203. Franco Faraudo, Co-Founder of Propmodo on the Challenges of Valuing Real Estate with Flex

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203. Franco Faraudo, Co-Founder of Propmodo on the Challenges of Valuing Real Estate with Flex

00:00:01 Welcome to the everything co-working podcast, where you learn what you need to know about how the world wants to work. And now your host coworking space owner and trend expert. Jamie Russo, Welcome to the everything coworking podcast. This is your host. Jamie Russo. My guest today is Franco Ferrato. I reached out to him after reading an article. He wrote in early April in pro Modo entitled underwriting flexibility.

00:00:41 How and why flexible offices should be should change the way we value buildings really quickly. If you don't yet read prop Modo, I find most of their articles to be really interesting and relevant, promoted to ciphers and defines trends for commercial real estate professionals. Through a combination of news research events and marketing services, you can find them@propmoto.com. I will include a link to the show notes to find our show notes,

00:01:08 by the way, go to everything coworking.com forward slash episodes Ford slash number of the show. We also link to them right in the podcast player. So when you look at the description of the podcast, you can find the link right there. I know that can be challenging to find some times so back to Franco. So Franco basically talks in this article about the challenge that lenders have underwriting office buildings with flex office in them.

00:01:34 So he did a bunch of research and interviews on this topic and then wrote a really detailed article. And I really wanted to hear him voice over some of these points and ask him some follow up questions. I thought the article was really interesting. I mean, it highlights a really practical challenge that asset owners have putting flex into their buildings, which is can they get the financing that they need for it?

00:01:57 So he says in the article, the reason real estate is not flexible. The reason we have ten-year leases is because of financing finance years don't know how to underwrite flexible space. So there's a mismatch in the needs of the market to the needs of the financier's. So I agree with him. I think there are more reasons why there is not more flex,

00:02:17 but that is certainly a hurdle. And so that is the focus of this episode. Before we dive in, if you are just working on opening a coworking space, you were in the right place. And I want to invite you to join me for my free masterclass three behind the scenes secrets to opening a coworking space. If you're working on opening a space,

00:02:38 I want to share three decisions that I have seen that successful operators make when they're creating their coworking business. The model is simple. I talk about this with folks all the time, but there are some essential things that you can really get wrong. Masterclass is totally free. It's about an hour. And if you'd like to join me, please register at everything co-working dot com forward slash masterclass.

00:03:02 That link is also in the show notes, and you can find all the links to Franco on LinkedIn, the prop Modo article that we're talking about it all in the show notes, everything coworking.com forward slash episodes forward slash the episode number or link to it in the podcast. Okay. Now onto my discussion with Franco welcome, I'm here with Franco Ferrato who's in San Diego,

00:03:27 California, and he is the founder of prop Modo. And I'm an avid reader of your articles. I get all your emails and yours is one of the publications where I literally want to read almost everything you sent and it's, you know, broadly real estate prop tech, and I pinged you on LinkedIn. And for anybody listening, sometimes you can just make things happen on LinkedIn,

00:03:50 thank you for responding and agreeing to do this podcast, but Franco published an article about underwriting flax, and it's such an interesting topic right now and really relevant for my audience. So I pinged him and said, Hey, you know, I'd love for my audience to know more about prop Modo. And can we talk about this topic? And he said,

00:04:12 sure. So although we're, we're on a 30 minute clock, which is my listeners know, I, I usually can't do 30 minutes. So my timer's on. We'll keep moving. But Franco, tell us about your background and prop Modo and how it came to be and anything else you want to share before we dive in? Sure. Yeah. Well,

00:04:31 thanks for having me. It's really exciting. And now try to talk fast and get through plenty. It's a big topic, obviously. So my background is in real estate, I was doing real estate and you know, some marketing consulting. And I really saw that there wasn't a lot of, I didn't think a lot of good stuff coming out about,

00:04:47 you know, particularly commercial real estate in the built world kind of innovation. So we started this publication and it's really taken off, you know, a lot of people are interested in, you know, flex. So we've always kind of looked at technology kind of with the lowercase T right. It can be kind of anything. It doesn't have to be software and hardware.

00:05:04 And I think, you know, flex was, is a big example of that, right? It's kind of just a new way of thinking about base and utilizing space that I think is very innovative, you know? And so, you know, this particular piece I wrote recently was something that I'd been thinking about for a long time. I, you know,

00:05:21 when you come from the real estate industry, you realize that how they value buildings is, is very different than, you know, how most things are valued. Kind of don't look as much at market value because it's very hard to kind of have any kind of comparable to a very unique building. And so it's all about these, these revenue streams, right?

00:05:42 And so I really wanted to understand without, you know, these hard and fast leases, what that would look like, you know, how would you even, you know, would you be able to value this? And so I just set out, I just interviewed probably 20 people for this article and just try to get every expert I could to weigh in one way or another,

00:06:03 how to, you know, do pretty complicated thing, which is, you know, value of building with flexible space, which to Your point you think like, until you think about it, you don't realize how complicated it is. And most operators and I would include myself in this camp have no background in real estate finance. So if there's anything we need to,

00:06:23 you know, glossary for people, I'll stop and do that. But yeah, so I'll link to the article in the show notes, which is underwriting flexibility, how and why flexible office should change the way we value our buildings. Yeah. I'd love to cover some highlights. I mean, I'd love to hear in your words, kind of some of your conclusion,

00:06:41 this is a hot topic because I think a lot of folks are really bullish about management agreements and landlords offering flex in their building, partnering to do that, doing it on their own. We see some of the big players, you know, doing only, you know, I think industrious, no leases, only management agreements. Premier does them. We work has some,

00:07:05 you know, mindspace comma desk. A lot of folks are doing management agreements, but it's not that easy to get them done, partly because of this issue. I mean, it's, it's the lender mindset and the asset owner mindset of, you know, the security in quotes, you know, of a lease, right? So I recently hosted a course on management agreements with a gentleman named Michael Abrams and he was our content expert.

00:07:36 And he just spent a lot of time talking about the mindset of the owner and how just that mindset goes back for so long. And to your point, like, this is how things are done and that commercial I've also loved to hear from your perspective, since you have a real estate background, some of the roadblocks that folks kind of point out from your article,

00:07:57 you know, these things are solved. These challenges are solved in hotels, apartments, you know, in other sectors. And why is it so challenging to kind of transfer that over? So I'll stop talking. I'd love to hear kind of your takeaways of, you know, kind of the general sentiment that you found when you talk to people and, and what you,

00:08:18 what you think might be next. Yeah, absolutely. So I guess, you know, tobacco, most things are valued based on the, you know, the cost of owning it and the possible appreciation of it, right. And particularly real estate, but where that kind of falls apart is when you're looking at, you know, in a traditional building,

00:08:40 we can all kind of understand that. And usually they boil that down to these leases. Right? Okay. I have a certain set of leases. I know what they're going to pay out. I can calculate my net present values of those cash flows, and I can make an assertion of, of what that means right. Over a fairly Long period of time,

00:08:56 right? 10 years, Usually 10 years, right? The reason it's usually 10 years and I'll get to that later is the financing right loans last 10 years. So that's who really kind of holds the key to all of this. Everybody sees the growth in flux. Everybody knows that there is possible, you know, the density is higher and flex have higher.

00:09:16 I don't know if I would say margins, but you certainly charge more, right? Per, per unit for flex, you can make more revenue with flex. Everybody kind of sees that and knows that's coming, but they, you know, they seem to be focused on the downside, which is the loss of these kind of S you know, solid cash cash flows.

00:09:35 Often when they're looking at a traditional lease, what's the most underwriting goes into understanding the tenant, right. And what is their possibility of them having a hard time paying this? What is their possibility of, of going bankruptcy, right? So you kind of take the lease for granted and you look at all these other negatives. Well, when you lose the,

00:09:54 you know, like I've heard for a lot of people say, we don't have teeth in these leads. You can just leave them, come and go. When you want, it sends the makeup of focus on the downside, right. Which is if something hits the fan and you could go to zero, there's nothing guaranteed about this revenue. Right. It's basically,

00:10:12 so even though we know that there isn't an upside where, you know, we think the downside is too much for us to be able to get over. So the question that I pose to everybody I talked to, to kind of help bring this together is let's imagine that we had a 10 story building and the two 10 story buildings completely identical. One of them had 10 ten-year leases,

00:10:34 all great tenants, right? Like the most easiest model you could ever build on, on evaluation software. The other one has nine of those same great leases, but one floor of just flex, right. Which of these buildings is worth more. And, you know, I talked to a lot of valuation experts and over and over again, I heard,

00:10:56 well, the, the one with all the traditional leases is worth more right. That had, because we see the risk is less, right. We give that a premium and, you know, I kept having to kind of go like another layer and another layer. So I, you know, and then I would ask, well, what if you had,

00:11:14 you know, you had a management agreement and what if you actually were able to have participate in the upside is like, you know, like a retail rent and, you know, and retail so they can, okay. Yeah. But we wouldn't know what that was. Right. There was always these blocks, another block, right. Another point I made was,

00:11:30 well, what if you could charge more for your traditional leases? Right. Flex is kind of an amenity is how a lot of people are thinking about it. Right. So again, yes, they thought that the idea made sense to everybody. But when you really tried to look at how to actually do it again, if you're looking, having to do the calculation of the valuation,

00:11:50 it just doesn't work with your mathematical models. So really I think has hampered the industry, but it's something that will eventually change. It really has to. Yeah. I was, I thought it was really interesting cause I was just like, well, this is certainly a reality, you know, we don't operators. Don't like to hear, you know,

00:12:10 this outcome of like this rigidity of like, well, we have certain inputs and then we get the output. And so we don't really know how to input this. We can't, you know, we can't get the output, so we're going to do it the old way. Right. Do you get the sense? So I'm curious, you hold in high regard,

00:12:27 the founder of Notel, you know, their model is very specific, right. They, I would call them like the riskiest of models because they're taking on most of the time they were taking on the liability of the lease and then they had one tenant in that space, unlike, you know, a more diversified flex model where there are lots of different members,

00:12:51 do lenders differentiate those models or do they maybe not understand the nuances? Well, again, they really look at this as if it was a tenant, which they are, right. So they look at what, you know, what are their financials look like? What size are they, what industry are there yet? So, you know, I think there are some people we'll,

00:13:14 I'll, I'll give you an example. I heard a lot of, a lot of the lenders that I talked to in particular said, well, we would be okay if it was like a big property company, right? Like Tishman Spire has theirs. Right. Well, we would be okay with a CVRE or a JLL. Right. Because we know those names,

00:13:35 like those, we know those companies aren't going anywhere. Okay. Like we work is big and makes us feel a little better. People know them, but you know, they've raised a lot of money. So they do really have, you know, really understand. I think it's more or less about the model and more actually about the company itself. Right.

00:13:52 So when you see a company that's raised a ton of money and you know, has debt. And I think in the end, that's kind of what, I don't think it was no, it's not, it wasn't no tells business model that sunk them. It was a combination of debt and the wrong investors. Right. That, so, you know,

00:14:10 in a lot of ways, I think people looked at no tells death as well. That just, I told you, you know, there's no, it's a risky business, but I think that isn't, you know, there's a lot of other factors that happen there that don't support that. Yeah. A hundred percent, although, you know, if one tenant walks on Notel that you'd lose occupancy,

00:14:30 whereas another flex, I mean, we work as an example. They're probably not going to lose a hundred percent of their members at any given time. Do you think, do you think the pandemic, I mean, you just wrote this article, do you think the pandemic helped or hurt sort of the progress with the lenders on the model? Because we,

00:14:53 I mean, we're seeing, you know, big brands, like we work, give back space, which can't, you know, can't go, well, it's the it's the lenders are reading that, but we also saw a lot of operators who held their occupancy, you know, during the pandemic. Is it, do you think, in some cases it's a case,

00:15:10 a little bit of a case by case because these don't, it's not that they never get done. Right. This is sort of generic lender, not just, I mean, it's a sample of folks that you talk to and they're probably not saying, never say never, these are the struggles we Have. We know these get done. I work with operators who own the building and put a hundred percent flex in there and they had no problem getting financing.

00:15:34 Sure. So local, you know, local lender long-term relief To do it. Right. But when you're looking at bigger buildings with lenders, it starts to be a lot harder. I mean, it's look, it's hard because there is such a new industry, like one of a couple of things that are really holding this back, right. One is the definitions you'd ask what,

00:15:59 you know, w well, has this, has this hurt lenders on their outlook? Is it of flex? So it's like, well, coworking, I would say yes. Right? I think we all, we need to be a lot smarter about how we separate this out. Coworking is a very different business model than inner pie suites. A hundred percent coworking.

00:16:17 I would say the pandemic. Yeah. Whoa, this could happen. Something had happened and no one wants to come to these shared spaces. Well, on the other side of the coin, if you look at enterprise seats, you could say, well, it's a kind of a, been a hard year. It's an unknown business environment. There's a lot of all these kinds of people are wondering what's going to happen in the economy because of this.

00:16:38 Maybe that would support a more flexible right now we're seeing companies that will likely want more flex space. I don't think they're going to want to put, you know, their, their people into a coworking. They will likely want a suite. And, you know, I, I had interviewed the guy, you know, from Boston properties who was really instrumental in their kind of studio.

00:17:01 And he had told me that even though they took a hit, it wasn't in their flex. It wasn't even as bad as it was in their traditional office occupancy wise. Right. Like obviously, you know, most of their offices didn't, you know, break their leases. Right. And that goes to the point of me, it's easy to break a flex lease,

00:17:19 but it also comes with it too. Right. So I think there's a big distinction needs to be made there. That's keeping the industry back. Cause we kind of lump very two different, two very different things together. I've had a lot of conversations recently about sort of the terminology. And I wonder if that's partly because of this sort of new end user who to your point wants a different product right there.

00:17:45 They're not going into open space, coworking it's team suites. And I don't know if you're familiar with novel, they've just rebranded to expansive, but they do smart suites. They call them, which are kind of, you know, so expansive will take a building and they'll do some flex, some traditional tenants of event space, et cetera. But they'll do these smart suites that are sometimes they have their own entrances.

00:18:09 So it's really for that enterprise Searchie small business, you know, that wants their own suite within the broader amenity access, but they have their own kitchen. They have their own restroom, they have their own conference room and that's right. A different product than a lot of the sort of traditional co-working spaces. So Yeah, I mean, it's, I think it's hard to do.

00:18:30 It's very hard to categorize because any one of these little changes is a, is a big deal. You know, Watson properties doesn't have let's you brand this suite. Right. And put your stuff. Okay, well that's a little bit, you know, should that have a different premium? Does it have a printer service? Does it have food service?

00:18:46 Does it have, you know, some places now have their own conference room inside the suite? Right. Okay. I believe it Expansive does their own everything really. So they can come out and mingle and do whatever they want in the common space, but it's really their own, their own. And that kind of lends itself to the other thing that is really,

00:19:09 I think, holding the industry back, which is, you know, a lack of data. So you had talked about earlier, you know, why, why can we do this with hotels? And like, those are one night leases. There's no teeth quote-unquote in those either, but we have a pretty good understanding of, of how hotels can get valued.

00:19:27 And the reason is that we have these, the market data that you can look at, you know, I mean, STR is a company that's done that the best they just got bought by CoStar. They, you know, you can go in with one subscription and get every major market in the country, know exactly what you're buying opt In to share their data.

00:19:46 Right. That's part of the transaction. I mean, do you think, so Austin Frazier used to talk about this. He was on our, he works for car companies and was on the GWA board and he used to talk about this problem too. And do you think it'll get, will somebody do it? Yeah. There was a couple of companies that are trying to,

00:20:05 I think it likely will happen again. It's not easy because okay. Let's look at what we just said. You know, we would likely be looking at either, you know, price per square foot and square foot per desk, right. Within city measures. And those would, but those get really wonky when you start saying, okay, well we have a suite that's,

00:20:25 you know, a 3000 square feet. Well, 500 square feet is for a common area. How do we divide that up? Okay. Well some of the co-working desks use the common area. We'll do it, we'll divide 5% each desk. So the, you know, it's one hard to get everyone to sign on, but to just kind of a very complicated,

00:20:43 you know, calculation to have to make, especially when you really do need to boil these down to two or three metrics, right. That finance teams that maybe don't have, you know, they don't spend all day in this can jump in and look at and say, okay, our investments and we can give it a, you know, a, B or C rating.

00:21:02 Yeah, I, yeah, It's an, it's an interesting question to see. So I was curious about your, so one of the people you interviewed kind of mentioned, she said that if you give the consumer what they want, which is flexibility, and I biased over here, what are you, you know, better service, a better experience, which yields,

00:21:28 you know, more engaged, productive employees. They won't buy what the lender wants them to buy it, which is a long-term lease. But she was sort of saying like, if a building offers flex, isn't there an opportunity cost for someone who would have taken a long-term lease now takes the flex. And I thought, wow. I mean, this is so like not aligned with sort of consumer demand,

00:21:55 right. We're sort of doing what the lender wants and therefore what the owner wants, but not what the consumer wants, which is such a big conversation these days like that. That's kind of a, an old school way of thinking. I was curious about your, Yeah. I mean, I think it's an old school way of thinking. I think it also it's of the assumption that there isn't a,

00:22:18 another building next door, right. That does have a flex option. Right. That, that this is the only kind of game in town. You know, I will say that the real estate thinks a lot about highest, best use. Right. And so that's another thing I heard a lot. Was that okay, well, if I have a top floor with a great view,

00:22:35 like why wouldn't I just sell that as a big, great place? Okay. If I have kind of a floor with a weird layout, you know, it's ground floor, maybe not a great view. Well then that's a much easier to make the highest, best use flex. Right? So throw the people who want flex into the dungeon now, but here's the problem.

00:22:57 The problem with that view is that flex doesn't work in subpar locations, right? Like flex consumers are usually buying with their own money. Nobody's telling them to go to this place, right. I'm spending my, you know, 1200 bucks a month to put my business in this place. I want, I want the top floor. I don't want to be in the bottom floor with no light.

00:23:18 I'm not paying for that to your point. I'm going to go next door where they put the flex floor on the seventh floor. So that's an interesting, Yeah. I mean, there's a, you know, a lot of, kind of conflicting ideas. And again, like I said, one, originally people had really thought that, you know, will there be a little bit of flex here?

00:23:41 And now I think we're looking at, well, there will likely be flex component for many, many buildings. Right. And that's why we need to start. It's not about having one. We work in your neighborhood, right. It's for flex to really do what we all hope that it does. Right. It makes the industry, you know, better and more efficient and activate spaces and,

00:24:02 you know, increased density and collaboration, all the great things that everybody wants and likely needs to happen in almost every building. So that's why we start to get into this new conversation about like, well, why should you be punished? And if you are punished for the risk, then okay, then you should also be, at least be rewarded for the possible upside and for that to happen.

00:24:23 Cause we can under, like I said, we can understand the risks very easily. Okay. It can go to zero tomorrow. Everybody could leave and say, I'm not going to renew my lease next month and then it's over, but we don't know the upside. Like you can say, oh, well what is our, you know, how much more is the average coworking slash executive,

00:24:41 you know, flexible suite, then they're going lease rates, right? That's the kind of data that people are really going to have to be able to have, to make these calculations on. Exactly. There's just Not a lot of transparency around that. Right. Because operators know, but to, you know, to your point, so an industrious we'll have that conversation with an E Q or whoever their Heinz or whoever they're partnering with.

00:25:07 Right. And say, this is what we can do. But outside of sort of the bigger institutions, when you talk about, you know, every building should have, like, there's a lot, that's a lot of fragmented real estate that like doesn't know the model. And I think that's a lot of what we talked about in our management course is how the management agreement course that we did was really both for the owner of the asset and the operator.

00:25:33 Right. And how do you talk to each other and speak the same language and help each other, understand the risk and reward. So to your point, it's like, there's really no data about the reward. So an operator is selling, you know, really selling the opportunity for reward. And if they have a history of creating that upside, then that's an easier sell,

00:25:58 you know, but the landlord still has to take that risk to see it and believe it. So there's a couple of layers. I mean, I don't mean to pick on the lenders because the asset owners feel the same way. Right. They don't, they, you know, they really prefer the security. I mean, I think they're starting to see and certainly be entrepreneurial owners are starting to see,

00:26:17 okay, this is going to be a part of what I'm doing at some point and trying to figure it out, but how, how does it play out and, and what does the risk reward look like? And certainly there are cases where it doesn't work right. That, well, I mean, you can get it wrong too. So mean. I think we're starting to see a split,

00:26:36 right? There's, let's say probably the majority of large real estate owners. They are asset, they right. They really want to work finances, get the loans and, you know, own, own the asset, but which is fine, but it's very different business model than managing a building, particularly when you now have these very high hospitality spaces that,

00:27:01 you know, so it's, you know, do, do you try to do it yourself or do you hire someone in and find a management agreement? Yep. W where do you put spec suites on the spectrum? I don't know. I mean, again, you know, who's, how big are they? You know, like there's yeah. I think really it's anything,

00:27:27 it should be a month, you know, anything. Yeah. Is, is there for no longer that flexible in my mind, but yeah, I, I expect suites have their own thing. Right. There's a whole, you know, amortization argument around this too. Right. Usually when companies have large, long leases, they have large build-outs did they get to amortize over the,

00:27:53 you know, those 10 years, let's say of the lease. When now that doesn't happen right now, they have a straight expense, you know, the out is a big conversation who usually it's the landlord now that's responsible for most of the build out. Right. And so not that goes into that, but every, every kind of person seems to be finding their own way.

00:28:15 You know, that's, what's really interesting is there's we kind of are, it's so much more nuanced than I think we still know. Right. A lot of people are predicting, you know, there's going to be a, you know, a flex space for, you know, life sciences and a flex space for, you know, creative agencies and a flex space for,

00:28:35 you know, hardware developers. You know, I think there certainly could make a case for that, but all of them are offer different things, have a different market, right. Have a different premium against the market, additional markets. So, you know, understanding those is key to knowing what, what the value of any of this stuff really is.

00:28:58 So in the spirit of keeping us to our 30 minutes at the end of the piece, you kind of, you quoted somebody who said, you basically said, like, there are no opinions. You know, the market will adjust to reality. Do you think, what do you, what do you think that progression will look like? You know, if you were to speculate,

00:29:19 what will that process look like? How long will it take? Well, I think it really depends on what the com how fast people come back to the office. You know, I've talked with some people in Australia, it's kind of a fun way to look into the future to see what it is. And some of them, you know, large kind of building operators and facilities managers.

00:29:42 And they said, oh, we do all this work. And we got everything ready. And we opened the doors and we were so excited and one person came. Right. And so I think if we don't see in a lot of industries, people coming back to the office regularly, that's going to really advance this. Right. And I do really think the market will eventually push its way through.

00:30:08 Everybody sees it. Everybody sees this as a growth, you know, 30% it could be, you know, a third of our office space and, you know, the next 10 years, but it, there are a lot of headwinds and, you know, that's a risk averse industry. A certain type of person owns a commercial real estate, you know,

00:30:24 commercial office building. And they're not one that is really all that speculative. So yeah, we, we shall see what happens. But I think if we do see companies not wanting to return to their normal office, that's certainly going to accelerate this Lot of acceleration across the board happening here. Well, I appreciate the work that you do. So I look forward to your next article on the evolution of what's happening across the board.

00:30:55 I enjoy your publication a lot. I will, for those listening, I will make sure we link to pro Moto in the show notes. So you can find it and do some readings, subscribe to the emails. That's what I like to do. So I always get your, your headlines to make sure I know what I should be reading every week.

00:31:13 So Franco, thank you for taking the time to share your perspective. I appreciate it. Any, any parting thoughts or anything we else we need to know about prep Modo? No, I mean, thanks for having me, you know, we'd really try hard to make fun and insightful articles. Cause we know all the people out there deserve it. You know,

00:31:32 we're all busy and this is a, an interesting, I think commercial real estate gets overlooked as boring and stodgy and that, you know, we're all just a bunch of robots, but it's really not the case, especially now. I'm really excited for all the kind of great stuff that's happening and we just want to keep covering it and highlighting all the great innovations.

00:31:51 So That's exactly the vibe I get from it. That it's an exciting time to be a part of it. So perfect. We'll link it up in the show notes. Franco, thank you again until next time. Thanks for having me.

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