrial, always tight, uh, demand, always, uh, you know, low vacancy," we, we narrate ourselves into failure.
Joe Muratore: I'm thinking through the five patterns we just spoke about, and there's one thing that r- rings through, true through all of them.
People optimize for internal consistency over external truth. What does that mean? It means we're humans. We want smoothness. We want things to follow a plan. We wanna come to work, do a great job. We're not built for reality, which is violent and brutal and changing. Uh, we- we're optimizing, not us, but, like, all companies tend to optimize for harmony instead of reality.
I'm reading this book about John Boyd, he was a fighter pilot, and he came up with this system called OODA. When you're up in the skies, and, you know, he was in the Korean War, but it's, uh, observe, orient, uh, decide, and act. And he would say the faster you can make that turn, the faster you can go through that cycle, the safer you are.
And, and the point being is if we're not always observing, reorienting, deciding, and acting, then we're in trouble. And he says that orienting is the most important piece. Reality is shifting, and the question is not necessarily are we making good decisions, it's how fast are we reorienting to reality?
Because the faster we're orienting to the current terrain, the less likely for drift. So our systems, our people, our investments all need to be oriented towards current reality over consistency or harmony or smoothness.
Ryan Swehla: Yeah, and the last thing that I'd add, since we were talking about failure, just to put a bow on it, is- Failure is success.
Failure is success when it is used to be better at what we do. Mm-hmm. So on the one hand, our goal is not to avoid failure. Our goal is to mitigate that downside as much as we can through being conservative and prudent, but at the same time, using each of those moments of failure to make us better investors over time.
So there is no success without failure along the way. So how do we Uh, get better at not having large failures along the way.
Joe Muratore: Well, there's a, a few proven techniques. Um, this last year we've been, uh, doing this idea of a, a red team or a pre-mortem, which is to start by, you know, instead of going to the end of a deal and saying, "Let's do a post-mortem.
What went right? What went wrong?" Start in the beginning and say with a pre-mortem, "What's about to go wrong?" You know, start... This is back to failure science of don't start with the target, start with everything that's not the target, 'cause there's just giant, uh, sand traps around the green, and just call those out right, right at, right in the beginning.
It's important to compare always to outside benchmarks is the second one. So every year we re-budget. We examine our budget, we compare it to our original forecast, and we look for what do we think is gonna happen this year. A great one also is to l- figure out where you went wrong, so trace failures back to information.
The more you practice getting from what happened back to where you went wrong, the better you are at seeing those things about to go wrong in the future. I mean, this is why failure science is so important because there's some, like, pretty obvious traps that people fall into. Like, we spend a lot of time talking about success, but there's some pretty easy like, "Oop, fell off the, fell off the ladder that way."
And, um, so tracing back failure to the first pieces of information, the first pieces of distortion is a habit that'll make you stronger in the future.
Ryan Swehla: You know, and another is really having a culture of openness because we have a team of experts in their field and, uh, those experts, their job is to mitigate risk and, uh, execute on the business plan.
And the more we have a, a culture and an environment of openness and allowing that feedback loop to spot those problems as they come in real time, uh, it keeps us from having the, the blinders of, "This is where we're going and this is what we're doing."
Joe Muratore: Another one, a tough one, is, uh, rebuild the system periodically.
There's no business plan that's gonna take you through the next 30 years. Every business plan needs to be tweaked and I, I'd say the story of the last... I mean, if you go back to 2011 through 2022, the market went up and to the right reliably for, you know, a decade. A decade. A little bit longer. The, the name of the game was, uh, was IRR.
The name of the game was buying, doing part of the business plan, selling the story to the next group a- and exiting. As we're in the middle of this decade, the story is NOI. The story is cashflow. The future is, uh, less certain. Interest rates decently might go up and they might go down a little. You have to build the system for stability and a longer term hold.
You have to have that optionality because you can't count on any single, uh, outcome the way that it played out over the last decade
In this episode of Durable Value, we talk about the science of failure—why even great companies and properties can drift off course, and how to recognize and prevent the subtle missteps that lead to bigger problems. We discuss the difference between luck and skill in investing, the dangers of narrative reinforcement, and practical strategies for building resilience in your business. Whether you're a real estate investor, entrepreneur, or leader, you'll find actionable insights to help you avoid common pitfalls and turn failures into stepping stones for long-term success.
Timestamps:
00:00 - Introduction: The Science of Failure
01:26 - Luck vs. Skill in Investing
02:20 - Information Machines & Signal vs. Reality
02:57 - Luck as Skill: The Genius-Idiot Cycle
03:15 - Real Estate Market Cycles as Levelers
03:38 - Execution Engine: Buying the Right Assets
06:20 - Navigating Seller and Broker Dynamics
07:03 - Macro Understanding from Multi-Market Experience
09:05 - Short-Term vs. Long-Term Thinking
10:33 - Capital Pressure and Market Cycles
11:25 - Institutional Capital and Volatility
12:07 - Raising Capital in Down Markets
13:31 - John Boyd’s OODA Loop: Orienting to Reality
13:50 - Failure as a Path to Success
14:32 - Red Teaming & Pre-Mortems
15:12 - Building a Culture of Openness
15:39 - Rebuilding Systems for the Long Term
16:02 - From IRR to NOI: Adapting to a New Decade
16:22 - Building for Stability and Optionality
19:58 - Closing