Bruce Norris is joined this week by Hunter Thompson. He is a full-time real estate investor and founder of Cash Flow Connections. Since starting CFC, Hunter has helped investors out to allocate capital to over 100 properties, which have a combined asset value of over $350 million. His experience includes investments in self-storage facilities, residential mortgage notes, mobile home park, single-family acquisitions, hard money loans, office buildings, and multi-family real estate syndications. In connection with these investments, he has worked with some of the most experienced and well-respected asset teams across the U.S. and Canada.
Bruce was surprised how old Hunter was with how much experience he had. Bruce asked him how he got started in real estate in the beginning. Hunter said the timing of the market is really important. For him, when he left college around 2010, there was an incredible amount of opportunity in real estate. He was always the kind of person interested in looking left and going that direction when everyone else is looking right. This was his entrance into real estate. He saw there was blood in the streets and was very interested in the asset class.
Not only was there a complete deflation in prices, there was a lack of liquidity in the sense that there was incredible operating partners out there having trouble raising capital for the first time. He was able to build relationships with institutional quality sponsors. He was also fortunate in terms of the market timing and the lack of liquidity, which allowed them to have some big conversations early on. As the track record was solidified, he built the business around this. It has grown significantly since those early days.
When Hunter first started, he was only 23 years old. He was so drawn to real estate because he liked the idea of finance. If he was five years older, especially with moving to California at that time, it would have been very challenging for him to understand what systems and processes were going to withstand the recession. Everyone was making so much money, and he tried to be humble in the sense that he was fortunate not only in the sense of market timing but also when he started building a network. The people he built it with in 2010 and 2011 were able to weather the storm. The earliest networking events were very somber and filled with really influential people in the state of California and the people off which he modeled his career and investment thesis.
Bruce asked about his ability to go left when others go right. He asked Hunter if he had a model for this or if it is his gut instinct. Hunter said it is mostly gut instinct and something he did from a young age. He was always looking for interesting opportunities. He never made much of a good employee, but he always had that entrepreneurship mindset. His introduction to finance was not connected directly to real estate. Originally, it was the that the stocks, bonds, and mutual funds market was so strong and was where he was originally drawn.
When 2008 happened, he would watch CNBC every day and thought there would be incredible opportunity in stocks. As he was ironing out his main financial goals, most importantly the predictability of outcome and cashflow to pay off expenses, he noticed that with stocks there was not a direct way to accomplish those two goas. As he was looking at that and come to that realization, he noticed 2008 was that last straw moment for many people. For him, it was not until 2010. He had experienced gains in stocks, as most people would, starting in 2008. However, in 2010 the European debt crisis happened. This is something that does not get near enough attention when for him it was a paradigm shift-causing moment. The European debt crisis is very similar to what happened in the United States in 2008, but with the European banks. There was a complete lack of liquidity in the market, and there were central banks that were having serious liquidity challenges. This was causing massive volatility challenges in the U.S. markets. He remembered watching CNBC and them talking about the Greece bond yields. They were saying if these remained below 7%, the S&P 500 was going to be fine. However, if it went above this it would collapse.
Hunter was waking up at market timing and trying to understand why after all the research and book he had done that something like the Greece bond yield was now playing a significant role in his financial well-being. This was when he really had that complete moment where he said he needed to find a vehicle that was straight-forward enough that he could mitigate against the completely complex challenges that one single person or a family office cannot understand.
Bruce asked Hunter if he was involved in the funding arm of other people’s deals or if he was initiating the deals and then doing the funding. Hunter said his position in the marketplace was the syndicated space. His start in the business and where he is still positioned in the company is being able to rely on the expertise of other experts through syndications and GP and LP structures. He was very drawn to this because it allowed him to get that significant diversification across asset classes.
Initially, he was investing his own capital before he started helping friends and family invest. As they began to iron out a due diligence process, which was significantly above what a typical passive investor could conduct, they built a business around creating that system and an infrastructure to take on additional investor capital. Going from five investors to ten investors and now upwards of 300, they leveraged the size of their investor group to get favorable terms from these operating partners and joint venture with them and interface with investors so they do not have to do it. This way, they can focus on the properties and Hunter and his company can focus on telling the story.
At this point, Hunter received a call from somebody who had an opportunity, and they became the funder and partner of it. There is a value on both sides of the equation. Most sponsors want to focus on making sure the supply and demand equilibrium is correct. They want to make sure that the actual functional property managers are doing a good job. Hunter really likes interfacing with investors, communicating with them, explaining the benefits of different asset classes, and explaining the benefit of asset protection upside potential gains. This is really the vision of labor, so when they come to a sponsor they tell them they will proportionately easier to deal with than the several hundred investors they represent.
At the same time, they issue distributions, executive summaries, and communication, which completely takes this off the table. Meanwhile, investors get the benefits of investing with institutional quality sponsors without having to source those relationships or make a bet on someone with whom they have never worked. It’s hard to have experience in all the product types with which Hunter works. Bruce has done a lot of investing, but it is mostly in the single-family space. At Cash Flow Connections, Hunter covers a lot of territory. Bruce asked him what his first product type he funded was and how it has changed over the years. Hunter said the first deals he ever did were hard money loans. On a risk-adjusted basis, those were still some of the best investments he has ever made. The rates have changed since those early days; but when he found out what a hard money loan was, he couldn’t believe more people weren’t doing it. He could give you $60,000, and you put up a $100,000 property as collateral. Then, everyone started doing it and the rates came down significantly into a much more proportional way.
During the process, Hunter felt really compelled to commercial. Because of the complexities of the asset class, it lends itself more favorably to that passive approach. Single-family is one of the most popular ways to invest in real estate because most people are more familiar with it, the barrier to entry is relatively lower, and the investment amounts can be lower. You can control an entire property for a $30,000 down payment. With the self-storage business, it is extremely complicated. Those complexities do incur certain risks; but more importantly, there is a huge discrepancy between a mom and pop owner and a best in class owner. That discrepancy lends itself to the operating partner taking a percentage of the gains it generates since the sponsor is bringing much more to the table.
The complexity of the asset class lends itself to the passive approach because the sponsor is adding so much value since mom and pop owners don’t have those systems in place. The simplicity means you can control the risks since there are less moving parts. The more moving parts there are, the more outsized the returns can be if you have that significantly favorable or experienced manager.
Bruce asked about when someone comes to Hunter with self-storage, not only can he fund the money side, but he also has a clue for how to go from mom and pop to best in class. Everyone is looking for asymmetric returns, or the disproportionate return for a proportional or lower risk. Self-storage paints a good picture of this because a lot of the returns can be generated by management expertise as opposed to something like capital expenditure. He will start with the reverse and back his way in from there.
If you are doing something like expanding a commercial property 50%, you should anticipate a proportional increase in the risk and increase in the return profile. However, you are incurring risks to generate those returns. They can buy a property based on in-place income that does not have a commission structure with uHaul or another truck rental company. They buy the property based on the in-place income. Then, in 30 days they contact their contact at uHaul, who parks 5-15 trucks at the facility. They then rent out those trucks and get a commission for facilitating the transaction.
He has personally invested in properties where the one-line item has gone from $0 a month to $3,800 a month directly to the bottom line. This is what he considers an asymmetric return in the sense that you are not buying or maintaining those trucks. You don’t even have to interact with the trucks, you are just facilitating the transaction. It is a matter of that infrastructure already works. It has been successful across many properties and does not require a big investment. You buy the property and just implement it. That is one example. There are many in the self-storage business because of those complexities.
Bruce said self-storage has become very common. Bruce asked about key points to where somebody brings him a self-storage and what he would say is not the best setup. Hunter said in the single or multi-family business, you frequently hear people talk about replacement cost. If you can buy a property below replacement cost, you know you are getting a good deal to a certain extent since it is really challenging to compete with that product. Other people cannot develop a property right next door and have comparable rents if you are below replacement cost. You almost never hear that metric in self-storage because it is very inexpensive to build these products. They are simplistic, and the cost to build is frequently below the purchase price. People do not lead with this as a marketing component. What you need to be very cautious about is the supply/demand disequilibrium in a particular market, especially within a 5-mile radius.
One of the first things we want to do is identify markets that are completely or significantly undersupplied. If you are looking at a market and there is a five-mile radius, the national average is about 7.7 square feet of self-storage per person. If you are looking at a property in a market where there is only 3 ½ square foot per person, that is likely an undersupplied market. There are many moving parts to this, but that is a really good estimate of how desirable self-storage will be in that particular asset class. If it is a quarter million square feet under-supplied, that means there could be 2 or 3 properties built next door, and you could still raise rents aggressively and continue to see occupancies increase if you can manage effectively.
The key is you wan to buy from mom and pops that are not doing things that businesses would be doing. They were doing due diligence on a property, and the previous manager was renting out a pair of scissors to people moving in and cutting boxes. That may cost them$15 a month in revenue and is not that consequential; but from an optics perspective, when you see things like that there are many other things in that massive Excel sheet, and each line item is probably not being optimized. This is where the NOY can be generated.
Bruce asked Hunter if he is involved in the building of these from scratch. However, Hunter said it is not necessary at this point to incur that type of risk. About 77% of the business is owned by non-REITs, and a large portion of those are single-asset owners. You can generate those returns without incurring the risk of development. The fact that they are inexpensive to build means there is always an opportunity in self-storage because certain markets will be overdeveloped. Developers could have problems raising occupancies, then firms like Cash Flow Connections can come in and buy those properties and rent them. It constantly goes in that cycle, and it is a great vehicle because of nuances with the asset class and tenant base.
Bruce asked Hunter if he finds that the rules of engagement change state to state or town to town. Hunter said one of the benefits of it is the regulatory burdens are quite low. People are not supposed to be living in them, and there has been problems with that in places like California. However, since people are not supposed to live in them, the laws are more favorable. You can do between 5- and 30-day evictions for non-payment since you are not really evicting someone. You are locking the self-storage facility, and if they want access to it they pay the late fees. Bruce said on occasion he has looked at these things with jealousy as he would open it up and think how great it would be to have a tenant with a lock and a light bulb.
Bruce asked how these compare to mobile home parks since he would primarily provide the funds for existing mobile home parks. He is a big believer in the mobile home park thesis, and now it is something that is much more in trend. They have seen a significant amount of cap rate compression because of that, but back in 2011/2012 it was not talked about as often. The paradigm has slowly shifted to where there is a lot of interest in the sector.
The key with mobile home parks is, firstly, the demand is inversely correlated with the overall economy. The worse the economy does, the more demand there is for affordable housing, particularly mobile home parks. There is an interesting part of the asset class as well, which there is less and less of every single year. You have a tremendous amount of demand being driven by baby boomers relying on Social Security. You have this increase in demand due to that demographic shift, but a contracting and stagnating amount of supply. That paints a unique picture from an investor standpoint.
With the type of business they like to invest in, you own the park itself rather than the home. The tenant base owns the home, and therefore there is a lot more pride of ownership in the multifamily sector. You want people to treat the apartment like they own it. In the mobile home park business, they actually do. The pride of ownership is higher because of that, and the expense ratio is lower. Most of the horror stories you hear about the mobile home park business were in parks where the majority of homes are owned by the park and the tenants are renting out the home. This is categorically different from the types of investments they like to make.
When you see things on tv that are about mobile home park businesses and the challenges associated with them, it is mostly from people renting the homes as opposed to those who buy them. This is a categorical difference.
Bruce and Hunter next went on to talk about due diligence. Hunter made an interesting comment about the best deals being the ones you don’t do. Bruce asked what he had done that he was glad he avoided when looking back at it. Hunter said there are so many, and unfortunately, he sees more and more. Part of that is the fact he has seen an incredible increase in the amount of investors involved in real estate. They have simultaneously seen all this interest in the crowdfunding space and all this funding going to commercial and single-family properties from new real estate investors. This paradigm has shifted and is a very good thing for the economy and for real estate. However, you simultaneously have this massive run-up in prices.
Now the question is if the investors have experienced gains because of their due diligence process and their expertise or because of a once-in-a-lifetime runup in prices. When he looks at due diligence, this is really the key to who will succeed over the next ten years. There are so many deals out there that if these cap rates revert to their mean, there will be a major challenge with debt payments or refinancing. Interest rates and cape rates are low while occupancy rates are high. It is very hard to make the argument that we have much room to go. If you look at some of these deals in the Midwest trading at 5 caps in markets that were trading at 8 ½ caps five years ago, you will need a debt piece that will give you enough time to recover from some correction or your underwriting will need to be conservative. Otherwise, you will not be able to execute it.
At this moment, Hunter is biased toward very sophisticated and expert and established sponsors. In 2011, he was willing to take a little more risk on relatively new firms because he assumed we had a lot of tailwind. Right now, he wants to make a bet on firms that have a significant market advantage from both a relationship and operational standpoint. When things go sideways, what you really need is a best friend. He wants to make sure he makes a bet on someone who has a lot of best friends in the business.
Bruce speaks once in a while in front of apartment owners’ associations, and he will ask them if they would buy their own apartment building at its current valuation. At one, four hundred people laughed. This was an eye-opening experience for Bruce because he realized they know all these things are at a cap rate that does not make sense. It does not mean they are going to sell it, it just means it will probably change. It is a matter of setting expectations reasonably. Everyone talking about protecting principle, which is basically what should be the underlying thesis of most investments, says the best way to get to the bottom of that is to look at the debt portion. That is something that does not get enough attention.
If more than half the capital stack is debt, your due diligence should be proportionally focused on that. What is the debt service coverage ratio? What is the term? Is it fixed or floating? What are the repayment penalties? Those are the types of questions not asked enough since people are more focused on the return profile. When things go wrong, the debt portion is what really causes that loss of principle. While 2008 was an aberration in terms of the significance of the downturn, it was not in terms of where real problems come from in real estate. If you invest in cash, even if it’s raw land, the likelihood you will lose money is very mitigated. The capacity is for it to sit there forever, which it tends to do especially in a downturn. If you are holding it leveraged, then the whole dynamic changes.
Bruce thinks the attitude change of the lenders would get very aggressive. If you are in a cap rate market that is five or under, then you revert to a mean of 8 ½, that LTV on your current loan is an unacceptable risk to a lender. If something is going to come back in a problematic way in terms of refinancing, the real challenges those businesses faced in 2012 or 2013 is because of the lack of the buyer pool. If you have a real equality property in a real equality market along with a single or multifamily property, you are going to find a lender for that property because there are so many available.
Where these tertiary asset classes like mobile home parks and self-storage have challenges is when the buyer pool shrinks. When the economy turns around, everyone starts focusing on exactly what they know. What they typically know is single-family and multifamily. This is something you want to be cautious about, and it comes down to the debt. There has been a mitigating of that challenge because of the fact that there are so many investors now who are interested in mobile home parks. The buyer pool has expanded significantly, and that mitigates that challenge. At the same time, one of the reasons they entered into the space of the more tertiary asset classes goes back to that “look left when everyone is going right” mentality. Paradigms are always changing, and you have to be on top of that. One thing that does not change is that the importance of the debt component is critical.
If you want more information, you can visit his website at www.cashflowconnections.com. If you are interested in the self-storage business, send him an email at firstname.lastname@example.org and he can send you a free e-book.
The Norris Group originates and services loans in California and Florida under California DRE License 01219911, Florida Mortgage Lender License 1577, and NMLS License 1623669. For more information on hard money lending, go www.thenorrisgroup.com and click the Hard Money tab.