← The TreppWire Podcast: A Commercial Real Estate Show
The TreppWire Podcast: A Commercial Real Estate Show
389. Why Smart Capital Is Still Betting on Office with Mike McDonald, JLL Capital Markets
00:46:56
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Foreign.
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Welcome to the Trepwire Podcast, the show where commercial real estate meets data and insights. This is a special guest podcast. I'm Hayley Keene with trep, a data modeling and analytics firm for the CMBS commercial real estate and CLO Markets. I'm with Lonnie Hendry, chief Product officer. Today we are joined by Mike McDonald, Senior Managing Director of JLL Capital Markets Americas. Mike is also a co leader of the firm's national Office Group and JLL's investment sales and advisory team where he concentrates on growing the brand's national and global capital markets business. Over the course of his career, Mike has handled over $70 billion of capital markets transactions, including office, retail, multifamily and logistics assets, in addition to strategic investment banking transactions. Mike, we are so excited to chat with you today and hear all about what's going on in your world. Welcome to our show.
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Thank you, Hayley and Lonnie and good morning to you all and everybody listening. Really appreciate the opportunity.
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So we start almost every interview the same way. We want to kind of hear more about your background and find out how you got your start in commercial real estate. Was this something you always knew you wanted to do or did you kind of fall into it?
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C
I fell into it without question. I started as a young child actor, which gave me the kind of confidence and ability to be in front of people. So that was the first step. Second is I graduated University of Georgia with a banking and finance degree in the in the late 80s and actually graduated college a year early. Shows you how I was so ready to get out into the workforce. Moved to the northeast with Kimberly Clark Corporation as a business analyst, worked five years there. Part of that job was I was a part of a 10 member team to select a new site for manufacturing facility, which we did in Corinth, Mississippi. And I got bit by the real estate bug during that process. I was just enamored, amazed with everything related to real estate. I came back to Atlanta, was went to graduate school at night, got a master's in real estate. And the very first day of my master's program, I met a professor, Dr. Julian Diaz, who also changed my life about commercial real estate. And I was very focused at that point about the industry that I'm in right now.
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Yeah, that's great. And if you've listened to any of our guest shows, everyone has the same answer. They fell into commercial realty. I think we've had one guest that said they were born into it and they, they kind of lived it out. But you know, you're obviously the first one that's got child actor. We might have to that at some point during the show but you know, clearly some transferable skills there in acting and working in the commercial real estate space. You're dealing with people all day, every day, pressure packed presentations, questions and you have to be quick on your feet. So I'd love to see and hear how that translates at some point throughout the show today. But maybe just drill down a little bit for us before we get into some of the property sector questions around your role at jll. I know Haley gave a kind of a lead in intro but you know, I know you've worked at a couple of large brokerage firms throughout your career so maybe just give us some details of of those stops and then how that helped you land where you are now and what you're doing day to day now.
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Yeah, absolutely. Think about going back to the early to mid-90s real estate. Commercial real estate wasn't a real asset class. It kind of sat at the kids table at Thanksgiving dinner, not at the big table. And what happened in 94? It really became a part of the asset allocation model with pension funds primarily in the REIT universe. Grew up. So it really became a true asset class. A structured environment. Today there's a progression and path. You start as an analyst, associate vp, director, managing director, senior managing director. It's run like an investment bank. The industry is. It was not the way that was not the case back in the mid-90s. It was more the wild wild west. So anybody at that moment in time, most likely other than being born into it, you will kind of fall into the industry. It's not, it wasn't structured like it is now. So I started at a boutique firm in Atlanta as an analyst and a research analyst and kind of learned the environment. And then in 2000 opened with a partner of mine, the Eastdale office in Atlanta. And then in 2014 opened the Eastdill office in Dallas. Spent a lot of time in Texas. So I was at Eastdill for 18 years. Sat on the management committee. Extreme well run organization. Very happy with my time there. Spent four years at Cushman running the national platform on the office side overseeing the Sun Belt co locating in Atlanta and Dallas like I do now and then I was blessed four years ago to join JLL as part of their office investment platform. I co run the platform, also sit on the executive committee, expanded executive committee for the firm. Kind of working on strategy for the organization. Not just focus on office sales but Focus on our clients first and foremost. I now co locate between Atlanta and Dallas. I fly 175,000 miles a year. I sleep in hotels 200 nights a year. I tell people my office is really delta 5C based on amount of travel I do. They're family to me. My job is to be in front of clients. My job is to make sure that we are weaponizing our data as a platform and, and helping our clients grow their platforms, either manage their existing portfolios or place their capital wisely. I'm obsessed with that. I sleep three to four hours a day. I wake up in the morning before anybody else does. I go to bed after everybody else does. Not run really, really fast. And so going back on my child acting career, it's given me the confidence to be able to get in front of people, have conviction and passion about what I do, and communicate all the things that we can do for our clients and help to take them to a better place than where they are right now.
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I mean, that's an incredible answer. And I, you know, I, I jokingly tell everyone on our show, my address is American Airlines, row 12, seat C. So one, I gotta figure out how to get to 5C because that's much better. But yeah, I, I feel you. It's. The travel thing is real. Living in hotels is real. And we've done a lot of research around just the decline of hotel service over the last couple of years. Post Covid, prices have gone up, service levels have gone down. But for today, we want to stick really with the office, since that's where your primary focus is. And I think it's an interesting top because we've seen the evolution of office. I mean, if you go back pre Covid, everyone had institutional capital flowing into office. CBD office across the US was a very strong conviction investment. I like the way that you framed the early 90s pre 95 or 94, like the wild, wild west, because that's really what commercial real estate was. But once we started bringing some institutional perspective to the sector, office has always been one of the preferred asset classes. And for good reason, obviously. Fast forward to Covid and there's been this huge paradigm shift. So I know you've been really outspoken around your optimism around office, but maybe just give us some context of the evolution of office from your perspective over the last 25 years and then we'll get into kind of where we are in today's office cycle.
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Yeah, absolutely. I do take this personally. This coming Friday will be 32 years and exactly 10 months doing what I'm doing right now. So I have great passion over it. And it's like when a little brother gets punched in the cul de sac. I take it personally. Like I want to make sure that people are thinking about Office the right way. It's so easy to snap to a conclusion without really understanding the data behind it. And so I'll kind of walk you through the kind of evolution from my lens of what's happened. So really going back to the RTC days when after that the commercial real estate industry really grew up, you know, 93, 94, office became a big part of the asset allocation model with pension funds, with open ended core funds, with separate accounts, with REITs, it really became a big asset class, actually the largest asset class when you look at commercial real estate. It was that way for 20 years. We went through a period of time in the 90s where the REITs bulked up. And then we had the dot com issue and the Russian ruble crisis in the early 2000s got through that. And then GFC clearly hit in 2008. Coming out of GFC really looking at 2010 and after office was a big asset class for institutional investors. We did not have the work from home dynamic like we do now, or at least the perception of that like we do now. So it really grew through 2010, through 2019, it just accelerated. We worked on a plethora of transactions during that. Cap rates, compressed valuations went up. The overall metrics of the leasing environment were extremely positive. And then we had another disruption into our market with COVID in 2020. What happened after that, really, I don't even consider 2020 as a real year. I don't consider 2021 as a real year. It was fictitious based on where debt was really starting in 2022, we start really seeing what happened to Office and the evolution of the institutional investor and their desire or lack thereof, and to invest in Office at that moment in time. 2021 was a pretty important year where Office from the Odyssey standpoint, from core fund standpoint, was close to 40% of the allocation into commercial real estate for a very long period of time. What happened in 2021, it juxtaposed with industrial. And industrial now is the largest category with core investors. And I really kind of go back in time and look at it where office went from 35 to 38% now down to 15% of the core allocation. And industrial did the exact opposite. And what I think Happened was in 2021, industrial changed their name to logistics. It was a great PR move. Cap rates went down 200 basis points. the same time, Multifamily changed their name to living and cap rates went down 200 basis points. Office has a PR problem. I now refer to it with my clients and during presentation, it's an alt in some degrees. It's like daytime housing, like, let's call it that instead of office. Office has a bad connotation, but I took it personally. Our platform did so literally four years ago, almost to the day, we just, we decided to change the narrative office sector, get away from class A, Class B, Class C. That was so antiquated. In yesterday's news, we created a tiering system. We went through two and a half billion square feet of office in the top 20 MSAs and created four tiers to really track that office, tiers one through four. And as you can imagine, somewhat based on quality and vintage, but tier one is the highest quality 2015. And after vintage office buildings, and you kind of go down, you get lesser in quality. So tier four is just a vintage, candidly 80s, early 90s buildings that are just big bombers. So we decided to create a stratification for our clients and really get detailed analytics behind it and predictive analytics behind it on how office is going to perform. So we rolled that out four years ago, and it's been hugely successful. I think we've changed the narrative. We see others using the tiering system. You know, it's a great. It's a great compliment, right? When others imitate what you're doing, we see institutions doing it, our competitors doing it. It's the way to look at office. You need to slice and dice it because not all office is bad. I fully admit there are some really bad office buildings. I also admit there's some really good office buildings. Once you kind of say that you stand up in a crowd, everything else makes sense. And that's what we're really focused on, is making sure our clients understand the data behind their investments, both the ones they own and the ones they want to place and really capture that and use that to their advantage to operate the office, their office assets efficiently.
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So I got to tell you, Mike, as. As you're talking here, Hayley and I are messaging back and forth because I think you're my corporate twin. I mean, I've been saying the same things, I mean, almost verbat at some level for the last several years, and it's really interesting. I love that you guys went away from the traditional subjective classification and into more of an objective tiering system. Because I feel like the market has just accepted the adopted approach for so long. But when you have a disruption like we had with COVID it forces you to look at things differently. And you know, I, I've got a kind of a pet project that I haven't been able to complete yet. But I, I have this supposition that you can look at the tenant credit scores in office buildings and you could come up with some sort of a composite credit ranking or composite credit score the building and that will objectively give you a much more concise qualification or classification of the building than age you're built, et cetera. And it's really interesting because right now everyone's using terms like bifurcation or flight to quality. Those things are true, but it needs to be anchored to something. And then your tiering system helps with that because it paints a much clearer picture to your point of, you know, industrial. I mean, I've taught at the college level for about 14 years and I tell a joke all the time to my students that when I got into commercial real estate, I've been in this business 23, 24 years now. Nobody wanted to work in industrial. Everyone wanted to graduate college and become a developer or work in office sales or multifamily sales or capital markets. Nobody wanted to do industrial. And to your point, as soon as you made it logistics, it sounds sexy. And everyone loves industrial, not just the investors, but like the students now want to go work in industrial because it's technology and logistics and all this cool stuff. It's really just a marketing play. And office, to your point, needed that pivot. It needs to figure out a way to position itself even amidst work from home and all of the things that are negative, perception wise, and turn that, that into a positive. So one thing that I've noticed, and I'd love to get your insights on this is, you know, one of the reasons there's a flight to quality is pretty obvious. One, the occupancies in those buildings, because they're usually in great locations, highly amenitized, and they have a great tenant roster, they're high occupancy, which maintains that level of lower ownership investment. So like, what we've realized is offices that are 60% occupied are a lot more capital intensive than what people were used to when they were 95% occupied. Because when the elevator goes out, you still have to repair it, but you only have 60% occupied occupancy and you're incurring a lot of that cost as the owner. Those highly Amenitized buildings that have high occupancy. They continue to run on the model that everyone has understood and accepted for a while. But I think the real opportunity is in some of these like offices that maybe only have 60 or 50 or 40% occupancy. If you can pivot them, change the narrative, kind of acquire them at a price that's attractive today. What are your thoughts on, you know, I know you've said that the next five years there's going to be an incredible amount of profit made in office investment. Is that your thesis? Buying some of these less than buildings today and turning them into something better? Just give me a little understanding of how you, you view that.
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Yeah, absolutely, I, I do. I do agree and I know I'm biased, I'll fully admit that. But I'm also objective. I've worked on every single product type there is in the capital markets, commercial real estate, business. And I, I firmly believe the next five years that we will see wealth creation more in the office sector than any other sector. I firmly believe that. I think the other sectors primarily living and logistics, or you may call multifamily and industrial, they're priced to perfection right now. Great asset classes, but absolutely perfection. Where in my assessment it will generate beta returns and not alpha returns. Alpha in my opinion will be derived in the office sector. It's a contrarian bet for sure. But you go back to kind of 1990 forward contrarian bets made by smart investors during that, Those past, whatever 36 years have always outperformed the other investments. So you have to kind of hit them where they're not and kind of focus on asset classes, maybe assets themselves that are out of favor. Office is in that, in that category. So I kind of see two areas in my opinion to really make money in the office sector. Really? 3. Let me give you 3. One is to buy high quality tier 1, tier 2 assets at a dislocated cap rate at a cap rate that is well above the historical mean. And then over time, as we see both the fundamentals on the asset level as well as the fundamentals of the capital markets improve, we'll see cap rate compression on those assets and buying an asset at a 7 cap that's 95% lease with 7 years Walt and 20% below market, holding it for 5 years mark to marketing some of those leases and then selling that asset at a six and a half cap for not doing a whole lot. You'll get paid handsomely for that. So I think that's one area, High Quality Tier 1, Tier 2, focus on the cap rate compression. When we see more capital come back to the sector, I've done this a long time since at the outset and if passes prologue, which I believe it will be, we'll see that institutional capital continue to creep back into our sector. So investors buying assets now and in 24 and 25, they're going to reap the benefit of that when they're selling in the 2029-32 window with the depth and breadth of capital. Second way to make money in the market, in the marketplace to your point exactly. Buyer that buy the lower quality assets that may not be as stabilized and focus on operations. If you get it at a basis to where you can actually reduce rents and operate and provide capital infusion into the asset and track the tenancy, that's another, that's another area where we think it's going to be really, really strong over the next five years to make money in the sector. So it doesn't have to be kind of new, bright, shiny and sexy to make money in the office sector. It just takes operational excellence and prowess. And the third, which I firmly believe is equal as to one and two is new development. I make this presentation, make this case. When I sit in front of students at a school or I give a big presentation to a client. I start with saying we don't have enough office buildings in the country just to have a shocking comment. And I get the kind of response like what do you mean? We have way too much office. We don't have the right office building in the country. So we absolutely need more development in the right growth markets. Not to go crazy. I think that we have a governor now for the next five years, which is candidly very good for our industry. We were not always that, that controlled over the past 35 years in the office sector. We may have built too much in certain markets. That will not happen right now. There's capital constraints in that, both on the equity and the debt side and the tenancy side. So I think that if I look at the three prongs, high quality tier one tier at two assets via cap rate compression because more capital is going to flow into the sector. It's pretty simple. Adam Smith had it right a couple hundred years ago. It's supply demand fundamentals that drive everything in our business. All the other metrics are really important. What the rental rate was, what the TI was, the absorption is for the building wildly important. It comes back to supply demand fundamentals. If you're selling widgets, used cars, or office buildings. If there's more demand than supply that will be accretive to pricing. Second to what I've commented on the lower quality buildings in the right markets, it doesn't, this is not a general comment for everybody. I've had people tell me there's no way I can lose that $50 a foot in downtown Atlanta or downtown Dallas. I can point to many examples where you can lose at $50 a foot and to go and use your operational expertise, improve that asset both from a physicality standpoint and from a tenancy standpoint and then again benefit from that cap rate compression which will spill over into lower quality assets. And the third new development, maybe not the big million square foot towers we saw in the 80s and 90s but more boutique 250 to 350,000 square foot buildings and growth markets, you will be paid handsomely and make a very good return in that regard.
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Yeah, no, I agree with all three of those. I think the cap rate compression in the tier one and tier two and again you guys, you said you did this across 20. I think you said 20 msas. I mean that's where the bulk of the transaction volume occurs anyways. And so I think that's a very strong thesis. The you know, the little bit less than office. I think we're at this part of the cycle across a bunch of different asset classes where operational expertise really drives profitability. So to your point on industrial multifamily being priced to perfection, you saw when you 2020 and 2021 when interest rates were zero, those prices went through the roof. Especially in multi and industrial, it's really hard to generate returns now. I mean unless you can buy something at 50 cents on the dollar from the latest transaction, you're going to have a hard time driving those alpha returns that you talked about because the markets are just, they're priced in and renters are so much more knowledgeable on what rents are and they can do their own market analysis and they can, they're just, and it's, you know I have some friends that are multi family developers and it's, it's a really tough slog right now. I mean land costs are prohibitive and then just the competition is really, really strong especially across the Sunbelt which I, we were on record of saying we thought there was going to be a lot more disruption in multi across the Sunbelt just because of the activity, the value add reposition of the 70s vintage that just didn't materialize. But those markets, because of the population dynamics that have benefited them. They've been able to maintain. On the whole, there's still pockets. I wanted to go back to a little bit on the cap rates for office, though. You know, I've given this talk track in several presentations that I've done. So we track a lot of different financial metrics at the property level, line item income and expense. We have cap rate information, appraisal information at origination, all this stuff. And so I give people these stats. I'm going to give you these stats and just it speaks to your positive outlook on office and mine as well. In 2017, nationally, across the data that we track, cap rates on a going in basis were 6.6%, 2% 2018, 6.81% 2019, 5.57%, 2020, 6.1%. Now, these are the same office buildings that today people are calling functionally obsolete and have no value in the marketplace. Now what I know is a lot of smart people were underwriting deals. A lot of smart. The bricks and sticks haven't changed. The perception has changed. People's view of office has changed. But in 2017, 18, 19, people were buying office buildings at, you know, six or below Cap rates all day long, not thinking twice. So if you can buy something at an eight or a nine day, that's where you're. That's where the profit is. Because it's going to revert back to the mean at some point. Like we are a people of habit. People will come back to the office. And I think if people are being honest with themselves, we never tracked this at the level we do now with Castle and some of these building card swipes and other things, but most offices only had 60 to 70% of their people in the office every day anyways, with time off, sick leave, et cetera, travel, business travel, et cetera. I think we're pretty much back to that in the major metros. And I think to your point, if you can buy something at an 8 or a 9 cap and just operate it, well, I mean, the outlook has to be positive. Go back just six, seven years ago. These same offices that now people think have no value, we're literally trading at 6 cap all day long. Nobody batted an eye.
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C
Yeah, my fingerprints are on that murder weapon. I have to admit, I mixed up that magic at Lixer in 2013-21. Right. And kind of provided it to the investors because we really firmly believe, you can probably tell by now, I have passion over this industry. Okay. I really, really like what I do. I can't imagine doing anything else candidly. And so I, we helped on driving some of those cap rates down because we had a flush of capital both domestic and offshore into our marketplace looking to place back to that supply, demand imbalance that we had. And then today buying these assets, you mentioned these functionally obsolete buildings, I refer to them as dark matter. You know, they're in, they're in a, you can go and find out. It's a 1.1 million square foot building and you pick a downtown. It's 48% leases, three years. Walt. There's a quasi owner, there's a, a quasi lender. It's kind of like the awkward 8th grade dance. Like nobody's on the dance floor. Nothing happens to the building. The building's there. You can touch, feel it and see it, but it really doesn't matter. It's not competitive to the buildings that are well capitalized and do have a really good landlord that can operate the building and provide the, the, the setting that the client, that the tenants ultimately want. So when we slice and dice our data, we just complete our own proprietary information and slice and dice the market and talk about which buildings are really competitive, the building we're working on, on and which ones are dark matter. But they do matter because that's where those, those owners can go grab those tenants from and put them into their building. So I am, I'm a firm believer of this capital flows into our sector. That will happen at latter part of this decade and early next and we will see. You know, we, right now we, we kind of all grew up in this industry kind of thinking about core, core plus value add and opportunistic returns. And today in the office environment, its core ish and value add plus, there's nothing in between, there's no core plus capital. So when that capital flows back in for higher quality assets, we're going to see both a trickle down effect of capital into lower quality assets and a compression of yields. Because we do need to have that core plus capital come back into the marketplace to take out some of these buildings that are maybe not brand new or 2015 or after, but they're really good office buildings and growth markets. And we need that capital to be not at a 25 levered IRR, to be at a 15% levered IRR. When that happens, which it will, we will see that cap rate compression and the in the people making bets today in the office sector will be absolutely rewarded for the risk associated with that. In four to five years when we see more capital flows I started, you know, thinking about this. I think our cycle, our current cycle started really January of 23. I commented my thoughts on what 20 and 21 were. 22 was kind of a shock and awe. We just, our marketplace saw a lot of distress. I really think our market started January 23rd. We've seen the trends and transactions since then, the capital flows since then. On a weekly basis, I'm having calls with Australia, Germany, South Korea about capital flows into the sector. The same thing I did back in the late 90s, before the capital flows really came came in and the same thing I did post gfc. So I'm seeing this evidence by the calls that I'm having. These office curious investors of 20, 23 and 24 absolutely have turned into office serious investors in 25, early 26. My job, if done correctly, I'll make them office delirious investors in 26 and 27. I, I firmly believe that's what's going to happen. So we're emboldened as a platform. But what we're seeing across our, our marketplace, we are up year over year 50% with our activity. There's a lot of product coming to the market. So we feel very strong about this sector now. Not, not every office building is created equal and we totally recognize that. So we're spending a lot of times not just as advisors, but counselors to our clients as well. Because a lot of our clients are in really difficult situations. Our job is to help them through that. Be there in good times and bad. It's easy to be there in good times. Right. Everybody shows up for that. It's a tough times where it makes tough people. Be in front of our clients with solutions, not problems. And that's what we're doing.
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A
Yeah, no, I think, look, we say on our show all the time that real estate by definition is a local and sometimes hyperlocal endeavor, which means two buildings on the same street can have two entirely different outcomes based on who the owner is, what the capital stack looks like, et cetera. And we're seeing that play out here. So for all the optimism around office, there's definitely still a lot of distress that has to work its way through the system, which creates opportunities. But some of this is just math. If you're sitting on a current three and a half percent coupon and you're having to refi into a seven and you're, you know, your walt on the deal is three and a half years, the lender's not going to be super favorable and you're probably Going to have to come to the table with some cash and we've seen a lot of people do that. We talked about an office story a couple of weeks ago on our podcast that you know, they brought in a couple hundred million dollars worth of capital at closing to get the deal refinanced because they had just signed a long term tenant with a very credit worthy tenant that occupied a large portion of the space. So their conviction in that asset was proven by their willingness to put capital down on the refi. So our delinquency numbers that we track are still teetering near all time high. So it's not all sunshine and roses yet, but I think there are some tailwinds for us in the sense that you talk about supply and demand and at the end of the day that's what this comes back down to across all asset classes. If you look at new office delivery, I think in your guys report report that you put out about 5 million nationally in 2027, which is considerably less than what we've seen over historical perspective. So that just organically creates some of this supply and demand kind of rebalancing that we need for people to get back into the sector. Give me some perspective. I know you said you kind of co locate or co reside between Dallas and Atlanta. What's going on in Dallas? I mean I'm in the Dallas metro too and it's on fire from my perspective. But I'd love to hear what you're seeing in the office market, especially in that uptown and in some of the, the north Dallas suburbs.
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C
Yeah, absolutely. I, I think I step back and look at the most sought after markets in the country and to me there are three or four. New York, but not just New York. It's Park Avenue, Grand Central, Miami, not just Miami, it's Brickell. Okay, the San Francisco, certain assets in the city and certain assets in the Bay Area. And then we come to one of the greatest cities in the greatest state in the union, Dallas, Texas. You said it's on fire. I absolutely agree it's on fire. It's one of the hottest markets from a performance standpoint in the entire country. We rents for the top, top buildings in the market have grown 40% in the last 12 months and the amount of capital flows and desire to be in Dallas. You look at what's happening with the overall macro economy, it's very easy to kind of look at demographic trends, right? New York to South Florida, California to Texas. Very simple that it wasn't, it wasn't just because of COVID this really started like 25 years ago. So we track all this data, data the tenants want to be in Dallas, Texas. The investors follow the tenants, and that's exactly what happens in our business. The market is super red hot right now. When we marketed 2000 McKinney last year, Texas Capital center, we had an amazing grouping of investors show up for that asset that we ultimately sold just for under $300 million. We were blown away by the interest and by what I mean by that is we looked at the final bid sheet and a lot of these people should not all be together on the bid sheet and they'd be at the same pricing like Opportunity Funds using aggressive returns and Core Capital using lower returns. I kind of, I kind of reference it as it's the red eye flight from Vegas back to the east coast on a Thursday night. All these people should not be together, but they, they are. And that's what our bid sheet looked like. We had a really good showing in that regard. Our pricing went higher than we originally thought. We sold to a really, really good group, and they're going to do exceptionally well with it. We are about to bring out another almost billion dollars of product in Dallas. And I think that the Dallas market right now is really sought after because, because of all the fundamentals that are happening. It's a great place to live, work and play. Having no income tax in the state is phenomenal. Just the growth metrics are phenomenal. For years, Dallas and Atlanta got compared to one another. Then I can kind of comment on both because I travel between both and I live in both places. Dallas is, is. Is in the state of Texas and Atlanta is not. Dallas is in the central time zone. Atlanta is not. Dallas has two airports. Atlanta does not. Atlanta should have done that 45 years ago. They didn't. I love, I'm sitting in Atlanta right now. I love, I love the Atlanta market. But I look at what's happened from a growth standpoint in Dallas. It is on the upper echelon of where investors want to be. 35 years ago, some graduate student, some Ivy League school kind of defined what gateway markets were. And I think at that moment in time, it was probably a little incorrect just to think about New York and Boston, Chicago, D.C. louisiana, San Francisco, sometimes Seattle, if those, if that definition also included Dallas, Miami, Miami, Tampa, Atlanta, Charlotte, Nashville. I think the investment trends over the last 15 to 20 years would have been different from institutional capital. And I think the returns overall with those funds in those separate accounts would be different as well. So we're not only educating, you know, a private capital, we're doing on the institutional side showing the metrics between those markets. New York is New York and is the greatest city in the world. That'll never change. But I think if that definition of gateway markets also included the growth markets across the Sunbelt, well, we would see more institutional capital flows and overall better returns. I think that's exactly what's going to happen in the next five to 10 years.
- [29:59]
A
Yeah, you're spot on. I mean I think it's going to be a defining moment that redefines what gateway cities are. And I think it comes back to the underlying fundamentals. And one thing that we've seen over the last five years or so is you cannot deny the population net in migration statistics for those markets that you just talked about and that drives demand. And what we've seen in Dallas, Fort Worth in particular, I mean over since like say 2018 to 2024, I think they've had over 100 corporate headquarter relocations into that metro area. Apollo announced in the last week or two that they're looking for another headquarters. You saw some of that with Brickell, with the Citadel guys and all the stuff buying Dallas is opening up another stock exchange. Like all this stuff is here. To me, if I'm, if I was putting capital to work, Dallas would be where I would be for the next 10 or 15 years. Just because the underlying population and fundamentals are so strong there and the cost of living on a relative basis is so much more affordable and quality of life, like these large scale employers that are looking for quality of life scores for their employees. Texas is always going to score very high because it's, yeah, it's hot in the summer, but we have all the sports teams, we have the airports, we have all the stuff you mentioned. It's really tough for some of these others to compete now. I split time between Dallas and New York. And so you know, to your, your point earlier, New York is just New York. I mean like it's tough for me as a Texan sometimes to compare myself to New York because you know, California, New York GDP is like larger by some multiple. California is like three times larger. Texas's GDP and Texas's GDP I think is like the ninth largest in the world, but there's levels to everything. So it's really interesting. California is losing these people to Texas, New York is losing people to Florida. But New York is still kind of the top tier. I mean it just every time I fly into the city, I'm reminded, like, if we were starting over today, there's no way we could recreate Manhattan and New York City the way it is because building laws, unions, all that stuff wouldn't allow it. We saw about $20 billion worth of issuance in New York City office last year. I mean, it dwarfed every other major metro in the US But I think Texas and Dallas in particular is on an upward trajectory that's going to be tough for people to compete with. Like, the capital is going to come here, the jobs are coming here, all the stuff is coming here. So maybe a couple more questions. This has been incredible, Mike. I think I could go for like four hours with you on this, but I want to talk a little bit just about what you're seeing on bid Ask spread. And are people getting a little more realistic on some of these assets when they're pricing them? I know for a while, because we agree with you, 2020 and 2021, they were the anomaly in terms of pricing, stimulus, interest rates, all the stuff just mixed together. Everything went to the moon. But if you're holding that price and now you got to sell, that's still in the back of your mind. And people were hesitant to let go of that. Are you starting to see a little capitulation? And is that bid ask spread narrowing across these major markets?
- [32:38]
C
It is narrowing and kind of going back to the tiering. When I look at Tier one, Tier two assets across our platform and the performance of those transactions, the bid ask spread was very, very tight. And a combination of two reasons. One, primarily more, more demand of the capital, better, more aggressive underwriting on those assets in terms of the fundamentals as well as yield compression. So I think the investors kind of met more than the halfway point on the field than the sellers did during the past three years. As it relates to Tier 1, Tier 2 now, it seems to be a very efficient market where there's been enough price discovery and most of the major markets understand where pricing really, really is, is. And we see some positive fundamentals that's going to drive pricing even higher, yields even lower. And then kind of on, on the other side, the tier, tiers three and four assets, really more capitulation than, than necessarily aggressive underwriting and, and decreased yields, more capitulation by the sellers. And what I mean by that is primarily the lenders have been really involved. So you look across our Tier 3, Tier 4 transactions, I would imagine we're a barometer for the market. That 80, 85% of those transactions in the last three years had some form of destruction, capital sack loan, maturing loan already matured. I mean, just some form of distress associated with that. Where if I kind of looked at our Tier 1, Tier 2 assets during the same time frame, 10 to 20%, 20% maybe in 23, 10% the last 18 months. So it's really come down. So more capitulation on tiers three and tier four by the sellers, primarily the lenders. Years ago, when we would do a value for an asset that a loan on it, and we knew it was somewhat troubled, we would get the information, information have a value for the, for the client or for the sponsor. And then two weeks later we would talk to the lending group or lender and do a separate valuation and conversation with them. Now we're getting mom and dad on the phone, you know, we're having one conversation. We're all in this together. It takes a village to work through the office sector. So when we do meet stress and distress, which we do have in our, in our pipeline, we actually get the entire, all the parties involved at one time to make the right strategic decision and not just try to go down the road, the road with the sponsor knowing that we need to ultimately have a conversation with the lender. And the marketplace knows that too. When you're in the market with an asset that is near or slightly below what the loan balance is, the market's not going to spend much time on that unless they know the lender is right there with you. A lock step, that's the way it has to be to have an efficient transaction. So we worked kind of through 23, 24, the market worked through kind of learning that. And as we kind of went through 25 and now into 26, the market, market has learned that and we are having those conversations together. So we're seeing that bid ask gap really, really narrow. Definitely narrow for tier one, Tier two, they still exist for tier three, Tier four. You know, some owners think like that their, their baby's beautiful and that the marketplace should compensate them for that. But I think when we have a distressed situation, really need to get both parties involved. But we're seeing that gap close and close considerably because of cap capital flows and because of capitulation for the lower quality assets. Assets.
- [35:27]
A
Yeah. I think it's an interesting dynamic this time around. And the gfc, obviously there was just a lack of availability of liquidity in the market. And so you had to have cash to get deals done. And as soon as you couldn't make the payment, you tossed the keys back because you probably Got a loan based on pro forma underwriting of rents and things that you just couldn't achieve. This time it seems like there's been a lot more cooperation between borrowers and lenders. There's been a lot more modification and extensions of loan terms. We've tracked that at scale and it's really remarkable to see how well that's played out. And I think to your point of getting everyone on the phone when needed, it's allowed for the markets to just continue to operate at a, you know, not peak efficiency, but an efficiency level that hasn't created this massive amount of distress that we all thought was going to happen in Covid hit. I mean like if you had polled any of us in March or April 2020, we probably would have said, oh my goodness, like that we're going to see distress worse than the GFC just never materialized. And I think it's because people learned from the GFC and participants both, you know, owner, operator, sponsor, borrower and lenders are working at a level that, that's creating efficiency for the market. Now opportunistic buyers are able to come in and take advantage of that. But everyone effectively makes out a little better than they would have had we gone back to the same position that we did in 08 where you just tossed the keys back. Like I think this extend and you know, I wouldn't even call it extend and pretend anymore, but just extend and kind of work it out seems to have worked itself out a lot better. So a couple, just two more questions and then, and then we'll let you get back to making some deals. You know, you mentioned several markets that are, that are hot. One thing I think a lot of them have in common are especially like in the Bay Area and in Dallas, is some of the AI firms really moving into some of these office spaces and taking down large chunks. Have you seen that at scale? What are your thoughts around AI and is that a net positive for office or is it something that people should be worried about?
- [37:13]
C
Yeah, I mean, haven't we all seen the movies? Right? Ultimately what happens, I think you've seen Terminator, I think, I think we have a good 10 year run in total running from the machines. We're taking it very seriously. I mean everybody conversation I have with clients, AI comes up. And so we're, we're taking the approach of writing a white paper on it right now. Looking at the trends that we're seeing in San Francisco, in the Bay Area, that's going to basically evolve across the rest of the Country Austin, we're tracking that right now. We're seeing a lot of AI companies look for space in Austin, Texas, which would not surprise me at all if you told me that a year ago. I knew that was going to happen. We saw the exact same thing with technology. And so I think AI and our platform, we're spending a lot of time on it with our proprietary and information database. It's going to make people more efficient, it's going to make people more profitable. And we think the tangential aspects of AI will be very similar to like when the iPhone and apps came out. We saw that business grow, grow in the office sector to all the businesses that support technology and the iPhone and apps. We think the same thing is going to happen with AI. Now, will AI encroach and impact a call center and you pick a location across the country? The answer is probably, probably yes, it'll become more efficient in that regard. But I think for the standard tier one, tier two assets and core markets, growth markets, we think it's going to be a net positive over time. Right now there's a lot of concern, right? Just like when, you know, think about when, when the Internet started, everybody thought that the bricks and mortar retail were just going to go away. What did the retail industry do? They didn't build anything for 20 years. Occupancy is now 95% of the country and there's not enough retail space, high quality. We think the office sector is going to mirror that with this kind of shocking office. Not only with COVID and work from home, but now with the AI concern. I think it's personally a really good buying opportunity, candidly to take advantage of that disruption. It's arbitrage in the system. People who make money take advantage of arbitrage in a good way. And I think there's arbitrage right now because of concerns with work from home, which have really dissipated, which you said, as well as the AI industry, which I think is going to be a net positive long term. It'll be a couple years of growing pains, no question, to really find out who the winners are, are and who are not. But I think long term it's going to be really good for our business. We, we take it very seriously on our side and we had a really big call on it last week. And overall we think it's going to be a really net positive for our ability to advise our clients with real time information and have it streamlined. And so we're looking at that from that perspective. We're hiring, we're adding people. We think, we think the same thing's going to happen across the office sector. Maybe a couple years of disruption. But therein lies the opportunity. Right. With disruption, take advantage of advantage of that disruption. I look back over the last 35 years and these moments in time, it always kind of surprises me. I kind of smile when everybody says New York is over, office sector is over. I mean, I would never bet against New York, like on the dip. Always buy New York City. I think as relates to office as well, it's a herd mentality when people start saying something, start swimming the other way. And people who do that tend to do really well, whether in commercial real estate or indie industry. Take the other look and kind of see what people are not doing and that that's where people really make, make money in whatever industry they're in.
- [40:10]
A
Yeah, I mean, that's where the transformational wealth building opportunities exist. It does take conviction and it does take capital. For a lot of these office buildings. For people that had the conviction, call it two and a half years ago, they probably were still a little early just because prices hadn't completely bottomed out. But I think at this point, the market has said in most of these major cities, we know where the floor is, we're past that point. And there's some still great buying opportunities because there's just not enough people putting money to work in these, in these buildings. And so I'm with you on the AI stuff. I mean, I think for white collar workers, for financial services, for real estate, et cetera, AI is just going to accelerate our teams. It's going to make us better, more proficient. It's not actually going to mean that we need less people per se. It just we're going to be better at what we do and do more of what we do well. And it sounds like you guys are aligned with that as well. So last question here. You know, we've talked a lot about Dallas. You mentioned some of these other markets, Brickell, some of the Bay Area stuff. If we're sitting here 18, 24 months from now, where do you think the best opportunities are? And if somebody's on the fence, you know, what, what is, what is the 30 second elevator pitch to get them off of, you know, sitting on the bench and not placing capital in office, what is it that's going to turn them into an office investor?
- [41:15]
C
Yeah, I think, I think I'll answer it in reverse order. I do. I compare and contrast. It's a relative investment market. So most of our investors are Speaking with, they're investing across not only other asset classes of commercial real estate, they're investing in other assets across the globe. And so I kind of look at it from a standpoint of risk and return and relative investment market and thesis and so when I sit with an institutional investor that's heavy in living and logistics logistics and they're underwriting those assets to a nine and a half to an 11 levered yield where the same quality asset in the office sector with same fundamentals on the wall and credit worthiness etc, that assets being underwritten to an 18 to 20 levered IRR. So is that market, is that, is office really worth 800 to a thousand basis points difference in overall return? Is it, is that the amount, is that the right way to price risk? I don't think so. Candidly I think maybe there should be some inherent risk associated with it, maybe a pretty premium, but not upwards of a thousand basis points. That's been the big pitch with institutional investors and we've seen really good results from that of capital flowing into our sector kind of saying yeah you're right, we don't need a thousand basis points, maybe 300 basis points premium. I think that's what's going to happen. We're going to see more compression in the overall office sector yields than we will in the other sectors. Back to my earlier comment about being priced to perfection. There's really nowhere to go. Great assets, great industries, but you're buying what you you think you're buying and you're going to get the return you're thinking you're going to get. Office is going to compress downward, there's no question. Because that same office asset in 2019 or 13 or 21 traded at a 9 and a half to 10 levered IRR thousand basis points less. So to me that has gone the pendulum has swung way too far the other way. And then to specifically to your first question, you know, where do I see growth and opportunities? I spent a lot of time in the Sunbelt and I think that there are certain markets in Sunbelt they're going to absolutely outperform, provide that alpha return to the investors. If I had to pick on one that's really down right now, that's the one I would pick on. It's Austin, Texas, not too far from where you're sitting right now. That market when I sold almost everything there from 2013 and 19, hottest market in the world by far, greatest in the greatest state in the union. And then we've seen a lot of Challenge with maybe oversupply and lack of demand. Those two together typically aren't. It's not a good formula but I look at the AI influence. What's happening. We're to trying tracking 40 companies, AI companies that are looking or have already domiciled in Austin, Texas. We think that's going to continue. We went back and looked at what happens in San Francisco. How long does it take to matriculate across the country, especially into Austin? Takes about 18 months. And so we went back and looked. What happened 18 months ago in San Francisco is what we're seeing right now in Austin, Texas. So the market that provides the greatest challenge also provides the greatest growth fundamentals in Mike's assessment. It's Austin, Texas.
- [43:50]
A
You know, I think it's really interesting. Austin you could buy high end class a tier one type buildings, 200 a square foot in 2014. By 2019 it was almost 700 a square foot. So cousins bought a building I think for about 450 a square foot kind of setting a new floor. And I to your point, if you go back at 2019 and you see things trading at over 600 a square foot, I think we end up there sooner than we do ending up at 300 or 400 a square foot on the long term. So you know, and Meta just announced that they were going to occupy their, their large single tenant building that they had built there on the river.
- [44:23]
C
River.
- [44:24]
A
A lot of positive things in what people refer to as Silicon Hills. So I'm kind of long Austin too. It is interesting. They crazily overbuilt multifamily there. So it's actually really affordable. Comparative to traditional Austin cost standards, multifamily rents are down about 25% which I actually think is bullish for office because when those large corporations are doing their cost analysis now, it's a lot cheaper for their employees to live in Austin than it was say three years ago. So I'm with you. I think Austin, Austin has some really good prospects for especially in the office market. So man, this has been great. Haley's gonna wrap us up but really appreciate you spending some time with us today Mike.
- [44:58]
C
Yeah, I tell you, I really, I really enjoyed this conversation of two things. Never bet against Texas and always wear your cowboy hat when you go to New York.
- [45:07]
B
I love it. Well, thank you Mike. It's clear your excellence mindset, you practice what you preach. We can hear it today. I know our listeners are really going to feel your insights and enthusiasm after this show. So before we let you leave, can you just tell our listeners how they can reach out to you or learn, learn more about your business at JLo.
- [45:27]
C
Yeah, absolutely. I love, I love for them to reach out. I, I, I, this is my, this is my, my world. And I would love to be responsive and help somebody think about the industry or help somebody grow in the industry. So the best way to get a hold of me is my email address. It's very, very, very simple. It's mike McDonald.com and I would just encourage your listeners, if they want to go deeper on a topic I talked about or talk about something else related to capital markets or the office sector, please shoot me an email. I'll be responsive and I welcome, I welcome the, the calls and the emails because I will be, I'll be very responsive. I want to help people in this industry grow. That's what I want to do. That's my legacy. I want to do just that with your listeners. But I really appreciate the opportunity and time today in the forum to talk with you. I really enjoyed it and I'm always willing to do it in the future.
- [46:15]
B
Thank you so much, Mike. I know you're definitely a friend of Tripp's. Now, we'll probably need to hear back from you in a few months to see what's going on in the office market. So thank you so much for joining us today. With that, we'll close this special guest podcast. Thank you, Mike, for joining our show today. Join us later this week as we look at what's happened during the week and how it may be impacting you. If you have a question or a comment, send an email to podcastrep.com until then, visit trp.com for more info and subscribe to the TRWire podcast with your favorite provider. Thank you for listening and stay well.
- [46:46]
C
Thank you all. Cheers.
- [46:48]
B
All right, all right. Thank you. This is great.