June 14, 2018

JF1381: What Do Owners Of Billion Dollar Portfolios Look For In A Real Estate Investment? With David Stein

David is the host of the podcast, money for the rest of us, which discusses money at a high level. He leverages his experience of working with billion dollar portfolios to tell us normal folk more about how money works, how the economy works, and how we can leverage that knowledge to benefit us. Joe and David will discuss a lot of these same ideas and thoughts on today’s episode. If you enjoyed today’s episode remember to subscribe in iTunes and leave us a review!

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David Stein Real Estate Background:

  • Produces and hosts the investing podcast Money For the Rest of Us

  • He was Chief Investment Strategist and Chief Portfolio Strategist at Fund Evaluation Group, LLC, a $33 billion institutional advisory firm

  • Say hi to him at https://moneyfortherestofus.com

  • Based in Idaho Falls, ID

  • Best Ever Book: Skin in the Game

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Joe Fairless: Best Ever listeners, how are you doing? Welcome to the best real estate investing advice ever show. I’m Joe Fairless, and this is the world’s longest-running daily real estate investing podcast. We only talk about the best advice ever, we don’t get into any of that fluffy stuff. With us today, David Stein. How are you doing, David?

David Stein: I’m great, thanks for having me.

Joe Fairless: My pleasure, nice to have you on the show. A little bit about David – he produces and hosts the investing podcast titled Money For the Rest of Us. Previously, he was the chief investment strategist and chief portfolio strategist at Fund Evaluation Group, which is a 33 billion dollar institutional advisory firm. Based in Idaho Falls, Idaho. With that being said, David, do you wanna give the Best Ever listeners a little bit more about your background and your current focus?

David Stein: Sure. I spent 17 years as an institutional investment advisor. I was working mostly with not-for-profits endowments and foundations, essentially investing billion dollar type portfolios. [unintelligible [00:01:54].23] That was primarily in a consulting role… But about ten years of that I also ran a discretionary portfolio; we had the ability to choose which asset classes to invest in, which managers to invest in… So my background is really from an asset allocation background, and real estate is one of those asset classes that I’ve invested in; I’ve placed money with institutional partnerships, I’ve invested individually, and for the last four years I’ve run this podcast, Money For the Rest of Us, just teaching individuals how money works, how the economy works, how it all connects together.

We focus on investing across the board, in many different asset types, but just helping individuals invest essentially their retirement assets, and hopefully they will have enough to live in retirement.

Joe Fairless: Yes, absolutely. When you were working with the billion dollar portfolios and you were consulting in that position, what do you do exactly with a university or a large group that has a bunch of money?

David Stein: Your first step is they typically have some type of investment policy, and you help them structure that policy. A big part of that is what is their target rate of return, what’s their spending rate, and what should their target asset mix spend. You’re typically working with some type of investment committee or board, and once they have agreement on the asset mix and the spending – these strategic decisions – then you work with them to actually implement that. That could be with public markets, it could be private markets, it could be active or passive… It really most depends on the clients.

But within the real estate segment, they might decide that they wanna allocate 10% to private real estate. Your typical endowment is not gonna go out and find an apartment building to buy; they’re gonna hire an institutional real estate manager in some type of limited partnership structure, and then will invest in that manager who is charged with finding apartments, or finding commercial property office buildings, things of that sort. That’s how your typical endowment would invest in real estate.

Joe Fairless: Target rate of return – what’s typical?

David Stein: Well, I left about five years ago, and typical – they wanna make sure these assets last forever. A typical endowment will be spending 4%-5% of their assets, and then on top of that you’ll have an inflation. So if you assume 3% for inflation, then a minimum return was about 8%. So you have 5% spending, plus 3% inflation – that equals 8%, and ideally they would do better than that.

It’s been a much more challenging environment (as you know) investing, just because interest rates are so low. But that’s sort of the minimum, and that’s why many endowments and foundations and pension plans are moving more toward private assets, venture capital leveraged buyouts, private real estate, because they don’t feel like they can get the returns they want in the traditional public stock and bond markets.

Joe Fairless: You mentioned spending rate… Will you define that for me what that means?

David Stein: Sure. Let’s say it’s a college endowment – they’ll have a typical spending policy, and they might say, as they set their budget, that “We are gonna spend 5% of our average market value of our asset base over the past three years.” So they’ll do a calculation and they’ll determine, “It’s 20 million dollars that we can spend based on our specific policy”, and that gets pulled out of those endowment assets and they get spent. So that’s what I talk about spending rate.

It’s similar to a retiree, where a retiree decides they wanna spend 4% of their retirement nest egg in a given year. Endowments and foundations do the same thing – they say they wanna spend a certain amount of money each year based on some type of spending policy.

Joe Fairless: Oh, okay. Got it. It’s like their working capital that they’re choosing to allocate towards whatever expenses they have?

David Stein: No, it’s just more their endowment or long-term assets, so into perpetuity. They’re deciding “Okay, of this huge 100 million dollar asset base, how much can I pull out this year to spend this year on our operation?” It’s working capital, but it’s just “What percent of these long-term assets am I gonna spend each year?” Because what an endowment is trying to do is to achieve what’s known as inter-generational equity. They don’t wanna spend too much in any given year, because then there won’t be enough assets for the generations ahead. And they don’t wanna spend too little, because then the students today at a particular college are missing out. There’s a fine balance to spend enough to benefit the current generation, but to make sure those assets are there into perpetuity.

Joe Fairless: Is 5% the typical amount?

David Stein: That was, and in fact, private foundations are mandated by law to spend 5%, which we’re seeing in the university space because expected returns are much lower; they’re creeping down to 4% or so.

Joe Fairless: The effective spending rate, because most of them have used some type of average of the value of the endowment over the previous three years, assuming the market is appreciating, that takes that net spending rate a little less than 5%. But you’re seeing a push to drop the spending rates just because the average college endowment over the past 10 years  – this is from the annual [unintelligible [00:07:24].24] they earned (on a nominal basis) 4.6% over the past decade, on an annualized basis. So if you’re spending 5%…

Joe Fairless: Yeah, that’s not good.

David Stein: …and you’re only earning 4.6%, those assets are gonna be depleted over time unless they find a way to either lower spending or increase the rate of return.

Joe Fairless: How are they only making 4.6%? What are they doing wrong?

David Stein: This is over a decade; I wouldn’t necessarily say they’re doing wrong. That’s the average of about 809 endowments.

Joe Fairless: Was that through 2008? Was that the decade that it covered?

David Stein: Yeah, so this was 10 years ending June 30th, 2017. So it included 2008 – you had the drawdown, you had the recovery… But over that time frame, bond returns were low, stocks returns were low. Some of the bigger endowments did better than that. But that’s just what the markets gave. It’s not so much they did something wrong. Retirees, if they calculated, did a similar thing. They would find their returns were probably in that 5%-6% range.

Joe Fairless: As far as the asset classes, you said later you were helping choose which asset class they should invest in… I believe you said that. Is that correct?

David Stein: Well, our typical relationship – you would always work with a board, and you would make a recommendation, and they would decide they wanted to invest in a certain manager or a certain approach.

When we ran more of a — it’s called an outsourced CIO, or outsourced Chief Investment Officer, the board would set the policy, and then we would decide “Okay, we want so much in U.S. stocks. We wanna go with this manager.” We would often work with them on the private side, but generally speaking, we had more leeway to adjust the allocation based on market conditions, essentially… So if the risk of recession was high, or some asset class was overvalued, we would reduce exposure and not have to always go back to the committee every quarter to get them to buy into the decision.

Joe Fairless: So I’m sure we’ve got a listener – or perhaps multiple Best Ever listeners out there – who is thinking “Man, how can I be that manager where a Texas university [unintelligible [00:09:30].19] in this case, or anyone that had that billion dollars, or the consulting group were to pick me as a manager that they wanna invest a whole bunch of money with?”

David Stein: Well, first, institutions are very risk-averse, so they’re not picking bees; they’re picking, essentially, asset management firms that have been in business for several decades. It’s hard for an individual – even a small group – that’s done mostly retail to get into the institutional space. Many of the institutional managers broke away from other institutional managers just because of how risk-averse institutions can be… And allocating those assets – they look at what their peers are doing…

So the best way, I guess, if somebody wanted to get involved, is to become an employee – let’s say a private real estate manager; start as an analyst, work your way up and sort of get part of that. Then we’ve seen those that have had 10-15 years experience break off and start their own firm, and they might have those relationships.

And again, it comes down to performance too, in that institutions want a proven performer that has shown the ability to buy assets right, be able to improve the real estate asset, and then liquidate and get it sold.

Joe Fairless: When you said retail earlier, who’s buying retail mostly – can you elaborate on what you mean by that?

David Stein: Yeah, by retail – the end client or individual investors, as opposed to institutions. You’ve probably seen this in the real estate space, where you see deals that are put together where they’re trying to raise capital – often times they’re raising it from individuals in some type of structure; that’s usually called retail money – retail just because it’s individual money… As opposed to institutional money, which would be the opposite of retail money, which is big endowments and foundations.

Not that one is better than the other, just a different market segment. It’s not that one can’t make money investing in real estate in retail type deals, but that’s just the distinction in terms of the playing field that the various operators are operating in.

Joe Fairless: I’m sure I know you learned a lot from that experience working in that position in particular, and then also just throughout your career… When you take those lessons and you apply them towards your own investing, what does that asset mix or allocation look like?

David Stein: Well, my personal approach is to have as many different portfolio drivers as possible. I’m a risk-averse investor by nature, and as a result, I wanna have public equity, but it’s less than 20% of my holdings. I have fixed income, I have gold, I have cryptocurrency, I have real estate, I have venture capital… So as many different pockets, both public and private, outside of the financial system. I own land… And that’s just not knowing what’s gonna happen 10 years from now in terms of markets, inflation, government… You just never know.

Your typical endowment is just as diverse. Maybe they’re not doing Bitcoin, but certainly they’re trying to get the diversification. There are many asset classes out there, and there’s many structures, and I’m always experimenting. But at the end of the day I’m trying to preserve capital, earn a decent return. I target a rate of returns of 5%-6% on my portfolio.

The other thing I learned is just to be patient. The market is what it is. In an environment now for real estate where cap rates are 4%-5%, in my mind that’s not an attractive environment to be, going into equity real estate deals.

Joe Fairless: The target rate of return 5%-6% – what’s inflation?

David Stein: 2%-3%. I’m not trying to earn much; I’ve got 2%-3%. At this point I’m just trying to maintain essentially my nest egg and keep up with inflation. So if I can earn a little bit more above inflation, I’m content. I’m not in the accumulation phase. I sold my investment partnership, and at this point I make enough money to live on through my podcast Money For the Rest of Us. I’m not in a situation where I have to earn enough (7%, 8%, 9%) because I’m still accumulating. I’m fine earning inflation plus a point or two.

Joe Fairless: You mentioned you’re as diverse as possible with your portfolio, and I’m sure you’ve come across some investment approaches that didn’t work or investment classes that didn’t work, and then some that really did. What’s an example of each of those extremes?

David Stein: Well, I mean, let’s focus on real estate, because I think investing in real estate – particularly if you wanna manage your own property – is a lot of work. There was a college town that we were living in Idaho; I’d spent seven or eight years on planning and zoning, so I kind of knew the people, I knew basically what the laws were… So we found a single-family home that was in a zone that could be multifamily, and we went through the process of converting a single-family home into a triplex.

We got all the approvals done, we got all the work done, and at the end of the day I couldn’t find anybody to manage the property, and I realized I don’t wanna be a landlord. So from not working out in terms of rental real estate, which was my idea, it’s not something I enjoy doing. And again, we had cap rates falling, so I sold it and we made 10%-15%. It wasn’t a huge deal. So it wasn’t a flat out terrible deal, but like with real estate or anything else, you have to figure out “What’s my spot? Do I like to be disinvolved in a transaction?” I didn’t like the one tenant we had calling me up saying they couldn’t get the internet to work, or call me up on New Year’s Eve and saying that they didn’t have any hot water. That just didn’t fit my lifestyle.

So you contrast that with the same town, this college town… I had a friend that built a 12-plex apartment building, and what you’re seeing is a lot of individuals want to take their individual retirement account, the retirement assets, and buy property with it, in some type of self-directed IRA. Well, it turns out there’s not that many banks willing to lend on that, because you can’t get a personal guarantee if an IRA buys a real estate building.

So in that case, the buyer of this brand new 12-plex student housing put up 50% in equity through his IRA, and I did the debt side of the deal. The debt was 6,5%. So my interest rate on this debt is higher than his cap rate on the building he bought. I like that much better, because I’m just collecting the interest payment and the principal to a 15-year note; so it’s very long-term, but at 6,5% I’m quite happy doing that because of the margin of safety, because he put up half the money.

Joe Fairless: Based on your experience as an investor, what is your best advice ever for real estate investors?

David Stein: I think you need to be aware of valuations. I think we sometimes only focus on the last 3-5 years… And I’ll give you an example. There was another student housing project that I invested in, this time as a limited partner. It was a friend that was putting it together, and he died within six months; he got a brain tumor and passed away… So he didn’t even get the project barely started.

They found another firm to come in and take over this student housing project and get it built, and on the conference call when they were introducing it, they had done all this analysis and their worst-case scenario for cap rate was 7%… That somehow the yield on real estate would never go above 7%, which in my mind 10 years ago you wouldn’t touch a deal unless cap rates were 9% 0r 10%.

I think that inflation can pick up, so worst-case scenarios shouldn’t be only based on the last 3-5 years. I think valuation matters, and when I’ve seen investors – even institutional investors – get in trouble is when they just assume that high valuations would continue. You saw this when commercial properties were over-built, prior to the Great Recession; the institutional managers that lost are the ones that paid premium prices at the top of the market.

Joe Fairless: We’re gonna do a lightning round. Are you ready for the Best Ever Lightning Round?

David Stein: I am.

Joe Fairless: Alright, let’s do it. First, a quick word from our Best Ever partners.

Break: [00:18:09].24] to [00:18:56].17]

Joe Fairless: Best ever book you’ve read?

David Stein: Skin in the Game, by Nassim Nicholas Taleb, is the best I’ve read recently.

Joe Fairless: What’s a mistake you’ve made on a transaction?

David Stein: We built a house in Idaho at the top of the market… But at $100/square foot. [laughs] I know it’s a lightning round, but the point is that even if you build something at $100/square foot, houses are used after eight years, and it can fall to $80/square foot.

Joe Fairless: What’s the best ever deal you’ve done?

David Stein: Probably the student loan debt deal on the IRA, where I’m getting 6,5% with very little risk.

Joe Fairless: Best ever way you like to give back?

David Stein: We like to help individuals. We give to charity, but we find it more rewarding to help somebody out that needs help with a down payment for a house, or they just need a plane ticket to go visit family… So just helping individuals like that.

Joe Fairless: And how can the Best Ever listeners get in touch with you?

David Stein: They can search MoneyForTheRestOfUs.com, Money For the Rest of Us Podcast wherever you hit your podcasts… It’s available all over.

Joe Fairless: Awesome. That link, MoneyForTheRestOfUs.com is in the show notes, so Best Ever listeners, you can just click that and go check out David’s podcast.

David, thank you so much for being on the show, bringing your depth and wealth of expertise in finances certainly from an institutional side. It’s interesting to hear how billion dollar portfolios think about investing, what they look for… And a roundabout way, or a very long, long game approach to perhaps landing one of them, as you said – you’re like “Well, no way. Well, actually, maybe become an employee of a private real estate manager, and then get the 15 years with that group, and then branch off.” It’s interesting to hear that, as well as jus their thought process for the things they look for – the target rate of return, the spending rate, the asset mix, and the conservative nature of the funds, what their annualized basis was for the last 10 years, or at this point 10 years from June 2017, previous to that 4.6%.

Thanks for being on the show. I hope you have a best ever day, and we’ll talk to you soon.

David Stein: Great, thank you.

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