What Is Quant Modeling? (And Why It Matters in CRE)

Episode Transcript:  

 What the heck is quant modeling and why should real estate investors care? We're gonna go back to school and learn that and more on today's episode. Let's get REady2Scale

Hey guys, my name is Jeannette Friedrich, director of Investor Relations here at Blue Lake Capital, and today I have a very special guest, David Leather. David is an assistant professor of finance and real estate at Chapman University. His areas of interest and research include pricing of commercial real estate, the redevelopment option, and affordable housing in the United States.

Prior to that, he was a teaching assistant and instructor at the University of North Carolina at Good Old Chapel Hill. And prior to that he actually had his dissertation fellow, or he was a dissertation fellow at the Federal Reserve Board. He has his bachelor's in finance, his master's in economics, as well as his PhD in economics from UNC Chapel Hill.

And he is just down the road in Long Beach, California. So David, welcome to the show. 

Thank you. Happy to be here. 

Yeah, very much appreciate you taking some time to help us continue our journey of lifelong learning. So along those lines, we throw around a lot of terms in finance that I think sometimes we forget.

Not everybody uses in everyday, language. So let's start off with what I introduce the show with what is quant modeling or quantitative modeling and why should real estate investors care? 

Yeah, so quantitative modeling that applies to finance is a branch of mathematics known as financial mathematics that is involved with things like pricing assets.

A long time ago, before the 1960s, 1970s. Some guy who ran a fund did some research and he looked back at all these magazines that kinda said what you should invest money in, and he realized that they were really bad. I. So then began the kind of mission of collecting a bunch of data about the stock market so we could make sense of this data.

And from the data came a branch of financial mathematics where we modeled asset prices as a function of the future income we'd receive as well as the future interest rate. That would allow us to discount that income back to today. And this created wall Street and all these kind of big industries around taking advantage of errors in the market in order to make profits.

So as it applies to real estate typically quantitative modeling is not used as much because for a long time we haven't had good data on real estate, especially commercial, real state. So these days we've started to get some pretty good data, and if you were to use a quantitative model. You could answer such questions as what would happen to real estate cap rates if the Fed increased the interest rates?

Or you can run scenarios like today. What happens if there's a trade war and we see high inflation and unemployment rise? How is this gonna affect my investments or asset classes? So it takes it one step further from a pro forma analysis where analysts are making assumptions and just projecting cash flows out into the future and makes it a little more rigorous or quantitative.

Fascinating. Very interesting. Yes. It sounds similar to underwriting, for those of you listening where, underwriting typically will focus on a single asset, whereas with quant modeling you can take into consideration an entire portfolio an entire region or other type of macro and micro factors that is so much more complex than just, a single individual asset underwriting.

Is that right? Yeah, 

that's exactly right. And actually at the portfolio level, there's a lot less randomness than at the individual property level. So actually it's more applicable to a portfolio of assets or things like mortgage backs charities than it is an individual asset itself because.

Pro individual properties can have all sorts of risks. You find out there's a ancient burial ground in your backyard or something, and then you can't rent it out or something like that. 

Yeah, for sure. That would be a very wild scenario. Interesting. All right, so let's talk now how you know, being able to capture this kind of data, which real estate historically has always slow to catch up to other industries it seems like. But finally, data collection is becoming a little bit more streamlined, a little bit more accessible. Still has a ways to go in all truth, but at least we finally are beginning to, to capture that kind of information, to be able to take a pragmatic and practical deep dive into, questions that people have about the market Now.

So on that note, I wanted to start off talking about the office sector, which has been in the news a lot. Been a ton of pressure on the office sector. And we know that nationwide there's still about 20% vacancy, which is very significant. So I'm curious to know, based upon your experience and your research, what signs would convince you that tenants are truly going to come back into these office buildings?

And how would that potentially impact, the math on people that are looking at these empty buildings for potential conversions into multifamily. 

Yeah, you raised some good points. So office has been hurt pretty bad since Covid as work from home has become a big thing. But also I think investors see a lot of opportunity in office because when, if people do fully come back to the office, which.

It's probably, they'll probably come back more, not like it was before then. That can be a really good investment opportunity. So yeah, I think we're already seeing some signs that people are more coming back to the office. I think every day you hear more and more about CEOs are saying, four days in office or five days in office.

Amazon has made that call and I think. Some employees are hesitant and they're kinda staying home. So yeah, I think as more and more kind of job listings and CEOs kind of push for this in-person culture, we're gonna see the offices fill back up. Especially kinda newer offices like Class A office is gonna fare a lot better than class B or Class CI.

And yeah. And then your second question was about the conversion to say residential. It's an inherently difficult problem because there are some architectural constraints that are not necessarily compatible. Where you could easily turn an office floor to five apartments, say. And I think there has been some research done by people like APIC Gupta at NYU that makes the point that like considering the financial barriers and the high cost associated with converting these office space, it was some number, like only 20%.

Could be financially viable. So I actually think there's a big opportunity there for the federal government or state governments to close this funding gap. And I think there are reasons why we'd wanna do that because the more offices, especially in these job centers that are very high price and have big affordable housing issues.

The more kind of offices we can convert to residential, it might be a particularly good solution to the affordable housing crisis Exactly. In the areas where we need more of affordable housing. So I've always thought it was a missed opportunity for kind of cities, states, or the federal government to sell subsidies for these conversions.

As a way to revitalize cities and stuff like that and make a big dent in the affordable housing crisis. Yeah, I think, until there's some big kinda policy levers moved, I'm not super optimistic that we'll see a ton of these conversions. I think there are a few office buildings that are more suitable to conversions than others, and we're starting to see more of those happen.

And then I think with time as like things don't get better and Class C office continues to herd, it's gonna be profitable for them to just tear down the building and build something new. All, all to together. I. 

Yeah. And let me double tap that. Talking about affordable housing.

So a lot of cities had boosted their low housing their low income housing tax credits by about 12.5% this year in order to try to, tackle the challenges with affordable housing. I know that you've already mentioned that you think one strategy would be for, the federal government to come in.

And assist with that funding gap for those office conversions. I'm just curious to know if you could also redesign maybe a policy or an incentive to make those low income housing tax credits go further, what would that be and why? 

I'm a big fan of the low income housing tax credits. There's actually some great research.

By Rebecca Diamond at Stanford that shows that these policies, especially when they're in high income neighborhoods, I. Have no effect on crime and maybe in the highest income neighborhoods only decrease property values by say 2%. And they find generally that like they make the world a much better place by helping out people in need and then not hurting the wealthy homeowners in these rich neighborhoods.

Very much I would say that kind of spatially targeting these policies. More towards high income neighborhoods that are close to jobs. I think a big issue that gets overlooked that we probably know pretty well in Southern California is that people trade off between affordable housing and the time it takes them to commute to work.

So it's not necessarily you know the issue, there's a lot of affordable housing in the country. It's just not close to where the jobs are. So I think, in terms of making litech go as far as it can, I think it's about spatially targeting them. Maybe to target the areas where the NIMBY kind of concerns our greatest.

Yeah. And it is a very interesting conundrum, right? As far as I can honestly appreciate and relate to the NIMBYs and then I can also of course understand the dire need for quality housing at an affordable rate for people. And it's definitely a very big challenge, and I certainly agree with you about the affordability aspect.

Effect being an option, but being an inconvenient one typically for people because most of the time those types of locations are much further out from the work centers and require people to have additional additional burdens when it comes to maybe, maybe they don't currently own a car and now they need to buy a car.

And so those trade-offs become sometimes not even pragmatic or possible for people. So yeah, there, there's certainly a lot of challenges surrounding this. Now, I'm gonna pivot back to. Talking about lenders. I know that you had brought up the fact that we've got a need for these capital these equity fundings for conversions, potentially to, to multifamily.

That, is one, particular challenge. But another challenge too has been the regional lending front where, especially when it comes to construction lending lenders have really tightened their belts in that regard. And so for those that are into, developments or maybe are invested in some development deals that are hoping to be able to refinance, say, come 2027, what should they be doing differently right now in order to be positioned to do that as favorably as possible?

Yeah, that's a tough question and I'm not sure I have a great answer to it. I do think in the long run, funding constraints will be relaxed from where they are right now. I think mortgage rates will probably fall in in the perspective of these developers or property owners. Their refinancing rates will fall eventually, but I do think.

There's a lot of uncertainty right now with whether they're gonna fall, say, by the start of 2027, given the federal reserves in this tricky position where they're worried about increasing inflation. So today, like Walmart just announced that they're gonna raise their prices and that's gonna trigger a lot of other retailers to raise their prices as well as possible.

Unemployment and a stack inflationary situ you, asian where we see high inflation and high unemployment happen at the same time. I don't know if that's super likely, but it's definitely a, realistic probability that we have to consider right now. So I would say if I was an investor or a property owner that had to refinance soon.

I would really be trying to balance these two risks. The fact that I know things are gonna get better eventually, but they might not get better in the next two years. And things are bad right now. It's possible they get even worse. So to the extent that maybe I would be trying to. To at least consider locking in funding now to prevent against that risk that when my loan comes due, that we're in even a worse situation.

You might be better off trying to lock in some financing now. But yeah, that's my take. I honestly haven't had a lot of time to, to think about it though. 

Good insight. There's also a lot more options now when it comes to finding lenders. Private lending has become very popular and I know that has been one particular vehicle that a lot of owners have had turned to given these tight, regulatory and lending stipulations that are in place right now.

Yeah. Very interesting. Now, speaking of the Fed, though. Their outlook has definitely shifted. And of course we are hoping to see those mortgage rate movements. But what I am curious to know is along the same lines that I was talking about, how private debt has become very popular.

It's become very popular because the rates have been so high. And some people have been quick to rush into getting into those investments and those play spaces. However, it doesn't seem like it's gonna be very long lived. Maybe we'll see. But I'm curious, what is your opinion for any investors that are interested in that?

What should they be tracking to know when the debt markets are about to turn and, hopefully be at least a little more favorable. 

Yeah, I would be looking at just the economic conditions and the economic uncertainty right now. So I think once we have more certainty on trade policy and we've absorbed any inflation that has come from that.

I think once, if we do see inflation and we do see these restrictive tariffs come to fruit issue once inflation starts to come down, I do think that will give the Federal Reserve room to lower interest rates. And I think they actually do want to lower interest rates, but I think they're much more hawkish right now where we just finished fighting a high inflationary period.

And in general, inflation can be much more damaging to the economy and much harder to tackle than unemployment. So I would say once uncertainty in markets start to come down the vix, is steady and we've are sure that there's no more inflationary pressures. I think that's when the Fed will start lowering interest rates and we'll see financing across the board get cheaper.

I. Many are certainly hoping. So I'm actually a little bit more of the contrarian view and I continue to sit here. I'm not sold, in my position, but given how, we'll see how tariffs play out and the other factors begin to take effect in the economy and kind of ripple through.

There's a part of me that actually wouldn't be surprised and is a little bit braced for the potential of the Fed actually having to increase rates. One more time. I don't think it's as likely now that we've been able to smooth the waters out and calm down in our trade relations with China.

I think that has certainly given me a little bit more confidence that we may actually, indeed see that cut coming eventually. But I don't know. We'll see. We'll see how it plays out. Is that a wild thought to you? 

No, it's not a wild thought at all. In fact, there's something known as the Taylor Principle, which kind of says, to get inflation down, we have to keep the interest rate higher than the in inflation rate.

So right now there's a pretty big gap, but if we start to see inflation go above 4.75%, I think the Fed will absolutely consider raising interest rates to get that down. 

Yeah, I agree. I, the way that I look at it, and I don't know if others do or not, but given the fact that you actually got to spend some time quite a bit of time focused on this to me it's not emotional, it's just their job.

They have a job to do and it has to be done. And that's that. It's, the data points are what the data points are and then they need to just execute their job. Maybe that's overly simplistic but that's how I view it. How do you think it's viewed internally? Is it viewed in that same fashion?

Yeah, I think, I've spent just a brief time at the Federal Reserve. But I can tell you the people who work there are very serious about their job and they're very committed to stabilizing the economy, not just for the United States, but the entire world. I think they do see themselves.

As being a political and really focused on fulfilling this dual mandate, which is low and steady inflation and full uni employment. And at times it switches between the two. They might be, okay now I need to focus on inflation, not care about unemployment. At times, inflation's not an issue. I need to focus on unemployment.

I think right now we're tend to be somewhere in between, but I think they tend to lean slightly more ish and until Congress tells 'em to do something different I think they're gonna act in this mechanical way that you've described perfectly. 

Great. I appreciate your insights. Now, David, we've arrived to what I call the lightning round portion of our interview, which is when we ask just some fun five questions about all of the guests that we have on the show.

So are you ready? Sure. All right. So when you're not, quant modeling or teaching folks about real estate, what do you do for fun? 

These days I've discovered making music with a eye, which is something kind of crazy I never thought I would like. But just that being able to have a thought for a concept album and being able to bring something to life in a nine days or something, or even shorter than that.

Has really sparked my creativity even though my cats play my keyboard better than I do and I can play four chords on a guitar. So that's been really fun. 

Wow. Very interesting. Very interesting. Alright, and what is something interesting about you that most people don't know? 

What is interesting about me, I.



That first one was pretty interesting. 

Yeah. I'm not sure, apart from being an economist, I, do find time to go to a lot of concerts. I. And travel and yeah, I don't know. So I'm a big concert goer. So I recently saw the Rock Band Fish play three nights at the Hollywood Bowl.

It was very fun. I don't know, maybe most people don't associate being an economist with being a fish fan. But that's me. 

Nice. I like it. All right. And then now as far as a book or a podcast, if somebody wants to get a better handle on really understanding basically the economy or economics specifically or even quant modeling, what would you recommend that they either listen to or read that can help them sharpen their pencils a little more?

Yeah, I have two really good podcast recommendations. One is capital isn't. Which is a podcast by the University of Chicago with this very renowned economist, Louis Zen galas and Bethany McLean, who's the journalist who broke the Enron scandal. I. And they're focused on talking about this key tension we have, which is what is good for capitalism and what isn't good for capitalism, particularly on antitrust issues, mergers issues of fairness.

And it's an excellent podcast. The other podcast I'd recommend. Especially if you're concerned about ai, auto nation, stuff like that is my colleague at Chapman, Seth Zel, just started a podcast about AI and economics called Justified Post Here Re or so I would also recommend checking that out.

Ooh. Very interesting to both. All right, great. Now something that we also like to talk about on the show is, yes, we all wanna make good money. We wanna have some good returns, but the whole point is really about being able to build an extraordinary life. To live an extraordinary life, and, money simply being a tool that we can utilize along the way to do that.

What is your advice to someone that is focused on that? 

I can say as a. Youngish, maybe mid thirties guy living in Southern California thinking about wanting to own a home. The American dream build wealth, but also dealing with really high interest rates. I think it's pretty prudent right now with the high cost of home ownership to consider.

Instead putting the extra payment that you would pay on a mortgage over rent in REITs. I think investing in REITs right now with conditions how they are, is actually a better financial move. I. Than buying a house. Especially because one of the costs of owning a home is you give up mo ability, which can be very value, valuable, while still capitalizing on real estate appreciation.

All right. Very good. All right, and then last but not least, David, if folks wanna get in touch with you, how can they find you? 

Yeah, I have a website, Dave leather.com and yeah, you can send me an email at david dot a dot leather@gmail.com or LinkedIn. I'm sure you can search David Leather and find me.

Yeah, and I encourage everybody to follow David. He posts some pretty cool stuff. That's how we got on the radar of my team. So definitely encourage people to check him out on LinkedIn. All right. David, thank you so much for your insights. Definitely appreciate your time and it was a fun conversation.

Lot of food for thought. 

Yeah, thanks so much. Really. Had fun. 

For those of you that invested your time with us today, thank 

you. 

Please leave us some comments, let us know anything else you want us to dig into. And in the meantime, be bold, be extraordinary, and we'll see you on the next episode. Ready to Scale is brought to you by Blue Lake Capital, where we hunt down the best multifamily investment opportunities that we can find and invite investors to join in with us.

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