Transcript

Aaron:

Hello everyone. And welcome to the Dealmakers’ Edge. I want to welcome David Valger, our guest today who founded DVO real estate. David’s responsible for overall management, operations, and investing activities of the firm. He’s got a ton of experience in all aspects of real estate investing and finance: originating, structuring, underwriting, and managing commercial real estate transactions volume in excess of $6 billion.

David, we’re really, really thrilled you’re here today. I know your story is great and we intend to get it out of you today for our listeners. So thanks for joining us.

David:

My pleasure, Aaron, thank you for having me on.

Aaron:

What I’d love to do is start off with some personal background, your beginning, and professional life before you launched DVO.

David:

Sure. My family immigrated to the United States in 1980 from the former Soviet Union from Moscow, Russia. I probably disappointed my parents by not becoming a dentist or a doctor, although I did attend dental school at NYU for a year. And that was all I could handle from dentistry. After college at Binghamton, I graduated with a double degree in art history and biology. It took a while to figure out exactly what I wanted to do because I realized that business was really my calling. I first started a company with a few partners right before my dental school path, because I took a leap year between college and dental school. I wound up running the sales of marketing for the company which was a multinational packaged goods company. It was a great experience. We did business with Russia, the former Soviet Republic, CIS Eastern Europe, Israel, a little bit in Western Europe, and came to the conclusion that I needed more of an education to get to the next level in my business development.

And so I went back to business school, having founded a technology company, realizing that going back to school was the right thing for me to do, I got into the University of Pennsylvania at the Wharton school and received my MBA there. During my first year I made the commitment to myself that I really wanted to find myself in private equity. At the end of my tenure at school, I wound up getting a summer internship with a company called RCG Longview with three brilliant real estate professionals, Michael Boxer from RCG Longview/CenterSquare, John Estreich, from Estreich & Company, and Jay Anderson from the Feil Organization. Unfortunately, we lost Jay last summer, just a brilliant real estate mind who taught me a great deal about professional life, a great deal about the real estate business, and a great deal about just being a human being.

So I focused on the structured debt business of the company. Within a year I partnered with Fannie Mae and ran a partnership which included RCG Longview becoming the exclusive provider of mezzanine and preferred equity behind Fannie Mae nationally for their multi-family business; followed on a series of funds where Fannie Mae was our exclusive limited partner and we were the general partner; and ran a team within RCG Longview and a team within Fannie Mae to originate due diligence, underwrite, and ultimately asset manage a portfolio of mezzanine and preferred equity investments.

After the great recession, I came to the realization that being in the subordinated or structured debt business, from multi-family at least, was a very poor risk-adjusted return. Because all the math in the world that you do upfront, and say the attachment point is this or that, it all comes down to if there’s a substantial correction during your hold period, especially right before your refinance or exit, you’re taking pretty much the same risk in mezzanine at an 80 to 85% attachment point in total capitalization that you are in equity. And in the Great Recession, we had roughly a 30% on average peak-to-trough value correction in multi-family. So did it really matter whether your mezzanine loan was 73% or 93% attachment point?

It did when you originated it, but it did not when you had to work it out. Because if you had a control appraisal at a certain time, that would show that you’re underwater, and unless you were willing to cure the default of the senior loan, which could mean investing 10 to 20 times your loan amount to keep the deal– usually it didn’t, but it could–it meant that you lost your investment. So when struggling with this binary risk, and worst of all, two things: having a capped upside. So when things get go great, you don’t participate in that upside as a mezzanine investor or a hard preferred equity investor, but if things go badly, there’s a binary risk for you to lose all your money. To me, I found that to be a very poor outcome.

So I tried to figure out a way where I can continue investing in multi-family, but doing so on a somewhat differentiated equity basis because multi-family is the single largest commercial asset class. And therefore, a majority of institutional investors and other professional investors, fund to funds, life insurance companies, and family offices, are heavily invested in the space. So if you’re just doing what everybody else is doing, I don’t really see the alpha. I didn’t really understand, what I’d have to do. I suppose the only way to be successful would be to be the largest, and I never was attracted to having the largest assets. I never was attracted to doing the biggest deal. Although fortunately, or unfortunately in my career, I have participated in some of the larger financings in private multi-family deals. I would prefer always to participate in transactions with great partners that ultimately do the right thing by tenants and by our business plan over size or sexiness any day of the week.

Aaron:

That’s a really well-articulated value proposition for your current core business. Maybe you could talk about just the founding of DVO and the early days. Where you are now is a whole new level, but no one starts there. How you got there and how you got started, and how you broke in with your own firm with that institutional experience.

David:

So if you asked me to put together a model of the business and say, well, here are the risks, here are the costs, and here’s the payoff. If you truly wrote a business plan and a case and did right by the model itself as a business, forget the investment thesis, but the business, you would find it very difficult to start because you could always say to yourself, “But I can make more money that year or this year being a senior executive or a partner somewhere else for someone else or with someone else.”

But starting a business…I think the statistics is that in normal, ordinary economic times, without volatility, something like 75 to 80% of all new startup businesses, don’t make it past year five. So when you layer all that in and you think in real estate, private equity terms, what are the ways to start a business? Most people gravitate towards, I’m going to find a sugar daddy, I’m going to find a really wealthy family, or some sort of asset manager, or a big bank, some brand that can appreciate what I do. Maybe I’ll make less money, but they’re going to pay a salary. I’m going to have a team of people that I can capitalize. I can hire any lawyers I want. And a lot of the work that, you know, otherwise would be done by me or one other person would be done by a team of people. And I think that’s wonderful. And I think people that do that probably are really much smarter than I am.

I started the business with the idea that I have lots of great relationships. Over decades, I’ve fostered quite a bit of direct relationships with sponsors, originators of the multi-family finance and of course, a number of lenders. And I was thinking, look: if I can come up with a slightly tweaked model, a different mousetrap or a better mouse trap, and I could differentiate myself both to investors and local partners,  I could start a smaller business and I could self-fund it. It has been, I can say, non-linear. Has it been successful? Yes. You know, we’ve deployed over $2 billion in total capitalization, probably $300 to $400 million in equity. And I can tell you that on the LP side, we have two products–I’ll talk about that in a second. But our LP business set out to create a different kind of soft preferred equity variant, which we call gap-equity, not giving up the upside, but also creating some subordination with more equity from the local partner, but otherwise being an equity partner as opposed to a lender. And then we also have a GP co-investment business in the LP business. For the majority of our equity that we’ve invested, our goal was to generate on average of 15 net investor IRR over the last decade for investors. There were deals that were targeted to generate 12.5. and there were deals targeted to generate 17, but on average, 15%. We’ve thus far generated over 21% over that period of time where we basically are investing preferred equity position, but at the same time, we’re making returns that are very much JV or opportunistic fund level on an institutional basis. You know, we compare from a returns perspective with the highest risk-takers in our industry, but we’re taking a whole lot less risk.

Aaron:

Would you say your business almost lives between the traditional big institutions and the traditional syndicator? You sort of bridge all that risk and the market with your umbrella, but still give access to that sort of real middle market product?

David:

Yes, but more specifically, what we do is we bring an institutional approach to entrepreneurial company. So our sponsors often times are entrepreneurs who are not quite at the institutional level and we help get them there. Or they’re already institutional, but for some reason they realize that they have a real winner on their hands, a triple or home run deal, and they’re hard pressed to find a competing structure that gives them the kind of returns that we can give them if they succeed, without forcing them to take additional leverage risk and a more conventional preferred equity or mezzanine structure. So it’s purposely differentiated both to investor and to local partner on the gap equity side. And I think we can call ourselves smart all we want, but the real reasons for why we outperformed, is because we incentivize the right kind of behavior on the part of our local partner. It’s because we underwrote more conservatively than the rest of the market. We said cap rates were going to expand, they really didn’t. We said the cost of financing is going to go up, it really did not. We said that the average rents in the marketplace are not going up beyond two and a half, 3% a year, and they did. So you layer that into the fact that when we saw opportunities to exit and it didn’t necessarily drive a hundred percent with our original underwriting, we typically underwrite to somewhere between three and five years of hold, so on average 48 months, and if by month 40, we see that we can get the kind of sale price that we originally underwrote, we’ll take it all day long.

So yeah, it’s a unique structure borrowing from a little bit of debt in terms of the subordination of the local partner and the additional capital they have to put in. So on average, they’re putting in 20% of the total equity versus our 80%, rather than the typical 95/5 or 90/10 institutional JV kind of equity contribution. And on the liquidity event, you know, until we get our money back kind of 10% compounded return set and other ways of 10x IRR, their entire equity position is subordinated to us. So that’s, that’s the gap equity business in a nutshell.

We’ve also developed GP co-investment, not wanting to compromise the uniqueness of the structure. We want it to do more with the same sponsors. And so we said, what kind of equity do you need? And everyone of course always says, “JV equity.” I said, “okay, but everyone does JV equity. What other kinds of equity do you require to grow your business?” And eventually they come clean and they say, “Well, we could use GP co-investment capital because ultimately we need 10 to 20 million of fresh cash every year.” And while they’re getting, you know, better on our personal financial statements, right, as real estate people well know, liquidity is rare, but your net worth, hopefully grows. And so their net worth is growing, but they need to find fresh liquidity every time they do a deal.

And so we try to work with good groups that are experienced, but need capital to continue their growth.

Aaron:

Yeah. That’s great. Both sides of the business covered. And you found a way to get diversified upside with a lot of great local sponsors and it’s a win-win for your investors, but also for those wonderful sponsors you team up with who really need your expertise and the capital and the structuring and experience you bring to the table. So it’s a wonderful story that you brought a long way. I mean, you’ve done so much. Maybe let’s move a little bit more into the market generally.

You’ve been in multi-family for a long time. You’ve seen a tremendous deal flow. You’re doing a tremendous amount of deal flow. And we’ve talked about this in the past, but maybe we can talk about macro and micro. Markets move fast. You have bumps in interest rates; everyone’s run into multi-family; it’s all about the story about rent growth and how much more, and a hedge against inflation; all the common themes. But I know that you’re a very thoughtful on these topics and maybe you can start to give us an overview, just a couple minutes on sort of the macro market. Does it have room to run? What makes you nervous? What makes you lose sleep at night and what excites you these days?

David:

So you say, “Long in the business,” and I feel like I need a mirror to comb my hair, but alas, I don’t have anymore! Look, I think what keeps me up at night is–I was too young, really to appreciate the last time it happened–and that’s stagflation, a combination of a stagnating economy with an unbridled inflationary pressure across the board. I think that is one risk that could absolutely impact multi-family values in a way that few others can. The reason that multi-family is otherwise very well-protected is because, 1) we have a consistent source of liquidity for the financing of our business — the agencies, Fannie and Freddie, and FHA. They are there to make sure that if the capital markets somehow can’t find a home, these organizations come in and instead of their average 50 to 60% of the total financing they take on to upwards of 80 to 90% when push comes to shove. Now what’s not guaranteed are spreads and total cost of borrowing. But I can say to you having witnessed two and a half, probably if not three cycles, that there is a path forward for good sponsors and owners of multi-family who are willing to put capital back into their deals when the world stops because of the agencies. And that’s a big distinguishing feature. Other asset classes in commercial real estate simply don’t have that.

The second reason that I think multi-family is very unique is because you have the consistency of the cash flows, having a roof over your and your family’s head is secondary only to putting food on the table, or even if you don’t have a table, feeding your family. And so having that priority helps, especially if you’re not investing in fringe assets in multi-family; by fringe, I mean, the C -/D’s of the world.

If you’re investing in middle market B, it stays occupied during a tough economic period because the A’s and the single-family home evacuees move in, and it stays busy when economies do robustly because your C’s move up and your sort of B’s move up to B+, and your B+’s move into A’s and single-family homes.

The reason why I think the forecast for multi-family is rather strong is fundamentals. We are currently somewhere in the 770,000 to 790,000 units of shortfall in terms of how many multi-family units we need to be in balance in terms of supply-demand in our business nationally. And by the end of this year, our expectation along with that of many economists is that we’re going to have a high 800,000 number of shortfall. In other words, based on the number of units that we’re going to lose as a result of just the fact that they can’t be occupied anymore; age, dilapidation, whatever the reason, and the number of homes we’re going to create versus the number that will be in demand, we’re going to grow that 770-790 shortfall to somewhere in the high eight hundreds. And that tells me that as long as you’re investing in markets that have an understandable growth trajectory based on new household formations, based on demographics, based on employment and wage growth, based on the fact that there are high barriers to entry, and those markets also have a diversified employer base, then investing in three- to five-year cycles in those markets either to renovate and improve cash flows or to ground-up develop sounds like a very promising investment.

The next caveat, as I said, stagflation is the worst. The second worst is unbridled inflation. Even if the economy is doing well, the risks are amplified by the Fed, stepping in and making not just grandiose statements about how they’re going to raise rates, but actually raising rates too quickly and creating our very own recession as a consequence to attempt to try to slow down economic expansion and inflation. So I’m not fearful of inflation per se in multi-family, but I am fearful of the decoupling of the economy’s growth and inflation causing stagflation. Does that make some sense?

Aaron:

It does. And I think we have to wrap in a minute or two, but maybe you could just end off with how you keep your mental edge daily with all the stress you’re managing and all the deal flow you’re managing. How do you keep your head in the game constantly?

David:

A lot of yelling and cursing.

Aaron:

Beyond that. Any other techniques our listeners could apply?

David:

You know in race car driving they tell you, when you turn, you make turns; don’t look just to the end of this turn, look beyond it. Because if you look to the end of your turn, you’re going to wind up off the road. But if you look beyond that, you’re going to wind up eventually where you need to be. And so, I try to look past the immediacy of  the disaster and try to figure out how to get through that turn and take advantage of the next turn or the next straightaway.

Aaron:

I really appreciate the time today. I’m sure our listeners are going to learn a ton, and I know they can find out more by looking up your company, DVO Real Estate, and maybe some people listening will want to ping you directly, which would be great. And hopefully we can have a follow up because you have so much going on and there’s a lot to cover, but you’ve been an amazing guest. And I really, really want to thank you again for your time today.

David:

Thank you. We’ve had the pleasure of knowing one another for a good bit of time, and I look forward to our next physical session as well as our next meeting virtually.