What is a Syndication, How to Underwrite Deals, What is Replacement Cost
In the last episode we interviewed Reuben Torenberg and learned specific details about office leases such as lease negotiation points, what makes for a good office landlord, and what does base year mean on a lease. In this episode we are interviewing Matt Shamus. Matt is the founder of Driven Capital Partners, a real estate private equity firm based in California. Driven Capital Partners maintains a diversified portfolio that includes 700 multifamily units, 40,000 square feet of office space, and a mixed use opportunity zone development project. With Matt, we’re going to learn what is a real estate syndication, what types of asset classes are safer for us to be prepared for when we go into a recession, how do they underwrite and pick deals, as well as what does replacement cost mean.
Matt and his partner Dan run Driven Capital Partners, they invest their own money and bring passive investors along for many deals, they pool money and other assets together from multiple people so that we can buy bigger, higher quality assets than they couldn’t buy on their own. They focus mostly on markets outside of California that have strong growth dynamics, and places where people are moving. Typically that happens as a result of job creation, and job creation typically happens as a result of local municipalities incentivizing jobs to be created in that region. These are places where businesses are investing or are moving to, where jobs are being created, where people are moving as a result, where there’s opportunity. These areas are largely in the Southeast United States: the Carolinas, Georgia, Tennessee, Alabama, and Florida.
How did you find your partner and how did you guys decided to become partners? This business is all about partnerships and relationships. I actually believe that your partners are more important than the asset class, the property, or even the market that you buy in. We didn’t find each other per se, we’ve been in each other’s lives for many years since our wives are best friends, so over the last 12 years we had no choice but to hang out with each other, and get to know each other very well. We have very complimentary skillsets, complimentary views, we don’t always agree on everything, but we have a relationship that is strong enough that we can disagree thoughtfully with each other, which I think is very important. We also enjoy doing different things. Dan is very outgoing, he likes to take action and to move quickly. I’m very analytical, I like to get just a little bit more information before I make a decision. So our skills balance each other out, and they’ve allowed us to achieve a lot more in a shorter period of time that either of us would have been able to do on our own.
What is a syndication?
A syndication is pooling assets together to achieve something that neither of us could achieve on our own. That term is used very commonly, especially today in real estate investing for a structure where you have the sponsor who is outsourcing the deal, underwriting the deal, packaging it together, and then raising money from individual passive investors, that structure is called syndication. I actually don’t love the term syndication or syndicator, and I don’t really apply that to what we do because it has a bit of a connotation. In fact, one of our investors recently told me that he considers our group a little bit more like an investing club than a syndication, and I think that’s the approach that we’re taking. We started Driven Capital Partners because Dan and I were investing in real estate for ourselves on the side and we thought that we could achieve something better by pooling resources together. We are investors first, we put our own money into every deal that we do, so it has a different feel than some other syndicators. Broadly, it’s simply pooling together resources so that the group can accomplish something greater than the individual, and real estate is very well suited for this structure because you have some people that are very experienced in the operational components of real estate, that are highly analytical, that understand how to underwrite properties, how to negotiate and win a property at a price that makes sense. These are all just a small portion of the skills required to run a successful real estate investing operation. But you can imagine that not everyone has these skills or even wants to have them, and even if you have the skills, do you have the time and inclination to go out there and do it? Even if you did have the time and inclination, is the return on the investment of your time going to be worth it?
What we’ve found is that a lot of our investors want the benefits of investing in real estate, they understand them, but they don’t have the time, the knowledge, or the expertise to do it on their own. And we offer a partnership where we bring in the expertise, the deals, the deal flow, the due diligence process, and it’s a project that we are putting our own money into. This allows investors to be invested passively, and everyone has a chance to play a role in, to be better off than they would if they would’ve done it on their own. It is very important that the sponsor put some money in the deal because that shows that they have skin in the game.
What is your investing strategy?
We have a bit of a unique strategy since we are investing for our own account, meaning we are investing our own money into deals. We want to be diversified across asset classes and across markets. What typically happens is that a real estate syndicator or sponsor will specialize in a particular market or on a particular asset class, and typically both. You might have a syndicator that focuses exclusively on multifamily properties in Houston, and maybe even further specializes in a certain size range, 100 to 200 units, multifamily in Houston, class B apartments. That’s the only thing that they do. There’s tremendous value in that approach because they can be a specialist. The downside is that you have all of your eggs in one basket. What we decided to do from the start was to have a diversified approach where we want to create a portfolio of multiple asset classes in multiple markets. We want exposure to the markets that we like, and we want exposure to the asset classes that we like, what we don’t want is to be specialists in any one of those. We want to be knowledgeable enough to be dangerous in the industrial space, in multifamily, medical office space, and various other asset classes. Our approach is probably unique.
Is there a particular asset class that you prefer today?
“Today” is a very important modifier to the question because we are in May, 2019 and in the middle of a trade war between the United States and China, there’s a lot of uncertainty in the stock market. There’s a lot of uncertainty with regard to when are we going into a recession, and our belief is that we will be entering a recession at some point. What that means as a real estate investor is that you have a choice: Do I stay on the sidelines and see what happens and forgo potential gains for the sake of being “conservative” and waiting it out? Or do I take the approach that everything that I’m investing in, I’m looking at a little bit more closely, specifically through the lens of “we’re going to enter a recession at some point”.
For the properties that I’m underwriting today, I need to be able to hold through a recession. We’re going to buy very selectively, and this means we’re going to say no to some projects that would be profitable. But the projects that we say yes to are going to be projects that we’re very excited about because we feel like we understand the downsides, and we feel like we are appropriately and conservatively leveraged with debt, that we have enough in operating reserves in case we have more vacancy than we expected, for instance. We’re essentially becoming more conservative the longer that this market runs. We’re also looking at some of the asset classes that we think will fare better in a recession. For example, we have two medical office projects under contract, medical offices where you have dentists offices, optometrists, physical therapists and outpatient center for a hospital.
Any kind of place where you have office space that is occupied by someone in the medical services profession, we think that it’s going to fare very well in a recession because in a recession you still need to go to the dentist and you still need to go to the physical therapist. Your insurance is going to pay for a large portion, if not all of those costs. So we think that that asset class is probably relatively conservative in a recessionary environment, whereas we’re less interested in something like multifamily simply because it’s so highly priced today. There’s so much demand and new investors in the market bidding up prices for apartments that we just feel like we are at a disadvantage buying multifamily versus some of these other asset classes that we think are still a little bit undervalued comparatively.
How do you guys decide to move forward on a deal?
I covered a good portion of that with the previous question, but we’re looking at everything through the lens of “can we and do we want to hold this asset through a recession?” We only buy a deal when we are confident that we are buying it below its actual value. Oftentimes this is replacement cost, or there’s something fundamental about the property that is undervalued and we can see and capture. We only buy something when we have a very strong plan in place to improve the value after we acquire it. If those two conditions are not met, then we just won’t proceed on the project. We say no to a good chunk of projects that probably would be really good projects for us, but there’s something just not quite right about it that we can’t wrap our heads around and therefore we’re willing to pass on it.
And I think this is an important characteristic that we want to maintain. We don’t want to feel like we have to go buy a project just to do a deal. We want to maintain quality over quantity of deals.
Can you elaborate on what does it mean when a property is below replacement cost? I’m writing an offer today on an industrial warehouse, it’s 86,000 square feet, it’s mostly warehouse in a great location appealing to someone that needs a distribution center, high height space, which is essentially space that a large truck can back up into and you can stack the merchandise very high so you can maximize the square footage, and also has office space. That combination is very appealing in this particular market. We are looking at buying this property for less than $60 a square foot.
If I were to build this exact same property on a similar parcel, I couldn’t build it for $60 a foot. I’d have to pay more just to build the property and then I would have a vacant property sitting there waiting to be leased. So the risk associated with the development is meaningful. What we look for is where can we buy something that is below the cost to replace it. That’s one way of determining if it’s undervalued, and it’s one way that a lot of brokers will use if you look at an offering memo. One thing to watch out for is that brokers are salespeople. It’s easy to say that this asset is below replacement cost, but what they will never they tell you is “this actually would be replacement cost, and here are the real numbers that we used”. Below replacement cost is a term that is used very loosely with a lot of brokers.
You should really have an understanding if you’re going to use that yourself, or if you’re going to believe it, you should have a pretty good understanding of what you think the replacement cost would be.
Where do you go to triple confirm that it is indeed below replacement cost? This is the beauty and the pain of real estate, there are very few sources of truth. The market is inefficient, it changes day to day. It doesn’t really come from a website, it comes from asking a lot of questions and gaining experience, and then using your own judgment at the end of the day. I wish it was a cleaner, simpler answer, but that’s really the truth.
Let’s go over a deal that you guys have done from beginning to end. Right now we own just under 700 multifamily units, we have 40,000 square foot of office space and we have one opportunity zone development deal. We have three projects under contract, and they total about 80,000 square feet of industrial and medical office space.
I’ll share a little bit more about the opportunity zone development deal because I think this is probably the most interesting. There are major tax incentives for taking capital gains and investing that money into an opportunity zone project. Opportunities zone projects can be real estate related, and we look for where are the opportunities zones in the country in the markets that we like. In other words, where are places that are designated opportunities zones, but are not really economically distressed and the project probably would have penciled out anyway. The tax benefits associated with investing in an opportunity zone project simply makes the overall development project just much more appealing. We happened to find one of these opportunities and we own it now. It’s a four acre parcel on a very high traffic corner lot and it currently has a vacant building. It’s a building that was built in the 60’s and it’s just been neglected for the last handful of years. We originally bought it with the intention of refurbishing the existing building, and putting a significant amount of money into the renovation. But as we got further down the due diligence process before we actually closed on the property, we realized that the location is so strong and the particular city that we are working with is very motivated to see something big and exciting happen at this location. We actually sat down with several city officials including the mayor, had some great conversations with them, and realized that this is actually a development opportunity, not a renovation opportunity.
We’re in the early stages of putting together design concepts and it’s going to be a multi-use projects, that means two or more uses. In this case it’ll probably be retail and office. It’s located in an office park and we’re excited about going through this process and bringing something brand new into the world that wasn’t there before. That’s the one deal that I would highlight just because I think it’s the most interesting and exciting.
Where is this deal?
In Huntsville, Alabama, which is the fastest growing city in the state of Alabama, and somewhere that we are pretty excited about.
Is there anything else that our audience should know? We covered a good range here. I certainly don’t want to portray myself as an expert, I’m learning everyday and I love sharing whatever knowledge and information I have, I just encourage everyone to continue to learn more.
If you’re interested in what we’re doing, one thing that I do recommend is finding a few sponsors, subscribing to their email lists and getting a feel for how they communicate with their investors and potential investors, getting a feel for the kinds of deals that they have. And the more deals that you look at, you’re incurring more repetitions. And in this business you need a lot of repetitions in order to feel confident. I would encourage you to sign up for our email list if it’s something that you’re interested in learning more about, and you’ll learn pretty quickly if it feels like you click with their style and if you’re aligned with them.