Why Perspective Starts With Principle, With James Holleman

Impact investing has gone mainstream in 2022, but Grubb Properties was “doing well by doing good” before the concept came into fashion, as far back as the 1960s.

James Holleman, VP of capital formation at Grubb Properties, joins the show to discuss Grubb’s incredible backstory, plus the firm’s focus on “essential housing,” and why it represents an appealing opportunity for HNW investors.

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Episode Highlights

  • Insights into Grubb’s back story, and the approach the firm took to create housing for those who had been “redlined” from homeownership in the 1960s.
  • James’ perspective on the nationwide housing shortage, and why middle class housing has gotten squeezed the most.
  • The appeal of the unique “essential housing” market segment that Grubb focuses on, and how this segment differs from Class A or luxury housing.
  • How vertical integration and efficiency can work together to enhance investor returns for LPs in a diversified multifamily fund.
  • Some unique tax strategies that Grubb employs to enhance investment ROI (even aside from the Opportunity Zone tax incentive).
  • Details on the advantages of structuring an OZ fund as a private REIT.

About The Alternative Investment Podcast

The Alternative Investment Podcast covers new trends in the alternate investment landscape. Hosts Jimmy Atkinson and Andy Hagans discuss tax-advantaged investment strategies to help you grow your wealth.

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Show Transcript

Andy: Welcome to “The Alternative Investment Podcast.” I’m your host, Andy Hagans. And today, we’re gonna be talking about Grubb Properties and essential housing, and their incredible backstory that I think is super interesting if you haven’t heard it before. And joining me today, I have James Holleman, who’s the VP of capital formation at Grubb. James, welcome to the show.

James: My pleasure, Andy. Thanks so much for having me.

Andy: Yeah, and, you know, I just wanna dive right in. I got some notes off the Grubb website. I love the tagline on your all homepage. I’m sure it’s all through your brochures, “Perspective starts with principle.” And I just…I think it’s an incredible backstory, and, you know, as a comic book guy, it’s almost like Peter Parker and Spiderman, right? Like, every good comic book has a great backstory. But I just wanna read this and then ask you about it.

So, “Beginning in 1963, Grubb Properties built our company on principle and took a different approach to real estate by creating housing for those who had been ‘redlined’ from homeownership through banks practicing a form of loan discrimination. Today, we continue to deliver essential housing for the underserved with highly strategic investing, development, leasing and property management through our Link Apartments brand. In fact, Grubb Properties may be one of the only companies in the country to focus solely on this critical market sector, offering excellent quality of life for our tenants, improvements to our communities and outstanding returns for our investors.”

And I like that last part about outstanding returns as well. But, I just, again, I think this story is really inspiring, and it’s obviously a part of your company’s history. Could you flesh this out a little bit and tell us more about the early history of Grubb Properties, and how this became, you know, your niche?

James: Absolutely. So, our current CEO, Clay Grubb, took over in 2002, from his father, Bob, who started this company in 1963, as you stated. And when Bob started it out, he was more of a single-family residential home developer here in Lexington, North Carolina. And, you know, saw a need in the market. You know, he was concerned, and, you know, didn’t really agree with the practice of redlining and what banks were doing within that timeframe to shut certain demographics out of the system, and really, you know, discourage them from homeownership and that first step up in upward mobility and their chance to build wealth.

I think that, you know, Clay’s dad, you know, saw a need for that then, and essentially started a not-for-profit finance arm to his real estate development company, that would go out and get loans from commercial banks. And then, at no cost, no markup, provide those loans to individuals within these communities, who would then, in turn, develop a home with him. And it fed his development business, but really, it helped frame that do good while doing well model before anyone ever mentioned that term, or that phrase ever become catchy.

You know, impact, and providing impact into communities that we operate, right, you can do good with these investments and still provide impact, right? And I think that that frame of mind has always been present within Grubb Properties. We’ve had different strategies throughout the years, based off whatever opportunity we saw in the current market environment. But our principles and what we fell back to always centered around building communities and helping those in those communities. And today, our current strategy in the development of our internal brand of multifamily housing, called Link Apartments, we’ve framed this as essential housing, as you’ve stated. And this is really a new type of property type that we’re trying to coin within the multifamily marketplace.

And so, you know, it’s not workforce housing. It’s not, you know, Class A luxury housing. It’s not affordable housing. It’s right there in the middle. And it’s catered towards that moderate-income earner, you know, that young working professional, that wants to position themself in that live-work-play environment, near a transit-oriented location, next to where they like to have fun, go to school, go to work, but at a moderate price point. And you find that really rare in today’s market. You know, most Class A multifamily that you’ve seen developed over the past two decades is catering towards those that represent the top area median income class, right? A 140% area median income or above.

Affordable housing essentially is 60% area median income or below. Where’s the middle, where the majority of us fall, right? It’s the moderate income earner, and the inventory that’s been added hasn’t really catered to those individuals from, you know, just a sheer economic perspective. They can’t afford the new inventory that’s being put in these marketplaces. They can’t afford a new home, in most cases. I mean, the average home price today, nationally, rests right above $400,000. That comes at a time to where 80% of millennials make less than $50,000 a year. Don’t qualify for these high-end apartments. They don’t qualify to buy a home, but they also don’t qualify for affordable housing. So, where’s the give?

Andy: Well, and that has…what you just mentioned there, you know, in the stat on millennials, I think people underestimate how much of an effect that even has on our society, like, on family formation and other metrics probably outside the scope of our conversation. But you kind of alluded to this nationwide housing shortage, and I always quote the 5 million housing unit, you know, statistic, and I’ve heard some other numbers. So, maybe it’s 5 million, maybe it’s 6 million, and maybe it’s more than that, to be honest with you. But could we talk a little bit about that housing unit shortage? I mean, are there factors that people overlook? You know, like, what’s causing that? I guess, most simply stated, what’s causing that?

James: Sure. You know, several factors are causing it, you know, especially depending on the market. Right, there are different factors in different markets. But, you know, from a macro perspective, you know, the main problem here is that we’re still not adding enough new supply to keep up with existing demand, right. And so, peak births, the peak birth rate in the United States occurred in 2007, right. And so, those individuals born in that year will start flooding the workplace in the early 2030s, give or take. And you’re going to see an ever-increasing need of new supply up until that point, right. That’s just with general demographic growth. You’re not considering immigration trends. You’re not considering, you know, trends from people going from tier one markets into tier two markets in some cases.

You know, I think that, you know, it’s really gonna be a stressful housing environment for the next decade, right. And in certain conditions, you can’t build enough inventory in some of these markets, if you’re targeting the right price point, right? And so, yeah, I think, you know, in some markets, you know, where you continue to see double Class A apartments that are trying to win the amenity war, and really, you know, attract people through that type of, you know, market, I think it’s overplayed, you know. We don’t need more of that, in my opinion, right now.

What we need are units that have amenities, base need amenities, gyms, pools, you know, those types of things, but don’t overstretch it, that are well-positioned in transit-oriented environments, so people can let go of a car if they choose or need to, right, and, you know, allow that moderate income earner a chance to live in these areas that they work in, right. Because we find that a lot of people are commuting extreme amounts, you know, to get to their workplace. And look, that’s no way to live.

Andy: Yeah. You know, it’s like the cop or the firefighter who lives in Chicago or New York City. What are they gonna do? You shouldn’t have to commute an hour to work, you know, in those sorts of middle-class jobs. You know, based on what you’re talking about, that 60% to 140% of area median income target, I would think every mayor in the United States of America would be calling Grubb and saying, “What kind of incentives can we give you to come build here?” Because I think you’re right, it’s like a sandwich. It’s, you have developers chasing that luxury segment, where, you know, potentially, there’s a higher profit margin, at least if the timing is good, depending on the timing.

And then you also have, you know, low-cost housing. A lot of times, there’s government subsidies and things for that. But the biggest area of demand is in the middle. You know, do you find that local governments, you know, are they more of a help or a hindrance? I mean, do you get the call from the mayor, saying, “How can we get Grubb to build in our city?”

James: You know, I think that, you know, our executive team, and Clay and the guys have great relationships in the markets that we operate in. And the communities that we engage with are very supportive of our projects and the inventory that we’re looking to add to these markets. But they’re cautious, right. And they should be. You know, and certain municipalities have different views about how to address the housing affordability crisis that we find ourselves in, of course. But, you know, I think that once someone understands our product and our price point, and what we can add to their municipality, we get a lot of partnership, right.

And we do get a lot of abatements and subsidies. And we do work with a lot of programs that help us bring even more attractive investment returns to our investors. One that kind of jumps to my head immediately is, you know, out of New York. Specifically, New York just ended a program called the 421a Affordable New York Program, that was essentially a program put into place to inspire development through the downturn of COVID. When we started to see a lot of development flee that area, you know, the local government leaders decided that, you know, that was terrible. You’re not keeping up with new inventory coming to meet the supply demands.

And so, you know, they initiated the 421a Affordable New York Program, which is a 35-year partial property tax abatement. And so…well, I mean, we’re doing a deal in Long Island City on top of the Queens Plaza train station. We’re doing another deal just down the street from One World Trade, in FiDi, on Carlyle. They’re both being done through this 421a Affordable New York Program. And we recently did a net present value on our Long Island City deal to see what the incentive was worth today. It’s more lucrative than the land cost.

Right? And so, governments see a need for more inventory as well. And, you know, how they go about getting that inventory, and the controls they have around that inventory, depends on market. But, you know, I think with what we’re looking to do and how we’re doing it, we come in as a great actor, right, especially within Opportunity Zone communities, right? And, yeah, we’re getting a lot of buy-in, tax incentives, and participation in our deals from community leaders.

Andy: So, yeah, a couple things there I wanna touch on. So, you mentioned some of the tax abatements or tax incentives you’re receiving. So, do you have some Opportunity Zone projects that have additional tax incentives? So, are you basically talking about stacking those tax incentives on top of each other?

James: Well, you know, with an Opportunity Zone, what’s interesting is that the real estate developer themself receives no tax incentive for an Opportunity Zone investment. Who receives the incentive is the investor in that Qualified Opportunity Fund. But, within that Qualified Opportunity Fund, we have individual properties that have tax incentives associated with them. So the fund will benefit from a tax incentive, tax abatement, brownfields agreement, whatever it may be, really interesting form of financing. But then, secondarily, right, the investor will benefit from the tax depreciation on the OZ investment.

Andy: So, that’s an interesting approach, because, you know, I’ve talked with several sponsors lately, who have basically, you know, they basically have a strategy of, you know, I heard one of them refer to it as the “Smile States,” or, you know, the Sun Belt, whatever you want to call it. It seems like a lot of developers, a lot of sponsors, are kind of moving to where a lot of the migration is, to those Smile States. Which makes sense. I think it’s, you know, lower regulation, it’s, a lot of times, it’s more friendly, more developer-friendly business climate. It sounds like you guys are almost running in the opposite direction. Is that the case, or are you just more diversified, you know, across all 50 states?

James: We’re more diversified. You know, we really take a double-pronged approach. But we most certainly saw opportunity and started to go against the grain very early in 2020, you know, in regards to addressing tier one market dislocation. Right, and if you’re looking at Southern California, LA, the Bay, New York, and the surrounding boroughs, D.C., you know, all those markets, at the beginning of COVID, got smacked, right. And they took a pretty severe downturn rather quickly, which, you know, pretty much all throughout 2020 went down. But, at the beginning of 2021, you saw the V-shape recovery again. And each of those markets are now past where they were from a pre-pandemic rent rate perspective. It’s more expensive in every single one of those markets.

Andy: Wait, so you’re telling me New York City didn’t just die?

James: You’d think, you know, most people’s sentiment is that it, you know, can’t believe that it didn’t, or believe that it will. But go spend some time in New York, go spend some time in the Bay. You know, it’s not going anywhere. You know, it may adjust from a pricing perspective, but you’re always gonna wanna have, you know, companies in Silicon Valley next to Stanford University, and that environment’s not changing. Okay? And so, there’s tremendous opportunities still there. It’s already, the thesis for that, has already came true. You know, we’re already past where we were in 2019 in these markets. But, you know, for us, we had been eyeing these markets for quite some time, because we love how resilient historically they have been, right, in the face of a downturn.

And, you know, we just…you know, these are also markets in which our moderate-priced product is so desperately needed, right? Where else is a moderate-priced product needed other than Palo Alto, right? Where the area median home price is $3.1 million today, plus, right? It was just too expensive for us to go into those markets and make a good investment, because at the end of the day, you need to do good while doing well, right? And if we’re paying too much for land, or a value-add asset, it doesn’t make sense for us. We can’t [crosstalk 00:16:41] price point.

Andy: Hold that thought for a sec, because I think I know where you’re going, and I wanted to ask you about your white paper. Right, so hold that train of thought. And by the way, for our readers and listeners, I’ll include a link to that white paper in our show notes. But the white paper mentioned that the lockdowns of 2020 and 2021 created “a unique opportunity for developers to enter resilient markets at a discount, as people temporarily shifted from high-density cities to lower-density cities. And this short-term shift in demand for housing created buying opportunities for sites in these dense markets, lowering the cost and availability of one of the most critical inputs, which is land.”

That really…that kind of caught my attention, and I wanted to ask you about that quote in that white paper. So, it sounds like Grubb was basically ready, and wanted to enter some of these markets, and basically, you bided your time. So, how did you take advantage of that opportunity of the last couple of years?

James: Right. So, we were watching it closely before the dislocation began, and developing partners in these markets to help us enter them, right. I mean, we’re a vertically-integrated real estate development company. You know, we take pride in having these specialists in-house. And we recognize the value of partnering with other developers and coming together on deals, and helping, you know, just broadening our relationships in the given markets that we’re looking to go into. And so, it’s not like we went in blindly. You know, we had been stress-testing these markets and developing those relationships for decades. And when we saw this pricing opportunity, we jumped.

You know, and I give it to our CEO, Clay. Like, for him to have the foresight, right, and, you know, the intestinal fortitude to swallow that, and go head first, right in the middle of COVID, right when it began. Wow. I mean, what a guy. You know, I’ve loved watching this kind of unfold. And at first, even myself, I’m like, “Whoo.” You know, “Here we go. You know, this is it, you know. This is it. We’re gonna go.” And man, it really, the thesis played off, you know, quicker than I could have ever imagined, and continues to do well for us. But now what we have are portfolios full of these assets that come at a very attractive cost basis, some of which have extreme tax incentives tied to them.

Andy: Sure.

James: And we’ve recovered that market before we ever developed one of them. They’re all in development. We’ve not even stabilized one of these assets yet to catch this market demand, right? And we’re already…

Andy: But they’re all sitting in the money already, essentially? Probably pretty [crosstalk 00:19:31]

James: Some of these assets, we’ve already made a tremendous amount on, just because of the land acquisition.

Andy: Sure. Wow. So…

James: But, this comes at a time, Andy, that we’re taking a double-pronged approach, and you see it in our portfolios, to where we’re not letting go of where we’ve been successful. We’re still executing on deals in the Southeast, and filling our portfolios with them as well. But you’re also starting to see that opportunistic trend towards tier one markets, to take advantage of that opportunity when we saw it. And we’re still executing on that pipeline.

Andy: So, with essential housing, like, with Link Apartments, with this, you know, the 60% to 140% median income-type housing, I mean, you’re right. That’s needed nationwide. That’s needed in New York City and San Francisco. But it’s also needed in Denver, and Austin, and Houston, and Atlanta. I mean…

James: Absolutely.

Andy: It’s just needed nationwide. You know, you’ve talked about a lot of the tailwinds. I do wanna ask, I mean, I think, at least from what I have heard, you know, a lot of the appeal of creating the luxury apartments, luxury multifamily, as well as, you know, any kind of luxury housing, is in that pricing power, the higher profit margins. And especially, like, back in 2021, you know, when the price of lumber was shooting up, just a lot of developers and sponsors, they kind of wanted that, you know, margin of safety, whatever you wanna call it, where if you’re building Class A or luxury housing, you have a little more margin to absorb potentially higher inflation, potentially higher labor costs.

You know, so if your model ends up being, like, “Wow, our costs are actually coming in higher than what we modeled for,” maybe rent revenue’s gonna come in higher as well. But it would seem to me you’d have a little bit less, you know, room to maneuver, a little bit less room in the model at this lower-cost housing. Is that the case? I mean, how, I guess, have you weathered this higher inflation? Is it a worse issue with labor? Is it a more significant issue with materials? Or is it just not a concern at all, you know, because the rent growth has outpaced it, so it almost is a wash?

James: Rent growth has outpaced it. I mean, you know, that’s definitely true, but how long can that sustain itself, right? And where we’re positioned at in the market, at that moderate price point, I like to kind of frame our product as a lite luxury model. You know, with Link Apartments, it’s Class A, it’s amenitized, it’s in that live-work-play environment. You know, we’re just efficient in how we design it. We’re creative in how we get to the development for it, right.

And so, I like to say, you know, what we’re looking to approach in these markets, we’re not looking to be the cheapest product in market. We’re looking to be a little bit cheaper than the rest of the Class A market, right. And if we can undercut somebody building right across the street from us, we’re gonna lease up faster, and we’re gonna keep our tenants longer, right. And if we do see a point to where they’re become more renters by necessity, and less renters by choice, a distressed environment, we’re gonna capture a lot of that falling inventory, a lot of those falling tenants, that are looking to cut cost from their double Class A luxury multifamily asset, that’s got a golf simulator in the basement, to more of a middle-of-the-road, Class A, still gives them everything they want and need, but not any of the excess, right.

And so that’s Link Apartments. Still giving our tenants everything they want and need, where they want to be, at a little bit of a reduced cost. Two hundred to $500 a month, depending on the unit, depending on the market. But, like you said, for the fireman, for the police officer, the teacher, the nurse, that’s who I like to frame our product for, the nurse. You know, these other double Class A, you know, developers are catering towards doctors. We’re catering towards nurses. There are a lot more nurses. Right?

And so, from that perspective, and just catching tenants that might migrate downward in the case of a recessionary environment, or if rental rates continue to go up, I think that we’re very well-positioned. And when you look at, you know, construction costs and things of that nature, just inflation generally, you know, we’ve been dealing with that for quite some time in our business, right. That’s not recent news. And so, you know, we are dealing with that as any other multifamily or real estate developer would deal with that. But, I think our vertical integration does help us to a certain extent.

We have an in-house finance team. You know, we have in-house development teams, that are more or less commodity traders, that are gonna buy certain things in dips, based off our projected future development. Which is easier for us to project, because, within Link Apartments, we only have six-unit floor plans. Most of our competitors will have at least 30 in a given development. I’ve toured some sites that have 70.

James: So that keeps costs [crosstalk 00:24:41]

Andy: It keeps it so tight. It’s like Lego blocks. We just look at a development site and say, “Okay, how can we stack these Lego blocks to maximize the space here, drive up what we take in per square foot?”

Andy: Sure.

James: “But reduce what we’re charging per month?” And oftentimes, Andy, you’ll find that in comparison to other comps near us, we will take in more per square foot than they do, but they’re charging more per month, right? And I have never met a tenant that has come into an apartment and asked, “How much am I paying per square foot?” No. They don’t care. They wanna know, what is my monthly cost? Does this give me everything I want and need? Is it where I want to be? And it’s cheaper than that option? How much cheaper? All day.

Andy: Yeah, I might ask about number of bathrooms, number of bedrooms, but I think you’re exactly right. I’m not asking price per square foot.

James: Price per square foot. No, I mean, no. And even our smallest… Okay, so, we have two studios, two one-bedrooms, and two two-bedrooms in our model. Even our smallest studio has walk-in closet, full bank of drawers in the bathroom, right? European cabinets, stainless steel appliances, granite countertops. It’s well-positioned, transit-oriented location. Right? And we’re just cutting some of that wasted space and some of that excess cost to get there. We’re attracting people from an economic standpoint, rather than from excess.

Andy: Understood. So, with the Link Apartments brand, you know, y’all own all of these assets across the country. Or they’re owned by your funds. Do you, does Grubb ever exit or sell any of these assets? Or is the plan to essentially grow this brand and grow this collection of assets, you know, indefinitely? I guess, what’s that look like 20 years from now, with all of these assets?

James: It’s a great question, and one that separates a lot, you know, us a lot from our competitors. We’ve always been long-term holders of Link Apartment assets. You know, this internal strategy of Link Apartments began in 2012. The first development site we approached is in the Manchester neighborhood of Richmond, Virginia. It’s in an Opportunity Zone today. We still own and manage that property. Along with every other Link Apartment project that we bought, or built, thereafter. This is not a value-add strategy. It’s a raw development strategy, mainly because we can’t buy a building and convert it into this efficient form of style that allows us to get to the moderate price point. Right? And so…

Andy: Especially in today’s environment, where, you know, even with this higher inflation, you can potentially build below replacement cost, so I think that would be more true than ever in [crosstalk 00:27:27]

James: Well, also, when you look at, you know, repositioning value-add multifamily, what are you really doing there? You’re taking basically moderate-priced existing inventory and turning it into double Class A. Right? That’s the pitch there, you cut costs, thereafter you flip it, and you move on. And then, you know, so goes the property. For us, you know, it’s not like that at all. We’re looking to add new inventory to these markets that are moderately priced, right, and help address this supply issue that we have.

That’s what we need more of. You know, but also, like, the value-add game in the Smile States, like you refer to them as, is incredibly expensive right now. I mean, we’ve not always been a straight development company, and we never will be a straight anything. We stay opportunistic. If there’s a value-add office building that could lead to a multifamily development through a re-entitlement process, and densifying that land through a re-zone, we’ll do that. We’re very opportunistic in that regard.

But, one thing that we’re really shying away from right now is paying too much for existing inventory. Right, and you see it all over the place. We had a prior portfolio called Sterling, which was a workforce housing value-add strategy, that we started to execute on out of the last cycle, 2008, 2009, that we recently sold as a portfolio sell. We had seven remaining assets in that portfolio that we sold at the end of 2021. We received over $50 million more than what we had these assets and currently booked at through that disposition. That’s how hot this market is right now. And our funds, our flagship funds two, three, and four, that housed those Sterling properties, all are now above a 3X net equity multiple. Our fund three is at a 3.69.

Andy: Wow.

James: So, look, you know, we’re gonna be opportunistic, we’re gonna take advantage of the current market environment, and we’re not gonna shift because of some new trend or tax incentive. That’s one huge point about Opportunity Zones is that we had zero deviation of strategy to address them. We were always long-term holders of those assets. And we recognized 40% of our current portfolio fell in Opportunity Zone census tracts when they were identified.

And so, for us, you know, whether you’re investing in our flagship fund offering, or our Opportunity Fund offering, it’s the same strategy, in the same markets, in different census tracts, right. It’s really a different way for us to raise capital. And at the end of the day, if we get a property through investment committee, it gets approved, and it falls in an Opportunity Zone, the Opportunity Fund gets first right of refusal at that asset. And if it should pass, it can go to our flagship funds.

Andy: Right on. So, actually, I wanna talk about the different fund offerings you have. So, I understand that, you know, the Opportunity Zone wrapper, I mean, that one is pretty clear-cut, right? So, either a project is in a census tract that is designated as an Opportunity Zone, or it’s not. And if it is, and you’re gonna do ground-up development there, you’d almost be silly not to structure it as an Opportunity Zone project, you know, with a certain, couple of assumptions aside.

So, I saw from your website you have several open funds right now. So, there are a couple of closed-end funds, I think, as well as a private REIT. Could you talk a little bit about the different fund wrappers? Or why certain projects might go into one fund wrapper or another? Or maybe which type of fund wrapper might be appropriate for one type of investor versus another type of investor?

James: Yeah. Thanks for asking that. You know, so, within our flagship funds, we are a typical LP structured fund. You know, clients receive a K-1. It’s a commingled fund structure, closed-end. You know, right now with Fund VII, we’re 85% called-in. You know, likely we’ll call the remaining 15% in the next 12 months. And then put that money to work over a seven-year term, right. And then we’ll liquidate thereafter.

The Qualified Opportunity Fund program, we chose a different route, for various reasons. And we found that to be very compelling when raising capital in the space. I mean, our Opportunity Fund today is a $400 million vehicle, with 19 total properties scattered around the nation in select tier one and tier two markets. And we’ve worked with over 60 private wealth managers with that product to take it to their clients, and [inaudible 00:31:58] vetted the product, the structure, everything. But, from a very high level, the private REIT structure within Opportunity Zone investment allowed us to retain our strategy, right. And a huge portion of that is, you know, within a…

Andy: I’m sorry to interrupt. So, the private REIT is your Opportunity Zone Fund. Your Opportunity Zone Fund is structured as a private REIT. Okay.

James: That’s right. Yeah. That’s correct. You know, and from a high level, you know, step one, when deciding to choose the private REIT, it was really about retaining the flexibility if we ran into a disposition. You know, the structure allows us to… Okay, so, breaking down a scenario, a bread-and-butter strategy of ours is to approach value-add mid-rise office building, like I sit in right now, with the intent of rezoning the property, chopping up the parking lot the office sets on. You know, getting the zoning rights to make it mixed-use, build a parking deck where that parking lot was. Wrap that parking deck with Link Apartment units, and then share the parking between the office and multifamily. There’s a ton of synergy there, right.

And essentially, we’re getting the land for free to build the multifamily on, because we’re winning it through the entitlement process, right. But in a transaction like that, which we’ve already executed on this within our Opportunity Fund, in a transaction like that, once we uplift the office building, late ’70s, early ’80s, vintage office, here in Charlotte, as an example, and we lease it up, we modernize it, we’re typically gonna look to sell it if the market opportunity is right, because we’ve executed these long-term leases, there’s a huge duration of time now before tenant improvement cost and more leases come due. That property is of its most value to us at that point, and the least amount of risk.

And so we’ll look to offload it. If we were a typical LP structure, you know, and we ran into a scenario like this within our Opportunity Fund, the only option that we would have, to avoid a taxable event to our investors, would be a 1031 exchange. Right? And a 1031 exchange in an Opportunity Zone can get hairy. Right? That’s not something we wanna present as a risk to the portfolio. And we don’t wanna limit on our execution because we’re afraid of that scenario. We wanna execute as we’ve always executed.

The private REIT basically allows us, if we run into that scenario, to pay the taxes on the disposition of the office at the operating business level, from within the private REIT, which essentially sets between the REIT and the investor, right. It’s kind of like a buffer. And recycle proceeds back into the fund after those taxes have been paid, corporate-level tax, and make new investments, make accelerated debt payments, whatever’s opportunistic at that time, trying to amplify the back-end multiple of the Opportunity Fund.

Andy: So then, so, your LPs then, the investment from their end, is still treated as that 10-year hold, that qualifies for the tax-free capital gain coming out the back door after 10 years. That frees up you all at the operating, at the management sponsor, operating business level, to basically be better capital allocators, to free you up to make whatever decisions you feel opportunistically make sense. Like, yeah, you might need to eat some tax liability, pay some taxes, but ultimately, it’s better to have that freedom. So, you get the freedom on your end as the manager, and the investors still get that, the 10-year tax benefit, which, by the way, is incredible.

James: Or more. Or more. There’s a key comment there. But yeah. You know, essentially, that’s our bread-and-butter strategy. I mean, we’re killing it when we can approach an office and get to a multifamily development opportunity. We don’t wanna limit our Opportunity Fund to not be able to address those opportunities. Private REIT made sense from that perspective. But more, it allows us to internalize depreciation. And we thought this was extremely powerful, because, you know, with an Opportunity Fund investment, the true value in it is the tax-free appreciation over time, and the backend tax-free multiple on invested capital, right?

I see way too many investors approaching Opportunity Zones thinking about income generation. Because let me tell you, for every dollar of income that comes out of that fund, it’s taxable during the fund’s life as net income distribution. That’s one less dollar that you’re gonna get on the back end of tax-free appreciation.

Andy: Yeah, it’s zero tax benefit whatsoever to the operating income, right?

James: Zero. You’re just reducing your tax-appreciated multiple on the back end, every dollar that comes out taxable.

Andy: I mean, so the ideal investment would be weighted between the income and capital gain would be all capital gain.

James: If you could achieve that, absolutely. The private REIT allows us to internalize depreciation with the intent of offsetting those net income distributions, recycling that capital back into the fund to make accelerated debt payments, treated as working capital, right. And so, yeah, you know, that’s our thought. You know, we have a 2.5X multiple in mind for our fund at a 10-year duration. We want as much of that 2.5X to come out at 10 years or after as possible. Right?

And so, even when properties start to stabilize in our 19-unit portfolio, or our 19-property portfolio, like, the first one will probably stabilize next year. It’ll become cash flowing. But we’ll offset that cash flow with depreciation, intentionally limiting, or hopefully, eliminating all cash flow, until we get to a point in which enough of the portfolio is online and cash flowing that it outweighs the amount of depreciation that we’re generating.

That’ll take several years. That’ll happen around the time deferred tax obligations come due. Right? And even at that time, we’ll still keep dampening net income distributions with depreciation. We just won’t be able to offset at all when everything is online. And at a certain point in time, investors will get a 1% to 4% per annum distribution, depending on where we are in the fund’s life, give or take. You know, so that’s still less than what you see from other types of funds. But look, I get it. You know, some investors do want that income. They don’t wanna, you know, throw it in for 10 years and not look at it. I get it. But, I’ll say this, you know. You’re doing yourself a disservice. You know, within the Opportunity Zone program, take full advantage of the back-end growth, because that’s the true value here.

Andy: Yeah, I mean, if you want current income…

James: Go buy [inaudible 00:38:35].

Andy: …Opportunity Zone Fund is the wrong, it’s the wrong product type to be looking at, you know, I would say. And, you know, I think that the market for Opportunity Zone Funds, we had DJ Vancouren [SP] on the show. He’s family office guy, and he called it “patient capital.” And I think that’s exactly right, because it’s more…it could be self-directed high net worth investor, it could be institutional. Could be a family office. But you have to be patient. You know, if you need the cash in 24 months, don’t put it in an Opportunity Zone Fund. There’s nothing wrong with that, you know, but…

James: Sure. That, it’s not the best route for you, though. And, look, the private REIT is not the best route for everyone. You know, there are certain real estate investors who are very depreciation-needy, right? And, look, they want that pass-through depreciation on their investment. But what I would say to it is, the depreciation doesn’t vanish. We’re actively managing depreciation internally within our operating business, and maximizing the value of the fund for our investors, not requiring them to balance their entire financial situation, externally of the fund, with the depreciation that we kick out. Right? And, but look, there’s an investor for each, you know, fund structure.

One thing that I have found of value for high net worth investors within the private REIT structure is its ease of use, right. One thing about alternative investments is they can get quite complicated, especially for someone addressing it maybe for the first, second, third time. The private REIT, I like to frame as a turnkey solution to addressing the Opportunity Zone tax incentive, right. We call capital every month, 100% up front, it goes to work directly into the private REIT, and, you know, there they are. And they never receive a state-level K-1, right? That’s extremely powerful, because…

Andy: Wow. I didn’t know that. That’s a… Because I think a lot of our…

James: Well, here’s why this is so important. It’s important because it’s easier to use, and nobody likes receiving 10 state-level K-1s. But it’s exceptionally…

Andy: Especially because you all are diversified, so, with a diversified fund, I mean, that can turn into a real nightmare if you have project [crosstalk 00:40:41]

James: It can turn into a nightmare. It can turn into a cost burden. But, here’s the real risk within Opportunity Zones that no one talks about. There are non-conforming states. If you have a fund that is commingled, and structured as an LP, and you’re an investor in California, in North Carolina, any of these non-conforming states, and you get issued a K-1 from those states, guess what you’re gonna owe at the end of the day? State-level capital gain taxes. Our private REIT, and the 1099 structure, it separates investors from that. The only state that they have to be concerned about is the one in which they reside.

Andy: Sure.

James: And so, it’s easier to use. There’s no K-1s. That turnkey solution, instant access to a 19-property portfolio, diversified across the nation, in different market segments. Very interesting as well, because our 2019 Qualified Opportunity Fund set looks very different from our 2020 and 2021 set. But together, man, it’s just a great portfolio, because you see a lot of Southeast exposure in 2019. But, the Southeast was not affected by COVID’s downturn. It was continual increase, right. And so it’s a nice, balanced portfolio of both growth markets and resilient markets, addressed in opportunistic times.

Andy: So, is your OZ fund still open to new investors?

James: Yeah. And it will be through the end of next year. [crosstalk 00:42:09]

Andy: What’s the minimum investment? Like, could you talk about your capital base a little bit?

James: Yeah. So, I mean, we work with, again, about 60 private wealth firms that take this product to their clients, and I think somewhere around 900 individual investors that have invested directly with us. And, you know, we’re happy to accommodate $100,000 minimum investments. And I love that. My background was coming from a feeder fund within a major private wealth organization, to where I raised capital for hedge funds, private equity funds, you know, managed futures, private real estate, all across the spectrum. Some of those investment managers required $5 million to go direct.

You know, before the feeder fund craze kicked in, high net worth investors had no access to these types of asset classes. You know, so, for a vertically-integrated real estate developer, that gives you access to the asset, as close as you can get it, other than doing it yourself, at $100,000 minimum, that is a great addition to your portfolio. Right?

Andy: Yeah, and especially with the diversity of assets, and all the states that you all work in. So I would think, you know, a lot of times, like, institutionals, and ultra high net worth, you know, you’ll see an allocation into alts, 20%, 25%. Heck, 30%, 35%. I think now we’re starting to see, you know, the mass affluent, or, you know, the “everyday” accredited investor, there’s just increased interest in alts, I think, from high net worth self-directed and on up, and certainly…

James: It’s gonna continue to grow. It’s gonna continue to grow. More wealth advisors are going to continue to adopt, right. And it’s wonderful. This is what should be happening. Investors should have always had access to these asset classes and various types of vehicles. And I think it’s great, and I wanna be part of it, you know. But what I would say is that, be careful. You know, be careful with the type of manager that you’re working with. You know, there are a lot of what we call allocator funds out there, that are not the specialist in the given class. They’re financial professionals, that make an investment fund, that then go and allocate to the professionals doing the actual deals.

We are those professionals, and what you’ll find is that there are multiple layers of fees that are introduced there. One that’s very prominent in real estate are acquisition and disposition fees. And they’re not gonna show this on the asset management fee inside your presentation deck. They’re gonna show it within the private placement memorandum. And it’s gonna be hard to find. And when you look in our private placement memorandum…

Andy: But James, most investors read the PPM, you know, every word.

James: Religiously. All 455 pages, right?

Andy: Right.

James: Like, Control-Find “acquisition fee.” Control-Find “disposition fee.” Look at this. And I’m telling you, if you look at our PPMs, what you’re gonna find is beside of all of those, it’s gonna say “none.” Because we’re the people that are on the ground. We’re the specialists doing this. And investors can come to us direct, and not have to go through these middlemen. They don’t have to go to a financial advisor that’s gonna charge them 1%. They don’t have to go to an allocator that’s gonna charge fees they’ve never heard of, their own carried interest fee, and their own asset management fee above what the real estate developer’s charging. Look, this is the purest way to address it, other than doing it yourself.

Andy: Yeah, and, you know, in talking with investors and advisors, I think that vertical integration model, it holds a lot of appeal, because, I mean…so, I hate to say it, but at the end of the day, this is housing, right. I mean, in a way, you know, there’s differentiation, but at the end of the day, these are widgets, right? They’re housing widgets. Of course, you can differentiate them, but that’s why we have Class A, Class B, workforce. We have this language, because it…

James: Very defined buckets. Very defined.

Andy: Exactly. And so there’s a lot of value, you can create a lot of value, just by setting up a lower cost structure. I mean, you see that in other industries. Like, why is Costco so successful? I mean, ultimately, you’re getting the same product at Costco… Well, maybe the hotdog and the rotisserie chicken is better, but, you know, you’re getting the same Coca-Cola, the same brand of paper towels at Costco, but they have a lower cost structure, so they essentially, you know, pass that back to the consumer. And so I think what, you know, housing, at the end of the day, it’s a business sector, or industry, just like any other industry, so that vertically integrated model…

And then, where you talk about, you know, housing units being like Legos, I think there’s certain investors, or listeners, or viewers today, they might hear that and be, like, totally turned off. And like, that’s fine. But I think there’s another type of person who, you know, maybe they’re an entrepreneur, and they’re like, “I totally understand how in my sector, in my industry, that kind of efficiency is actually a core advantage. It leads to a better end product at a better price point.” [inaudible 00:47:09]

James: And I don’t wanna cheapen our product by framing it as a Lego block. I mean, when I was first told about Link Apartments, when I was, you know, coming to Grubb, I thought it was Class B. I’m like, how do you get into a moderate price point? And then I walked on a project, and I’m like, “I would live here. This is fully Class A. How are you guys doing this?” And it’s really through efficiency, eliminating wasted space. I like to describe it as a lean type of methodology. And these guys have been doing it for a long time, and they know what they’re doing.

And, you know, in our 58-year history, and I think this is a good fact. Just talking about longevity of the company and getting better over time, we’ve never had a property-level bankruptcy deed in lieu or foreclosure, and I think we’ve been through seven recessions now. You know, recessions are an opportunity to take advantage of market dislocation. And if you’re not overextended on your debt, right, if you’re minding your leverage, as you should be, you can take advantage of it.

And that’s where we’ve positioned ourself, and, you know, took advantage of 2008, 2009, and we’ve taken advantage of the downturn that we saw briefly in 2020 in tier one markets, and we’ll take advantage of the next one. Because we’re not over-levered, and we have great overall duration in our portfolio. And, in some cases, our financing terms add value in a rising rate environment or a distressed environment, one of which we’re being led into.

You know, and I can give some examples there. You know, in our Opportunity Fund, we have a project in Winston Salem, North Carolina called 4th Street, that has a HUD loan on it. And we used the various forms of lending. Our in-house finance teams will work with insurance companies, they’ll issue bond offerings, they’ll go through organizations like HUD. But this HUD package, we’ve used several times, and I find it most attractive, and really highlights how we can, you know, add some inflation-protected, and security to a portfolio through our investments. The HUD 221(d)(4) program is what it’s called. And it’s a 42-year, construction-to-permanent, fully assumable fixed-rate loan product. And we locked in, on this specific asset, we locked in 42 years at 3.99%.

Andy: Wow.

James: And if we sell this property 20 years from now, the acquirer of the asset has to pay us the arbitrage value of assuming that 3.99% and then holding it for another 20 years. And we’ve sold a property that had one of these loans attached to it. It was in Raleigh a few years ago. Just from the assumption of the loan on the property sell, it brought $6 million to the sell for us.

Andy: Wow.

James: So, look, you know, in a rising rate environment, when over half of your stabilized portfolio is fixed, and the average duration is 10-plus years, and you start adding loan products like that, we welcome it.

Andy: Absolutely. Yeah. And I just love hearing about that long-term vision, long-term duration, you know, the track record that Grubb has, and, you know, that quote that I started with, “Perspective starts with principle,” and, you know, we kind of joking about 350-page PPMs. Like, the truth is that, you know, most high net worth investors who are self-directed, and, frankly, even RIAs and financial planners, they’re gonna be time-limited. And, you know, you probably don’t have time to read every document with a fine-tooth comb. You know, hopefully, you employ a team of professionals, specialists, whether you’re an RIA and you have specialists that help you with due diligence, or whatnot.

But, to me, my big thing that I preach is you wanna look for sponsors that have long track records, and, you know, know what they’re good at, and you have proven that out over time. And so I think, you know, the Grubb backstory, you know, your “Peter Parker,” “Spiderman” backstory, I think is super inspiring. And I know we’re short on time, but I wanted to remind our listeners that if you want links to all the resources that we discussed on today’s episode, including the white paper, and links to the private REIT, you can access our show notes at altsdb.com/podcast. And I also wanna remind you, don’t forget to subscribe to our show on YouTube and on your favorite podcast listening platform, so that you never miss our new episodes as we release them. James, thanks again for joining the show today.

James: Bring me back again. I love this. Thank you so much, Andy. And, you know, for anyone listening that’d like to have a conversation with me, please feel free to reach out any time. I’m always happy to engage [crosstalk 00:51:39]

Andy: Oh, you know, James, and I forgot. I have that in my notes. I ask that to every guest, and just got away from me. Where can our viewers and listeners go to learn more about Grubb and about your funds?

James: Absolutely. grubbproperties.com. Great starting place. It’ll lead you down the rabbit hole for whatever fund you might wanna engage with. And, but at the end of the day, anybody that wants to pick up the phone and give me a shout or send me an email, I’m always happy.

Andy: Sounds great. Thanks, James.

James: Andy, this is a pleasure. Thank you so much.