How real estate investing works with Moses Kagan

This week I'm joined by my Internet buddy Moses Kagan, who does residential commercial real estate investing and property management in Los Angeles. In every industry there are some rare individuals who just exude care for the details, and Moses waxing rhapsodic about lease clauses or something similar put him on my radar years ago.

I brought him on because many of you enjoyed my episode with my father Jim McKenzie, which covered real estate development. Real estate investing is another part of the value chain which brings homes (and other real estate) into service and keeps them there, and given that we're all dependent on it, I think it is worth more considered study than it typically gets. Plus, it sits at a fun nexus of finance, societal choices about what forms of ownership and equity risk to subsidize, and our individual and collective choices about our built environment.

[Patrick notes: As always, I include notes in the transcript, set off in this fashion.]

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Timestamps

(00:00) Intro
(00:25) Understanding the stigma of the maligned landlord
(04:07) Landlord spectrum: from mom-and-pops to institutional players
(05:29) Inside Adaptive Realty
(06:13) Owner vs. property manager
(07:34) Challenges and complexities of property management
(15:00) Capital stacks and loans
(26:25) The role of banks and underwriting in real estate
(40:28) Federal subsidies and small scale landlords
(44:26) Understanding commercial real estate classes
(46:20) Challenges of Class C assets
(47:13) Explaining cap rates
(52:20) Raising equity for real estate deals
(54:16) The syndication process
(56:30) The role of brokers and execution risk
(01:00:52) Legal structures and documentation
(01:10:59) The power of networking and reputation
(01:23:34) The impact of supply and demand on rents
(01:28:03) Wrap

Transcript

Patrick  

Howdy everybody, my name is Patrick McKenzie, better known as patio11 on the Internet, and I'm here with Moses Kagan.

Moses 

Hey Patrick, how are you doing?

Patrick  

I'm doing very well, thank you. 

So recently we had an episode about real estate development. You have been working in fields which are quite related for that for a while, and I became aware of you on Twitter – which we'll talk about later.

Understanding the stigma of the maligned landlord

There are lamentably few public intellectuals in the field of landlording and property management in the United States. [Patrick notes: I mean this entirely literally.] 

Since that is obviously relevant to everyone – because all work that is done on infrastructure takes place in a physical location, and all of us need to live somewhere, and these business models are sort of intrinsic in that calculation regardless of whether you buy or rent – I just wanted to have you on and help raise the sanity level among people. 

I do say ‘sanity level’ because landlords, maybe uniquely among any other business in the world, I feel, get maligned. (I suppose I have to make a disclaimer. I'm technically a landlord given that my property in Tokyo is currently occupied by another family.) 

Why are landlords so maligned in our culture?

Moses 

Yeah, great question and happy to be here – thank you for that. 

I think it's because everyone needs a place to live. There are a whole bunch of people who, for various reasons, can't or don't want to buy; all of those people are reminded every month when they send in their check on the first that they are paying for the privilege of living in someone else's property – and in general, that is an unpleasant feeling, I would say.

Patrick 

I think it's also one of the most legible expenses to people. (Legibility to governments, to organizations, to everyone is a recurring theme of this podcast.) A rent check is kind of unique in your expenditures in that it's very large and it is to one person, or one entity, repeatedly, and so it is very difficult to not know how much you pay in rent – whereas is very easy (in fact it is designed to be very easy) to not know what you paid in interest this month or to not know what you paid in taxes this month.

I have an essay at Bits about Money about how the payroll industry exists in large part because it is in the government's interest to make it less than legible to wage earners how much of their wages went to the government this month.

Moses 

For sure – and let me also just say that there is illegibility on the other side. I think that many renters sort of implicitly believe that rent is 100% gross margin – in other words, that the landlord just pockets the check. To that, I always respond, “Then why am I paying all these salaries to the property managers who work for me, to the repair people and to purchase materials, et cetera?” I mean, it's not a low-margin business, but there is enormous complexity in safely running apartment buildings, particularly in highly regulated markets like Los Angeles.

[Patrick notes: By the standards of software it is certainly a low-margin business, though I suppose by the standards of software almost everything is a low-margin business. Figure about 25-30%ish on an EBITDA basis, though this will vary with location, vintage of the property/portfolio, entrepreneurial skill, and scale.]

Patrick 

Yep. And I don't think people necessarily appreciate how sophisticated the landlords are, because there is a sort of spectrum of sophistication in the market – and because our image of a landlord is often informed by fiction in which it is a particular wealthy individual who runs a block of apartments in Brooklyn in 1930s, which does not necessarily correspond one-to-one with how blocks of apartments are run in Brooklyn currently. Or it is a “mom-and-pop” landlord.

Moses 

Yes. I would say that mom-and-pop landlords are overrepresented at the extremes: they are usually overrepresented among the best, friendliest, nicest landlords who hold your rent low and care about your family and everything, and then they are also overrepresented among the landlords who violate fair housing laws and, you know, take people's doors off their hinges when they're late with their rent or all kinds of other crazy stories that you that you hear every once in a while.

Landlord spectrum: from mom-and-pops to institutional players

Patrick 

Yeah. So feel free to counter-propose the taxonomy here, but I like to think of landlords along a spectrum: on one hand you have mom-and-pops who perhaps bought a house for their own family, outgrew it, then bought a new house to live in and now they rent out the old house; there's a variety of different family stories that end up rhyming like that because part-time or other-than-intense use of landlording as a side business is one of the great stories of wealth creation in the United States, historically. 

But so we've got the mom and pops on one end; on the other end of the scale we have institutional players who raise dedicated funds and have hundreds of millions of dollars of capital available. Perhaps people have heard recently that the BlackRocks, the large asset managers, have moved into single-family residences for the first time in history in the last, say, 15 years-ish – I think that is oversold as a story for reasons we might get into. 

[Patrick notes: BlackRock takes pains to disclaim any investment in that asset class, but as one of the largest asset managers in the world gets thrown into discussions frequently.

The actual large portfolios of SFHs run institutionally were mostly assembled in the wake of the 2008 financial crisis by taking over bank’s portfolios of distressed properties after mortgage holders had defaulted on them en masse. Invitation Homes and American Homes are publicly traded examples; there are some private ones.]

But large apartments being run by institutional capital is very much not a new phenomenon. It's almost the only way you can do it for reasons we'll get into. 

Then there's firms that are in the middle of those two extremes, where you do have external capital partners, you are operating in the business as a business, versus operating as “this fun little hobby that throws in a couple of hundred dollars into your savings account every month” – but you are “sub-institutional.” And I think that's where you play?

Inside Adaptive Realty

Moses 

That's right. Maybe for the benefit of your listeners, let me just give you kind of a sense for who we are, where we are, etc. 

I have been buying and renovating and managing apartment buildings, exclusively in Los Angeles, since 2008. I founded my present firm, Adaptive Realty, with a partner in 2012. We currently own approximately 50 small buildings with investors, which works out to about 400 units. We also have a property management operation, through which we manage a total of, I think it's actually approaching 1,200 units now. So the 400 that we own with investors and then approximately 800 that we manage on behalf of a small group of third-party owners.

Patrick 

And so for people who have not been in this industry, what is the division of responsibilities between a landlord and a property manager, for those landlords that choose to bring in an external property manager?

Owner vs. property manager

Moses 

Yeah, so just to be clear: first of all, I would use the term owner, versus property manager. Landlord kind of sometimes blurs the distinction between the two, but they are two very specific separate roles. 

In a classical sense, the owner – and let's just imagine that the owner in this case is a family or a wealthy individual, because then it gets more complicated if you start raising syndicated investment capital the way that we do – but imagine you're an owner. Your name, or an entity that you control's name, is on the deed.

You own the property. You are responsible for financing it – so, you know, obviously the simplest thing to do is just buy all cash, but mostly people use some kind of debt, anywhere from probably 50% of the purchase price all the way up to, in extreme cases for first-time home buyers using FHA loans, 96.5% of the purchase price. (That, by the way, is an amazing rung onto the ownership ladder for many, many families.) So that's the owner – to identify and buy the property, to capitalize it, and then typically, for larger properties, to hire a property manager to oversee the property.

[Patrick notes: I’d also note that society has a large number of expectations of property owners, and they attach to the landlord rather than the landlord’s agent, in a buck-stops-here fashion. One is paying property taxes. If you stop doing that, you will fairly deterministically stop actually owning the property, in a commanding majority of relevant jurisdictions.

Many people understand that employers are deputized by the state to act as tax collectors, due to payroll taxes, and that few employers started their present business because of a burning urge to become a tax collector. Comparatively few people understand that landlords are also tax collectors.

And, indeed, part of the reason we call them “landlords” is because one method of medieval social organization was hierarchical arrangement for tax collection, including by buying commissions from political authority allowing one to collect tax (from which one would extract a rake).

You require a roof over your head, and your government charges you for the privilege on a sliding scale, set by (in much of the United States) a department of people organized for the purpose of doing this. If you are a renter, the fact and amount of this taxation is simply not disclosed to you.] 

Challenges and complexities of property management

Moses

There are, of course, some owners who choose to self-manage, but in general, as you start to go up the ladder in terms of the size of the assets, it gets pretty painful. We can talk about it: it's painful for the owner to manage, and there are some significant benefits to scale on the management side. So typically, people who are sophisticated hire property managers. 

So what does the property manager do? The property manager is a company, typically. The revenue for the company comes from several different sources, but by far the most important one is typically a percentage of the rents collected. So in our case, depending on the asset, Adaptive takes somewhere between 5 and 6% of the gross revenue collected as a management fee. There are some ancillary fees too around leasing and inspections, and some people charge a markup on maintenance – we don't – but that's how the property manager is being compensated.

[Patrick notes: I expected to be quoted about 10% for the U.S. but a large part of the work is based more on number of doors than on gross rent, and therefore a portfolio which has relatively high rents might bias in the direction of relatively low percentage. I pay 5% in Tokyo for similar reasons.] 

Moses

Their job is to ensure that the units are full with tenants who can pay rent, to fix problems with the units or with the property – my toilet's broken, my refrigerator has stopped working, etc. –  and also to act as a long-term steward of the property: apart from these sort of day-to-day OpEx issues, to do things like have the roof replaced when it's necessary, make sure that the sewer system is regularly hydrogenated to prevent expensive clogs and backups, things like that.

Really, the idea is to allow ownership to be as passive as possible so that the owner can think about owning the building as a financial investment, as opposed to running an operating business.

Patrick 

Yep. And the trade-off here that happens for all landlords or proto-landlords is, you can have a business which on paper looks higher-margin, if you are willing to internalize the task list of responding to text messages from a (perhaps inebriated) tenant at 11 o'clock regarding the toilet, or managing the sinking fund yourself, et cetera, and doing all of your capacity planning on that. 

[Patrick notes: In an example of second language interference in my first language, I think I quoted the typical translation of a concept (修繕積立金 = sinking fund) which is quite common in Japan but perhaps less commonly called by that name in English-speaking countries.

The notion this concept points to is that a landlord should keep a reserve for repairs and periodic maintenance, which may arrive in a spiky fashion, out of the regular stream of rents. Getting this wrong is a good way to blow up your business as a landlord, and so you can ask property managers to do any of a spectrum from “I never want to think of this; manage it for me” to “Help me build a capital plan; I’ll have sufficient liquidity when the plan calls for it.”]

Patrick

This is one of the reasons why I think our mom and pops end up with higher variance under the spectrum: you can be a very great landlord for a very long time, and if you haven't set aside money for the boiler breaking, both you and your tenants will have a bad time in a hurry – and there will be relatively little evidence of that until the moment where a boiler breaks in the middle of Chicago winter.

[Patrick notes: This could be $8k-20k depending on circumstances, which is a check size that is awkward for many middle class landlords to navigate when it arrives out of the clear blue sky.] 

Moses 

Yeah. That's one scenario; there are so many more. I don’t want to get too dark here, but the range of scenarios that we've dealt with, from flashers, to violent crime, to massive leaks leading to mold – you name it, things can get very complicated. 

This is particularly true when you‘re in a heavily-regulated jurisdiction. All owners and operators of residential real estate are, to varying degrees, subject to regulation. Obviously in a place like Texas, let's say, that regulation is pretty light touch; somewhere like Illinois or California, that regulation is absolutely not light touch. There is a thick and ever-changing book of regulations to which residential owners and operators are subject, and it is very difficult for a mom-and-pop who's doing this at nights and on weekends, for one unit or for one building or whatever, to keep abreast of the current regulations.

Patrick 

Mm-hmm. Just a residential lease in Chicago was, to my recollection from signing one in the not-too-distant past, something like 60 pages [Patrick notes: 23 pages plus attachments summing to that ballpark] – and each of those subparagraphs is a responsibility of the landlord, which, if not fulfilled correctly, the tenant can first protest to them and hopefully it ends up fixed there, if not protest to the responsible part of the Chicago city government, which generally speaking favors the tenant in those protests – and refuse to pay rent until the issue is remedied. You can lose a lot of money in a hurry. 

Also, a thing not appreciated by tenants, which is...

I think much of the discourse about these issues kind of circles things that are, broadly speaking, impolite to bring up in United States society. Tenants broadly feel, “I am a reasonable individual. I have never intentionally taken an axe to anything in my apartment. And therefore, the maximum loss that a landlord has ever had associated with me is one month of rent plus a couple of hundred dollars, maybe of reasonable wear and tear, and that one time my kid accidentally broke a window.”

That is not actually the upper end of the spectrum. The amount of damages that can happen if someone, for example, runs a meth lab in one unit – which will make not just that unit, but all adjoining units on the property require an expensive multi-month remediation project – is just, ugh. [Patrick notes: The state of Kentucky tells landlords to budget $20,000 for this, and that is not the top of the range (low six figures).] 

Anyhow.

Moses 

Yeah, I mean, we once bought a building where one tenant had attacked another tenant with an axe. (Thankfully, we did not own the building when this occurred.) The broker told me, and I kind of – you know, you're getting a bunch of information when you're in the process of buying a building and I just kind of said, “Ok, this is a piece of information.” 

We got there to inspect the building, and there was literally a gash in the steel security door, which is in front of the regular door, from where the tenant tried to chop down the door to get at the other guy. The level of complexity and liability extends past even just the normal things that you think about.

Patrick 

Yep. I have a fun side anecdote for this. 

Laws are downstream of culture in a lot of ways, and cultures have their idiosyncrasies. One idiosyncrasy in the culture that is Japan is that there is an aversion to being in spaces in which people have died – so one of the, you know, 700 requirements [Patrick notes: number is illustrative] that you're expected to satisfy if you lease out property in Tokyo is, if someone has died in the unit in the most recent possession, you are obligated by law to inform prospective tenants of that fact.

[Patrick notes: The authority is in Article 47 Section 1 of the Real Estate Business Law. Interestingly, it isn’t specifically called out; this is so deep seated in cultural practice that the generalized prohibition against concealing material information from counterparties to real estate transactions is considered to obviously cover the case where the previous tenant passed away.] 

Patrick

This ends up being – (1) An operational issue – Landlords would of course strongly prefer people not pass away… and if they have to pass away, perhaps pass away after having moved out – and (2), a side quest which many Japanese landlords have to embark on is, “Okay, given that someone has passed away in the unit and one has done the usual level of cleaning up after that, summoned the family and dealt with the tears, and filed the police reports and similar: now you have to engage a Shinto priest to do an exorcism, because a large portion of the prospective tenant population will expect you to have dealt with potential ghost issues.”

I'm not saying that just as a bit of exoticism about Japan, like this is the culture that is landlording in Japan and you deal with it. 

But getting back to the more legible and Microsoft Excel cultures: if you have an apartment in Los Angeles and, say it's Class B maybe (we'll talk about classes in a moment) – if I'm doing my mental math correct, an eight-door apartment building in Los Angeles is probably outside of the capabilities of the typical middle-class American household, so there needs to be a capital stack put together to either acquire that building or construct it in the first place. What does the capital stack for that building look like?

Capital stacks and loans

Moses 

Yeah, it really depends. I should say that there are families who can and do: frequently what happens is, they started out with one small building and lived there and maybe rented a couple of units out or one other unit out, and then rinsed and repeated basically over and over, until it snowballed to the point where they can buy that kind of stuff.

Patrick 

I think that's one of the most common stories for intergenerational wealth in the United States: Often the case is, accidentally, families ended up levered long to the future of their city – and being levered long to the future of Chicago in 1950 or Los Angeles (and I know Los Angeles much less well) in 1920 or something, and just staying exposed to that beta plus leverage for 80 years, it works out pretty well for you.

Moses 

For sure. And interestingly, just before we get into the capital stack stuff, many of these families tend, in my experience, to be disproportionately immigrant, or one or two generations removed from an immigrant background, including my own family on both sides. 

I think part of what's going on is that in many places, you were not (and maybe are still not) allowed to actually own land. In China, for example, my understanding is that you get basically a long-term lease from the government. 

Patrick 

99 years to my understanding, but yeah. [Patrick notes: Inaccurate; had misremembered the lease of Hong Kong. 40-70 years depending on purpose per Wikipedia.] 

Moses 

So you get these energetic, ambitious, enterprising people who come to the United States and they start working whatever job they work, and then they realize that they can actually just buy land in a city, which probably they were not allowed to do for whatever reason where they came from. And a lot of times they jump on that opportunity, they just keep doing it, and like we said, they start snowballing it into larger assets. 

Patrick 

Can I pull out my immigrant card here? (And I literally have one in my pocket because I was an immigrant to Japan for 20 years, and I'm a landlord in Japan.)

[Patrick notes: Yes, literally literally. After 20 years of being notionally subject to arrest if I went outside without it, it is permanently affixed to the top of my wallet. My Illinois state ID, by comparison, sits somewhere behind my health insurance card and in front of the point card for a donut chain that I haven’t been to in years.]

Some of the other factors that caused this: in many times, in many places immigrants are restricted from doing many remunerative, high-status jobs within capitalism. Landlording is not typically considered a high status job. I think very few people listening to this had ever had one of their friends announce growing up, “You want to be president when you grow up? I want to be a property manager!” – you know, like, “Sign me up for organizing plumbing at 12 a.m. in the morning!” 

It's a kind of dirty, grungy, in many cases, you know, socially looked down upon occupation, and it ends up anti-selecting for people who go on to run many other businesses in the city – thus getting left over for people who have relatively few other options. Which is, you know – on the one hand, societal discrimination against immigrants is unfortunate always where it exists, and on the other hand, like, this has been an repeatable escalator for generations in places like the United States, also to a lesser degree (but to a real degree) places like Japan, et cetera. So this is an interesting ethnographic side note of this.

Okay, returning to our discussion of Microsoft Excel.

Moses 

For sure.

Let's see. So an eight-unit apartment building, call it – I mean, there can be a wide range of per-unit prices, but call it two and a half million bucks in Los Angeles. 

For a building of that size – first of all, anything above four units is out of the realm of the sort of standard, Fannie Mae-backed 30 year fixed-rate mortgage; once you get to five units and up, you're dealing with commercial mortgages. And there are one or two exceptions, but in general, commercial mortgages are not like 30-year fixed. For a building of this size in Los Angeles, what they typically look like is, you probably can borrow 65 or maybe 70% of the purchase price – and we can talk about what the governing factors are on that – but you are gonna borrow it typically with Chase, which is currently the best lender for this stuff. It will be a 30-year loan, but the interest rate is only fixed for the first three, five or seven years. 

Patrick 

That's the ARM (Adjustable Rate Mortgage) that many people might be familiar with, which has – I won't say disappeared from residential, but it got much less common after 2008, for a variety of reasons. [Patrick notes: About 8% of the market, down from about 35% during the boom years.]

Moses 

Yep, that's right. For these adjustable-rate mortgages, there's usually some element of interest-only – I.O. is what we call it – in those mortgages. The most appealing kind right now, frankly, is a Chase mortgage: a 30-year loan, seven-year fixed rate, seven years I.O. 

So for the first seven years of the mortgage, you're not amortizing at all. After year seven, if you still have the loan in place – and you probably won't for reasons we'll talk about in a second – the loan starts floating and amortizing. So there's a reference rate in the loan docs at SOFR, and then the loan is priced at some margin over SOFR. So once the fixed-rate period ends, you look at whatever SOFR is and you add something to that – some margin for the risk and profit for the bank. That becomes the new rate, and then in addition, you have to start amortizing, so after that seven year period ends, in general the debt service payments are going to expand a lot.

[Patrick notes: SOFR is LIBOR now that LIBOR is no longer LIBOR, as Matt Levine readers know. It has the advantage of being single-source, authoritative, and considered immune to corruption. The actual definition is simply “what’s the going rate to borrow money overnight if you are an institution which can secure 100% of your borrow with a Treasury bill, the platonic ideal of a riskless asset?”]

Moses

Now, it is very rare – it's probably happening a little bit right now because rates have gone up so much in the last couple of years – but in general, it is very rare for anyone to allow a loan to actually get to the end of that seven year fixed rate period. Typically what happens is, there's a prepayment penalty associated with the loan for the first three, four, five years after you get the loan – just to give you a sense for what it is, it might be 5-4-3-2-1. In other words, if you repay the mortgage in year one, you have to pay the bank a premium of 5% of the total mortgage value as a “let me out of this loan” penalty; year two, 4%, year three, 3%, etc.

And so obviously, once you start getting down to 1% or zero, that's when most people start to look to refinance the mortgage if possible. 

Patrick 

There are a few reasons for the prepayment penalty. One is “because we can” – banks are capitalist institutions and unlike for residential mortgages, there aren't structural concerns which cause them to not be able to do a prepayment penalty; in certain negotiations in certain places, it is kind of market standard.

[Patrick notes: Consumer lending with a prepayment penalty is relatively rare in the U.S. The place where I think you are most likely to encounter it is a car loan in a state where this practice is not illegal. Many auto loans are originated by the dealer but then quickly sold at a premium to face value; the dealership makes a lot of money out of manufacturing loans versus selling cars at a relatively small markup.

The party buying the loans often has a right to put the loan (force the dealer to buy it back) in a variety of circumstances, including very early repayment. Among other things, this discourages dealers from turning cash buyers into “sign this loan doc and I will put $500 in your hand then you can repay it tomorrow for all I care” buyers. The prepayment penalty is designed to discourage customers from triggering the put.] 

Patrick

The other big reason is related to the costs associated with writing a mortgage for a bank: they have an ongoing capital cost, which might get laid off on a different market (which is another podcast episode entirely), but their servicing costs are very heavily weighted towards the origination stage of the loan – no bank servicing department would tell you that servicing costs disappear after the mortgage is originated, but in terms of dollars and cents, they spend more than 80% of the servicing costs before the time the loan is dispersed.

As a result of that, if you disburse a loan and then repay it back a day later, the bank will take an enormous loss on that loan. To compensate them for both the effort on your loan and the effort for all the loans that did not get as far as disbursement, where they looked at it and decided, “eh, no,” –  typically nobody pays a fee in that circumstance – there is that diminishing prepayment penalty according to a schedule.

There are consumer loans that have that feature available. Some auto loans do, to my understanding, but for a variety of cultural and political economy reasons, we don't do it for standard residential loans in the United States.

Moses 

Correct. There's actually even a scarier version, which is called defeasance or yield maintenance where – and this has to do typically with when the loans are securitized – the bondholders really don't want the loans paid back [Patrick notes: ahead of schedule; they urgently want them paid back in a timely fashion as agreed]. So instead of being able to get out of the loan by paying this prepayment penalty, you are instead required, if you want to get out of the loan early, to provide the lender with a security that matches the payments that the lender would have received had you not prepaid. So there's a whole industry of these little investment banks that create bespoke rate products that allow you to get out of these loans if you need to sell the building or you want to refinance or whatever.

Patrick 

Yeah, to avoid a deep dive into the balance sheets of small and medium-sized banks in the United States, one bit of commentary I'll give: someone who has invested – and it typically will be a pension fund, or these days I suppose that people could have it in their IRA through an ETF or similar product, a mutual fund – someone who has invested in a pool of securities that the bank has issued, definitely wants it to be paid eventually, but they want it to be paid according to their schedule.

[Patrick notes: As a representative example, consider holders of the iShares Agency Bond ETF. They own, effectively, interest in mortgages, abstracted through a few layers. This is a product which will routinely be a retail investor’s portfolio.] 

Patrick

If they're a pension fund, they've had their actuaries work out, “How much money do I need 30 years from now given, you know, my current workforce size and my anticipated assumptions with regards to life expectancy? Okay, I'm going to put money in the market that will have payments that will be reliably available to me in 30 years.” 

They don't want you to pay back in year two because then they have to do that work again. Like, “Okay, boot up Excel again, let's bring in the actuaries. What do I need to buy to replace this?”

So, this financial product is structured by the finance industry. They go out to customers and say, “To manufacture this product, we need to make a durable promise to you [about expected payouts over time]. To make that promise durable and not take on an incredible amount of risk at the bank level, we have to push prepayment risk to our customers. We can do this in CRE (commercial real estate), in some cases, but we can't do this with respect to standard home loans.”

(Sorry, I geeked out on this a little too much, but we're the right people to geek out on it.)

The role of banks and underwriting in real estate

Moses 

No, no, this is good stuff. 

So that's your debt. And I should say before we move into talking about the equity that typically what the bank wants to see to make that loan – they're one of the cool things about particularly Los Angeles, but in general, the United States: we do have non-recourse loans for apartment buildings. So in other words, if things go wrong with a non-recourse loan, as long as you haven't misbehaved the bank is forced to look only to the property for repayment, not to you personally.

That's really cool, and it's sort of the basis of my entire business. 

Patrick 

I lived in a nation which does not have this property attached to its properties, and the stories you get of people who might be in the third generation – they didn't put this real estate portfolio together, they just happen to be running it now… and they are all but indentured servants to a rate shock or similar, and will be unable to get out of that for the rest of their lives due to it attaching to the rest of their finances and social standing and similar – it is just really painful.

[Patrick notes: Relative sympathetic public interest stories about this are pretty legion in Japanese media, as are fictional depictions. By law when you inherit you get a three month window to disclaim all debts (which will result in also disclaiming all assets including, most relevantly in this discussion, the family business / real estate portfolio). If you do not act within that time, the balance sheet is now yours. Complicated norms of maintaining family businesses/ancestral homes and a historically strong norm against bankruptcies have resulted in a lot of people laboring under debt they didn’t sign up for for about two generations now.]

Patrick

I suppose theoretically speaking, it's a pro-capital regulation, but this is a choice the United States society has made to locate the risk here – not with the heirs of the person who originally bought the property, but within the banking system in this case.

Moses 

Yeah – and just parenthetically, it always shocks me the extent to which people don't differentiate between recourse and non-recourse loans. 

I was talking to a guy recently about a refinance scenario on a building. I asked him about a rate quote that he had got; he gave me the structure of the deal and the rate and everything, and I'm like, “Is it recourse or non-recourse?” He's like, “I don't know.”

I mean, it's an enormous difference. Just to make it explicit, it’s because if you have a recourse loan that is personal recourse and you fail to repay for whatever reason, the bank can decide to come after you personally. California is a single action state – in other words, even on a recourse loan, the lender needs to decide whether to go after you or the property, it can't go after both, and the result of that is typically they're still almost always going to choose to go after the property. 

But you can imagine a situation where you've got that meth lab that you talked about that has devalued the property, and on the other hand, you have a borrower who has a bunch of, let’s say liquid assets, in a stock market account or bank account or whatever. The bank says, “You know what, it's a lot easier to go deal with getting back a bunch of cash out of his checking account than it is to deal with this meth-polluted property. Therefore, we're going to go after the person.”

So yeah, so there's an enormous difference between recourse and non-recourse. The loans that I'm talking about via Chase are available without recourse, and so that is almost always what we use. (We have a few recourse loans – we can talk about why in a minute if you want.) Anyway, that's the debt.

Patrick 

How does recourse interact with personal guarantees for loans?

Moses 

It's basically the same thing. To get into it a little bit, the loans are not technically totally non-recourse. There are carve-outs to the non-recourse nature – they're typically called the “bad boy carve-outs,” and they are like, “Look, we're not gonna go after you personally if you don't repay this – except if you do the following things…” 

And the following things are things like, “Well, if you misrepresented your own financial condition before purchasing the property, or you misrepresented the financial condition of the property itself; if you commit wastage, which is basically another way of saying you just strip the rents and don't pay the operating expenses (which is something that unscrupulous owners will sometimes do); if there is an insurance loss at the property and the insurance company pays out and then you fail to give the insurance proceeds to the lender the way that you're supposed to under the loan docs; et cetera.” There are a number – one or two more, I think. 

Basically, as long as you behave yourself, the loan is not recourse. However, if it is demonstrated subsequently that you have not behaved yourself, then the loan becomes fully recourse to you. 

So given that these loans are non-recourse, the banks typically devote the majority of their underwriting time and attention to the building itself: How much are we paying? What is the financial condition of the building? What are the rents? What do we expect the operating expenses to be? Et cetera. However, they do look at the borrower – not to the same extent that you would on a recourse loan because probably they're not going to get to have the recourse unless you misbehave, but they still want to make sure that what they call the sponsor, the buyer of the deal, has some financial heft.

The standard [isn’t] hard and fast, but typically it is that you need to have a net worth equal to the loan amount and you need to have liquidity equal to 10% of the loan amount. Again – we own, with investors, maybe, I don't know, $200 million worth of apartments and I owe banks a hundred million dollars worth of loans on those apartments; I don't exactly know how it happened at the beginning, but for sure I did not have a net worth equal to the the first loan that we got. So these are not hard and fast rules, but guidelines that the banks try to stick to.

Patrick 

As a bit of an aside, it is often the case in the tech industry that people during their first angel investments could not pass the traditional bar for accredited investing, but somehow make it happen anyhow… and then if that one goes well, then you will be able to paperwork future deals better. Be that as it may.

[Patrick notes: A common way this happens: suppose you have a small business in the tech industry. It doesn't really matter what it does. Would anyone pay you $10,000 for 1% of that business? Highly likely yes, right, given the business comes with you semi-durably attached and tech employees are very generously paid. Accordingly, any business owner in tech, even if that business is a day old, owns a business worth a million dollars.

Good. Now, observe one way to be an accredited investor is: do you have $1 million in assets net of liabilities? Well, if you own a business worth $1 million and don’t have any debts, you do.

A lot of first angel checks are written by someone who has two months of wages in liquid sources of wealth and a brief conversation with an accountant or lawyer who says “You know what you look like to me? A business owner in the tech industry.”

And thus there isn’t formally a I-work-in-the-tech-industry-and-this-is-culturally-important-to-us exception to the SEC’s definition of accredited investor but, well, market norms are market norms. (The formal paperwork for this individual, if it exists, will be signed by a CPA or lawyer and have one sentence of payload.)]

Patrick

So, one, as people are in landlording as a career: this essentially means that unless you have a source of familiar wealth or are very, very good at recruiting people to go in on a deal with you, you typically like start on the ground floor, as it were, and then buy larger, better properties, more simultaneously, etc., as you experience appreciation in your properties and as you collect rents on them over the years. 

I think that you will see in many of the career histories of people is, “Started with one building and then ended up with more as time goes on” – that snowball effect. 

The other thing I would say is that it's my understanding that banks, in addition to providing some sort of formulaic underwriting of your financial heft, will also consider… back in the day they would call it a “character question” though I think the word character has mostly disappeared in discussions of this. They want to know that you're operationally sophisticated enough to bite off the project that is in front of you. Can you talk a little bit about what operational sophistication looks like?

[Patrick notes: Young bankers were once taught the five Cs of credit: character, capacity, credit, collateral, and conditions. We’ve largely moved away from assessing moral worth of borrowers, for mostly praiseworthy reasons, as “character” often smuggled in hefty amounts of “ideal demographic profile.” And so, in modern commercial real estate underwriting, the variable under discussion is a sixth C: competence.]

Moses 

For sure.

For a real concrete example: my parents had always owned a few tiny apartment buildings – real immigrant stuff of the type we were talking about previously, in upstate New York when I was growing up. But when our family bought the first apartment building in California in 2008, my brother and my parents and I partnered to buy a 16-unit building for, I think it was for $1.8 million.

I think we got a 65% LTV – loan to value – purchase loan from the bank, but as part of that loan, even though we had this experience back in New York of being landlords, the bank required that we hire a property management company.

Just to get back to your character thing, first of all, they credit check you too – ask you, “Have you ever been bankrupt? Have you ever had a building foreclosed on? Have you ever given a deed back in lieu of foreclosing? Etc.”

They're trying to get at like, what is your credit history too? And then separately, as you bring up, there is this question of “Can this person be trusted to operate the building?” But you can get around that by hiring a reputable property manager.

Patrick 

And the underlying reason for this is that they will probably separately, perhaps informally, underwrite the property management company you choose – so if you choose an LLC which has existed for 30 seconds, that might not redound to your favor, but if it's the usual suspects with whom this bank has 12 properties currently: “We have loans on 12 properties with this property management company, they've been in business for 30 years, we've never had an anomalous event with regards to any property that they've managed.” 

Then they're far more likely to say, “Okay, yeah, we trust those guys.”

Moses 

Yeah, that's right. We've had numerous occasions where, as part of the underwriting process for a loan, the bank has asked us to submit effectively a resume for our property management business.

Now, the lenders with whom we have long-term relationships know us because of course we've had loans with them for a long time and they've seen our reporting, et cetera – the tax returns every year and everything – so they're obviously comfortable with us from the beginning, but new lenders, for sure: if you're not one of the largest property management companies, one that everyone knows in your market, they still want to know, “let's hear about your background.”

Patrick 

And this is one of the reasons that the United States banking industry looks the way it does, oddly enough.

Generally speaking, the banks like Chase, for example, which operate nationally, have relatively rigorous, relatively formal underwriting standards – they might ask for a document like effectively the business resume for this property management company, and rely on that explicit knowledge of them and their explicit written down standards in the underwriting department. Like, this many years in business, this many number of BBB complaints, upper limit, yada yada. 

On the flip side, smaller banks might have the, “Everybody knows Jimmy from the block – yeah, Jimmy's reliable” versus “Really, Ernest? You were trying to give Ernest a Class B property? Ernest has been a slumlord for the last 40 years. I wouldn't trust him to be invited to dinner at a Class B property, much less rent it!” et cetera. There is some leeway here. 

Sorry, I'll get on my soapbox for a moment: One of the reasons the United States has a policy goal of having so many small banks relative to other large, peer nations is that the United States, through its elected representatives, believes its cities to be sufficiently diverse from each other that the kind of big bank operations which work very well in Los Angeles and Chicago and New York would not work well in say, rural Iowa – and yet there are eight-door buildings in rural Iowa, and those buildings must be financeable or people will have nowhere to live in rural Iowa. 

As a result, the First National Bank of Rural Iowa is the one that knows that Jimmy's reliable, and the ways they come to the knowledge of Jimmy's reliable are sentences that you might not even be able to say in large bank – like, “Jimmy's reliable because I've gone to church with them for the last 30 years,” for example, which used to be the only way underwriting was done within the United States. (And then we got credit scores, and that's a discussion for another day)

Moses 

Yeah, let me just jump in here and say a couple of things. One is, you're absolutely right that these local banks and credit unions are often willing to do loans that a Chase or something would absolutely never do. One of the more interesting lessons that I've learned recently as I've started to work with and get to know people who are doing these deals outside of Los Angeles, in more like secondary and tertiary markets, is that a very good thing to do is to proactively treat the banks as if they are effectively equity partners. 

There's a guy I've gotten to know who has recently rolled up a very large portfolio in the Midwest, and basically every year he produces what is tantamount to a public company annual report, and goes around and meets the bank presidents of the 10 different lenders that he's worked with – Local credit union A, local credit union B, et cetera.

He basically goes through and sits down with them with this highly-produced annual report and talks through his situation, his stabilized properties, the ones that he has in progress, his property management operation – really, again, is treating them as if they're equity partners, and that has gone a long way to getting him loans that are, like, way, way off the menu for a normal, let’s say anonymous business.

Patrick 

Yep. So just to riff on that for a moment, a typical small to medium sized bank in the United States – and medium covers the whole lot of ground – is effectively a small business, and the typical borrower for them is also a small business. These are, you know, larger than your local taqueria but substantially smaller than IBM. 

If you have a bank that has, you know, a billion dollars in assets, which means a billion dollars of loans, some portion of that is deployed in the local community, $2 million at a time, into apartment buildings. So there must be less than 500 apartment buildings that ultimately backstop up to them. And when you think of who owns those apartment buildings, and you think of, like, who among those owners is plausibly going to get in trouble this year, the person that is most capable of producing a document that looks like “I went to business school. I know what public company standards look like. I have some plans for the next year and am managing my interest rate risk and similar” – that person just sounds much less likely to get in trouble than your median or let's say lowest 10% bower. 

The joys and terror of debt issuance is that your business is not made at the median and it is not made with your 90th percentile best operator. It is made entirely on whether your first percentile loan chooses to default or not. So, loudly showing people that “regardless of what happens here with my business, I'm certainly not your 10th percentile loan” is a good way to get things that are, as you put it, off the menu.

Moses 

I love the way – I would not have explained it the way that you just did, and I actually love that explanation. It's very good. 

Federal subsidies and small scale landlords

Let me also just say, because I think it's relevant to what we've been talking about: in these secondary and tertiary markets, the federal government does step in and subsidize multifamily loans – it's not the same as what Fannie does with 30-year fixed-rate mortgages for one to four unit buildings, so single-family homes… 

Patrick 

(Which is called the socialized market, which we don't say out loud.)

Moses 

…but it is a significant subsidy. So via Fannie Mae and Freddie Mac, the federal government will subsidize mortgages to apartment buildings all over the country. 

There are a couple of different programs. There's sort of like a small-balance program where the terms are less favorable because the loans are less efficient for the lenders to make, and there are the regular programs where the terms are better and they're not made directly. In other words, you don't borrow from Fannie, you're borrowing from a lender who effectively has a license from Fannie to loan, and then Fannie turns around and takes part of the risk on a pool of those mortgages. 

It makes the underwriting more complicated and it's a pain in the ass to use; in places like Los Angeles, Chase will beat their terms. But what is great about those federally-backed Fannie and Freddie mortgages is that they make borrowing for your little apartment building in some town in Iowa much cheaper than it would be if left to the free market. 

So a big part of the real estate business, I've come to learn, is equity capital flowing from your tier one cities, your Los Angeles, your New York, Chicago, into these secondary and tertiary markets where the unlevered yields are higher – there's less capital chasing the deals, so there's more yield available when you buy them – but using loans which are subsidized at the federal level so that the interest rate is lower than it otherwise would be, thereby creating a spread and thereby creating a much higher levered yield than you would be able to get if those loans did not exist.

Patrick 

Yep. If I can recall something you said earlier in the conversation, the one place where the federal government does an extremely large amount of subsidized lending to landlords is in the non-commercial segment, one to four units. And one of the reasons that duplexes, triplexes, and quadplexes are historically such a great wealth generation engine for people is that the rates for duplexes are effectively the same as the rates on single family housing, and the underwriting standards are quite similar. And so it is effectively a policy decision of the United States that the middle class be subsidized with respect to their rates there.

Moses 

This is why so many people start by buying a fourplex – you're getting to take advantage of subsidized leverage and you can get a 30-year fix. You're getting the benefit of what looks like a residential mortgage, so you're not exposed to rate fluctuations, nor to refinance risk. It's tough to find, but if you can find one of those fourplex deals, where the numbers roughly work when you buy it and you just hold onto it, you're probably going to do very well.

Patrick 

Yep. So one of the reasons for a persistent above-market return in that particular asset class is because the polity of the United States has decided to make a subsidy which happens to be capturable by small scale landlords but is not easily capturable by (without loss of generality) BlackRock, because BlackRock can’t buy a portfolio of quadplexes.

Now, with my little pitch to people for, “maybe in the future if you want to try this, it is a wealth generation engine” out of the way, I would love to talk about the raising money from “tier one” cities and deploying it into “tier two”/”tier three” in a moment as sponsors. I think there are interesting business models there. 

Understanding commercial real estate classes

But before we talk about that, let's just explain one thing that we've both alluded to but not mentioned: what's the difference between Class A, Class B, and Class C in commercial real estate?

Moses 

Yeah. I will explain, but just so everyone knows, these gradations are very much gray. 

But your Class A building is going to typically have been very recently constructed or thoroughly renovated. It is typically going to have all of the amenities that a relatively affluent tenant would expect: air conditioning, washer, dryer, dishwasher. It is also typically – particularly the larger ones – going to have amenities like a gym, a pool, a dog walk, things like that. That's typically what you'll see institutional owners building: Imagine a 200 unit, you know, parking garage on the first floor and then a bunch of apartments above it or whatever. That's what is typically meant by Class A. 

Class B buildings tend to still be nice, but they're typically not brand new. They typically lack some of those in-unit amenities, like they might not have air conditioning or a washer, dryer in-unit, and they very rarely include the full panoply of modern apartment amenities; there's usually not like an awesome gym and a sauna and things like that. 

Challenges of Class C assets

Class C buildings really are older ones that frequently are in rough shape in various ways. Because the rents are lower at Class C buildings, the clientele tends to be people who are less affluent, and so there are many of the issues that you would expect. One of the traps that I think people have fallen into is that running Class C assets is really hard – that is, running them well and safely and in accordance with the various regulatory regimes is really hard. You can be seduced by seeing a high yield, a high cap rate on these Class C assets – you're like, “Why would I buy a Class B? I can buy this six in a Class B and I can get an eight in a Class C. Why wouldn't I just buy the Class C?” And then when you actually own it, you find that you're dealing with a whole bunch more complexity than you are with a Class B or a Class A building where basically your tenants are like normal, responsible people.

Explaining cap rates

Patrick 

Can you just tell people who might not know, what do those six and eight refer to in the sense you just said?

Moses 

Yeah. A shorthand way of evaluating the yield that is available from apartment buildings and being able to compare the yields available from different apartment buildings is what is referred to in the industry as a “cap rate” or capitalization rate. It’s a very simple calculation, and crucially it ignores debt, so it treats the acquisition of the building as if you're doing it all cash.

The calculation is as follows: in the numerator, it is the total annual rents minus the total annual operating expenses. (Operating expenses include property taxes, insurance, repairs and maintenance, et cetera.) So that's on the top – as you can see, it's your net operating income, your rents minus your operating expenses. Then in the denominator, it is the price, the cost to buy the building.

The result of that is typically a number in the low to mid, maybe sometimes the high single digits. Currently in Los Angeles, the cap rate for a newly constructed Class A building is probably in the four and a half range – which is insane relative to interest rates, and we can talk about why that's so insane – but that should give you a sense. 

In my career, probably the highest that number has ever been is somewhere in the sixes, probably in like 2010, 2011, and it has been as low in real terms during COVID, when the rates were just insane, when interest rates were insanely low – cap rates for those new construction A buildings were really like in the threes. So that gives you a sense for how it moves.

Patrick 

Yep, and so just drawing out the implications of the math, if you own a building which is worth $2 million, at a six you're $120,000 a year of net operating income, and at an eight you're getting $160,000 a year. So some people looking at those two numbers would say, if markets are efficient, I would like to get 40,000 more if we're the same work – and markets are efficient because you are not doing the same work.

Moses 

Yeah, you're dealing with evictions, people breaking into apartments, stealing stuff from cars, and just the whole range of misbehavior. One of the ways that people are good at Class C landlording is they become adept at selecting tenants for those Class C buildings who are responsible, well-behaved people who just happen not to have a lot of money. 

I have personally inspected thousands of apartments in very rough C- buildings, all the way up to Class A+ buildings. There are people who live like absolute slobs in disgusting ways in the Class A buildings, and there are people in the Class C buildings where you feel like you could eat off their floors. So it's not entirely correlated with income. But what good Class C landlords do is they expel the drug dealers and prostitutes and people who otherwise make life miserable for the community, and they thereby attract the poor people who want to lead clean orderly lives. Honestly, those Class C landlords are doing a real service for society, in my opinion, by creating safe, orderly places for poor people to live.

Patrick 

If I can say something explicitly which is implicit and which landlords often do not want to say explicitly: to the extent that broader society retreats from law enforcement and from orderliness of a society as a goal, landlords often end up having to essentially pick up the slack. When you withdraw police presence from an apartment block, for example, that doesn't mean that crime disappears there; it either means that crime impacts everyone there to some x degree, or you are effectively passing an unfunded mandate that the landlords there either allow the experience of life to deteriorate for their innocent tenants, or you are asking them to fund a essentially private police force (or in some cases a private social services agency) to work with the people who are experiencing challenges and/or other than good intent renters or occupants (or temporary guests) of the apartments.

Moses 

Yeah, I mean, one of the most successful property management companies in Los Angeles was actually created and is currently owned by a police officer. I think he was retired by the time he started the business, but basically his business was explicitly to manage these Class C assets (eventually he ended up owning a lot of them too). What he was doing was just using the fact that he was himself law enforcement and familiar with the ways that you can get law enforcement to do what you want them to do, to provide that kind of umbrella of safety to the people who lived in his buildings, with good results for them and for the communities and for the owners.

Raising equity for real estate deals

Patrick

So we talked about debt a bit, but we didn't talk about equity. In the case where it's not simply “your family put down $25 on the barrel back in the day and then rolled up your gains,” but you've actually borrowed 65% loan to value or similar from the bank, but 35% had to come from somewhere – where does it come from? What does the structure look like?

Moses 

Sure. So obviously the most straightforward thing that can happen is someone just saves their paychecks until they have enough cash, and then it's obviously simply a wire transfer from their bank account to escrow, typically two days before the deal closes. If, like me, you would like to own a lot of buildings and manage a lot of buildings and you do not have the cash to buy a lot of buildings yourself, you can raise the equity.

The process for doing so is very different for me than it is for a Blackstone or something, so let me just be clear: what Blackstone and other institutional operators are doing is, just like a VC or a private equity fund, they're going around to pension funds and endowments, and they're getting huge checks, $50 million commitments, $100 million commitments.

My business is different from that. We have raised capital in various configurations (and I'm happy to talk about them) in ranges as little as $50,000 in a few cases, up to the largest check we've ever got is a $20 million check from two people who are partners.

So that's kind of the playing field that we're on. And these are kind of what I guess you would call reg D solicitations. In other words, I'm not like advertising on TV or running ads on Instagram or whatever; in theory, you're supposed to have a preexisting business relationship with these investors before you solicit them for capital. 

The syndication process

And so there are a number of different ways that you can do this, but the classic syndication model is that an operator like me is constantly scouring the market for deals where the returns are supernormal – and it's actually interesting to talk about explicitly what that means, but let's for the sake of argument for now, that you find a good deal. You go – and I actually just did this yesterday, and I'm going to do it again today – you make an offer to the seller at a price that you think would generate returns sufficiently high to interest investors in capitalizing you. 

Assuming that the seller says yes, you investigate the property to make sure that it is indeed what you thought it would be, and then you go through the process of creating legal documentation and a marketing package to go out and pitch investors on providing the equity for your deal. So it's actually interesting, let me just say, just to make it explicit – comically, you are making a deal to buy a building with money that you do not have. Yeah.

Patrick 

Yep, absolutely the case. Absolutely normal, happens every day in every city in the United States.

Moses 

That's just the syndication game. There are ways to get around that, and I'll talk about them in a second, but classic syndication is, you don't know that you have the money; you think you're gonna be able to get it. What happens over time is that, when people do this successfully over and over and over again, the market begins to treat their offers effectively as if they had the money. Because you've demonstrated over and over and over again that if you say you're gonna buy something, you buy it, then people say, “Okay, we get it. You can raise capital and then you're good.” 

But in the beginning, it can be quite hard to get a seller to tie up his property – in other words, to allow the exclusive right to buy it for 60 or 90 days while you go round up the money. If you don't have a reputation when you're doing that, it can be pretty challenging to convince a seller and his or her listing broker to allow you that opportunity.

The role of brokers and execution risk

Patrick 

Many negative things have been said about real estate brokers over the years (and goodness, I have perhaps said a few of them myself). Again, this is very different than in the – well, it rhymes with the residential game. In the residential game, you have typically much more assurance that someone will continue on making an offer, be able to successfully close on that offer. In the commercial real estate game, inclusive of apartment buildings, one of the core value adds of a broker is being able to tell the client a good estimate of what is sometimes called execution quality – “this prospective buyer who has offered $2.5 million is maybe 80% likely to close, versus this prospective buyer has offered $2.4 million – less money, but I know 95%+ that this will actually close” – and then you as a client need to evaluate, “do I want more money or do I want more execution quality?”

Moses 

Yes, and let me just say that the execution risk can come from both the equity and the debt. We talked a little bit about that underwriting process that the lender goes through, and one of the reasons that people in Los Angeles, for example, prefer to borrow from Chase than via one of those Fannie or Freddie loans is, even if all else was equal in terms of the terms, because there's two levels of evaluation – when you get a Fannie loan, you have to convince the conduit bank that's gonna make the loan and you have to convince Fannie – you're adding a bunch of paperwork, and also a bunch of risk that one or the other or both of them say no. 

So that introduces execution risk on the debt side, in addition to the risk that the syndicator or sponsor or whatever may not be able to raise the equity.

Patrick 

Fun little parenthetical note that I can't resist saying: for medium to large size real estate loans historically, it might be the case where that bank with a billion dollars in assets has the relationship with the potential borrower who wants to do the loan, but can't sensibly do the loan because they couldn't accommodate a $200 million deal on their books – that's just too much risk in one asset of the bank.

They would do something called ‘syndication,’ which is similar to how the borrower might be syndicating the equity piece: they go out to 10 banks that are run by social peers that might be in town, might be slightly out of town and say, “okay, I've got a live one, it's really good, but I can't bite off $200 million of it. I'm good for $40 million. Can I put together like eight buddies that are each good for $20 million of this loan?” You are going to underwrite it, kind of, but I'm the one with the relationship; I'm the one with the most risk. You're mostly going to be assuming I'm good at my job, and you are just putting your balance sheet at risk for these things. 

So now a broker has to be good at banking too, or least good at reading the signals from banks when saying, “Well, Chase obviously has more money than God, Chase will never be capital constrained at any of the scales that we're discussing; First National, it's capital constrained, sure, but Bob, CEO at First National, he gets things done – versus this other one, like, I've been in eight deals with them the last two years and two of them collapsed at the finish line.” [Patrick notes: I often make up bank names using effectively madlibs and then discover, after I’ve made them up, that those are in fact real banks. I did not mean to specifically identify any real financial institution here. Well, aside from Chase.]

So, maybe we close with them, but we need a letter from First National or Chase or somebody to show the selling broker that we have high quality debt in place or likely to be in place.

Moses 

Yeah, and interestingly, on larger deals, frequently the listing broker will work at a large shop like JLL or CBRE that has a debt brokerage business in addition, so when they market the property for sale, they will do so with a debt quote from their internal loan brokerage.

The first time I saw that, I was sort of like, “Well, of course, they're just trying to scrape that 1% loan brokerage commission,” you know – and that's true, but part of what they're doing is also trying to steer you to their loan brokerage because from their perspective, it reduces the risk that you're not going to close. They know that their internal loan brokerage team will figure out very quickly, “Can this person get a loan?” And then they'll obviously have relationships with the lenders and therefore get more certainty from them.

Legal structures and documentation

Patrick 

So, going back to the syndication of the deal perspective, if you're raising money from multiple families, multiple individuals – I suppose typically at the scale you wouldn't be raising from multiple institutions, although that does happen with the BlackRocks of the world – what does that structure with them look like? You've identified this eight-door apartment building, it's in an up-and-coming neighborhood – “I have a rent roll in hand, and I have an exclusive right to purchase it for the next 90 days because I've signed a contract with the current owners; you should really invest in this deal.” How do they invest in this deal?

[Patrick notes: A “rent roll” is real estate investor jargon for a table of what units are in the building, what rent they are paying, current occupancy status, and (perhaps) remaining time left on leases. They’re customarily produced for loan underwriting and for selling properties, as higher revenue numbers and higher quality revenue numbers lead fairly directly to higher valuations.]

Moses 

Well, so mechanically, the way that they invest is they read – if everything's being done appropriately – they usually first read a marketing deck, then they read what's called a PPM, a Private Placement Memorandum, that is akin to the risks section. It does a lot of things, including sort of summarizing the deal, etc., but really the reason it exists is because it has an extensive list of (typically boilerplate) risks: “The property may not be marketable. There may be a meth lab. We may not be able to obtain financing, blah, blah, blah.”

Patrick 

“You might not know this, but earthquakes occasionally hit the state of California.”

Moses 

Exactly. The law firms that create these PPMs have extensive lists of risks, and then every once in a while, some new risk like COVID emerges and they have to add a new paragraph to their list of risks: “There may be a global pandemic that causes people not to have to pay rent for four years…”

Patrick 

Which, man, we need to take a moment to acknowledge: in many places in the United States, it was society's considered opinion that, “Congratulations on being in the landlording business! You are no longer legally allowed to entitled rent if the tenant is unable to pay it. You cannot evict them for an unbounded amount of time starting now. We'll tell you when you are entitled to collect rent again.”

[Patrick notes: This was about 18 months in Illinois plus some fudge factor based on how long it takes to get through local evictions processes, as a data point.

I think there are plausibly good reasons to seize people’s property in the national interest during an emergency, but I think we should acknowledge that we did that. And also that this is a decision to raise rents going forward, because rational investors in housing stock available to people who are low-income but not receiving rental assistance will need to price in “Sometimes you just can’t charge rent for 18 months, as a policy decision.”]

Moses 

Yeah, and luckily for the viewers, I'm wearing earphones because otherwise you would see the steam coming out of my ears as you recall that time in my life. It was a pretty unpleasant way to spend my early 40s. 

Okay, so as an investor, you read the marketing deck, you’re interested in the deal, you read the PPM – then you will also receive a copy of the operating agreement.

So maybe backing up a bit. When you syndicate a deal, in almost all cases, a new LLC will be formed for the express purpose of purchasing the asset. It's a single asset entity, an SPV, special purpose vehicle. So if you're going to buy 123 ABC Street, it's typically going to be like “123 ABC Street, LLC.”

Patrick 

Sorry to get off track here, but in discussions of real estate finance and anti-money laundering and similar topics, sometimes it has been advanced that, well, “There's shell corporations throwing out stupid amounts of money in this town,” et cetera, and this is a face-palming moment for those of us who grew up around either LLC formation (used to be kind of my job [Patrick notes: I worked for years on Stripe Atlas and am still an advisor to Stripe, which does not necessarily endorse what I say in my personal spaces]) or in real estate, because a “shell corporation” which only owns one asset and has no operations other than operating that one asset is the dominant way to buy commercial real estate in the United States, starting at four doors and up. 

So this is totally normal – it is in no way outside the norm for a lawyer to call you up and say, “Yeah, 123 Main Street, LLC wants to wire you $2 million today.” Who is 123 Main Street, LLC? It's 123 Main Street, LLC.

[Patrick notes: This is, as I have remarked upon before, a challenge for AML at banks, because real estate transactions are sizable, conducted largely via wires, and frequently intermediated by lawyers using e.g. pooled relatively opaque vehicles like escrow accounts. AML authorities are extremely aware of these challenges and have agitated for years to bring real estate into the fold regarding AML compliance. Real estate as an industry is politically influential and has largely resisted this, not because they are a conduit for dirty money but because they decline to build an uncompensated intelligence agency into their firms the way the financial industry must by law.

Is this abused sometimes? Absolutely yes. One genre of the abuse is making the specious claim that one is a real estate investor and laundering tens or hundreds of billions of dollars. (This was previously used by Tether’s then-banker.) Another is putting dirty money into real estate then extracting clean rents and/or sales of properties. This, unlike many forms of money laundering, has a strong, facially legitimate domestic advocacy arm: owners of property, particularly high-end property in globally desirable cities.]

Moses

Yeah. I mean, I personally am responsible for 40-something entities or something like that, various configurations of funds and partnerships and everything. So, yeah, this is absolutely the standard. 

So as an investor, you will see a marketing deck, PPM, and then you will see a copy of the operating agreement for the entity that is going to own the property. And in that operating agreement, the relationship between the passive investors who are putting up the money, and the active person or company that is going to be running the deal – the sponsor, me, or more accurately an entity that I control – that relationship is spelled out. 

The relationship is spelled out both in terms of the economics – like, the sponsor will get an acquisition fee equal to 1% or whatever of the purchase price, a loan fee equal to 1% of the loan amount, some split of the profits after return of capital, et cetera – so there's kind of like an economic structure, but crucially, there are also control rights: “Who gets to decide if we sell the building and at what price? Who gets to decide what kind of loan we can take? Can the manager, the sponsor be fired? Under what circumstances?” So that document, the operating agreement is effectively like the constitution of the entity that will end up owning the asset and into which the investor's capital flows. 

The final document typically is a subscription agreement, which is (and this is really mechanical and in the weeds), basically it's a document saying, “I have read the PPM and the operating agreement and I hereby commit to investing $100,000 or a million dollars, whatever it is, into this deal – and by the way, in doing so and signing below, I am agreeing to the terms of the operating agreement.” Mechanically, the act of syndicating is sort of collecting enough of those subscription booklets with a high enough total dollar figure among all of them to allow you to have the equity to purchase.

Patrick 

So, people have asked on Twitter before, “How does DocuSign possibly employ 7,500 people for what seems like simple software?” And the biggest reason is that DocuSign has effectively convinced the entirety of the United States of America that, rather than getting these agreements done via courier on an accelerated timeline (because much of the time you are going to be raising capital with, say, a 48-hour window if somebody has fallen through, et cetera, et cetera, and you very literally need 100 pages of documents in someone's hands by like 48 hours from now and for all the numbers to match, et cetera), DocuSign convinced a huge portion of the entire real estate industry in the United States: “No, just DocuSign it and you're done.”

And that is what took 7,500 people. [Patrick notes: Doing what? Marketing and sales, mostly.] 

(Getting off my software soapbox.)

Moses

Yeah. Two things to say. One is, the first fund we ever raised was before DocuSign was standard, so people actually had to mail us the documents. I'll never forget, my friend's mother took a risk – you know, we didn't really have that much of a track record, she took a risk and invested, I think, $100,000 – she sent the documents and somehow they weren't delivered.

I spent an afternoon banging on the desks at the local post office – because, like, part of raising money is respecting rich people's time; she agreed to do the deal, she had gone through the pain of filling this whole thing out, signing it, mailing it to me, and it was lost. And even though I wasn't the one who had lost it, it was still incumbent on me to go see, to take every possible measure to see if I could find it before asking her to do it again. 

I hadn't thought about that in 12 years or something, but that was an extremely painful afternoon. 

The other thing to your DocuSign point that is interesting is – and this is something that we've lived through very often – it's not quite as simple as just one signature flow to execute one of these subscription agreements. Because, for example, you may be investing as an individual,

you and your wife may be investing through community property, you may have an entity like an LLC or something similar from which you're going to invest; each of those different ways of investing requires that the form be filled out in a different way. 

There's actually a lot of complexity in getting an automated signature flow to work based on which type of entity is subscribed.

Patrick 

Yep. And the joys of this cause paralegals to tear their hair out because of the “signature block.” When people see this as like an angel investment or something, they think, “Why does this matter? My signature is Patrick. I'm me.” But what happens in signature blocks in some cases is, you know, “Chicago real estate firm management company, acting as manager for X Fund, acting as a manager for X Fund Series II Limited Partners, acting as a member for… skipping a few steps here… acting as a manager for 123 Main St, LLC..”

And when you are attempting to compose this entity diagram, it looks like the scene in police procedurals – “Okay, get out of corkboard because the manager is a member of the thing that they’re managing and…”

[Patrick notes: My father has told me some stories of cap tables which resembled Targareyan family trees. Generally speaking: less murder, more insanity.]

Moses 

Exactly. I’m in that exact situation with respect to a lot of entities. Let me just – and this is for any of your listeners who are in fact investment managers themselves – I'm about to give you a tip that will be worth the time you spent listening to this. You can sign something like, “authorized signatory” in many cases. I mean, not when it comes to loan docs or something, but for many of the less important signatures, you can sort of avoid having to write “Manager of, which is manager of, which is manager of…” by just saying “Moses Kagan, authorized signatory”.

Patrick 

I stole this tip from you, because you tweeted it out once; I make angel investments occasionally through my LLC and have just replaced it with, you know, “Patrick McKenzie, authorized signer” and I've never gotten a question after that for my “standard signature block” – which, it is amazing how much frictional effort is required for stupid reasons. Like, this is just this anachronism that we've carried from the past into the present, which has burned… I don't even want to know how many hours of my life, and then more of paralegals’ and expensive lawyers’ time, chasing like two sentences that probably never in the tech industry have actually been questioned.

The power of networking and reputation

Be that as it may, that's a decent enough transition to (1) Twitter specifically – that's how we know each other – but (2) here is this emerging business model of connecting pools of capital in places like Silicon Valley and other places where people get rich without owning real estate and decide, “I would love to own real estate” – looks around – “man, it's really expensive here. But I would like to get on this wealth accumulation train – could I buy it in Kansas, for example?” 

And I think one thing that I've seen sponsors do, interestingly, is to run, effectively, Internet marketing operations for their business with the goal of not attracting customers, but attracting investors – attracting the engineer at Amazon who wants to put a $50,000 check into real estate this year. 

So you do this very adroitly – can you just talk a little bit about what the Twitter presence does for your business?

Moses 

Yeah, and let me just say there are basically two ways to go about this.

[Patrick notes: The SEC has a handy reference chart for non-specialists who want to navigate the thicket of registration exemptions. You will, unfortunately, need to become conversant with one of these if you raise money professionally, and you will likely rack up sizable legal bills. Sorry. Or you can do what crypto does and pretend this doesn’t exist, then act surprised in a few years, and hope that works out well for you.] 

Moses 

One is – I'm blanking on the exact section of the legal code  – but you can go down sort of the crowdfunding path where, if you organize the offering in a specific way, you are allowed to directly solicit; you can literally put an ad on Instagram and be like, “22% IRRs, we're going to double your capital in three years,” wherever the number is. You can do that (which in some ways is actually kind of insane to me), but that's not what we do. 

What we do is still a Reg D fundraising, which is to say that we want to have pre-existing business relationships with our investors. But I did not come from a family that was friends with lots of billionaires or whatever, or particularly rich people at all – and while I went to, you know, I went to Andover and Princeton, my network from those places, particularly when I was getting started, was not full of super rich people yet because my contemporaries had not yet ascended to the wealth that many of them now enjoy. 

[Patrick notes: This is probably Regulation D 506(b) fundraising, which is the same way that most startups choose to raise angel money. Two immediate consequences: you can’t solicit the general public, and you are limited to raising investment from accredited investors.]

Moses

And I don't play golf – you can kind of look at me, I'm not like a country club kind of guy – so when I moved to Los Angeles and got into the deal business, my problem was like, “How do you raise capital? Where do you meet these people?” I didn't, I wasn't, I didn't grow up in Los Angeles, so it wasn't like I could meet them at my temple or whatever. 

So I ran across Seth Godin's book, Permission Marketing, and it really changed my life. And the concept, you and your listeners are probably familiar with this, the concept is that you freely provide information, you teach, effectively, on the internet – and initially this was a blog for me and then later Twitter and LinkedIn now – and in exchange, all you're asking for from your audience is the right to contact them again. It used to be a Twitter follow, when you used to be able to post something on Twitter and be confident that all of your followers would see it, but that's no longer the case – but ideally, it'd be like an email address or maybe even a cell phone number. 

What you do then is you provide all this free, high quality information – you're educating your audience, you are demonstrating to them over a long period of time that you are someone who is smart or thinks like they do or whatever, and that you have experience in whatever field you are working in, whether it's mobile homes in the Midwest or office buildings in San Francisco or whatever it is – so that when you then have an opportunity that you would like to raise money for, you are able to reach out to that list that you've built and say, “Hey, look, you've been following me for X number of years and you know that I have devoted my life to thinking about apartment buildings; now I have found an apartment building that I think merits your attention.” 

So that's how it works. And we can talk more about how you might go about building that following, do's and don'ts and everything, but that's kind of the core.

Patrick  

I think we could do an entire podcast just on the marketing of capital solicitations, but to tease out a couple of things here: one I think you've mentioned on Twitter a couple of times, is the shadow case for sending your children to private school – well, you've articulated the thought, why don't you take it away from here?

Moses 

Yeah, I mean – and I actually have not done this, for a couple of different reasons, but basically private school is sort of akin to a golf course in some ways; you're joining an exclusive club. So one thing is, you as the parent sending your kid there meet a bunch of wealthy people, but maybe even more importantly, you are introducing your kid to other kids who either are or are likely to become wealthy in the future, and thereby creating a network of potential investors for them. 

It’s interesting: one of the characters that you encounter in the private real estate business is the kind of ne'er-do-well kid who basically spends a lot of time on the golf course well into adulthood, who never really did anything, but because of his family and the connections that he's made at those schools, at the schools that he's attended and at his country club, he is capable of raising capital. 

And so that person frequently ends up being a partner in real estate investment platforms with people who actually know how to do the business of buying and fixing up and selling buildings because he's in a position to raise capital for it.

Patrick

I've heard people discussing networking in college (and believe me, I did not understand that was the assignment when I went to university).

But the notion that you can choose on your own behalf to be in a… perhaps target-rich environment (Patrick chuckles) for folks that will have investment capital, and choose to put it with you versus another manager or, you know, it gives you that ability to get a meeting without necessarily needing to ask for a meeting – is one that I thought was useful for highlighting for the world, particularly as many people start to make their own choices of like, “Where do I send my kids to school?”

Moses 

Yeah, I mean – well, the first deal I ever did (as we discussed) was with my brother and my parents, but deals 2 through 11 were all funded by my best friend from boarding school who made a fortune in high-frequency currency trading, and much of the capital that I raised subsequently was from other people who I had gone to college and high school with, and sometimes their colleagues, et cetera. But yeah, those networks were and are incredibly valuable. 

And I'll say another thing, this is something I've written about on Twitter as well, and actually I'm in mind of it because I had this conversation with my oldest son this morning: one of the weird things about the fundraising business is that you are shaping your reputation and therefore your access to capital from well before you reach adulthood – which is to say that much of the money that we raised in the beginning was from people who knew me from when I was like 15. 

And at 15, I didn't even know private real estate was a thing – I guess maybe I remember my parents owned some buildings, but I know we didn't raise capital, I just had no idea about any of this stuff. But those people were impressed with me because I was good at school and polite and whatever, seemed responsible or whatever. And that made a meaningful difference to my career trajectory later on.

That's a lesson that I've tried to impart to my children: yes, you're 13, but even now you're starting to shape the opportunities that you will have.

Patrick  

This is one that I totally didn't get as I was growing up, and I'm glad that you brought it up. If I were hypothetically to raise a VC fund in the next while, I think a lot of the people would be investing, essentially not in that VC fund but investing in the guy who wrote about bingo cards on the Internet 15 years ago, because they think some level of intelligence there probably cross-applies. 

The other thing I would say is that, switching gears for a moment, it’s my impression that historically, commercial real estate including, you know, this scale of apartment building, was largely funded by people in the community – typically by, for example, dentist money. 

The financial industry makes fun of dentists a bit more than is necessary, but the ethnography of this is that dentists typically make a lot of money providing valuable services and helping people with their teeth (as I accessed yesterday, if people can tell from my accent right now); they want to invest in something.

They are not financial professionals, and so some of them for whatever reason get the real estate bug and they go out to events in their community and people in the community say, “Ah yes, I'm sponsoring an apartment deal. You have money and you are an accredited investor, you should put your money in a building. You might not understand what a cap rate is yet (unless you've been to a few of these meetings and taken notes). You certainly understand what an apartment building is because everyone understands what an apartment building is, and you know that intersection because you pass it every day on the way to work. You can kind of see the thing you're investing in, rather than investing in, I don't know, a chemical plant somewhere in a different city, and so this feels very concrete for you. So please write me a check.”

And increasingly, through avenues like the Internet, you are having people establish their credibility as real estate operators, as potential sponsors, et cetera, and bringing in capital from the places where capital tends to accumulate in places like the United States to those rural Kansas, tier two, tier three markets, where, you know, because traditionally the source of capital was the local dentist and the local dentist does not operate in a maximally professional fashion, the cost of capital is implicitly high and then the cost of capital gets bid down by people who are better-capitalized, operating in markets with different norms with respect to pricing, et cetera, et cetera.

Moses 

Yeah, that's exactly right. And I think it's an interesting, maybe let's say double-edged sword, which is to say that country club money – or to use your example of the local meetup where you bunch of dentists get together – at least in theory, the operator who you meet at that event is part of your community, you know him from your country club or your kid's school or whatever, so maybe this is true and maybe it's not, but at least you might have the idea that you probably can trust that person because of the links that you have to them. 

Patrick  

(And you kind of have extra contractual recourse in the case where something goes south.)

[Patrick notes: This heuristic, while popular, is wrong so frequently that there is a word for intentionally abusing it: affinity fraud. It periodically sweeps typically tight-knit communities and causes highly correlated damages..]

Moses 

That's a good way to put it. Now, the flip side is, that if you restrict your investment activities to opportunities brought to you in the golf course, then obviously you are not seeing a very broad swath of the private investment opportunities.

You’re being confronted with whatever the guy who you're playing golf with that day happens to be raising money for, and you do that over n times in your local area – and yeah, you'll see some good opportunities, but it might be the case that there just aren't that many good opportunities for whatever reason in your area. What the Internet has obviously allowed is for people to raise money from people in other geographies or outside their social networks, which of course broadens the scope, the range of potential opportunities, and potentially exposes much better ones, at the cost of losing that extra contractual leverage. 

Patrick  

We've got two more quick notes before I think we wrap up for today. One is that we've discussed exemptions from registration: those are exemptions from filing registration statements with the Securities and Exchange Commission because these little LLCs that are just holding an apartment building are considered stocks and/or bonds or similar kinds of securities under various acts in the United States, and all offering documents which are exposed to the public need to be registered with the SEC, even if it's an offering document covering one building, unless you hit one of these exemptions. 

We don't have to go into the entire pretending to be lawyers on the Internet thing, but that's why we bring this up – and that's why if you invest in tech companies you are asked if you are an accredited investor, because that is a different exemption that one could apply for here. (I forget which one it is.)

The impact of supply and demand on rents

And then the other thing that has to get mentioned in any discussion of residential real estate in the United States: does the law of supply and demand apply to rents?

Moses 

Yes. Short answer is yes. 

And you're obviously alluding to this crazy argument that anyone involved in the business finds themselves in when it comes to the discussion of whether more buildings should be built in a given jurisdiction, and it's very frustrating because obviously supply and demand applies to everything; for various reasons, sometimes ignorance, but in my opinion, very much more often sort of motivated reasoning or cynicism, you have people who believe in supply and demand in every other context in their lives, but sort of throw it out the window when it comes to thinking about the impacts of supply and demand on rent. 

Patrick

And so they will say – I don't want to characterize the following as insane things, because putatively serious people will purport to believe them – that if you build more apartment buildings in a city, rents will increase.

Moses

Which is, I mean, it's just, it's so comical and frustrating for me to hear that because of course my entire investment thesis is to invest in Los Angeles specifically, because it is hard to build buildings here. 

A guy who spoke recently at the conference that we run annually for real estate operators and passive investors, Reconvene. He owns a portfolio of like 30,000 units all over the country, so he's got a very broad exposure. And without a doubt – by far, I mean by like five or 10 times – the factor that matters most to his returns is supply growth. 

It absolutely dwarfs the effect of other regulations and dwarfs demand. It all comes down over the long term to how much supply is built into his markets. 

He and I are owners, and so we obviously would like the rents to be higher; we would prefer that supply be constrained. But for anyone out there who is a tenant or has just an interest in living in a fairer, more dynamic society, for sure, you should be advocating for relaxing the constraints on building.

Patrick  

And we can see this in a comparative fashion too between – we mentioned earlier that in real estate one uses cap rates as a sort of shorthand for how lucrative it is to own a property: you you prefer higher cap rates as the owner, all else being even, so you can look across jurisdictions in a very comparable cultural context in say the United States and see, blue state cap rates are higher than red state cap rates, kind of as a rule due to exactly this issue – well, maybe not as a rule…

Moses 

Actually, I think it would be other way around – you would say the cap rates are lower in blue states than red states. In other words, the investors are competing to buy in places like Los Angeles and New York in large part because they are aware that it's much harder to build a building to compete with them. 

Patrick  

Oh, yep.

Moses 

Whereas in somewhere like Austin or whatever, the government basically says, “How can we help you?” if you go to build, and therefore, as a long-term owner, you're constantly competing with new supply coming on the market and it's much harder to raise rents, and therefore, at least in theory, if the market were actually acting rationally, cap rates ought to be a little higher in those less supply-constrained markets.

Patrick  

And indeed we see this in Tokyo, which is almost a utopia for construction. Tokyo successfully outbuilt the top five cities of the United States combined for a period of about 20 years; even with Japan's gradually declining population, the population of Tokyo increases by about 100,000 a year over multi-decade time scales, simply because Tokyo is a wonderful to place live and draws people from across the world – (points to self) – and across Japan. 

And because you can bring new supply onto the market, it is relatively less lucrative to be a landlord of the existing supply, and landlords such as, again, myself, need to do things like put extra money into their apartments. You definitely want to do a minor renovation before you flip it, or no one will buy your thing. No one will rent your thing. They will rent from one of the places two blocks over there getting constructed this year because Tokyo is capable of doing constructions. 

So you have two landlords here admitting against interest, if we just built more stuff, landlording would be a much, much less lucrative occupation. 

With that exhortation for broad reform of United States political issues out of way, thanks so much Moses for coming on the program today.

Moses 

Patrick, thank you so much for having me.

Patrick  

Where can people follow you on the internet if they don't already?

Moses 

Yeah, thank you. The easiest place probably is on Twitter or X @MosesKagan. You can also join my mailing list at kagansblog.com, which is, I wrote about the business of buying and renovating and managing apartment buildings for about five years every day.

Patrick

Cool. Thanks very much for coming today, and for the rest of you, we'll see you next week.