Listen: Masters of Risk | Episode 7: John Kevill

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Yashi Yadav

Hello, everyone, and welcome to another episode of Masters of Risk, a podcast by S&P Global Market Intelligence. My name is Yashi Yadav. I will be hosting the conversation today, and I'm very excited to have joining me John Kevill, who is a long-time market participant in the brokerage and capital markets specific to real estate and is now leading his own firm, Solitude Cove Capital. Hi, John, thanks for joining us today.

John Kevill

Thanks for having me. Happy to be here.

Yashi Yadav

Yes. Very exciting to have you on. So just to kick things off and give everyone a little bit of background and context for our chat today, would you mind sharing a little bit of your background, how many years you've been in the industry, your experiences? What's the story?

John Kevill

Yes. I mean, I started the business in the very early '90s when almost no one was getting into commercial real estate on the back of one of the other historic challenging times in commercial real estate, which was the late '80s and early '90s.

And I joined as a researcher at a regional developer called Spaulding & Slye that had transitioned from being a developer to a services firm during the late '80s market crash and which was a fantastic sort of baseline for me, which was understanding how to write market reports, how to understand the ins and outs of the demand side, particularly on the office equation and then worked for a bigger global company, but not quite as big as it is now, Jones Lang Wooton, which was the predecessor firm to JLL for a long time.

And then in 2011 or so, went to a boutique -- joined a boutique investment bank called Eastdil, which was a slightly different experience, larger transaction size and a little different spot in the market. And the last larger firm I worked at was Avison Young, where I ran their capital markets business before I founded my own boutique here in D.C.

Yashi Yadav

That's great. And what inspired you to, I guess, start working for yourself and build your -- build this company, build your own boutique? What was that journey like?

John Kevill

Well, it's interesting because I think the -- it's -- a lot of the challenges we have in the real estate markets right now are a product of the shock to the system that the pandemic gave us, particularly on the office side and certainly in other ways as well.

But the other thing that occurred during the pandemic was that a lot of the technology we've used in real estate, in finance and in virtually every sector, the technology was there, but the use of it really accelerated because it was necessary.

And what we learned was a lot of the information, a lot of the tasks could be automated, a lot of the information that we relied on had become commoditized and was available in ways we didn't realize.

And you could connect with a lot more people a lot more efficiently using all the technologies that evolved. So the result is a small team can do much of the work and provide virtually all of the value that you would have that five or six years previously, you would need to be at a much larger firm to have that visibility and to provide that value.

And so I've always been excited about the business and what I wanted to do is take advantage of that efficiency and be able to more directly provide that kind of value to clients and also at the same time, more systematically invest personally in real estate and align my interests a little bit more on the deal side with my clients and really take advantage of some of the evolution of the business.

And so it's probably a fairly natural progression of some of the things that occurred during the pandemic, although the challenge being a lot of the things that occurred during the pandemic are making the market really, really difficult to figure out right now.

Yashi Yadav

So you think we're still dealing with the aftermath of the pandemic kind of and what we're seeing today?

John Kevill

Absolutely. So the -- of course, one of the major or the most visible asset class in commercial real estate is office. No question. And there's also no question that the shock to the system of the pandemic that changed the way we work has -- those effects, that shock has not stabilized to the point that we truly understand how we're going to use office space going forward.

Virtually every tenant when their lease rolls, they get 25% to 30% smaller. Many tenants. I spoke to a tenant -- I spoke to a service provider to the real estate business this morning who 10 years ago, they were in 30,000 square feet in Midtown Manhattan. They now take zero square feet.

Yashi Yadav

Zero...

John Kevill

Because they're in the graphics and design and brand management element of the business. They're finding their people can be anywhere. Their -- the production resources they needed are not the same.

They're largely electronic. And their clients have evolved to be everywhere around the world. And they've determined that it's way more efficient to run their business without any space. Now that's an exaggerated example because obviously, that's not occurring everywhere, but it's occurring in some places and then most tenants are getting smaller.

So that is one of the major challenges to the business. We can talk as much or as little about that as you want from a capital markets and value standpoint. But the other challenge is, quite frankly, the pandemic has created an environment where there was all this economic stimulus that needed to be sort of ramped back.

And one of the other gifts is a historic rise in interest rates in a very short period of time, which has dramatically affected the math involved in all investments, but of course, in real estate very directly.

Yashi Yadav

Yes. Now, that definitely sounds right -- your analysis. I guess something that I would be curious to get your thoughts on is between the efficiencies that you were talking about earlier and then all of these challenges, how is that impacting, I guess, the competitive nature of this market, whether that's in like from a deal standpoint or just from running your own shop standpoint, like what does that look like?

John Kevill

The massive rise in interest rates, the lack of clarity on value of office properties and virtually every other property type right now because of the -- as the market finds itself has led to an unprecedented -- in my experience, an unprecedented time where there's -- there really is no price discovery.

And along with that, owners, capital providers, lenders are all trying to figure out where they are. And so from a service provider, from an advisor standpoint, it dramatically changes your approach to your clients.

You are now problem-solving way more than you're providing information that gives them an edge or providing them tools to find the right capital partner. You're trying to -- you are very quickly understanding the situation where whether there's a lender, a capital -- an LP capital provider, an operating partner, maybe a mezzanine lender or a preferred equity provider.

And with the change in values and the change in the market, everyone's interests are now aligned a little bit differently. So one of the most important things you're doing right now is taking a step back and saying, okay, who's involved, what's important to them.

And this -- and then applying your product, your property level expertise and your perspective that you're getting from other clients and from other markets as well as what you think your knowledge of the capital markets is to see if you can come up with a solution.

And I almost guarantee what you think your knowledge of the capital markets is, is different than what it is when you go to the market and start talking to people. It changes almost every day. So you are much more now more than ever more of a problem solver and more of a listener because of how the market is evolving right now and how much -- because of the lack of clarity, quite frankly, right now.

Yashi Yadav

Right. It sounds like a lot of people are having to kind of make decisions, not necessarily on the fly, but because of the lack of clarity, you're making a lot of assumptions, which is why it looks like -- and I mean, maybe you could speak to this based on like the numbers, they seem, like the valuations that you're seeing. What's your opinion on them?

I mean, do they seem off? Do they seem too high? Do you think it's priced currently in today's market? Like what are your thoughts there? I know I have a little bit of -- I feel like I know what the answer to this is, but go ahead.

John Kevill

Valuations are a wet finger to the wind right now in many respects, right? So there's no question, if you do the math, well, go to office, for example, if you do the math, valuations are off 40% to 70% all day long, right?

So it doesn't take much, right? If you -- the most common -- and this goes across asset classes, but office is the most acutely affected. 100 basis points in cap rate changes -- residual cap rate can -- over a 10-year hold changes the value -- lowers the value by 15%, right?

That alone is pretty dramatic, especially you change the debt coverage ratio, you change the interest rate, change the required cost of equity, all that changes -- all you have to do is change that and you're changing -- all that together changes the value 25%.

So now you say, okay, there are way fewer -- there's a higher vacancy rate and there's a higher cost of attracting tenants than there was before. And so you add in the vacancy rate and you add in the capital improvements required with -- to build that tenant space and you get without any -- with any other structural issues in the market, you're at 40% -- so it doesn't take long.

If you've lost a tenant and you're not going to replace that tenant for a long period of time, it starts getting even higher. And I think that's the big problem that people have with understanding the future viability of office buildings is some of these buildings, we may have 30% -- in many markets, we may have 30% more office space than we need.

And then the question becomes, well, which 30%. And that -- so if -- so that swings the values pretty wildly. Look, in the rest of the asset classes, whether it's multifamily, whether it's hotel, whether it's retail, whether it's self-storage, whether it's industrial, the fundamentals are actually not bad, right? They're not terrible.

Certainly, on the multifamily side, for example, rental growth in many of the markets that had great rental growth isn't really there in the near term because of the broader economic -- the broader economic conditions or the fact that there's been a fair amount of product delivering.

That being said, they're leased, they're cash flowing, all that stuff. But when your 5% loan, 4.5% loan comes due and you replace it with a 6.5% loan, guess what, you need more equity. So that's -- so there is -- and so by definition, the cost of equity capital has changed and cap rates have risen, that changes values across the board. That's probably closer to 20% -- 15% to 20%.

And again, very market specific, very asset specific, but there's no question that there's been a decline in values. And as you see price, I think the level of that really, in some markets, it seems like it's not that much. Some markets, it seems more. It's really just there's so little price discovery that we don't have a stabilized view of how much value has truly gone down. But that's, again, one of the many challenges we're seeing right now.

Yashi Yadav

Yes. And I guess continuing on the topic of office space and these vacancy rates, I mean, what are -- do you have any, I guess, success or failure stories around in cities like New York and other places, office buildings being turned into apartments or condos? And are there any obvious risks that you see there that maybe investors should be paying attention to?

John Kevill

Yes. I mean the great -- there was so much buzz early on about, okay, this is going to be great. We're going to see a transition of urban areas. The one I know best is the one I'm standing in Washington, D.C. We're going to see a transition of urban areas like downtown D.C., and they're going to become more mixed-use dynamic areas, and we're going to see office buildings converted to multifamily.

Everyone studied them. Some of the architecture firms started specing layout designs and rating the quality of the building relative to the conversion. And what we learned pretty quickly is it almost never works.

The costs are enough that you need to get the building between demolition and reconfiguring and everything else, you need to get the asset for a low enough price that the yields pencil to what the developer will need.

And once you do that, you're actually at about land cost. So you're generally better off demolishing the property and starting fresh, at least mathematically. And so that -- and again, it depends on the market, high-rise markets where demolition costs are excruciatingly high, that's more amplified.

But there are examples. You've seen smaller floor plate properties that were probably -- that were built a while ago and have less travel between the core and the window. And a lot of the older, smaller floor plate buildings tend to be in the older, more established markets, so maybe more suitable for multifamily.

Absolutely, you've seen some examples where that works. We have a couple going on right now in D.C., and that's great to see. There's -- there are government subsidies that are starting to be considered for that. That's great.

One of the biggest challenges in addition to cost, though, is actually getting control of the whole building because that's what you need to have happened. And if you have a couple of leases, if your building is 70% vacant, but you have a couple of leases that are going to last six or seven, you can't do it. And that's another big challenge.

So having -- there's the cost, there's the ability to get the whole building at one time. And interestingly enough, I think the repositioning, the adaptive reuse in the suburban markets actually has a lot more traction -- and I don't mean that, okay, someone is going to live in a two-story suburban office park and they're going to make those apartment buildings. Maybe that happens. That sounds pretty grim actually.

But what you're seeing is where there's a big parking lot and a three-story office building and you can get at the building, it's -- and it's an older building. Again, a lot of those older buildings have been in more established areas that are more high-traffic areas and demolition costs aren't so high and it may be a fantastic market for townhouses.

And you see these buildings taking -- or you may say, okay, I'm going to put some retail on one-half of it and some towns or a small apartment building on the other. And then so you are suburbany feeling...

Yashi Yadav

Yes, building on the community.

John Kevill

[indiscernible] (00:17:53) has more action. That -- there's more -- the risks are probably a little bit smaller from an overall capital standpoint, and the options are more in some of the suburban markets. So we're seeing that. That's where I think we're -- and it doesn't get as many headlines, but that's where a lot of the action is from a repositioning standpoint.

Yashi Yadav

Yes. So something that -- again, just given your experience, I'd be curious to understand is, have you witnessed instances where the demolition costs are too high and there was a miscalculation when pursuing a project or pursuing a deal.

Do -- like are these projects abandoned at any point where maybe you were going to go and convert an office space into a condo or an apartment building and then you realize it's just a lose-lose situation on either side?

John Kevill

I don't think -- I'm sure that's happened. I can't think of any times -- I can't think of any of those right now. I haven't talked -- but I'm sure that's happened in some other -- there are markets. What we hear a lot of people talking about is -- and this is -- there are so many uncertainties coming, and this is one of them.

Whatever the number of trillions of dollars of loans that are coming due in the next couple of years, I've heard such a wide range. I don't know if I want to quote it. But there are going to be instances of banks taking back office properties that are worth $0.30, $0.25, $0.20 on the dollars to what they were worth before.

And they're not suited to -- and no one really wants them because there's -- the bank isn't going to want to deal with them because it's too much and they're going to have a tax bill coming and maybe they turn it over to the city.

I think you're going to see -- you're going to see some things like that either happen or be threatened to happen, and that will be fascinating. There is -- in these urban areas where there is not a great path to renewed office demand, you are going to see some interesting things occur.

And all you have to do is pick up the papers and the trade rags and read about all the stuff that's going on in some of these big downtown markets, whether it's Chicago, San Francisco, L.A., Washington, there's -- there are going to be challenges that we're not foreseeing. And that, I think, is -- I hope abandonment isn't one of them, but we are going to see some interesting ones for sure that maybe aren't too far off.

Yashi Yadav

So switching gears a little bit. I know when you and I chatted earlier, you've -- given your years of experience in the industry, you've been on a couple of different sides of the market in different capacities. Could you talk a little bit about how risks differ, let's say, like on the retail side of real estate versus institutional? Because I know I think you've had experience on both.

John Kevill

Yes. Look, on the -- it's -- yes, so when you say retail, you mean more of the private small market, smaller deal type stuff. So yes, on the -- from a risk standpoint, on the bigger, more institutional stuff, what you find is when capital or investors want to purchase an asset, want to capitalize on an asset, want to lend on an asset, they're essentially dollar cost averaging into a strategy.

Their strategists, their people have said, we want -- whatever the number is, we want to have 20% of our capital allocated towards grocery-anchored retail in certain markets. So they are looking -- they're deploying capital into those markets to satisfy the risk profile that they've determined is the correct one, generally.

And depending on your yield requirements, if they have a high yield requirement and they want to take risk, then they're looking for those risks that they've identified. And so you tend to have a little bit more group think.

You tend to have -- capital tends to be commoditized within a box of those strategies when the market is on and when you can handicap it. I would say, if you can't figure out the odds, you can't make the bet.

And right now, for example, most of those odds cannot be figured out. So no one is making the bet. So -- and to answer your question from a risk standpoint, the institutional investors are generally looking to quantify -- you leverage information and market conditions to quantify their risk, makes total sense.

On the smaller deal side, on the private market side, there certainly is that, but there's -- the lenders are smaller lenders or more smaller private banks or other facilities and tend to be more relationship-driven and the investors are tending to invest certainly for return, but more often than not, they know it when they see it.

And I think -- and they'll have conviction around a strategy or a thought that may not be sort of -- the sort of strategy that comes out of a group of economists looking at their strategies saying, I've seen this, I've driven past this a million times, I want to buy this, and this is what I'm going to do with it. They tend to be more entrepreneurial.

And I think it's a fascinating juxtaposition because if you think about it, so much of the evolution of all the individual real estate markets, whether they're downtowns, whether suburban markets, sort of began that way, right?

Some investor, some developer, some owner that's more localized sees a trend that he thinks -- he or she thinks she understands that others don't see and are willing to make their own personal bet, they may not be able to justify that to a huge financial institution, but they can justify it to themselves and it worked.

And so what I very much believe, and this has been a big focus of mine personally is over the next moderately short period of time, we are going to go through a phase where most of the action is going to be with private real estate investors, family offices, high-net-worths that have been driving past the sites for years and have a strategy how to do it, how to execute -- have thoughts on how to execute a plan to drive return or just think it's a good investment.

And what I -- so if you play out some of the value depreciation, particularly the office side that I just laid out, your $100-million deal may now be a $20-million deal, now will be very easily taken down by a couple of private investors who are now going to go to work on it, change the texture of it and create a different environment.

So in many respects, some of the trends that -- some of the things that I see coming out of this downturn are going to be a little bit back to the future, right, or something like that, where you're going to see hyperlocal executions from private capital that are going to lead some of the place changing that definitely needs to occur in some of the areas that have been previously dominated by office buildings.

Yashi Yadav

So the landscape itself of the market is changing based on your observations. So to close this out, I do have kind of a fun question for us, for you, I should say, not for me. But do you have any thoughts around the metaverse and real estate in the metaverse? And I don't know, like do you believe in it? Do you think it's a bunch of bogus? Like what are your -- how do you feel about it?

John Kevill

Yes. That's an interesting -- that's a question I would have expected to be asked like two years ago, because it feels like that -- it feels like all the focus on -- some of the focus on that has fallen off.

And I got to say, I've sat through presentations and I've talked to some of these people that have their metaverse world set up. And I absolutely think that there's an intersection of the digital world and the real world that's constantly evolving.

I think some of the metaverse real estate strategies have been totally and completely overblown and don't necessarily make sense yet. But I love the thinking of where does -- how does the digital world and how does the real estate world intersect? How are technologies shaping our use of real estate in ways that we're not thinking about. The conversations around all that stuff is fascinating. I'm just not buying what they're selling yet from like a value standpoint, if that makes sense.

Yashi Yadav

That definitely makes sense. That's kind of I was curious...

John Kevill

What you think about the metaverse?

Yashi Yadav

Kind of similar to you, I feel like it's something that hasn't really been on the forefront. And I don't know if it's because there's nothing really happening in the space or it's just not a focal point given where we are in today's economy, there's so much else going on.

But if -- like I know a lot of, for example, luxury brands bought space and real estate and storefronts in the metaverse, right? So my thoughts are from that standpoint, maybe now is a good time to at least look into it, if it's not being focused, maybe you can make kind of -- it's an opportunity to go and invest or give it a test run and see how things turn out before it blows up and you end up spending more than what it's worth, I guess.

So we'll see. But thank you so much, John, for joining us on today's podcast. Masters of Risk. I had a great conversation. I feel like I learned a lot from you, and I hope that our listeners were able to take a lot away as well. And I look forward to continuing this conversation and chatting with you next time.

John Kevill

Awesome. Thanks, Yashi. I really appreciate the time, and it's fun to talk. And yes, we'll definitely talk again soon.