Dean Adler
Subject: Investing in Cheap Real Estate
Bio: Co-founder of Lubert-Adler
Larry Bernstein:
Welcome to What Happens Next. My name is Larry Bernstein. What Happens Next is a podcast which covers economics, politics, and investments.
The topic today is Investing in Cheap Real Estate.
Our speaker is Dean Adler who co-founded Lubert-Adler 27 years ago and focuses on investing in institutional real estate. Dean’s firm has over $17 billion of assets under management. Dean is an expert in investing in residential and office buildings across the capital stack.
Buckle up.
Dean Adler:
It's time to talk about the real estate business. What are the fundamentals? Number one you want to find undervalued real estate.
You have to buy something on the cheap during distressed periods. Then you got to add value, you got to renovate that. And when you're all done, you want to own your assets at 65% of cost, you have some cushion, you could take a few body punches and still be okay. And the second thing you have to do is own your real estate where you have a yield on cost advantage. It means I own it at a yield which is at 300 basis points higher than interest rates.
So, if the interest rates are seven, I need to own that asset at 10%. I have to have a positive spread to underlying interest rates and cap rates. The reason people are not investing in common equity of real estate today is they develop to a six percent, but the interest rates are seven and a half. Well, that's probably the stupidest investment you could ever make. So, when people come in and say, “Hey, Dean, will you fund me?” Why would I build new when I could buy preferred equity, which we will earn 15 percent. Or if I build new, it's at a 6% yield.
Larry Bernstein:
To clarify, when the real estate market is under stress, Dean is seeing deals which are senior in the capital structure that yield 15% and thus offer a better risk/reward as compared to more risky investments like in new construction that are only expected to earn 6% per year.
Dean Adler:
This concept of margin of safety is the essence of investing. If you listened to Warren Buffett and Seth Klarman, they say the three most important words of investing is margin of safety. The goal is to get to own an asset at a cost basis advantage and a yield on cost advantage. And if you could do that, A, you can have margin safety. B, you could have strong cash flow 10 to 15%, and C, you got appreciation because you own it at 300 basis points in excess of interest rates.
When could you buy cheap? Real estate goes through three different cycles. If it's a stress period, that's 2008 to 2011, you have a recovery period, everyone feels good and they're renovating and buying. That's 2012 to 2017. And then you go to the asset bubble period when the speculators come in and the interest rates are 3% and people have no idea what they're doing. They buy assets at four percent. Everyone joins the party, and it's hard to resist, but that's the time when you need discipline.
Why are distress periods the best time to invest? Because when people have fear in their eyes, when there's no money out there; that's the time you got to have the courage to step up and invest, back up the truck.
Interest rates were artificially low from 2018 to 2020. People just went hog wild when interest rates were three.
So, what happens if to refinance a loan in 2024 if the interest rates are 8% and they borrow at three, guess what? They can't refinance. Number one, they can't sell because their cap rates went up.
Larry Bernstein:
They would have to sell the property and recognize a big loss.
Dean Adler:
Number two. So, all they can do is try to borrow money, a lifeline to extend the period, hoping rates will fall. Okay, well guess what? So, you'd say, I need some gap financing. I borrowed 60 million before.
Larry Bernstein:
On the original bank loan.
Dean Adler
I can only get 50, I need 10 million. So the first thing you'd say is, well, let's just go put the money in. Okay, go write the check ourselves and do it. But Larry, if you know real estate investors, especially the passive ones they have short arms and long pockets.
If they haven't gotten a lot of cashflow for years, they're not going to write the check.
The capital market meltdown of 2024, this has to be the best time for 40 years to invest capital. The banks are on the sidelines, the debt funds on the sidelines, any group that bought a lot between 2018 and 23 are screwed. They have to play defense. But if you got money and could play offense. The goal of any investor is to get what we call asymmetrical returns. It's where I can earn equity like returns in a debt like position. So if I could earn 15 to 20% as equity returns, that's a good equity return. But rather than being between 80 and a hundred percent of the capital stack, I earn that equity return between 55 and 75%.
Larry Bernstein:
I want to explain what Dean means here. The equity in a real estate project generally puts up 20% and the banks put in 80%, so equity is between 80 and 100 percent of the capital stack. Dean wants to put money into the deal above the common equity holders between 55% and 75% which normally get bond like returns plus a kiss, but he is finding deals that earn 15 to 20 percent.
Dean Adler:
That's your dream equity like returns in a debt like position. Well, ladies and gentlemen, that is our position today. And it's those people who have the cash who know how to underwrite because values are down, because interest rates are up and can fill that gap of refinancing.
Larry Bernstein:
If you asked the typical listener on this podcast, they would be surprised that real estate is in a free fall and a crisis. The reality on the ground is that because of rising interest rates, high vacancies in office buildings, and trouble in retail malls, institutional real estate is in distress.
Dean Adler:
In the great financial crisis of 2009, both the capital markets and the real estate fundamentals were destroyed. There was no money - no lenders.
The real estate values collapse. Now what's interesting is 30 months later, the rental assets, multifamily, some hotels, they came back. But not discretionary assets. What's a discretionary asset? Your second home in Florida, your resort, your second home condominiums, those went down 60% and those didn't return for five years. Now why? Because people first had to focus on their primary home and their primary job, and if they had anything that was discretionary, it was worth nothing. So, one of the lessons you learned from the great financial crisis is only invest in rental assets that have reoccurring income.
Let's go into what I call the new distress, the capital market meltdown. Think of the title I just said, capital market. I didn't say the real estate market. I said we have a capital market meltdown. What does that mean? In 2018 to 2023, we were blessed with artificially low interest rates. The rates went down to 3%. Why? Because this was the stimulus that the Fed wanted to provide the stimulus to spur the economy to get to recovery. They went too far and you had Fed Fund rates between zero and 1%. Today it's 5.25%, and you had spreads of like 250. So, you're borrowing it three. So let's just say people loaded up, it was a dinner feast and they thought, oh my god, these cheap rates, let's go buy. Know what that happened? They grossly overvalued properties because if you could borrow at three, you don't need to pay a six and a half cap, you'd buy a four and a half cap because you got cheap financing. What happened was inflation roared after the pandemic. Inflation goes up, what happens to interest rates? They shot up. So, Fed Fund rates, which were zero to one, went all the way up to 5.25%. And number two, the credit spreads went from 200 basis points to 400. All of a sudden, a floating rate deal that was 3.5% could be 8.5%. So, if you are up for refinancing, it's impossible to get the amount of proceeds to refinance your old loan because when you put the new interest rate into the equation, the debt coverage ratios don't work.
Larry Bernstein:
Does the increase in interest rates and required rate of return on real estate investments result in price declines across all real estate or do some assets do better or worse?
Dean Adler:
Call it temporary devaluation of every single real estate asset across the board. Now, certain ones have suffered more. Regional malls haven’t been working for five years, and you only have 200 malls left, of which probably Simon owns 75%. And then the rest of the malls are not worth anything. They're a hundred acres that need to be redeveloped. The destruction, it went from 1200 malls 15 years ago to 200 today.
In the office space, office was overbuilt before the pandemic. Then what happened? Not only do the interest rates give a slug in the stomach to office space, but hybrid, the days of everyone going to work five days a week is over, and I believe it's permanent. As a consequence, every single office building, any tenants in there are going to take 20% less space. And this is an amazing fact. I'm going to tell you pretty much New York, Philadelphia, and Boston in three years will be 50% vacant, 50%! And why do you say that? Well, they started with 15% vacancy and then you reduce the amount of space people are going to take on rollover by 20%. And then you have companies that moved out of old buildings to the new ones and they left the B and C-class buildings behind. The office market has structural obsolescence just like the mall.
You'll like this. It used to be New York families would pass down their properties from generation to generation to generation, because the thesis was, diamonds are forever. So, if I own a building on Sixth Avenue, a beautiful office building 15 years ago, the family said, let's just refinance and pass it to the next generation. That's why you had family dynasties in real estate. Guess what? Diamonds are not forever.
It resets how one invests. You can't think of things forever, okay? Nothing's forever. You got to think in a five- to seven-year time horizons and you got to constantly monitor. The thesis of being a passive owner of real estate, it is yesterday's news.
Larry Bernstein:
Our audience I suspect will be surprised that many of those beautiful 50-year-old office buildings on Sixth Avenue are going bust and that the banks that lent money to the owners are going to lose a fortune.
For reference an A-class office building is a brand-new office building with all the latest amenities. B-class office is a 50-year-old-building that needs a face-lift. C-Class office building is old, a bit run down in the wrong location that is filled with small businesses that you’ve never heard of with plenty of vacancies.
Our next topic is the unfortunate economics of owning B-Class office. To make it attractive for the next tenant, the landlord must improve the lobby, put in new elevators, and then make it shine. And the second thing is that rents are coming down because of competition from other vacant buildings. And the net rents are insufficient relative to the bank financing, the math doesn't work and effectively you're under water.
Why are B-Class office buildings dead man walking?
Dean Adler:
What you just point out is spot on. It's hard to even articulate anything else. But I will say to upgrade your building today, it's not just new carpet and elevators. The world of technology has changed the infrastructure of office buildings. You may have to redo all your fire code to bring it up to today's standards. And the way people work today, the technology within the building has to be totally upgraded.
You're a B location, you're a B property, it's hard to get even tenants. And if you do get a tenant, they are going to give you less rent. They're going to want at least $200 a foot to put them in.
Larry Bernstein:
That means that the landlord will have to invest $200 per square foot to make the office space habitable with fresh paint, new lights, new carpets, and new doors, etc.
Dean Adler:
They're going to want a year of free rent. And then the final thing is who's financing you? And here's the most important part, who could you sell it to? No one wants to buy office buildings. So why am I going to go put in another 20, 30, 40 million in a building when I have no clear path who to sell it to?
I'm going to recognize that maybe in three years I may be sitting in a 50% leased market. So who's going to buy this thing when there's so much vacancy? Why would anyone want to own these buildings knowing that there's buildings that are going to trade for a dollar next to me? There's no way-out Larry.
Larry Bernstein:
Buying and renovating an office building to stay office does not make economic sense. Give us an example of an office building that you recently purchased and how you will repurpose it to make money.
Dean Adler:
Just last week there's a building in Philadelphia on Independence Park Mall where the Liberty Bell is. Former owners tried to do an upscale office building. They leased half of it and then the market stopped. They invested $150 million in the building and had a 3 million NOI. It was about 165,000 square feet empty. I bought it for $30 million.
Larry Bernstein:
To simplify this for our listeners, Dean bought a brand-new office building in the center of Philadelphia over by the Independence Hall Park. The building has 330,000 square feet of which half is leased. And after expenses, the net income of the property is $3mm a year and he just bought the building for $30mm at a 10% current yield. This was a building that cost $150 million to build a couple of years ago.
Dean Adler:
I got new elevators, new windows, new roof, great infrastructure. But here's the beauty. When the office tenants leave, I now have contiguous space to change the use. And whether I do the lower levels of apartments or I do it as a family friendly hotel on Independence Mall. And when I finished putting the hotel rooms in, I'm in for $250,000 a key where the Hyatt built new, they're in for $450,000 a key. Remember how I started the conversation? Intrinsic value. I want to buy cheap.
Larry Bernstein:
So, you buy a busted office building, convert it to a hotel, and your expected all-in cost will be $250,000 a hotel room which is about 55% of what your competition pays to build a new hotel from scratch.
Tell us about converting office buildings to residential properties.
Dean Adler:
Probably only one out of 10 buildings qualify to be converted to residential. Why? First of all, the corner buildings can, because you have three sided windows. If you go for interior buildings, you only have front and back windows. It makes it very, very uncomfortable to do the conversion. Number two, the floor plates. When you do apartment building, you're really like 27 feet wide and you go back about 30 feet, which gives you a 750 square foot unit. So, if your floor plates are 20,000 square feet, the ideal building of four side windows, great conversion. If your floor plates are 40 or 50,000, a terrible conversion.
Larry Bernstein:
Big floor plates are a disaster because it gets dark the farther away you get from the window line. You only need so many bathrooms and laundry rooms.
We spoke earlier about the office building on 50th and Sixth Avenue. These office buildings are an entire square block. The floor plates are massive, the internal areas are completely dark. We're stuck. This is not a good example of a building to be converted to residential.
Dean Adler:
The architects will tell you; we'll build an atrium and we'll create this internal light and we'll dig a hole. By the time you build your atrium and you go down 10 stories with the atrium, you don't have any natural light. You spend all this money and you look across the atrium, you see someone getting dressed. Okay? It is a fallacy. You know what those buildings will be? Cities are going to be having a lot of pocket parks where you're going to take down these buildings and once you create some green space, the buildings overlooking a park can do something. You're going to see demolition.
I have a building in Pittsburgh called Kaufman's. I took a department store 300,000 square feet and I have 300 apartments on my roof. I have a swimming pool, I have a basketball court that convert to an ice skating ring in the winter. And everywhere around me is okay, except for the building in front of me. It's dilapidated. Takes up a whole city block. It doesn't make any sense to renovate. So, everyone in Pittsburgh said, what do we do with it?
I said, guys, you'll never find a tenant. It doesn't work for apartments. There are no office tenants in downtown Pittsburgh. I mean PNC has a 1.3 million square feet and only 30% of the people even go to work. Take it down. Create a beautiful green park.
Philadelphia is built with eight different green parks. They made it a pleasure to live downtown when there's greenery. And I said, if you look at downtown Pittsburgh, you have three parks. Just take the building, make another park there, make it green, make it useful, allow people to go play in it. But what you're doing is allowing the surrounding buildings to look down on something beautiful and use it. You know what the problem is right now by having dilapidated buildings, people don't want to walk on the streets.
Larry Bernstein:
Crime is a problem. You are not going to want your daughter to rent an apartment where there is physical risk. One way to make a neighborhood seem less risky is to have lots of street traffic and successful retail and other nearby residential properties is necessary.
Dean Adler:
Now the biggest issue of redevelopment in the urban areas is the first-floor retail. If my daughter at 6:30 at night was going to come down to street level, I want to make sure there's a lot of people walking there and there's vibrant restaurants, there's cafes. If you lose the first-floor retail, everything above it is worthless.
I went ahead and I put in a Target, I put a Five-Below, I put a restaurant, I put Burlington. You know what? I need the other side of the street either to be retail or I need it as a park. Otherwise you don't feel safe, you don't feel secure. And what happens is everyone who lives above me above the retail, there's no place to walk. If it's 6:30 at night, there's no place to walk, you lose.
That's why if you look in New York City, the dark corridors of Sixth and Seventh Avenue, I don't believe they've ever become residential because they're not active at night. Okay? If you look at Chicago at the Loop.
Larry Bernstein:
Great idea, let's go to Chicago. I grew up in Chicago, very familiar with the downtown. And I want to just expand on what's going on over there. Let's use LaSalle Street as an example.
Dean Adler:
Worthless for residential.
Larry Bernstein:
My first job when I graduated from high school over the summer, I worked a runner at the Chicago Board of Trade in the Treasury bond futures pit. I worked for Henry Shatkin who passed away this week at the age of 96, and his office was located in the Annex at the Chicago Board of Trade Building. Each day, I took the commuter train to the Metra Station and walked East on Madison to LaSalle Street which is where there are historic office buildings in the Chicago Loop.
Dean Adler:
Gorgeous buildings
Larry Bernstein:
Interiors made of marble. And these are office buildings with millions of square feet. And originally they housed the biggest banks. And then when new office buildings were built elsewhere, the old ones turned into B and C class office with accountants and second tier law firms.
Tell us about that transition from A to C class office and then why these office buildings are now worthless and what will happen to those buildings.
Dean Adler:
Everyone talks about the 24-hour market, live-work-play 24 hours. Well, in places like LaSalle Street, you don't have live, work play because they're 12-hour markets. If people leave the buildings, I don't care if it's a buildings B or C, at six o'clock it's deserted. So even though you could have the most beautiful space and you can have marble, you have architectural gorgeous details and you have iron railings. If the street is not vibrant, they are worthless. Places like LaSalle. They're dead. And compare that to the 24 hour market. I go to the West Loop where the warehouses were, where Google is, where restaurants are, Soho house, Equinox.
That is as good a submarket in the country, the West Loop, go to the North Side, go to Lincoln Park. Those are true 24-hour markets. So, if you are a 25 to 45-year-old renter, I don't care what the rent is, you aren’t going into the loop to LaSalle Street to live. It's all about connectivity and community. The waterfront's beautiful. Miracle Mile is beautiful. You go to Lincoln Park along the lake there, it's beautiful. West Loop is fantastic, and downtown is dead. And what is the answer? I hate to tell you, I don't know. But it only gets worse as this hybrid work comes in. And the truth is, you could go in and buy these for a dollar, but even if you lease them up, who are you selling it to?
You have no exits. The only way you exit is just cash flow with no exit value.
Larry Bernstein:
Tell us about San Francisco Office.
Dean Adler:
San Francisco because of safety and security and the retailers moving out. You don't want to own San Francisco. Before the pandemic it was the heaven on earth, the rents were the highest. There were high barriers to entry. No one has the guts to go into San Francisco and there's another 20 - 30% drop in price before you start getting some dollars in there.
Look at LA. West Side of LA is amazing, Century City amazing; Beverly Hills amazing, West Hollywood amazing but downtown LA worthless.
Larry Bernstein:
Could you expand on your previous point about vibrant neighborhoods and the importance of street traffic to physical safety and success of a community.
Dean Adler:
You have hit the most important component of reviving cities that'll thrive and which ones will die. What is the most critical thing of residential living is what's happening on the street and not the retail in my building. It's not fancy apparel retail. I need the cafes, the coffee shops, tables outside, the wellness, everything's about verticals. You need food and beverage, you need entertainment, you need a theater, a playhouse. Here they've created community where people bring dates and friends and they all enjoy something together. So what first floor retail does, it creates connectivity and community. My concern when I talk about Pittsburgh is I may have a grocery target in the first floor, but if the other buildings don't fill up with similar type retail, guess what? My tenants will leave. So finding neighborhoods that are in place.
If I were going to look to take aging class A office buildings, my first thing is I walk the three blocks. If those are three blocks that I'm okay for my daughter to live there and come home from work. If I feel they're safe and secure, that's a good deal. If I feel that if the blocks are empty or the stores are closed, you don't attract people on the street. As soon as you have safety and security concerns, if you don't have that first-floor vibrancy, it's all over. And any money you spend above the first floor, shame on you. You'll never get the money back. You run - You don't walk.
Larry Bernstein:
I am going to give you some real estate investment opportunities, and tell me if you would invest in them at current market prices. The first is new construction near the Fulton Market in Chicago. This is an exciting area with lots of young people and a vibrant 24-hour street activity.
Dean Adler:
100% reject it.
Because if I'm going to build new, my return on my cost will be 6%. So, if we spend a hundred million to build it, the income generated by the tenants, the good restaurant, the wellness, the apartments will give me an income of $6 million and I am in for a hundred million. At 6% yield, I'm probably borrowing at 7%.
The key in investing is what are your alternatives? You can't be in a vacuum and say, I'm a developer. I'm going to build, build, build. What I find fascinating is so many developers don't know how to pivot when the economic climate changes, they think they're very smart, and they want to just do the same thing over and over.
What is the definition of insanity? You do the same thing over and over no matter what the economic climate is and expect the same results.
Where I want to put my money is in preferred equity. I get 15 to 17% today.
Larry Bernstein:
Ok, no new construction projects even in the hottest part of town. What about investing in B-Class office buildings with small floor plates, where it is priced right?
Dean Adler:
Maybe. It's like a small apartment building. I have multiple tenants. I don't have that one bulky lease. I have a fundamental factor. I only want to invest in things that have huge diversity of tenancy. So apartments have 200 residents, select service hotel is 200 guests. Self-storage has a hundred different spots. What I avoid is anything that's bulky leases. Bulk, meaning a lease comes up in five years in seven years because everyone says, “Dean, don't worry, it's under market.” Bullshit.
You don't know what's under market in five years. And if 40% of your building rolls in five years, you have a big hole, you could lose your money. So I don't invest in office, obviously they have bulky leases. Truthfully, I don't invest in logistics. The industrial where everyone loves because it's a business of five- to seven-year leases. And I'm not that smart to tell you what the future is.
Your example of the small office building, you have a bunch of 3000 square foot tenants. I have 30 of them. Not one tenant can hurt me. Okay? The only thing I would caution you is for the local person to own it. They want to own it for a long time. Great, but it has no liquidity today, Larry. I don't think there's an exit today. Without an exit before the pandemic, would I have done it? Yes. Post pandemic. No.
Larry Bernstein:
What about the strip mall?
Dean Adler:
Love it.
Larry Bernstein:
Tell me why.
Dean Adler:
People want to be outside even in the colder environments and want the convenience of shopping. No one wants to go to the mall and shop, put your cart in the third floor, go through a parking deck. Every mall in America looks the same.
I haven't been in a mall probably for 10 years. Occasionally I'll go up to King of Prussia to see what great things Simon has done and they really are the innovators.
Let's talk about the strips. The most important part of the strip is the grocery store. So the strong grocers only got stronger in the pandemic. Because they were the ones with the supply chains to feed the people. So not only are the Whole Foods and the Publix that are very good chains, but the middle market chains such as Kroger and Albertson's exploded because they had size and strength to bring the supplies in. You want a new 15-year lease to buy a strip. The last thing you want is a grocery store that's aging at seven years left and then you're done because of the grocer ever leaves, you own all these service retail and it goes to zero. So if you don't have the big grocer, you don't do it. If you have the big grocer, then you have to look at the other tenants.
Movie theaters paying $20 a foot for 50,000 square feet, a million a year, that's worth $15 million. Do you bank on having a theater in five years? The way the kids watch on their screens? I don't know if movie theaters will be here in seven years, so I don't want to buy a center with a theater.
I also don't like bulky leases. So they're small service retailers, the hairdresser, the nails, the doctor, I think that's great. But if I have Ross or TJ Maxx or things like that and their leases up in five years, I'm not smart enough to let you know whether they're going to stay or not. I was on the board of Bed Bath Beyond for 15 years and we were the best big box concept out there. Amazon came and Bed Bath Beyond, who had one of the best brands in the country, didn't survive. That was 1000 stores. So my point is, I would do the traditional grocer. I'll have great outdoor seating for F and B because restaurants are your new anchor today. But they're a risky tenant because the failure rate of restaurants is pretty high. I do love grocery anchored centers, but be weary of your other tenants. But if I have a new 15-year lease and I'm an upscale grocer with real credit, I think that's great.
Larry Bernstein:
Dean, I end each podcast with a note of optimism. What are you optimistic about as it relates to investing in real estate?
Dean Adler:
I'm very optimistic. I have a responsibility to mentor younger people, just the way I was mentored by the Sam Zell's and people like Steve Roth. And when I called them, they spoke with me. And I feel it's my turn now to provide the same mentorship, not only to all these young kids in the business schools, but an underserved community that needs access to our industry. They need access to internships and they need access to jobs. I use the 40 years of experience and the mentorship I received and pass that down to the next generation.
Larry Bernstein:
Thanks Dean, for joining us today.
If you missed our previous podcast, check it out. The topic was Pivoting to Asia to Confront China. Our speaker was Richard Fontaine runs the foreign policy think tank The Center for New American Security. Richard wrote a new book with Ambassador Blackwill entitled Lost Decade: The US Pivot to Asia and the Rise of Chinese Power. Richard discussed how to contain Chinese economic and military power. And we heard about the trouble that China is causing with international organizations like the IMF and what we can do about it.
I would now like to make a plug for our next podcast about the attempted assassination of Donald Trump. Our speaker will be Gerald Posner who is the author of Case Closed: Lee Harvey Oswald and the Assassination of JFK. You may recall that Gerald and I did a two-part podcast series on Oswald and JFK that could be found here and here.
I want to learn from Gerald about what we know about the alleged assassin and why we Americans gravitate so quickly to conspiracy theories on both the right and left.
You can find our previous episodes and transcripts on our website whathappensnextin6minutes.com. Please subscribe to our weekly emails and follow us on Apple Podcasts or Spotify. Thank you for joining us today, good-bye.
Check out our previous episode, Pivoting to Asia to Confront China, here.
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