Navigating Investments: Why The Map Isn't The Territory: Durable Value Ep 78
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Joe Muratore: Ryan, let's talk today about a really interesting idea in both life and certainly in investing. It's, it's the, a concept from a Polish philosopher about 50 years ago, but the, the concept is the map is not the terrain. This is really prescient for, uh, investors, but also people. We all build mental models.
We all have a map of what we think an investment should go like, or life should go like, and we think that that's reality, but there's a whole lot of distortions that happen in our models For example, let's start with a really easy one. I see people on Instagram scrolling through Instagram, and every thing they're seeing is like, ah, this group's in Hawaii, or look at the kids, or whatever.
But the point is-
Ryan Swehla: Why, why are we not there?
Joe Muratore: Yeah. It's like it's sort of psychological for, for humans to think that like, "Oh, that's the map. I, I should be in Hawaii." But, uh, there's, there's, there's a lot of challenges that come into that.
Ryan Swehla: Yeah, I know we've talked about this a little bit, but this idea of, uh, it's like an archer who's shooting for a target.
The target is, you know, half a football field away, and it's this little target. We get focused on how do I hit the target? How do I get there? The target is actually the smallest point.
Joe Muratore: Yeah.
Ryan Swehla: Everything but the target is the largest point. And so no matter how much mapping we do or modeling that we do to get that arrow to hit its target, there are all these external factors around that we may or may not be appropriately factoring in.
Joe Muratore: But we are in the invest- investing business, and that means we're in the map-making business.
Ryan Swehla: Mm-hmm.
Joe Muratore: Because before we invest in something, we make a map about it. We map... What are all the things we map out? We map out rents, rent growth, exit cap rates, uh, entry cap rates, pro forma year one through year five, uh, tenant profiles.
Ryan Swehla: Cap ex spending. Yep.
Joe Muratore: Cap ex spending, uh, debt, a bank environment. I mean, a key idea here is that we're turning a movie into a snapshot. Like a, like a spreadsheet lives in time, an ARGUS model lives in time, but investing is a three to seven-year picture.
Ryan Swehla: Yeah.
Joe Muratore: Uh, and it's a movie. Factors are going to come into it that you don't see at the moment you're making the spreadsheet.
One way to say is, "Well, just be conservative." Absolutely. Another way to say is, let's break out what we have here is five key factors that create problems in building models, and our, our hope is that the people listening, as they make their models or examine our models, will, uh, look for distortions that are common.
Ryan Swehla: Well, yeah, and let's talk about one of them is definitely kind of psychological or mindset factors. Investing involves humans, and unlike a mathematical equation, uh, there is all sorts of psychology that gets into how we invest and how we view the world. One common problem is that we have a series of successes in a row, and we think therefore the map or the model that we have is absolutely the perfect model, and we just need to keep replicating that model over and over again.
And then the world changes, and what looked like an absolute rock solid business plan all the way along changes.
Joe Muratore: Key thought here is that people don't behave like spreadsheets. They just don't, and so much of the psychology of this is people. And not just you and me, but the 62 people that work here And the team that executes the business plan.
If your team isn't aligned around this model, if, if this map isn't understood, it's easy to sort of buy into a map. It's another thing to, like, really examine can we execute at this level? What are the things we can execute on? CapEx spending. Mainly that, it's spending and business plan. But what you can't control is leasing environment, market rental growth rates.
You can project this, and we certainly do, and we subscribe to outside sources that provide us that data, but these things are happening in real time. They're, they're predictions until they're not. What's a way to solve this one? Well, certainly what we do, which is, uh, bake execution slack into your model.
Bake conservatism into your model or call it out. Actually, at our company, we like to bright line the conservatism, not bake it in where it's hidden three layers deep, but call it out. But also recognize that That construction project you think is going to happen in 90 days, well, it might take six months.
It might take four months, but perfect execution is, uh, is rare and hard to come by, and should be budgeted for. And those that don't budget for it still have the same problems, it's just not in their model.
Ryan Swehla: Another way that we filter out our psychological biases is through the investment committee process.
Because the investment committee process, when done well, forces us to factor in the various perspectives that are coming to the table, and it makes it a lot harder to be ingrained in one's decision-making process and think, "Well, it's always worked for me this, this way, so of course it's gonna work for me go- going forward."
Joe Muratore: Absolutely. We, we all bring 15 to 30 years of experience to this, which helps. And it certainly exposes where, uh, we might be being too bullish or we might be making, uh, next year's decisions based on last year's information. That, that takes us to the next one, which is market cycle misidentification. It's easy just to think that last year's data is going to drive next year's decision, and that's where things go wrong.
One thing to keep in mind here is that market cycle shifts happen quietly. At a peak, there's a buying frenzy, frenzy and a belief that it can't go worse or better, and at the, at the trough it's just utter despair. And there's, uh, different cycles in the middle. There's also cycles by city and region, and there's also cycles by asset type.
It's one thing to work to understand it, it's another thing to have it be actually right is, uh, is a big challenge.
Ryan Swehla: Yeah, I think one of the ways that we help mitigate against that is this idea that sensitivity analysis, looking at we think the market environment is this, we think rents are going to do this, we think we're at this point in the market cycle, but what if?
And the sensitivity analysis looks at, okay, while these are our underlying assumptions, if it goes here, what does it look like?
Joe Muratore: Yeah.
Ryan Swehla: How do we build conservatism into that modeling?
Joe Muratore: You can model a downside cycle in your initial model. It's really tempting, especially in a competitive environment, to model an upside part of the cycle, to model growth.
I mean-
Ryan Swehla: Yeah ...
Joe Muratore: especially if you're in a acquisition funnel, a broker's funnel, and you're competing for an asset. What it is? There's a call for an offers, then best for f- best and final.
Ryan Swehla: Yep.
Joe Muratore: I mean, you're really having to say like, "Okay, what if rent grows 4% not 3%?" And, uh, by the time you're, you're asking that, you're in trouble.
Ryan Swehla: Well, you're touching on one of the other ways that we try and mitigate for that market cycle misidentification, and that is working not to be in a broker's funnel. But working our own funnel. Yeah. Because it gives a little bit of a breathing room f- and latitude for that frenzy that's associated with the, really the peak market because we're working our process across multiple investments instead of the broker working his funnel into who's gonna be the highest and, and best bidder.
Joe Muratore: I love asking the question too, what's already changed that we're not accounting for? You know, like recessions, like you don't know a recession till afterwards when you see the data coming out. Like, it's hard to call those changes, but always asking, like, what has already changed that I'm, that we aren't recognizing yet?
What shift is happening right now or happened a month ago, for good or bad, that, uh, hasn't been ackn- acknowledged yet? That's a important question to ask.
Ryan Swehla: Well, and we touched a little bit, uh, on psychology and the fact that investing involves humans. And, uh, one of the other ways that we try to mitigate for misidentifying where we are in the market cycle is being as aware, a- as possible of the general psychology of the market.
You know, Howard Mark speaks to this pretty extensively. Buffett as well. You know, when, when people are frenzied, when it feels like you can't make a bad decision, you know, everything is good, that's the time that we try to add a little bit of conservatism into our, our modeling as best we can. And of course, the market cycle is working actively against that.
And then the flip side is when it feels like doom and gloom and despair, that's when we try to add a little bit more resolve and conviction to our process- Mm-hmm ... to help mitigate for the, the
Joe Muratore: broader, you know, market sentiment. I think a big part of what you're saying, and a big part of the map is not the terrain, is that our ideas and investors' ideas are- different from reality.
Reality doesn't care about your ideas. Reality doesn't know about your spreadsheet or your map or why you have it all figured out. And there are second order and third order forces that are coming into play and creating pieces of chaos in the future that are, that are hard to call. And a big part of the map not being the, the terrain is number one, building a good map, but number two, realizing that there better be a lot of conservatism in your map, but also that maps aren't perfect and that you're gonna have to adjust the map.
Because if you have the most conservative map in the world, guess what? You'll never buy a deal. But if your map is gospel, guess what? Reality doesn't care about your map. So somewhere between those two, uh, a- a- a- and you know, the first thing to do is, is be aware. Self-awareness and investing awareness are, are step one.
Ryan Swehla: Yeah.
Joe Muratore: And if you're in a posture of ego, you're usually in trouble, and if you're in a posture of open-mindedness, uh, and resolve at the same time, holding both, uh, you're usually in a position of strength.
Ryan Swehla: That kind of speaks to our third point about the map not being the terrain, and that's this idea of execution friction.
The, the map is what we set out to do at the beginning of an investment. It is the roadmap, but it is not the Bible, and the reason is because at the end of the day, there will be external factors that come into play as that e- that investment is being executed, and our ability to be nimble and respond to that is a critical part of the investing process.
There's a little bit of peace of mind in, in recognizing that we have boots-on-the-ground people at our properties in our markets, because it gives us that real-time feedback loop to be able to say, "Yeah, the model said that market rents are this and that we should be achieving this." But it goes both ways, by the way.
The boots on the ground experience says, "No, we're- this is where the, the market seems to be softening and this is really where we can get..." Or, "Oh my gosh, we, we've hit our, our projected rents, but it seems like there's more room there, and let's keep pushing to see where that goes," and allow that feedback loop to effectively modify the business plan or modify the map as, as we go in real time.
Joe Muratore: Well, and to help this along, number one, we, we buy, like, 95% of our properties off-market, uh, in a non-bidded environment. We generally allow 50 to 75 bips of cap rate, uh, slack between what we think is actually going to happen. Usually, our rents are 5 to 7% below what we think is actually going to happen, so in a- in several places, we build in, uh, these pieces.
But I think the thing to understand here is that, you know, most losses are, are death by a thousand cuts. And, uh, and, and death is the wrong word to use, but the point is friction. There's lots of little pieces of, of friction, and they amount to a, a bigger thing. Your handoffs, when it went from acquisitions to asset management, how clean was that handoff?
From asset management communicating to property management, is there a clear quarterback? Did someone pick up this football and say, "I own this football. If this goes wrong, it's on me"? These are challenges that companies deal with. But also tracking execution weekly, like, looking for the friction when it starts, because problems don't age well And they fester.
Those little, that little ch, ch, ch, ch, ch. Yeah. It, it just adds up, adds up, adds up.
Ryan Swehla: Well, in creating a culture and an environment that is high in communication-
Joe Muratore: Mm-hmm ...
Ryan Swehla: where, uh, people, regardless of where they are within the organization, they feel comfortable speaking up and saying, "Hey, this isn't working out the way that we anticipated.
Here's what I think we should do." Mm. And creating that environment that allows for the, the feedback loop and allows for bring, making those game time decisions along the way.
Joe Muratore: One, one other thing I'd add to this is working with, uh, outside vendors. We have a lot of third-party vendors that are involved in construction and other parts of the business, not in the management side, but you're relying on outside parties too, and that's, um...
It's important that you have a very reliable set of vendors and that you work with them seamlessly. So to work on five to seven projects at a time in this organization, in the value add stage, it requires a, a, a real symphony of vendors, and property management, and asset management. And also on the acquisition side, loading the fi- loading the, loading the gun, I guess, in the right, at the right time so you're not overloading any of the parties.
So, uh, those are little pieces of friction.
Ryan Swehla: Or, uh, loading the arrow-
Joe Muratore: Loading the
Ryan Swehla: arrow ...
Joe Muratore: into the bow. Yeah. Another common distortion is misreading, uh, market depth or tenant demand. This is an area that we are experts in because we work in secondary and tertiary markets. These are markets that, uh, tenant demand can be less than primary markets.
Market depth can be less than primary markets, and we offset that with less competition, so we're able to buy at better prices. We aren't competing as much, but we have to be sharpshooters with understanding tenant depth and demand.
Ryan Swehla: Another way that maps can go wrong is when we misread the market or tenant demand.
That's a real problem i- regardless of where you invest. I think one of the ways that we mitigate against that is that w- since we don't participate in bidded environments, we're able to buy with a little bit more latitude. If, you know, we th- we think tenant demand is X and it ends up being Y, whether that's because we didn't have our underlying assumptions right or because the market changed in the meantime, we've got more latitude because we're participating in a more inefficient market with, with less buyers.
In a bidded environment in Dallas, Texas, for instance, as an example, you have to get every single assumption just right because you're competing to that last highest price, which means that that is the bidder that had the, the most aggressive or tightest assumptions, and it just doesn't leave as much margin of safety.
Joe Muratore: I mean, a nuance to that is that in a spreadsheet- We use averages. We look at Yardi Matrix and CoStar and our, uh, our, our actual experience, and we say, "Well, this is what rent should be." And it makes perfectly logical sense to us. And one thing we might miss is that tenants aren't reading any of that. They have sort of emotional, on the, especially on the apartment side, uh, emotional ceilings about what they're willing to pay.
Not willing to cross 1,700, not willing to, like, that much for that neighborhood. Just because it makes sense in our spreadsheet, it might be lumpy in execution. Yeah. Because they're going through, as we talk about, stages of grief on, like, "Well, why would I pay 1,725? I h- I used to pay 1,534." Point is, this is a piece of bias that can, uh, creep into models.
Ryan Swehla: Yeah, and I think that's where building in additional conservatism on the underwriting, uh, helps mitigate that. But even on the multi-tenant industrial side, it's not as emotional, but tenants, you know, w- we think this building's going to command this rent, and Tenants say, "Well, but it's across the freeway from where I wanna be, and so I, I'm only willing to pay this, not that."
Joe Muratore: Mm-hmm.
Ryan Swehla: Uh, so it is definitely a fluid environment that just requires the ability to react to the environment at the, along the way.
Joe Muratore: So in building your map, which isn't the terrain, you can sort of bridge this gap by spending a lot more time on the ground, walking the actual streets, standing at the actual comps, talking to the leasing agents.
Mm-hmm. Uh, personally, I, for every apartment complex we buy, I go there and pose as a renter. And I don't know how convincing I am always, but sometimes I walk into these places and they look at me like, "I don't know." I say, "Got any one bedrooms?" And, uh, you know, I go through the whole process. And I was one there at one recently, and it's interesting.
Like, I walked in, I thought, "I don't know if this is gonna be convincing." It was a, it was definitely a workforce housing kind of, uh, on the upper scale. But I went in there, and you know, I, I, "Got any one bedrooms?" And before you know it, the leasing agent was, like, showing me photos and explaining all sorts of things.
I left there understanding, you know, the true vacancy, uh, how long it took to lease things, the culture and feeling of the, the complex. This is, this is certainly true when you walk multi-tenant industrial and you talk to people on the ground there, too. It's surprising how much people will share, how open they are, and it's shocking how different...
I, I would say you learn an additional third about the property and the market by being on the ground and actually- Yeah ... walking and talking to people over what the data shows.
Ryan Swehla: Another mitigant that we have for, uh, misreading market depth or tenant demand is involving our property management team at the beginning of the underwriting process.
Joe Muratore: Mm-hmm.
Ryan Swehla: Because, uh, the property management team is not shy about speaking up if we're making assumptions that they don't feel comfortable executing on. And when you're relying on a third-party property manager, there's a little bit of a disconnect there of, okay, well, this is where we need the model to go.
This is where we believe the model to go. Then I hand it off to a third-party manager and hope that they are able to execute on the, the map or the mission that we've outlined.
Joe Muratore: The more ways we can touch the property, the more ways our team can be there, the better our, our data will be and the better they'll call out our assumptions.
Oh, let's talk about the next one. Future market assumptions. Especially rent growth and exit cap. Oh, man, it's amazing how much a little bit of rent at a certain cap rate can swing IRR. Yeah. Such a dangerous place to be. I, I think this is probably where most maps go wrong. Yep. Rent projections and exit cap rates, so.
Ryan Swehla: You know, these really are the two variables that are the most subject to distortion. What future rent is is a projection in the future. What cap rate we will exit at is a projection in the future. And so both of these become the areas that are most subject to distortion when I'm in a bidded environment and I need to get to this IRR, and if I just change one of these two variables that I have no control over, I can achieve the IRR that I think I can on a map.
Joe Muratore: Back to bidded environments. Uh, sellers are not our friends.
Ryan Swehla: Yeah.
Joe Muratore: Brokers are not our friends. They're all great people, but, uh, you just must buy things right 'cause so many things can go wrong when you don't. So there's always pressure to make that cap rate a little bit tighter. There's always pressure to make those rents a little bit higher.
I'd like to say, well, just make 'em all really conservative. But you have to actually say, we have the discipline to say, what is, what do we believe the actual market's going to be? What do we think that this really is? And also to ask plainly, where are we pushing rents too aggressively? Where-
Ryan Swehla: Yeah ...
Joe Muratore: how is that cap rate got a buffer in it from what we think reality will actually be?
And also, what would happen if there was no rent growth? Does this model just blow up? Is it crater? Yep. What, you know, what if cap rates were this? Does it crater? So looking at your downside scenarios is, uh, is really helpful.
Ryan Swehla: Yeah, there are a couple other ways that we mitigate against this. Uh, but again, to underscore what, what you were saying, these two variables, exit cap rate and future rent growth, are the two that are most subject to distortion.
But a couple other ways that we mitigate a- against that is, uh, we like to look a lot at untrended yield on cost. And what that says is, if I just cure the current rents to the current market rents, if I just do that- And I'm not factoring in any, any future rent growth. What sort of a unlevered cap rate am I sitting at?
What sort of a cap rate am I sitting at? And it, that brings a peace of mind because it kind of, like you said, what if rent growth is zero? It gives us that measurement that says, "Okay, if I just solve the current in place problem, and I don't make any assumptions about where rent is going, I'm still sitting at a reasonable, you know, cap rate and a reasonable r- uh, yield."
The second way that I was gonna mention is we look at, um, unlevered returns, because leverage has a way of distorting the magnification of returns. So just like moving the cap rate a little bit, moving rent growth a little bit changes the, the returns pretty dramatically. If you take off leverage, it doesn't allow that amplification.
So again, it's a way to, to kind of calm the distortions and look at, "Okay, what if we had no debt on this property and we were just looking at an unlevered investment? Is, is it still an investment that has the merits, uh, that we're looking for?"
Joe Muratore: Let's close this out, Ryan. The main goal here is to say that be suspect of maps.
The best investors take maps with a grain of salt. It's crucial that we have, you know, well-made maps. It's also crucial that we understand that maps are a snapshot, and that reality is a video, and that we make the best snapshots we can make. Then we run the best, uh, video we can, and at times, we adjust.
Reality will play out. So-
Ryan Swehla: Yeah, be nimble
Joe Muratore: Be nimble is right. This means be in the reality business, not just the map-making business. That means be at the properties, be in the markets, be talking to the tenants, be blending, uh, reality with the maps you make. And make conservative maps, make reasonable maps, and then test those maps.
Look for friction leaks, and, uh, build the right flywheel. That's what we're here to do
In this episode, Ryan and Joe talk about an intriguing philosophical concept relevant to both life and investing: 'The Map is Not the Terrain.' The discussion touches upon creating mental models, the importance of conservatism in investing, psychological biases, misidentification of market cycles, execution friction, and much more.
00:00 Introduction to the Concept
00:30 Mental Models and Instagram Illusions
01:28 Mapping in Investments
02:49 Psychological and Mindset Factors
09:49 Execution Friction
13:25 Market Depth and Tenant Demand
18:12 Future Market Assumptions
21:29 Concluding Thoughts on Maps and Reality