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Origin Investments recently published their Multifamily Markets to Watch 2022 report, which included five cities which the company believes are appealing markets for investors to consider. The cities were selected with a methodology that includes both practical knowledge, as well as with input from Origin Multilytics, a proprietary suite of machine-learning models.
Michael Episcope, principal at Origin Investments, joins the show to discuss how machine learning is helping to guide the future of multifamily development.
Watch On YouTube
- The story behind Origin Multilytics, and how Origin is using machine learning to help guide their capital allocation decisions.
- Why Andy thinks publicly-traded REITs have been overvalued (and why Michael totally disagrees).
- Michael’s opinion on whether the economy is already in a recession, as of late June 2022.
- Insights on the supply and demand equation for multifamily, and the continuing bull case for the sector.
- The single reason that Origin focuses on ground-up development, rather than value-add or the acquisition of existing assets.
- Michael’s favorite MLB team (hint: it’s not the White Sox).
Featured On This Episode
Today’s Guest: Michael Episcope, Origin Investments
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.
Andy: Welcome to “The Alternative Investment Podcast.” I’m your host, Andy Hagans. And today, we’re going to be talking about multifamily. And we’re going to talk macro, we’re going to talk about machine learning, and a lot of different exciting topics. And with me, I have Michael Episcope of Origin Investments. Michael, welcome to the show.
Michael: Andy, thanks for having me.
Andy: And I should say welcome back to the show, because you are one of our first few guests. So, any listeners can check out our backlog of episodes and listen to the original one. I think I have a better audio setup now, so, hopefully, it’s a little more pleasant. But Michael, I’m gonna jump right in. My first question, it’s a little bit controversial, but rather than skirt around it, let’s just get it out of the way. I know you’re a Chicago guy. So, Cubs or White Sox fan?
Michael: Cubs, absolutely. Not even a question. And it’s been a little difficult to watch lately, but you gotta have some patience. They’re rebuilding right now. And I would say that Wrigley Field, though, there’s no better place, even when they’re losing, to watch a baseball game.
Andy: Yeah, you know, it is an awesome field. I just took my kids to a Tigers game. And so, as a Detroit Tigers fan, I think the Cubs, or almost any team in Major League Baseball, probably having a better season than we are. But anyway, either answer would have been accepted, for the record. Unless you say, “Oh, I like both.” That’s just sort of hedging your bets. Nobody likes that. But I want to jump in and talk about Origin Multilytics because this is actually…
And for our listeners, actually, I should disclose something, in all seriousness. I am an LP investor at Origin. This isn’t a sponsored episode or anything like that. I just happen to like the product. So, Origin products are part of my own portfolio, but I didn’t even know about Origin Multilytics. So, I was reading this report that you all published, “The Multifamily Markets to Watch 2022,” and that included five cities which your team believes are appealing markets for investors.
And I know the methodology included both practical experience and knowledge, but also this Origin Multilytics, which is “a proprietary suite of machine learning models.” So, for our listeners, some of which may not be as familiar with machine learning, could you talk a little bit about what it is, and how it works into your investment process?
Michael: Yeah, let me, first of all, thank you for partnering with us, Andy. I’ll take you back a little bit of, like, why we even created our own machine learning. And in the world of finance, whenever you’re creating a model, one of the most important variables in any model is growth, and, especially in real estate. And historically, real estate has grown, multifamily real estate, at 2% to 3% revenue growth per year. And that can fluctuate, though.
Some years it’s zero, or even minus two, and then other years, it’s plus five or plus six. We’ve never seen anything like we have in the last couple years, where you’re getting north of 20% in certain markets like Austin, and Tampa, and Nashville, and places like that. So it’s really kind of thrown, you know, traditional models or traditional thinking out the window, because…
Andy: Michael, are you talking about rent growth, or are you talking about just asset price when you…?
Michael: No, I’m sorry. Rent growth. Yes, yes. Because it’s really rent growth. And revenue growth is one of the most important things that you can model, you know, put into any model, right? A 3% to deal works great, and you’re doubling your money. At zero, you might be losing your money. And it sounds like that’s a thin margin. It’s going to depend on other factors, leverage, and things like that, but it’s really important to get growth right. And, for us, we were basically renting a product that was in the market, and several products, and we would look at these together.
And then you use historical averages, and it was one of these things that we were really frustrated by, because there were times that, both looking at deals where you got rent growth wrong, and it wouldn’t crush the model, we’ve always been conservative in the way we’ve underwritten, but it was also about missing deals. And if we’re underwriting 2.5% in our model, that’s going to create an economic value that we’re willing to pay for an opportunity. Whereas if somebody else is using 3.5% in their revenue growth, they’re going to be able to pay a much higher price.
Well, if the reality is that the rents grow at 5%, we would have made a tremendous amount of money in that deal. And the 3.5%, the people who actually paid more than we did, made a lot of money. And so, we’re always looking at ways we can innovate. We’re looking at our decision-making. And so, it was about three years ago that we decided to hire two individuals from the University of Chicago, some data science students there, and it was sort of like a Hail Mary. “Hey, let’s bring them in. Let’s bring them in as interns, let’s have them in,” and they’re incredibly bright.
And we sort of took what was in our head, and I should say, the acquisitions team’s head, about what they know about the real world. Because you can’t create a model just by itself and set people loose. You have to take, or have a theory about the real world. What drives investment performance? And we know that it’s job growth, it’s population growth, it’s affordability, it’s barriers to entry, it’s things like this. And then there’s all kinds of things around the periphery that help you determine those variables, and which way they’re leading, right?
Are you getting a population growth that’s continuing and trending in that direction, or is this just kind of a one-time event? Are you getting real jobs coming here? And you’re scoring all these things. But when you’re doing it in a manual way, you can only score one city at a time, and it’s very laborious, and you have to take shortcuts. And so, for us, it was really important to get this right.
And we hired these data scientists. They’re incredible. They use all kinds of spatial data analysis, linking cities together, evaluating literally millions of pieces of data, something that a human couldn’t do, and using some serious computing power, to put all these things together, to ultimately arrive at a top-line rent growth. And when we started looking at this, certainly it’s been an iterative process. It always will be. We’ll continue to backtest it.
But even version one, when we backtested it… You backtest these things sort of blindly. You look at the data, and you pretend that you’re going back four years ago, but you don’t know the future, and you’re taking this, and you’re looking at this, “Okay, what does this machine learning actually spit out for an end variable or an end product, versus what we were using, right, the product that we were renting, spit out?”
And what we found over and over is what we were creating was more and more accurate than what we could rent. And that really became sort of this aha moment, “Hey, we’ve got something here. This is really, really important for what we’re doing.” And we continued to pour money, and resources, and time, and energy, and effort into this until we really got to a product that we branded, to your point, Origin Multilytics, that we use internally.
And we use this both, you know, sort of a proactive way, right, to look at cities where we want to be, but then we also augment that with a boots on the ground. Because you can’t outsource decision-making to just predictive analytics or a machine. You have to have people on the ground. And we’ve had people on the ground in their markets for years. We always believed that. But it was much more of a feel.
This is taking data and analytics, and combining it with that, feel to saying, “Hey, this is my theme. Is this right? How does this work?” And so, we can go at the macro level, look at the city, we can look at the sub-market, we can look at the site, to really dial in and become more and more accurate. And ultimately, what that does is it helps us deliver what we’re trying to deliver, which is higher risk-adjusted returns, protecting capital, just finding better deals, and protecting investor capital, and growing it.
And so, it’s been a very critical part of our business going forward, and it’s just something that now we’ve incorporated into our everyday sort of methodology. So when we go to credit committee, everything done there is evaluating what we’re looking at on a deal-by-deal basis against what our Origin Multilytics is actually predicting. And generally, I was saying this earlier, we tend to be very conservative. And if we can make a deal work… Let’s say rental rates per unit on a monthly basis, where we’re looking at a deal today, and the Origin Multilytics had this particular property trading for $1,900 per month, on average.
And I think we were underwriting right around $1,763. And when you can make a deal work at $1,760, when the comp set out there is trading for $1,800, $1,850, and you’re triangulating Origin Multilytics at $1,900, all that feels really good to point towards a yes. If we’re looking at a pro forma, and you have to price things to perfection, and you need to command $1,900 rents, and the Origin Multilytics is saying, “Hey, rents here are really, in three years, going to be $1,800,” and your comps are trading at $1,700, that’s a pass all day.
And a lot of what we do is, it takes a lot of time, and effort, and technology, and experience. But when you get to the end result, what I was just talking about, it’s a lot of common sense, just triangulating this and saying, “How does this feel against where the market is? Where are our cap rates today versus where the markets are? Where are the comps at? Where are the sales?” And you’re looking at things, and there’s probably, like, you know, maybe four or five things that really matter when evaluating an opportunity. And rent growth is certainly one of them that we’ve spent a considerable amount of time getting right.
Andy: Yeah, you know, that’s really interesting as an LP in your fund, or really in any fund. I think from an LP’s perspective, I’m always looking at a sponsor’s track record, right? So, you want to see a management team that has a long track record of doing a lot of deals. And as an entrepreneur, as a manager, if you think about any skill set that any professional has, a lot of the decision-making they have, you know, if they’re truly excellent in their field, is going to be almost on, like, the stomach, like, the gut level. Like, you’re going to have an instinct, you’re going to have knowledge, and it’s not even always easy to convey, “This is why I think the answer is yes,” or “this is why I think the answer is no,” or why I think the answer is three, or whatever it is. It’s that kind of gut-level knowledge that builds up with a lot of experience. And so, I think a lot of investors are looking for that experienced management team. But at the same time, even the world’s smartest manager, most experienced manager, is going to make a mistake, right? Warren Buffett, at some point, is going to make a mistake, a miscalculation. I mean, he’s made plenty, you know, but over time, it’s that batting average, right?
But so, the idea of a company that has that management team in place, with the experience, and that kind of gut-level knowledge, for lack of a better term, but then it sounds like you’re sort of stress-testing that against this external, or this more objective, not totally objective, because there’s still going to be some assumptions baked in, but against this machine learning model, that has data. Is that humbling for you? Or is that the way you like it, you know, that it keeps you humble?
Michael: Yeah, I, is it humbling? I think, as an organization, you know, we are always striving to make better decisions, because we are managing a lot of money, right? More than a billion dollars in equity now, and a couple billion dollars of assets. And we take that very seriously. And you have to, as an organization, continue to innovate, continue to get better, continue to find ways to make better decisions, because you know your competitors are doing the same out there.
And we use this in two ways. And one, you can be proactive, and it can point you in the right direction. But the other way, what you’re talking about, is when one of our deal officers, when they sort of have a gut reaction, right? And a lot of times, it starts with that. “Okay, let me test this with the AI, see if I’m right, see if this agrees with me.” And by the way, you know, no matter how right you think you are, you always have to reserve the right to be wrong. And in these cases, this is why we as a fund are diversified.
We love Phoenix, we love Tucson, we love Austin, and Nashville, but we wouldn’t be an Austin fund, we wouldn’t be a Nashville fund, we wouldn’t be, you know, a Phoenix fund, because there’s always X variables that you can’t even factor in into these models, that you just don’t know. So, diversification is a way to take out some of that X factor risk. Certainly, we’re denominated in the U.S. dollar. We’re only domestic here in the United States, but by being spread across different states, we do diversify away some of that risk.
Andy: Yeah, yeah. I mean, especially coming off of 2020, I think the X factor, just acknowledgment of the X factor, of stuff can happen. You know, the next black swan will not be the last black swan, right?
Michael: Yeah, it’s funny because black swans happen so frequently, they’re almost predictable now. You look at them every 8 to 10 years. And I was listening to an economist, Rosenberg Research, and he was saying that, “In every recession, there hasn’t been a single one where we haven’t had some crisis.”
And he went back 11 recessions, and he was talking about every single crisis that happened as a result of Fed tightening, a recession, something, and it’s almost like, “Okay, a black swan is so unpredictable, that they’re almost predictable in a recession.” I don’t know if we’ve seen it in where we are today yet, but you can bet that there’s something out there. There’s some leverage point, some crazy risk that somebody’s taking that’s about to get exposed in this world.
Andy: Yeah. And, I mean, I think it has in the crypto market lately, and maybe that’s a leading indicator. Maybe it isn’t. I guess we’ll find out. But, I mean, I kind of agree, you know, even this idea of the recession or business cycle. You see them come and go, and it’s part of the processes, and, you know, assets inflate and then they deflate. I want to talk about Growth Fund IV. And so, I brought up the webpage before our episode today, just to get a few details. So, I understand the fund as properties in Franklin, which is just south of Nashville, in Austin, Tempe, Colorado Springs, and Dallas.
And I think, at a retail level at least, I kind of get the thesis of investing in these, you know, I’d call them up-and-coming cities. I don’t know if they’re considered technically prestige cities, but places that, like, Millennials want to move to, places where there’s a lot of job growth, just a healthy local economy. But at the same time, I have to ask. It seems like a lot of developers are going into these same sort of markets, of the up-and-coming markets on the Sun Belt, or Smile Belt, or whatever have you. Is there a risk that this trade is becoming too crowded, that there’s too many developers seeing the same thing?
Michael: There’s always a risk. I’m not going to say there’s… You know, when you’re investing, it’s all about calculated risk. And what we’re looking at is sort of a high level, a macro view. This country is still under-supplied significantly when it comes to housing. We’re delivering 300,000 to 350,000 a year. There’s a demand for more than 500,000 units that’s been going on for at least two to three years. COVID, obviously, created a little bit of a supply issue, because you had a lot of starts that slowed down there. Certainly, those are picking up today.
Macro, though, like, I’ve told people this on many occasions, this is not ’08 and ’09. We are actually feeling the effects of ’08 and ’09, and the lack of spec home, spec developments over the last 10, 12, 13 years, that weren’t created to keep up with today’s demand. And the demand is really being fueled by the largest demographic generation in the history of the United States, the Millennials. They’re turning 32, 33. They’re in that, you know, the prime rental, home-buying ages right now.
And this is why we’re seeing so much upward pressure on rents and home prices. And again, it’s these reverberations of facts from 14 years ago, almost. It’s kind of crazy that we’re feeling this today. And I’m sure what we’re living through today, in COVID, we’re going to be feeling the effects of this for the next 5, 10, even 20 years going out there today.
Andy: So, wait. If I could just put a pin in one comment you made. So, I think you referenced the 500,000 a year is the need. Is that new multifamily housing units, and we’re only creating 350,000? So, not only is there a shortage, but you’re saying the shortage is actually continuing to get worse with each passing day?
Michael: Yeah. There is. Because, here’s the problem, right? You don’t solve this supply issue overnight. And it’s not just multifamily. It’s housing in general. And so, it includes for-sale housing and multifamily, they combine those together. In Phoenix, for example, in 2005, there were half a million people who were in some way employed in real estate, construction, development, etc. Today, there’s less than 200,000. And that’s not unique to Phoenix. That’s just one city. We know the big boom that happened there.
So many people have left the industry permanently. And when we think about how to start that engine back up, for the banks to be lending for spec homes, and things like that, you don’t have the same capital markets environment, and that’s a good thing. We don’t want the CLOs, the CDOs, you know, all the things that really created the great recession.
But you do have, the fundamentals are incredibly strong today, and a lot of them, you know, the supply and demand, some of it has to do with labor, some of it has to do with land prices, some of it has to do just with the fact that there’s a shortage of housing that’s really helping people today who are invested in multifamily, or even own their own homes in some of these growth markets.
But I know it’s easy… Like, we’re not running towards this trade. And one thing that we’re seeing in these markets, and the thing that… Like, when we’re evaluating an opportunity, whether it’s Denver, whether it’s Dallas, first of all, it’s where all of the population is going. So, our thesis is we want to be in climate-friendly states. We want to be in low-tax states. And the workforce is more mobile today than it ever has been. And what you saw happen in COVID has been happening for 40 or 50 years, where you’ve had a migration from the north to the south. COVID accelerated that.
And I fundamentally believe that this is the second inning. There’s not going to be a reversion to the mean here. This is the second or third inning. The first wave of people, we have them at Origin. We had several people who moved away, to be closer to their families, to be in tax-friendly states, to go to Miami, to Tampa, to Austin, to Nashville, these places, all the places we’re investing in for that reason.
You have another wave of people, for whatever reason, the frictional costs of where you live. For example, me, I have kids. I’m not going to pull them out of school for a lifestyle change. But in three or four years, that’ll be a decision my wife and I have to make, right, where do we want to live, because the crime, the taxes, the things, like up northern cities, and as much as I’d…
Andy: Time to go cowboy boot shopping, right?
Michael: Yeah. As much as I love Chicago, at some point, you’re like, “I’m a little tired of living in zero degrees in three, four months of the year, and the weather, and things like that, and it would be nice to go to some of these other states.
Andy: You know, it’s funny, Michael, that you mention all that though, because I love living in Chicago. I love Gibson’s. I love the Art Institute. I mean, there’s just places I love going. My wife and I, we had our first son, and so we kind of moved in that life transition, because I could kind of see it coming down the pipe. You know, and now we’re in a more rural area, we have five kids, I’m like, “I can only imagine what life would have been like if I had stuck around in Chicago.”
So it’s kind of interesting you mentioned that a lot of these moves happen at life transitions, and COVID was kind of its own special maybe one-off event. But this trend of migration to these Sun Belt states, it’s not really going to slow down. And if anything, there are still people sticking around other states that are still planning to move, right? So, like, there’s still future demand, what you’re talking about, people, possibly, like yourself?
Michael: Yeah, we’re not concerned. I’ll tell you what concerns me in the market right now, when you’re talking about Dallas, and Austin, and Nashville, and Denver, and these hot markets, are the buyers who are buying the existing assets, the value-add, the core plus, things of that nature. And when we’re doing development, the reason why we’re not buying any value-add or core plus today is because of replacement costs. And the only way that you can protect yourself in today’s market is by building.
That is how you are going to achieve the lowest basis in the market. And it might sound counterintuitive to build versus buy, that building could actually be less risk than owning, but if you’re buying a multifamily property, let’s just say, for $300,000 per unit, and the replacement cost is $260,000 per unit… And we’re seeing this all over. We’re seeing 10-year-old, 15-year-old properties trade $40,000 to $50,000 per unit above what today’s replacement cost is, and on top of that, the developer has to put in another, call it, $15,000 to $20,000 per unit, so their basis now is $320,000. And they have to make a profit on top of that in the future, so they need to sell these for $360,000. I would way rather be developing, and control my costs, and be into a brand new opportunity at $260,000, $270,000, $280,000 per unit than buying something new.
Andy: So, the “cap rate,” then, on that ground-up development is actually higher than the existing property you can go buy. And then, by the way, it’s not going to have a leaky roof on the first day, when you open up your brand new building, right?
Michael: Yeah, we use a term called return on cost, and return on cost is a cap rate in the future. So, you look at your net operating income that you’re going to produce in year three, you back that into your costs, and it’s the cap rate. And historically, you would have bought existing property, because your cash flow would have made that difference. You would have looked at it and you said, “Look, I’m going to buy this property because I’m going to generate an 8% to 10% cash-on-cash over these three years. And rather than building and waiting and taking this risk, you know, this makes more sense.”
Today that doesn’t exist, because people are paying 3%, 3.5%, and 3.75% caps. We’re starting to see the market move, the capital market shift a little bit, cap rates move up, but you’re not generating a cash-on-cash yield, because you’re borrowing at 4.5%. So when you’re buying at 3.5%, you’re borrowing at 4.5%, you’re paying the bank every month to own a cash-only asset, which makes zero sense.
Andy: Yeah. And I gotta ask, how could this even be happening? I mean, I know there’s, like, a lot of roll-ups occurring in various sectors because there’s this institutional money coming in that, like, we need to deploy a billion at a time. I mean, is it just because of these giant players that want to deploy it into an existing asset, or why would there be such a mismatch between ground-up development and these existing assets?
Michael: Well, for one, supply. So, you’re looking at limited supply, and what’s out there is getting bid up substantially. We talked about that earlier. And you’re right, it’s inertia. There are some funds out there, large funds, small funds, that have a mandate to buy existing properties. And so, when they’re competing in the market right now, especially for multifamily, you might have 10, 12, 14 people, you know, institutions that are competing to buy a single asset, and bidding up the price.
And then, when you have comparables in the market, and you see that properties are trading for $320,000 a door, well, that really feeds on itself because now people are like, “Oh, that’s the market. I can pay $320,000 or I can pay $330,000.” Ultimately, in multifamily real estate, the governor of pricing is replacement cost. Barriers to entry aside and things like that, and this is why we don’t want to be in a 15, 20-year-old property above replacement cost, because these distortions do make their way through the markets, and they normalize over time.
So as more and more supply comes in, your brand-new properties are going to continue to hold well and hold their value, and actually increase in value, while these older properties are going to be declining as people are selling out of those and realizing that there is no market for 20-year-old property trading above replacement cost. It’s sort of what we see in the market today, where you have, in some cases, used cars that are trading above new cars. As soon as we figure out this supply chain issues and the new cars start coming in there, that is going to just flip on its head very, very quickly.
Andy: Right. Yeah. No, that’s a good point, is that, you know, sometimes answers are as simple as patience, either personality-wise, or just, some people can’t afford to wait, whether it’s deploying capital or buying a car. You know, they just have to pay whatever the current market will bear.
Michael: Yeah. And Andy, I said before, I reserve the right to be wrong, and I reserve the right to be wrong. And we have been. We’ve been defensively positioned now for almost three years, pre-COVID, because of what we saw back in 2019, where value-add was creeping up to replacement cost. Well, at that time, by the time you were done with your basis selling, you were selling out way above replacement cost. The big shift that happened is replacement costs went way up during the last two years.
So anything we didn’t buy, whoever bought it did very well during the last three years. But that distortion has grown so large today that we don’t want to touch that with a 10-foot pole, existing product out there, and this is why we really have a barbell approach today. We’re lending to multifamily, protecting ourselves in the capital structure, by being lower, and having, you know, call it anywhere between a 20% and 30% cushion before we lose one dollar, and then, in development as well.
And in development, what you have to keep in mind is that you’re developing to a profit margin, of 30%, 35%, even 40%. And when we’re looking at development, and let’s say we’re putting $50 million into an opportunity, we’re looking at comparable properties that are very much similar, that are trading for $70 million, $75 million, $80 million. And when we’re done, that’s what we want to do is achieve that sort of $70 million and make our margin.
In order for us to lose a dollar in development, the market has to come down significantly, by about 30%, 35%, before a first dollar of ours is lost. And that’s how you protect yourself is through that development margin and in that environment. If you’re buying brand new, and you’re paying $70 million, and the market comes down by 20%, and you’re leveraged, guess what? Your equity is pretty much gone at that point, or you’ve lost 80% of it. So, I’d rather be in a position where we’re just making less rather than losing money.
Andy: Yeah. No, I like that. You know, that’s prudence. And speaking of prudence, I want to ask about relative value, okay? Because I know in the last episode we recorded, we talked about David Swensen, and the Ivy Portfolio, the Yale Endowment Fund, and just that kind of overarching theory behind alts, that ultimately, a healthy allocation to alternatives in an ultra-high net worth investor portfolio is attractive, because you get basically higher risk-adjusted returns when you go illiquid into some alts, right?
You have lower volatility, at least theoretically, and then higher returns for the amount of volatility you accept. And especially in the context, I mean, we were talking in, I think it was November or December of last year, where the stock market had had this huge run-up, and the bond market was…I mean, I want to say it was at historically high prices. I mean, I guess interest rates can go negative. Certainly, real interest rates go negative. But since that time, since six months ago, now we’ve seen corrections in the equities markets, we’ve seen a correction in the bond market.
I wouldn’t necessarily say bonds are a good value right now, but they’re a less bad value. They’re less of a rip-off, I would say, and I don’t know that I’ve seen the same correction in the real estate market. I mean, certainly, volume has decreased, you know, the transaction activity has decreased. But it doesn’t really see, you know, broadly speaking, I know every segment is a little different, but I don’t think we’ve seen that price correction. So, all of that being said, does real estate, do alternatives, do they still offer relative value compared to these more liquid traditional asset classes?
Michael: You were talking about David Swensen. And David, I actually saw him speak a long time ago. And I think it was my partner, David, who asked him a question. And really, his secret sauce was being able to select managers, and he had an entire team to be able to do this. And the reason why you want to get into alternatives is for alpha. That’s it. You don’t want to go get beta, you don’t want to just be in funds that expose you to the market. You want a manager who is actually creating value from the ground up, not through financial engineering. And that’s a really important concept.
And the other thing is that you don’t just throw asset allocation out the window. It’s a different way to perform asset allocation in a portfolio. So you still need your sectors, but you’re getting in through alternative managers. And real estate, I mean, I think it’s one of the easiest alternatives to expose a portfolio. And when you look at the math there, and we have this on our website, we talk to wealth managers all the time, but when you take a 60-40 portfolio, and you add real estate, it’s one of the few asset classes that no matter what period you’re looking at, not only does it produce higher absolute returns overall, but certainly higher risk-adjusted returns, too.
Because, if you think about real estate, theoretically, it’s a hard asset. It has predictable cash flows. It sort of behaves, from an investment standpoint, somewhere between a bond and a stock. And efficient market theory would tell you that, well, if it performs between a bond and a stock, and that’s where the risk is, well, your return should be priced somewhere between bonds and stocks. And historically, that hasn’t happened. Real estate has outperformed the S&P 500 over the last 5 years, 10 years, 20 years, 30 years, over this entire period. It is one of the most dynamic asset classes out there.
And we’ve been really, you know, just educating a lot of wealth managers about the role of real estate, and how to get into it, and why it should be added to a portfolio. And I’ve always been an evangelist about it. My partner, obviously, we believe in this, but we hired two PhDs. This goes back about five years ago, because we were doing a lot in the public REIT sector, and we asked them to put together a paper and do some analysis for us and some studies about how much real estate actually belongs in a portfolio.
And they’re the ones who backtested all this data and looked at private real estate, public real estate. And it was interesting because the more real estate they added to the portfolio, the better it got. And really, their conclusion was that, “Look, we just don’t even feel comfortable saying that a portfolio should be 80% real estate, even though that during every period, it performed better, so we’re gonna cap this at, I think it was 20% or 25%, because that…”
Andy: And I was just gonna mention, Michael, that sounds right to me because I think a lot of RIAs are moving off 60-40 as a default. And at least the ones that are kind of in tune with what we’re talking about, it’s more like, you know, 50-30-20, with 20 in alternatives. But, of course, you’re saying mathematically speaking, the 20 could be a lot higher.
Michael: The 20 could be higher. We’re just looking at real estate when you take 20%, because real estate is an asset class that really, it’s more predictable. So it’s going to create lower volatility, cash flow, appreciation. And you were asking about what’s going on in the capital markets. You know, the thing about the private market is it’s still, it’s not like just because you don’t see it, it’s not fluctuating. But as a manager, we have the ability to adjust our pricing according to what we think are reasonable adjustments.
And so, I’ll give you an example. Like, the public markets right now, I follow those, especially the REIT market, and the REITs are down about 30% right now. And you can make the argument that they were too high, that they’re too low now, but they’re subject to the whims of the market, to the emotions of the market. And the earnings don’t really change, it’s just the sentiment of the market, like so many companies out there.
In the private side, when we are marking assets to market, we’re marking them up slowly over time. And if we see an outlier, and somebody paid too much for a property, we’re going to discount that, and we’re just going to get rid of it. It doesn’t do us any benefit to create volatility within the portfolio by marking it up here, then a sale happens down here, and we’re continually remarking things.
We’re looking at, “Hey, based on all the information we have, based on what we know about the markets, the economic value, what is the value of our assets?” And I can tell you that the market today is different. It’s lower on the private side, and it’s lower on the public side. The difference is that the private side hasn’t been marked up as much. So you’re going to see a small correction, where funds are writing down 5% or 10%, whereas the public markets overshot to the top, and now they’re marked way down, and they’ve probably overshot to the downside as well, based on the information that we’re seeing out there.
So, there is this sense of stability in the private markets, because we just don’t have the volatility of the public markets to deal with, and we’re using, you know, information internally to get to the economic value of the deal, and then ultimately the fund.
Andy: Sure. So, yeah, I mean, you mentioned REITs. And, you know, I’ve been saying this for a while. I don’t really recommend investors invest in publicly-traded REITs, or at least I didn’t, certainly not last year, simply because it seemed to me that there’s this huge liquidity premium being paid for them, such that, you know, they just weren’t a good deal. Like, in the grand context of real estate, to me, they got too liquid, in the sense that big funds, or investors who just wanted an allocation to real estate would invest in a publicly-traded REIT. They became a crowded trade, but if you looked at the underlying fundamentals of the assets inside the REIT, compared to the assets inside an alternative, like a non-traded or illiquid alternative, the REITs were just a terrible deal.
And so, as you’ve said, you know, if they’ve fallen 30%, I think some of that is probably just, like, the liquidity premium. Some of the liquidity premium has, you know, fallen away, and then some of it is economic adjustment.
Michael: Andy, I’m going to disagree with you a little bit here. Okay, I’m a big fan of public REITs. And it’s not an or, it’s an and. And the challenge with only going into private is a company like ours, I can only give our investors exposure to multifamily. I can give them alpha through ground-up development. The public REITs allow you to gain exposure to other asset classes that you may not even be thinking of, which is why they’ve outperformed the S&P 500 over so long.
If you want to gain exposure to commodities, timber, lumber, things like that, you buy Weyerhauser. Timber is one of the best investments out there, and you have to be careful about price, to your point, but REITs are so transparent that you can get to the underlying net asset value, to understand when you’re getting a discount versus a premium, and paying, and they really don’t fluctuate too much around the true net asset value, as you can imagine.
You can get exposure to technology, through datacenters, through cell towers, things that we don’t even think about, through traditional real estate. You can take advantage of the trend in e-commerce by getting into private real estate, through industrial or, in public real estate, in industrial, on that side. So I really think it’s an and, not an or, that, you know, private real estate, a lot of times, especially in called capital funds, you have capital sitting around, you have deploying capital, and by using both together, that becomes the most optimal portfolio.
I actually think the public markets, we would never go public for this reason, or have, I think that they actually discount the true value of these REITs. And if you go back, even looking at Equity Office, what Blackstone did back there in 2008, Blackstone, and I think you’re gonna see this in the market today, Blackstone took Equity Office public, and instantly create an arbitrage.
They paid 40% more than the stock market was valuing the company for, then they arbitraged it, sold everything off except for Boston, and they essentially kept a $5 billion portfolio for free. And when we’re looking at cap rates in our markets today that are 3.5%, 3.75% on the private side, but something like Mid-America Apartment Communities or Camden Property Trust, that are also in these markets, their underlying cap rate today is, like, 5%.
So, the difference is, though, you have to be careful about saying, “Hey, a REIT is a property.” A REIT isn’t a property. It’s an operating company, and you have tens of millions of dollars of G&A that have to be allocated. So, generally, the properties have to work harder, right, because they have to pay all that G&A to trade at the same price. I hope I’m making sense there [crosstalk 00:39:48]
Andy: No, absolutely. And, I mean, I take your point. And especially, you know, after price correction, there’s probably a lot more value in REITs right now, certainly than there was, you know, 12 months ago. But, you know, on the question of price correction, interest rates, inflation, it looks to me like there’s a healthy chance we’re already in a recession, and maybe that information, just, we haven’t really caught up, I guess, to the news, but, you know, maybe not. I mean, what do you think? Do you think we’re already in a recession? Do you think that’s premature to say that?
Michael: I think we’re in a recession, personally. That’s a guess. Whether it’s today, whether it’s, you know, next month, in six months, we’re gonna see a recession, and it’s gonna look more like 2001. The Fed is reducing its balance sheet. I think the Fed fell asleep at the wheel as well, and they’re way behind the eight ball here. And they have all the data and the information. Inflation is not transitory. And I don’t think we’re gonna have a soft landing here.
If you go back to 2001 and you look at that recession, it took 18 months, or even longer, before the stock market hit the low. And then we were in that for quite a long time. It wasn’t even across the United States, but it took another 12, 13 years before the stock market hit a new high. And what’s scary is the generation now, they only know V-shaped recoveries, because the Fed stepped in in 2008, and the Fed stepped in, you know, during the pandemic.
And these bear markets, that just lull you into buying things, “Oh, look at that, it’s $300. I’ll buy it. Oh, now it’s $250. Now it’s $200.” And we haven’t seen capitulation in the market. So it’s really going to be interesting. No recession is the same. And this is going to take a while to play out because of the amount of debt and the Fed’s balance sheet, and everything else that has to be unwound, and a lot of the geopolitical events that are happening. But this is the time where a diversified portfolio, having liquidity, having some cash, is really important for everybody out there.
Andy: Yeah, I mean, but holding cash is hard, right? If inflation is 8.5% a year, that dry powder is expensive. So, what’s Origin’s strategy, then, in terms of dry powder? I mean, are you all, you know, waiting to see what unfolds in the next year, to see if this creates opportunities? Or are you more in a hunker down and execute existing projects mode, or how does that affect your strategy?
Michael: We are still deploying capital. And the conversation internally is about really predicting, and taking the information, the last six months, processing it, working those into our models, our variables. Because when you’re looking at, we had a conversation today about comparable sales that happened six months ago. Well, six months ago was a different world. It was a different economy. That’s when the 10-year was below 2%, and everything looked normal.
Now it’s at, you know, above 3.2%, 3.3%, right now. And so we have to make adjustments to our model as well. But as I said before, we’ve been defensively positioned for three years now. In all of our funds, everything we do is about protecting ourselves through capital structure or through basis on that side. And we have been a net seller of assets for the last two years, right, throughout COVID.
So our Fund II, our Fund III, we used the strength in the market to get a lot of that risk off the table. And we’ve seen, you know, the capital markets just pull back pretty considerably. And I would say, going into 2021, when we were getting brokers’ opinions of values on our deals, they would come up, I’ll just make it up, $70 to $75 million, and we’d strike at $80 million. And in the last few months, we were getting brokers’ opinions of values, $70, $75 million, and buyers were coming in there at $65, $66, $67 million.
And we were transacting at those prices, because it’s better, you know, because that same asset that we’re transacting at $67 million, well, a year ago, it was probably worth $55 million. So we think that’s still a fantastic price, and to get out at these levels today. And so, in some ways, we’ve been de-risking our entire portfolio, and then taking calculated risk on the other side where we can protect ourselves.
Andy: Understood, yeah. I mean, a bird in the hand beats two in the bush, right? And on the topic, then, of defensive posturing, I’m honestly wondering, can they tame it on the inflation question? Because, on the one hand, they can raise interest rates, and they can send the economy into recession, almost on purpose. It’s almost like that’s what you have to do to tame inflation. But that’s not going to solve the supply chain problems. So, can we be in a situation where we get both? Where we get sustained higher inflation and go through a recession?
Michael: Yeah, you’re talking about 1970s. I think that’s what everybody’s concerned about, is stagflation. Now, I did read some news today that was good, and China is coming back online. And they’re starting to ease some of their restrictions, so that could help some of this. And they will get inflation under control, by very definition. But the thing about inflation, I was looking at an article from “The Wall Street…” actually “The New York Times” a couple weeks ago, and they had inflation that went back all the way to the 1950s.
And what you notice about inflation is it’s whatever the prices are for a basket of goods, it’s here to stay. It’s not like you have 9% inflation, and then two years later, all of these price hikes go away. It’s sticky. It’s here to stay. And there’s only been one time in the last 60 years that we’ve had negative inflation, and that was in 2010, when you had the great financial recession. That was pretty awful. But that then spiked the next year because, you know, the economy just shut down.
So, especially when we’re talking about wage inflation, because it’s not… You know, when we’re hiring people, and we’re feeling this today… I belong to a Vistage group of a lot of business leaders, everybody’s feeling the war for talent, the wage inflation in there. Once you start giving people these new wages, you give them raises, it’s incredibly sticky. You can’t take them back. And you shouldn’t, because they have a higher cost of living as well, and inflation’s out there, 10%.
But what will happen is if you need to cut costs, you’re not, you know, reducing wages, you’re laying people off in that situation. We’ve already seen a huge freeze on hiring from a lot of major companies out there. So to your point, all the leading indicators point to the fact that we are in a recession or heading for it. We’ve already had one quarter of negative growth. Another quarter, and that’s textbook recession, so we’ll see what the future holds. The U.S. economy is resilient, though. This is not a time to panic. Just make sure that your portfolio has good investments in it.
Andy: Yep. So, for our listeners, Michael is a prudent manager, I believe. And I appreciate your candor, just with the balance of optimism, but also realism of what’s going on. And it’s really cool just to hear how that feeds into your investment strategy, which, to me, again, I guess if there’s one word I have in my head, it’s just prudence. And I think that’s a great stance to have as a steward of investor capital. And I think a lot of our listeners and visitors are probably interested in learning more about Origin Investments. So, Michael, where can our visitors go to learn more about Origin and all your offerings?
Michael: Go to origininvestments.com, or you can email me directly, [email protected]. And Andy, I want to say one thing about what you just said, which, you know, is really about experience as well, and you look back at this, because I’ve been a student of the markets for 30 years. And what I realized, and I told somebody this the other day, you have to keep investing. You can’t put your head in the sand.
If I would have told you that at the beginning of 2020 that there was going to be a global supply chain issue, that there was going to be a pandemic, the world was going to shut down, that Ukraine was going to war with Russia, what would you have done at that time? You would have put your head in the sand, you would have sold everything, and it would have been the worst thing that you could have done, because the market had this massive bull run.
So even in the face of us having all the information, we still might be wrong on what we should be doing with our money. And it’s so important. The most important thing is to always be invested in the market, and protect yourself along the way however you can, whether that’s through portfolio allocation, or whatever other methods you have, but make sure that you can sleep at night. But hiding your head in the sand is not a good strategy.
Andy: Absolutely. Words of wisdom to live by as an investor. And as a reminder for our listeners, if you want links to all of the resources we discussed on today’s show, including, I’m going to put a link in to the “Multifamily Markets to Watch Report,” as well as a link to Growth Fund IV. You can access our show notes at altsdb.com/podcast. And don’t forget to subscribe to the show on YouTube and your favorite podcast listening platform, so you can receive our new episodes as we release them. Michael, thanks again for coming on the show today.
Michael: Andy, thank you for having me.