Jerry Miller's Deep Dive into Real Estate Capital Stacks and Investment Strategies

Navigate the ever-shifting tides of the real estate market with the experienced Jerry Miller from Largo Group as he returns to demystify the complexities of the capital stack. From aligning investment strategies with educational expenses to launching a debt fund that adapts to market fluctuations, Jerry's personal narrative offers invaluable insights for both seasoned and novice investors. Understanding the components of senior debt, mezzanine debt, and equity positions is no longer a daunting task—this episode promises to leave you well-versed in the layers of the capital stack and how they could affect your investment's security and potential.

Venture into the robust realms of commercial real estate with a focus on thriving markets like Charlotte and Dallas. As we unravel the practicalities of legal leasing discrimination and assumable mortgages, you'll gain a clearer perspective on the nuances that differentiate commercial from residential real estate. Whether it's contemplating a new fund bridging the gap for land developers or aligning your risk profile with the right investment choices, this conversation is packed with strategic advice. Let's peel back the layers of real estate investment, ensuring you make informed decisions that resonate with your financial aspirations and risk tolerance.

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Transcript

Speaker 1: 0:01

Hey everybody, david McElwain here with another episode of Bricker Golden Handcuffs. Today I've got with me a return guest, jerry Miller. Jerry's with Largo Group and I'm super excited to have him on today. Today we're going to be talking about the capital stack and about some debt funds. Briefly, jerry's got a lot of experience in all kinds of real estate, from single family to commercial, multifamily, limited partner, general partner, value add, development and capital raising. So he's been there and done that. As they say in the Boy Scouts, he has the merit badge. Jerry, welcome to the show.

Speaker 2: 0:33

Thanks, david, glad to be back.

Speaker 1: 0:35

So I know we've talked a little bit about golden handcuffs and obviously I ask everybody if you've ever had golden handcuffs and you currently do have a W-2 job as well as this passion for real estate, right?

Speaker 2: 0:46

I do. I've probably got one handcuff on and one handcuff off. I'll explain that a little bit. I still have a consulting business and I still do that as my nine to five and I'm making that transition. I'm seeing nice increases in my passive income, some of my GP activities, but I'm not quite there yet with replacing that day job. I do have two in college, so those that are out there, I understand the expense thing and one of the goals is to keep all of my kids debt free when they graduate college. Thank you, real estate my oldest has already made it through and my middle, my middle son's a year away and my youngest is now a sophomore in college. So got a few more years before those educational expenses go away.

Speaker 1: 1:30

Well, congratulations on that. I have two step children and two children, and three of the four are either in grad school or undergrad school right now, and I have six figure college debts which have been paid off from my golden handcuffs of years past. Right, I'm going to empathize with you and thank God for investment horizons and high net worth income. So tell me, jerry, since we've last been on the show, the markets kind of changed a lot, right. We've gotten in a negative leverage. Cap rates have come, have not come expanded as much as we wanted them to. We're now in the spring of 2024. What are you seeing out there in the market right now?

Speaker 2: 2:15

Well, great question. I'm actually seeing the beginning of some nice multi families that are a little bit of a bargain. It's not every project but, as you said, cap rates have actually increased and that has actually caused valuations to come down. So some of the same properties that sold a year ago. They were 20% higher and so now they are actually a little bit lower. But probably we had more bad news than good news about fall of last year.

Speaker 2: 2:45

I noticed that a lot of my investors were a little bit nervous. They were a little bit hey, we don't know what's coming, and they just kind of wanted to pull back and they wanted to leave their money parked on the sideline. I personally had my very first LP position handed back to me. It was a situation where I feel like the operators did a lot of things right, but they had secured a property in 2022 with variable debt and it was coming up for renewal this year and they knew they had to sell. So the reality is that the equity position is a great idea, but there's no surety behind it, and so I'm making sure that I educate all my new investors on the capital stack, and that's actually what I want to talk a little bit about today, and it's really the understanding of the capital stack that led me to launch my debt fund just earlier this year.

Speaker 1: 3:36

Fascinating. So I think this is really. Let's dive into the basics, right? We talk about it's spring training. March 1st is tomorrow, which means that I think pitchers and catchers have either reported or are starting to report, and so it's fundamentals. If you're a Major League Baseball player, you learn how to catch the ball every year. You learn how to field a grounder, you learn how to throw through the complete pass. I never played baseball, so my analogy is kind of starting to fall apart here. But the capital stack is an elementary and crucial part of any investment model, so give me a little bit of an explanation of what a capital stack is.

Speaker 2: 4:20

Absolutely, david. So you know, the capital stack just represents all of the money is necessary to put together any deal, and so what we typically see is four general categories and there's a lot of hybrids. And so we're not going to try and make folks an expert, but when I first got into the business, nobody broke down the capital stack for me. I've sort of learned by talking to those within the space over time. So I feel like I try and lead with this with all of my new investors to the commercial space, where at the bottom of the capital stack is the senior debt. It is the most secure position on the piece of property. So there's a debt instrument in first position on hard real estate and then our next level is mezzanine debt. So this is just anything that's not in first position, but this is also debt on the property and then above that is what go ahead.

Speaker 1: 5:14

On the mezzanine debt. It's often called mezz debt and there are many other different names for it and we'll kind of talk about them interchangeably as well. It can also be it can also be preferred equity.

Speaker 2: 5:27

That's right, that's right.

Speaker 1: 5:29

As a piece of non-promoted equity. It could be a. There's a whole bunch of different ways to look at mezzanine debt.

Speaker 2: 5:38

Very very true, and so if you think about, it from a residential point of view.

Speaker 1: 5:41

Think about it like a second mortgage.

Speaker 2: 5:43

That's right. Yeah, I'm actually.

Speaker 1: 5:45

That's how I was talking about my investors.

Speaker 2: 5:46

I'm glad you leaned in there, david, because the reality is you're right. There's a lot of different ways to talk about the same thing in this space and if you don't understand somebody's vocabulary, you can definitely have a misunderstanding as to what that means. I wasn't going to go. There's lots of hybrids as well. Right, mezzanine debt is just in a position that's behind the senior debt on the project. And I, like your residential example.

Speaker 2: 6:15

All of us know our senior debt on our house is our first mortgage. Typically, you've paid that off. If you're my age and then you're. If you have a second mortgage, it might look something like a HELOC or an equity line of credit. That would be basically mezzanine debt. And then we move into like a preferred equity position, which is behind typically mezzanine debt.

Speaker 2: 6:38

And then the very last position in the deal is the common equity position, and when I first started investing in limited partnerships back in 2021, I didn't quite understand the risks associated with the common equity. We're all attracted to the rewards. We go wow, double my money in three to five years. That's a 20, 25, maybe a 30% IRR. We've never seen anything like that in the stock market. We hadn't seen other investments that performed at that level and it's very, very easy to buy into. Let's call it the hype, right the plan, and there's nothing wrong with the plan. I'm a firm believer in equity positions, but you have to understand that if you're up here earning high returns, it is because the intrinsic risk is much higher than any of the other positions in the capital stack, and that wasn't something that I understood. Go ahead.

Speaker 1: 7:31

Yeah, this is such a crucial thing to talk through and I wanted to jump in as well because I think that I'm really excited to go back to basics here. You know mezz debt I always think of as in an opera house or a symphony house. It's the mezzanine level, so it is not the primary level, and in theory it's the cheap seats. And so the further up you go in the opera house, the symphony house, the play house, whatever auditorium you want to use, you're going into the cheaper seats, and the cheaper seats come with greater reward for less or greater risk for less cost. And if you think about it, if you're going to buy orchestra pit tickets at an event, they're going to be the most expensive tickets there are, and so if you're going to put out a mortgage paper, it's the most expensive part of the auditorium. This is how I visualize it when I think about it as you go up the auditorium rows. Maybe this is confusing, maybe it's not, but it's crucial to it.

Speaker 2: 8:44

I get it, and I haven't heard it pitched that way before and I like it. But at the end of the day, I think the analogy is true as you move up the capital stack, you do move up in reward. You also move up in corresponding risk, and my message to investors I'm not trying to scare anyone is just simply if you're looking at a 25% return as an equity position, do you deeply understand the risks that are associated with why that return is 25%?

Speaker 1: 9:14

Yeah, well said, so well said.

Speaker 2: 9:16

Debt funds. Typically we see them at 6, 8, even 10%. In fact, I created a debt fund and we're offering a 10% preferred return and I created that fund because I didn't see that in the marketplace and I felt like for a lot of my new investors it is the premier starting place that they can understand commercial real estate, they can understand the development process and as they get more comfortable and get more educated in the commercial space, I'm a big believer in equities to supplement that debt position. But you need to start, let's say, in the shallow waters before you venture out into the deep waters, because you drop yourself off in the deep waters, you may not be able to swim as well as you think, and that's probably the best way that I can describe it.

Speaker 1: 10:06

Yeah, and being from Florida makes sense that you would use a water analogy right. And also, if you're in the deep end and you don't have a life jacket, you can trap. And the analogy here is that if you buy equities and you don't understand the risk involved with it, in an LLC, you could lose 100% of your capital.

Speaker 2: 10:28

This is true, it's true.

Speaker 1: 10:30

And it has happened, and it will continue to happen.

Speaker 2: 10:33

It has happened. It will happen. I don't know what the percentages are. I'm sure it's fairly small. But again, let's look at it from a if it's your first investment, you're investing 50 or $100,000, what if there's a one in 100 chance? Well, when that finally hits, you got to ask yourself can you afford to lose that $50,000? And my hope would be that the answer is yes. But the reality is, if you're going to have a one in 100 chance of losing your principal, then I want it to happen on number 99. Right.

Speaker 1: 11:05

I want to have For 400, yeah.

Speaker 2: 11:06

Right, I want to have a lot of successes that paid me before I lose a principal, and that's where I feel like I heard a lot of language in 2022 that hey, can't miss, can't lose, no brainer, recession proof, all these acronyms, all this vocabulary around yeah, great, great work. Thank you for that. All of this that basically minimized investors' fears and really just sent them headlong into believing the plan, and I have no doubt that many of those people were well-intentioned. I've got a lot of friends in this space. I respect everybody that I work with.

Speaker 2: 11:52

I would say that a bad apple in this space is very rare and is very few and far between. But the reality is that market factors can occur, like the interest rates increasing like they did. That had a profound effect on cap not only cap rates, but on the ability to sell the property, because now maybe they don't pass the DSCR test, which is the debt service coverage ratios that the banks demand whenever they do a loan. So there were just a lot of reasons why even good operators suddenly found themselves in a bad position because they happened to choose a variable rate loan product.

Speaker 1: 12:30

And I think this is really important to go through the capital stack protects the first-in position.

Speaker 2: 12:37

That's right.

Speaker 1: 12:37

And the first-in-the-position is always the bank. Unless you pay cash for it, there's a bank involved, true. And so the first position is always going to protect the bank with the deepest amount of redress in the game.

Speaker 2: 12:54

Okay.

Speaker 1: 12:56

Right Because the bank has leans on the debt. The bank has, I'm sorry, leans on the note. The bank can seize the property. That's right. When in doubt they don't want to seize the property, but they can and a limited partner up the capital stack has a real hard time getting redress. It's just a fact.

Speaker 1: 13:16

And so that's part of the risk that you take on Right, and I think, as we understand, this is important for investors to recognize that there is a lot of hyperbole out there and there is no such thing as the perfect investment. Investment inherently has risk. And just to give you the dislamers. Now, I am not a CPA, I'm not an attorney, I am not a registered investment advisor. I am talking from my own experience and no professional licensure.

Speaker 2: 13:46

Well. So, personal opinion, I do believe in the perfect investment, but it has more to do with the perfect investment for the investor's risk reward profile. It doesn't mean that it is going to perform perfectly. But if you know, if so I'm 59, if you know if I'm thinking I want to retire in two to three years, I should have a very different view on my risk reward profile than perhaps somebody that's 39, that's, you know, that's making more than enough money from perhaps their day job, where they can afford to risk a little bit more.

Speaker 2: 14:25

You know, let's face it, the rich get rich by investing and by taking more risks, and the really, really wealthy people can afford to risk larger shares of money and to larger enterprises, and the payoff is larger. So it's not a bad thing to risk. The bad thing is to risk that last $50,000 that you had that you really can't afford to lose, because if you lose it now, you're in a position where you can't easily replace it. And so, you know, it's just really important to understand that risk reward profile. And again, for the folks that are new to the commercial space, my advice and I'm not an attorney either, I'm not a financial planner is to consider a more conservative, a more conservative investment as the starting place for you.

Speaker 2: 15:13

Makes a lot of sense.

Speaker 1: 15:15

And as you look at the word conservative, it inherently means not too much disruption, not too much change. Right? That's what a conservative thought process, conservative structure, is. It's a reduction in risk. So I'm forecasting from this that you created a debt fund because you feel like it's more conservative, less risky and has a different risk adjusted return profile than an LP offering.

Speaker 2: 15:45

Tell me more about your debt fund.

Speaker 2: 15:46

Absolutely so. The debt fund collects money from accredited investors and then we turn around and we loan it to land developers. The land development process is it can have risks associated with it. So we get a first mortgage on our real estate. That could be raw land, that could also be hard assets like buildings and houses to the effect. The bottom line is just like when you get a mortgage on your house. The bank says, hey, we're gonna give you a 80% loan to value on that. You've gotta have some skin in the game. And so the bank knows that I can always turn that mortgage into cash by foreclosing. It's not a desirable process, it's the process of last resort, but at least it protects the principle of what was initially put into the fund. So as we collect more investor money, we turn around and we loan that out to developers. They typically pay what's called hard money rates. They pay 14, 16% plus points to get money to do their entitlement process.

Speaker 2: 16:54

A lot of people don't realize that in the commercial space it's very rare that somebody comes in and buys the land outright.

Speaker 2: 17:01

It's a much more common mechanism to buy it with an option.

Speaker 2: 17:05

So a three or a $5 million piece of property might be bought with giving the seller a $50,000 option and saying, hey, I'll give you the rest of the money in 12 months, but now I'm gonna go off and try and get entitlements. And really what they're doing is they're giving the seller an assurance that, yes, I'm a serious buyer. But the reality is, if the entitlement process does not work out in your favor and you're not able to get entitlements which is all the permitting is necessary at the local level to construct what you intend to construct then you might have to walk away from that $50,000. And that's why its banks don't operate in this space. They do not loan for raw land, they do not loan for options. But as a real estate guy, I can look at a deal and see that there are times where building, infill building and downtown environments the land can be amazingly expensive, and so, if you can get any deal on it at all, it's absolutely worth partnering with the land developers for them to go after these projects.

Speaker 1: 18:09

Fascinating. So tell me, why did you decide to go toward development? Only Cause I'm reading into this that you're not doing other asset classes as a fund. You're only doing development. And what kind of development are you focused on?

Speaker 2: 18:24

Well, to be honest with you, I had friends in the development space. I've got several different general contractors that I know in both the Charlotte area and the Dallas area. That are two very different markets very strong markets depending on the metrics that you look at. And I know when I've worked with them for years. And one of the things that is super important in the commercial real estate that you can do very well if you can marry the deal with the money within the timeframe allowed. And what I mean by that is there's great opportunities out there, but if you don't have the money then you can't take advantage of that. And then there are other times where you have a whole bunch of money but you don't have that great opportunity, so then the money loses interest. So if you can marry the two, then you can do well. And so what this fund is going to do is communicate with both sides so that when I've got a land developer opportunity, our first deal is a 43 acre tract of land.

Speaker 2: 19:22

Little plug for Sage Equity that's my development partner in Charlotte. They found a 43 acre tract of land in Marvin, north Carolina. It's in the south end of Charlotte. It's probably the nicest neighborhood. The houses next door are all at least a million to a million and a half. We're actually developing these lots to be actually larger lots acre to acre and a half lots, which are slightly larger than the next door neighbors and then we've partnered with a custom home builder, and so that's our development.

Speaker 2: 19:55

The land is worth a whole lot more than has been offered to pay for it, so I know that this is a win-win. These houses sell very well right now within the Charlotte market, and so the reason that I'm focused on development is strictly because I had the contacts in place and I actually chatted with my partners directly about this fund. Before I did it, I said, hey, this seems like this would be a good fit for the marketplace. My investors would be very interested in this more conservative position. You need money at better than hard money interest rates, and I think we can all do very well here. And everybody agreed that there was a need for this particular product, and that's actually why I created it.

Speaker 1: 20:38

Fascinating. That's really interesting as an investor. We have these opportunities out there all across the country. Right Right, yours is focused on two specific metros. Like everything else, I assume you have a series of offering documents for fund participants and all those things, like you were with a typical syndication.

Speaker 2: 20:57

Yes, of course, of course, of course, of course of course, right, of course, of course.

Speaker 1: 21:03

Where I'm going with this is, as you read them, as an investor. What are the things you should look at as an investor when you're considering to invest in a fund like this, in a you call it a mortgage-backed fund? Is that what you called it? I don't recall the exact name of it.

Speaker 2: 21:17

These are commonly called debt funds, debt funds Debt funds.

Speaker 2: 21:21

Simply because they're based on debt rather than based on an equity plan. My advice to any investor out there is before you even look at an investment, you really need to think about your risk reward profile. What I mean by that is are you in a position to be able to risk the money? Are you in a position where most of the equity deals take three to five years? If you're thinking about retiring in two, that may not be a good fit for you. You need to think about your needs and your uses for your money All of the things about your personal situation and your personal experience with real estate. I will caution you. Do not apply the things that you might have learned in the residential world with commercial. It's not the same animal. Yes, there are similarities. Yes, people pay rents, but no, not all of the things that we know from residential are true in the commercial space. You can't come into a commercial deal thinking that, well, I had a single-family home investment one, so I really understand being a landlord.

Speaker 1: 22:22

It's a totally different animal. Let me give you an illustration of this. I love this because, when you talk about this, I am a residential real estate brokerage. Right, the residential and commercial are massively different. Did you know that you can overtly discriminate in commercial real estate? I didn't know that you can literally overtly discriminate. There are no fair housing laws. At one point I was working with a client that was a church and we would not be allowed in a certain strip malls because this strip mall is precluded churches. As tenants, you can literally decide who, what, where and why you're going to put into any commercial property, what your decisions are. Now, there are zoning regulations, but the commercial world is by no means one that is always on a fair playing field. Insider trading is allowed. In fact, insider trading is often encouraged in some ways, because brokers will manipulate who gets what opportunities available for sale based on their relationships. Right, I couldn't say this more importantly, commercial and residential are ones a cat, ones a dog, or an apple or an orange. Texas and New York.

Speaker 2: 23:43

I'll tell you one of my most common investor limiting beliefs in commercial is hey, what about interest rates? The reality is a lot of the commercial deals, certainly in the multifamily space that are getting done right now, many have assumable mortgages. We haven't seen an assumable mortgage in the residential space in something like 40 years. Most people don't even know that you once could assume a residential mortgage. I only know that Interesting fact Because of history.

Speaker 1: 24:12

You can still assume FHA mortgages now today.

Speaker 2: 24:16

Okay, then that's for all the residential that I've done. I've never even talked about assumable I'm familiar with the subject two loans, but that's a little bit of a different beast and we're not going to digress there.

Speaker 1: 24:29

The reason they're not assumable mostly is because interest rates have fallen for the last 40 years, almost consecutively, until the Fed started raising rates for the first time at 75 basis points of shot in 2022.

Speaker 2: 24:43

Great, you're right. It wouldn't theoretically make sense. But one of my again a very common negative with investors right now is oh, I don't want to invest in commercial because of the high interest rates. I'll usually say, well, would it matter that this particular deal is actually assuming a 4% rate? From several years ago I was like, oh, that would make a difference. It's one of many residential. I call them limiting beliefs because people believe things that may be true in one market that aren't true for a different asset class or for a different investment. It's just very important that people don't come into a particular deal and assume that they understand some of the key assumptions and key financial situations, because it's not always true that the things are as fixed in the commercial space.

Speaker 1: 25:36

Love that. That's a great point to drive home and I'll reinforce it with a simple do your homework. People Read the actual assignment. I agree Read the book. Don't read the cliff notes. Read the book, yep.

Speaker 2: 25:50

Very true.

Speaker 1: 25:51

So we've been talking about this for a little while. I love the debt fund. I think they make a lot of sense for a lot of people. They're very solid things when you have a risk, adjusted return and your risk is decreased and obviously your returns are going to be somewhat smaller than when you take on more risk. So tell me, jerry, as we're winding down here, we try to keep it to about half an hour and we're almost there. What is one thing you wish you knew 10 years ago that you know today?

Speaker 2: 26:18

I wish I knew about multifamily syndications 10 years ago. I love them. I think they're a great asset class. I think people are going to there's going to be a need for apartments for the foreseeable future. And economics 101 supply and demand. When there's high supply and little demand, what happens? Price goes up.

Speaker 2: 26:42

I think we're going to continue and I've heard people say rents can't afford to go up because people can't afford them.

Speaker 2: 26:48

I don't know how to speak to that. If they're supply and demand, if people are demanding a low supply item, then the prices will go up and people will have to find a way to cohabitate or somehow lower their cost of housing. I don't know what that's going to look like, but I will tell you that in Miami my backyard it's rated as the most unaffordable place to live, based on what they believe to be the average income and what they believe to be the average housing. I think the numbers are personally a little skewed because we have guys like Jeff Bezos that buys a place down here and I'm pretty sure his fortunes did not go into that calculation. I'm sure he bought a really expensive place. That probably did go into that calculation, but the reality is that the rents as high as they are in Miami. As much as they've increased, they're continuing to hold where they are. They're not suddenly dropping because they're difficult for the average person to afford.

Speaker 1: 27:49

Yeah, it makes a lot of sense. Supply and demand are market forces that are unavoidable.

Speaker 2: 27:55

Yep, and they're bigger than yours or my opinion. They're bigger than what we like and what we don't like. They happen regardless of what you think is going to happen.

Speaker 1: 28:04

And they're bigger than governmental policy.

Speaker 2: 28:07

True, I mean government policy can influence some of the macro factors. But yes, I agree that at the end of the day, supply and demand is more powerful than probably any one factor that stands up against it.

Speaker 1: 28:24

Love it. So tell me, Jerry, people want to get a hold of you what's the best way to track you down in the Largo Group.

Speaker 2: 28:32

Easy. So website Largo Group 2011. 2011 is when I started Largo Group, so wwwlargogroup2011.com. If somebody wants to reach out to me personally, in my calendar you can book a call from the calendar. You can just email us. We've got a free ebook. We've got the usual freebies At the end of the day. If you're interested in talking to me, I'm fairly easy. You can find me on LinkedIn. I'll get you some of those links. I don't know if you want to supply those, yeah we'll put them in the show notes everybody.

Speaker 2: 29:06

Absolutely. And then, of course, if they're interested in seeing the debt fund, I'm happy to talk about that. We've got a marketing deck that folks can review.

Speaker 1: 29:13

And obviously this is not a solicitation in any way, shape or form for that specific marketing debt fund. Or there's no marketing offer. There's no solicitation here for securities. Thank you, just give it out of information.

Speaker 2: 29:25

Thank you, Dave. Yes, we got to be compliant At all times. It is our business, but yes, do slow down and read.

Speaker 1: 29:34

These are golden. I like to help people break golden handcuffs, not get put into real handcuffs.

Speaker 2: 29:40

I like that, I like that. Non-imprecious metal handcuffs.

Speaker 1: 29:46

So everybody, thank you so much Jerry for joining us and you've been listening to another episode of Break your Golden Handcuffs.

Speaker 2: 29:54

Awesome to talk, Dave.