Leverage Can Be Your Best Friend or Worst Enemy: Understanding the Capital Stack in a Fast Changing Market

Ed Aloe (00:02):

Welcome to the Real Estate Wealth Podcast, the show about how you can build wealth by investing in real estate. I'm your host, Ed Aloe, Founder and CEO of CALCAP Advisors. I'll dive deep into multi-family investing in today's current market. I'll also help you acquire the knowledge and tools necessary to generate passive income for life through discussions with friends and experts in the industry. 

Ed Aloe 

Malcolm, thanks for joining me today on the show.

Malcolm Davies (00:42):

Ed, thanks for having me.

Ed Aloe (00:45):

Malcolm is the Founder and Senior Managing Partner of Way Capital. He's a leading capital provider in the commercial real estate space and has been involved with over 15 billion worth of both equity and debt transactions. I met Malcolm years ago through mutual friends when he was a developer down in San Diego trying to manage through the 2008 financial crisis. I bring up the 2008 GFC because I know you had some rough years as a developer during that time, but I also think that experience helped create the person you are today and gave you valuable insights into the markets and business that a lot of your peers do not have. The old adage of greatness is born out of the seeds of adversity, I think really, really applies to you. Can you take a minute and tell our listeners who you are and kind of the work you're currently doing in the business? Then I'd also like for you to jump back if you don't mind, and talk about those years through 2008.

Malcolm Davies (01:45):

Sure. Well, thanks for having me, Ed, and my finest day, I'm a world class investment banker. My lowest day, I'm just a mortgage broker, but the truth really is somewhere in between. We are hired by developers and owners to go out and raise capital on their behalf in the capital markets. We act as their outsourced CFO. We're only compensated upon success. No different than if you were selling a residential home and you paid your realtor a fee to sell that home. We're paid in very similar fashion, at the closing. A client will call us who has six or seven people that work in the company and they're looking to do 150 million or a hundred million or a $50 million project, and we will go out on their behalf and find that capital to execute really their passion. That's in various spaces. We are involved in the multi-family industry, hospitality industries, commercial, which would be office, industrial, retail.

Malcolm Davies (02:45):

We have a big book of business in large scale development. This year will be probably my most productive year, which is about $2 billion in structured finance. It's an enjoyable profession. I think you mentioned a few things earlier. It's a very accurate statement that adversity is certainly the genesis and ethos of who I am. Way Capital really stands for an acronym, which is We Are You, and what I mean by that is I sat in the shoes of my clients for about a decade pre 2008. I graduated from the University of Arizona in 1998 with a degree in urban planning and regional development, and I worked as an intern for the Office of Economic Development at the university, and I really had thought that that would be a great career for me. I liked putting things together and just figuring things out that maybe others couldn't.

Malcolm Davies (03:39):

We, myself and two business partners went out and did a lot of real estate development deals in the 2000 era. It was projects in Los Angeles, projects in San Diego, Arizona, up in Washington as well. And Ed, when you and I met, the reality is the world in 2005 was incredible, but by the time you hit 2006 and 7, there were some nerves that you could start to see a few blips along the screen of risk and fear. I mean, I'm 47 today, but back then I was in my late 20s and early 30s, not necessarily recognizing that we were going to come into the greatest crisis that hopefully we'll all see in our lifetime. But certainly since the Great Depression. It was quite a rollercoaster ride for me personally. When Bear Stearns went under in March of 2008, I think at that moment I probably had $160 or $170 million personally guaranteed to creditors and banks and financial institutions.

Malcolm Davies (04:48):

By the time we reached the collapse of Lehman Brothers and Washington Mutual and Wachovia and the like, I was really in a tailspin on projects. Lenders who were our lenders had been taken over by the FDIC, something that I hadn't paid much attention to when we were capitalizing our projects. We were building a high rise project and we were 20 feet subterranean with temporary shoring, which means that you have that wood around the hole on the ground so that ultimately the surrounding buildings don't fall into the hole.

Malcolm Davies (05:24):

Well, my lender stopped funding the project in August of '08 and I spent a very long period of time rolling into what was a difficult moment for myself and my family, which was we had so many obligations and we were deficient on so many things, meaning that I had properties that at one point or the other, we had $20 million of personally guaranteed debt, had fallen so far in value down to $7-$8 million in value, which meant that I would have a deficiency judgment against me for the amount of money that was owed on the loan and ultimately what the value of the asset was.

Malcolm Davies (06:09):

As a young person, that was a significant challenge. I sat around with my partners and said, "Hey, what do we think we should do?" And my attorney came to me and said, "Hey, you're very young. You have an opportunity to come back. I would highly recommend that you think about going with a Chapter 7 personal bankruptcy." And obviously it's a very difficult decision, one in which I didn't take lightly. I had a lot of projects I was in control of as the managing partner. And in June of 2009, I filed a Chapter 7 bankruptcy, was I think 55 million, and went through the whole process and was discharged of all of my debt obligations. It was November of 2009. What was interesting, however, was we, or I should say I, I still controlled projects because they were so underwater that none of the lenders wanted it to actually take the assets back. 

Malcolm Davies (07:07):

In essence, I was able to work the plan to come back with certain strategies. In 2010 I worked towards and helped all of our investors to the point where we repositioned the asset. We ended up buying the loan back at a significant discount. Those investors stayed in the project and we were able to reposition the asset as a Marriott Hotel. The really fun fact about that hotel was that that project took another 12 years to actually get to a point where earlier this year that project sold and sold for an incredible number, and so all of the investors made a decent amount of return for a project that was a full wipe out. I say that story because relationships matter in this business, and I worked a lot during that era to do everything I could possibly do that in the right manner.

Malcolm Davies (08:01):

In 2011, because I had done all the right things for folks in tough times, the reputation for me was still there even though I had really very little left. I started my career as a capital advisor. I've been in this now for what would be over 11 years, 11 and a half years now. And like Ed mentioned earlier, I've transacted on over $15 billion of debt and equity on behalf of real estate developers and owners across the United States, and frankly think I'm actually better at this than I would be as just a traditional developer. You have to go and follow your passions and raising capital for others and seeing them succeed.

Malcolm Davies (08:42):

And at the end of the day, there are others that I've learned over this time period that are very good at doing things that I look back in my career and realize that I wasn't great at. In essence, you have to learn you're great at, what you're not so good at and be honest with yourself. The honesty is that I'm great at raising capital, but I have to lean on others who are great at actually developing and putting these deals together and executing those business plans and I get a lot of fulfillment out of it.

Ed Aloe (09:10):

Thank you, Malcolm, for sharing that story. I think it's an incredible one and what you went through at a young age is pretty amazing. To me, it just speaks of your perseverance, you persevered all the way through and kept your chin up and like you said, kept an amazing reputation of the business, which you still have today. Failing and especially failing young like that, as hard as it is and was at the time for you and for any of us, it's a super important part of growth. You see parents, and I'm guilty of it myself, we coddle our kids. We don't want them to make mistakes, but making mistakes and failing is really the best way to learn and succeed in the long run because no matter what you do, at some point, as we all know, life is going to slap you in the face whether you want it to or not, and you got to be prepared and be able to get yourself off the map, which you obviously did.

Malcolm Davies (10:06):

I think humility is one of the greatest attributes. I said, I've always looked back and think who was the person before 2008 and who's the person today? And humility is key attribute to having a successful life because you can be humble and have humility, but you also have appreciation and the greatest gift is to appreciate just what you have.

Ed Aloe (10:28):

Yeah, I think that's exactly right. I always say I try to live with an attitude of gratitude because we do have so much and oftentimes we take so much for granted when we really shouldn't.

Malcolm Davies (10:39):

Yeah, absolutely.

Ed Aloe (10:46):

Let's shift gears here and talk a little bit about the capital stack itself. For some of our listeners who maybe aren't quite familiar with the term, can you explain the capital stack, what we mean by that and break it down?

Malcolm Davies (10:57):

Sure. I'll just articulate it in a dollar amount and then we'll just kind of think through how it looks. If you were to do a, let's call it a $10 million project, the capital stack is how you look at dollar zero to 10 million. When I'm looking at that capital stack, I'm looking at it from a percentage perspective. From zero to let's call it 1 million, that's 10% of the capital stack, right? The reality of it is that is the least risky piece of the capital stack. In essence, if you had a $10 million building, from zero to 1 million, that is the reality is that that money will likely never be lost unless there's a fire and there's no insurance or something, right? We like to say is senior debt. That is what we call traditional financing. No different than if you're going to go get a loan for a house, a loan for a building, in general, a conservative bank or source of capital would provide that financing.

Malcolm Davies (12:04):

When we think about the next layer, there's a very unique piece of the capital stack, which we like to call kind of like your stretch or your preferred equity or mezzanine piece of the stack. And that's really in that range between 60 to 65% to 80-85, sometimes 90% of the capital stack, which in this case would be from $6 million to $9 million of that $10 million asset. That capital is certainly in a greater risk position than the senior loan. We call that really subordinate financing. We are asked many times to go out and find capital solutions that will allow our clients to execute a transaction where they don't need to put in somewhere between 35 to 40%, some cases even more, of the dollars to buy the building or to execute a business plan to buy something or to turn it into something else. In essence, that's really subordinate debt, it doesn't take profit, it just gets paid at a yield and they want to be paid back, but they don't get anything in a profit participation. I'll get into some more nuanced scenarios.

Ed Aloe (13:24):

For our listeners to know when we talk about mezzanine or mezz financing, that's basically like a second on a single family home, for example, right? You would have your first trustee, you would have your second, and then the commercial space it's really our senior debt and mezz debt, but it's basically the first and second.

Malcolm Davies (13:44):

It's a great analogy. The last piece will be the equity piece. Go ahead and put your cash into the deal and that's your investment, that's your equity. There's many ways to go get that capital. There's syndications, which is country club or crowdfunding. There's institutional equity where they come in and they'll provide the circumstance we're talking about, provide 90% of the equity capital needed. There's really a growing industry of family offices that are heavily active in commercial real estate that provide that piece of the capital stack as well.

Malcolm Davies (14:19):

I mentioned stretch. What I mean by stretch financing is that what we've seen over the last few years is the growth of mezzanine and the second deed of trust lender saying, "Don't worry Malcolm and Way Capital, we'll go out, we'll provide all 80% to 90% financing and we'll go out and get really our own leverage so you don't have to worry about it. We'll provide you an 80 to 90% loan and it'll be just one facility." And that's been a growing kind of structure because it simplifies it. You don't have to get two sources of capital, which is the mezzanine provider and the senior, it's just one.

Ed Aloe (15:00):

For example, when CALCAP puts a deal together, we typically create a limited liability company and LLC where we will raise money from members into the LLC, which are the limited partners. Then that example CALCAP, the sponsor is the GP or the general partner.

Malcolm Davies (15:17):

Correct. That's right.

Ed Aloe (15:19):

Let's talk about the development landscape today, how those deals are getting put together and typically structured say versus just a normal multi-family purchase or refinance transaction. When developers are building projects today, they look at the world much different I think, and they're using a lot of these mechanisms that we already talked about, like mezz financing, preferred equity. Let's talk about a typical kind of ground up multi-family deal that you might finance today and how much that sponsor is really putting in and what that stack might look like.

Malcolm Davies (15:53):

Any ground up multi-family, you're going to hear or say it's a class A multi-family, well, it is class A because you can't afford to build a multi-family asset in America today and not deliver a class A because you need to generate incredibly high rent to afford the project. We were highly involved in this project for many years. In fact, during COVID we were ready to close on the financing and the equity and then COVID hit. Again, many projects took some time to come to fruition. We were engaged by a entrepreneurial developer to build in the South Park neighborhood in downtown Los Angeles. It wasn't what's called a qualified opportunity zone investment. Now I can get into that in a little bit. The project was $120 million capitalization, so to speak. We had a big name institutional LP that came into this project. In this case, we brought in an institutional partner into the opportunity.

Malcolm Davies (16:56):

That institution really drove the decisions for many things, can't really reference who that institution is. However, it's a very big brand name. In that project we closed a construction loan, a $72 million construction loan. This was non-recourse. You need to do a few things on construction financing, even if it's non-recourse. You have to provide a completion guarantee, which means I've got to build this and deliver it, even if I have cost escalation, which we'll get into here shortly, no matter what. No matter what you do, you will have to finish this building and it doesn't matter if your cost went up $40 million while you were building it or not, you have to finish it. Nobody can do a project on development without it. Then for the remaining 48 million, there was basically the developer, my client had owned the land for some time, so we were able to contribute out of that project $10 million of land.

Malcolm Davies (18:01):

We were down to 38 million. The sponsor put in 10 million of their own land, considered that to be the GP equity commitment. Otherwise, if we contributed the land at their cost basis, which was $300,000, the project would be 10 million cheaper, right? Anyhow, we were able to have that as our GP investment. The limited, the institutional partner came in with 38 million. That institution is not going to provide a completion guarantee. They're not going to provide what we call non-recourse carve out guarantees. What does that mean? Well, there are provisions where lenders do not want you to do certain things. Remember I mentioned about bankruptcy for myself personally, you cannot file the entity or yourself in a bankruptcy filing. If you do, it will trigger full repayment guarantee on the loan. If you commit fraud, you misrepresent things, these are what they call bad boy acts. You can't do those.

Malcolm Davies (19:01):

The developer has to provide that. They also have to provide what's called an environmental indemnity. And that indemnification, you would think, "Okay, well as long as I have my environmental reports and the like, show that it's a clean property and it's not any challenges, well that indemnity will last forever." In essence. I mean, it's something that can be mitigated, but you have to understand these things. May seem like things we can gloss over, but they have happened in the past and so these are things that you have to do. But at the end of the day, missing link in this project wasn't the fact that I provided a $72 million construction loan. It wasn't that I provided a $38 million limited partner, it was that my client did not have the balance sheet to support a $72 million construction loan. That being said, the lender who's doing this project recognizes that that big institution, if something went really, really wrong, probably would write a check to help the problem. They have the right to do it, but not the obligation.

Ed Aloe (20:03):

One thing we didn't talk about Malcolm, but maybe you should touch on is you do also joint venture structures, JV structures. Do you want to kind of briefly tell our listeners what those are and how that might come into play?

Malcolm Davies (20:14):

Sure. Well, I think everybody probably knows that if you're going to go buy a large 50 million, 25 million and even greater, generally it's not going to come from all of your own money. There's only a certain number of billionaires in the world. The reality is a joint venture partner is a place that we spend an awful lot of time helping our clients find. Where the money really starts to come from is really either ultra high net worth investors, billionaires and the like, high net worth investors, millionaires and the like, traditional investors that are being syndicated through crowdfunding or others. But the reality is the money comes from somewhere and one of the first places it comes from is pension funds and endowments. When you think about California, CalSTRS, CalPERS, Texas Teachers, those investors, ultimately those pension funds and endowments, Harvard, Stanford, they will invest on behalf of those organizations to drive a return for all of our collective retirements.

Malcolm Davies (21:19):

We will then introduce our clients to these sources of capital. And it's exciting because there's very many places to go. Then something that's just happened in the last, I'd call it five years in general, which I think is exciting, besides being able to go raise money in the country club, right? Everyone says it's country club money. That means you're part of the country club and you're going to every friend of yours in that country club. Well, you had to be in the country club to actually be able to raise that capital, which meant that generally you're probably well off and it was easier for you to raise that capital from other well off folks because you knew them. Well, what's interesting, you're seeing things today in essence, what we call crowdfunding. It's "democratizing" commercial real estate investing and you're seeing an incredible amount of growth in this area.

Malcolm Davies (22:10):

And what does it mean? Well, these organizations are going direct to retail investors. The growth of retail investors and commercial real estate is incredible. We're talking not just in the millions, hundreds of millions, we're talking in the billions. A real estate sponsor can go to one of these crowdfunding companies today. One, they have to prove that they're reputable, they can do what they say they can do. They've been involved in the business for numbers of years in one capacity or the other, but they're now able to go direct to retail investors that they don't know and do things like promote and present the opportunity via webinar. Those investors can look at the opportunity, invest in that particular asset that they like, and they may know that area better than anybody else. They decide, "Hey, that makes sense to me." Just like if you're going to buy a stock on Fidelity or TD Ameritrade, you're having the ability to do that today, which is remarkable to see the growth. 

Malcolm Davies (23:10):

I'd say five years ago where a crowdfunding company would have the ability to raise $2 million for a project, we were involved in a project that closed two months ago where they raised 37 million. And I think that's just remarkable. I think this is game changer type. It's giving direct access to investors to really thoughtfully think about investing in something. I always think it's interesting that they get to watch the webinar, they get to make their decision if they like to invest or not. They get to ask questions of the real estate sponsor, but they don't have to feel the pressure either of getting directly cold called to answer the phone to invest in that. They can think about buying that "stock." I believe that this is going to grow and grow and grow. The structures are all basically the same in some sense, right? The reality is we talk about what those returns need to look like. A mid to upper teen return for an equity investment is an appropriate return, but it depends on how you come into it. 

Malcolm Davies (24:16):

Today they have the ability that someone who runs Harvard's endowment, they have always had the ability to invest in large scale and medium scale opportunities in commercial real estate. Well, today, someone who has $20,000 to invest, they can do that today. They had no access in reality to do that five to 10 years ago without being the member of the country club. Or they knew that they were somebody to do that real estate deal. If I was to say what's been exciting is just the growth and the retail investors and commercial real estate, it's adding a significant amount of liquidity into our industry. And I think it's giving people the opportunity to take what wasn't available before to go invest in something that they can understand. There's an apartment building down the street from a university. I went to that university, I know the demand is there, right?

 Malcolm Davies (25:04):

You didn't have the opportunity to invest in that apartment project before. Now you can. I think Ed, you and I are old enough to be people that have been involved in cycles. What's interesting today, I would bet you in commercial real estate that over 50% who are active participants in commercial real estate today, probably were not in the business in 2008. Generally speaking, that's positive because we've got a lot of entrants into the business and it's been a great industry. The negative is a lot of folks might not be prepared for significant corrections. And I think there's no question that all organizations have to be prepared for how to manage through that.

Ed Aloe (25:44):

Yeah, that's exactly right. And I think when times are good, like they've been, people think they last forever. And conversely, when times are bad, people kind of think, "Oh, this is going to last forever." The truth is neither cycle lasts forever, but there are always cycles in our industry.

Malcolm Davies (25:59):

Absolutely.

Ed Aloe (26:03):

And Malcolm, one last question. Been a lot of talk lately. The Fed is raising interest rates. We're seeing it everywhere we look in our industry, there's headwinds in the economy. What are you seeing over the next five years? This is kind of general take on the outlook of real estate, real estate financing.

Malcolm Davies (26:20):

Interest rates are going up. Sorry, it is what it is. There are some folks that believe it'll be significantly up next year. I think that there's only so far we could go because it's just very hard in the system that we have. However, I'm not positive we are going to get out of our inflation issues without significantly increasing interest rates. Nothing in the future will match what has happened in the past. You and I will talk about, "Oh gosh, the GFC, we're worried about the GFC happening again." Of course we are, right? But the reality is it's going to look very different next time. The overriding challenge right now is inflation, interest rates and their effect on inflation. In some sense, real estate's a good hedge, they say, right? I sort of believe that. But also interest rates will affect asset valuations significantly.

Malcolm Davies (27:13):

The question will be, can The Fed control it? There are some people that say there's only so much it can control, and in essence, we need to be able to temper the inflationary world we're in today. No developer that's in the business today, that's been in business for 40 years has ever seen what's going on today. The question is how do we see that going over the next five years? Nobody really knows. There's a lot of demand in this industry for returns, but we're going to want to be treading very carefully, so to speak. When cap rates go up, they're going up because interest rates are going up. However, demand has been really huge in the space, more investors today than there ever were before, who wins in that dynamic? The last part I would just say is you have to pay attention to, at least in apartments, how much farther can rent growth occur in apartments?

Malcolm Davies (28:11):

I mean, there's only so much money people can ultimately make. A greater percentage of someone's pocket has been going towards rent and that has grown over the last 10 years. If you are a 15% of your income going towards rent, it's probably 20% today. Those are things to really pay attention to. That being said, nothing today feels like it did when I was very nervous at '06 and '07, and in all reality, I also think that the one part that we have very different today is the government is much more quick to push liquidity, to offset pain. I don't know how long that will last for, but that ability for the government to print money, so to speak, to offset pain seems to be utilized often. And that's another effect that none of us can count on to figure out how that affects really commercial real estate in general.

Ed Aloe (29:04):

I mean, that has its own downstream long term effects on its own, right?

Malcolm Davies (29:10):

Correct. We just don't know when that end will be. I mean, you and I might not be around when that happens, so.

Ed Aloe (29:14):

Right. But I agree with you. It definitely feels different than it did in 2008 right now because the market seemed much more balanced. They're not over leveraged like we saw back then. And even though we have high inflation, and I agree with you, I think The Fed's going to do everything they can and they're going to over correct by raising rates too high to temper that inflation, the long term prospects of commercial real estate, depending on the sector. I mean, I'm obviously bullish on multifamily because of supply and demand drivers. Even though rates are going up in the short term and markets are somewhat disrupted, the long outlook on housing from an investor standpoint still looks very, very positive.

Malcolm Davies (29:54):

Absolutely.

Ed Aloe (30:01):

We'd like to thank our guest, Malcolm Davies, for being on the show with me today. I hope today's show inspired you just a little bit. I'm excited to bring you more episodes with interesting and informative experts to help you navigate your way to wealth in real estate investing.

Susan Rangel (30:21):

Thanks for listening to the Real Estate Wealth podcast. The Real Estate Wealth Podcast is produced by Gusto, a Matter company. Our producer and audio engineer is Jeanette Harris-Courts, with support from Gabe Gerzon and Susan Rangel. Maia Laperle is our writer. For show notes and more information about this podcast, visit edaloe.com. And for more information about CALCAP advisors, visit us at www.calcap.com or follow us on Twitter @CALCAPAdvisors.

Ed Aloe (30:58):

I'm your host, Ed Aloe, and thank you for listening.