Show Notes:
Welcome, everyone, to Part 1, Episode 21 of Offshoot. My guest today is Jim Griffin, the Managing Director and Co-Founder of Derivative Logic, a firm he started with his partner, Rex Evans, over 11 years ago. Before this recording, I didn’t have any personal connection to Jim, but I’ve consistently seen opportunities for operators to reduce risk through understanding and utilizing hedges and derivatives. I strongly suspected that having an expert like Jim on the show would be valuable for both you, the listener, and for me.
I think you’ll agree that Jim delivers.
Prior to his 11 years at Derivative Logic, Jim traded interest rates, currency, and commodity derivatives at UBS, Wells Fargo, Wachovia, and Bank of Tokyo-Mitsubishi. He holds an MBA in Finance from the University of Southern California and a BSBA in Finance and International Economics from the University of Arizona. His mission is to help clients achieve their investment goals by applying macroeconomic analysis, derivative products, structuring, and hedging strategies. He works with a broad range of institutions, including public entities, real estate finance companies, ultra-high-net-worth individuals, family offices, money managers, and tech companies.
We dive pretty deep into these topics, as I see hedging as a significant blind spot for many operators. With just a bit of awareness—some of which I hope you can gain from this episode—I think you’ll see how much money is being left on the table and how risk can be compartmentalized in unique ways.
In this episode, we cover topics such as:
- Providing clients with valuable technology to streamline your sales process and preserve internal resources
- How experience is a true differentiator in knowledge-based industries
- The impact of regulatory overlays and compliance on value creation at larger institutions
- Creative solutions that borrowers can use in response to lender-required rate caps
- The current lack of distress in the real estate market
- How a risk management document can help middle-market operators analyze and manage their cash flow collections
- Why both vision and execution are essential for success
- Why bank swaps are the most profitable product in a bank’s lineup, and how borrowers can gain transparency into the premiums they’re paying
- The inefficiencies in execution that are prevalent in the real estate industry
- Understanding fixed-rate loans by examining the lender’s creditworthiness and their internal cost of funds, plus the added spreads
- How integrity and relationships are central to Jim’s practice
Transcript
[00:50] Kevin Choquette: Welcome everyone to episode 21 of Offshoot. My guest today is Jim Griffin, who’s the Managing Director and co founder of Derivative Logic, a firm he started with his partner rex Evans over 11 years ago.
[01:03] Prior to this recording, I didn’t have any connection to Jim, but I’ve continually seen opportunity for operators to reduce risk through understanding and utilizing hedges and derivatives and I strongly suspected that getting an expert like Jim on the show would be helpful for you, the listener and myself.
[01:22] I think you’ll agree that Jim delivers prior to Jim’s 11 years at derivative Logic, Jim traded interest rates, currency and commodity derivatives for ubs, Wells Fargo, Wachovia and Bank of Tokyo Mitsubishi.
[01:35] He holds an MBA in Finance from the University of Southern California and a BSBA in Finance and International Economics from the University of Arizona.
[01:44] His mission is to help clients achieve their investment goals by applying macro analysis, derivatives, products, structure and hedges. He does this for the full array of institution including publics, real estate, finance companies, ultra high nets, family offices, money managers and tech companies.
[02:02] We go pretty deep here intentionally as I see hedging as a pretty big blind spot for a lot of operators with just a little awareness, some of which I hope you can gain here.
[02:12] I think you’ll see that there’s a lot of money being left on the table and that risk can be compartmentalized in atypical ways.
[02:19] Listen in as we cover topics that include giving clients valuable technology to start your sales process in order to preserve internal resources how experience really is a differentiator in knowledge based industries, how regulatory overlays and compliance kills a lot of value creation at the larger institutions, creative responses that borrowers can bring to rate caps which lenders may be requiring how little distress there currently is within the real estate market, how risk management documents can codify a system to analyze and manage the collection of cash flows that middle market operators have in their portfolios, why vision and execution are both required for success, the fact that swaps are the most lucrative product in a bank’s product line and how the borrower can get some clarity into the premiums they’re paying on their swaps.
[03:13] How inefficient execution is a hallmark of the real estate industry.
[03:17] How fixed rate loans can be better understood by looking at the underlying credit of the lender and their internal cost of funds, plus the spreads they put on that cost of capital.
[03:27] And finally, how integrity and relationships are at the core of Jim’s practice. I hope you enjoy the podcast.
[03:36] Jim, welcome to the podcast.
[03:40] Jim Griffin: Thank you, Kevin. Happy to be with you.
[03:42] Kevin Choquette: Yeah, appreciate you taking the time. I know you’re very busy and looking forward to the conversation.
[03:49] To get us started, could you just tell us a bit about Derivative Logic and what you guys are up to?
[03:57] Jim Griffin: Sure, happy to. Derivative logic is about a 11 year old consulting firm, for lack of a better explanation.
[04:07] And we advise many different types of entities in several industries in their management of interest rate and exchange rate risk.
[04:20] So you can think of really any business that exists that is either doing business cross border in some way or a business that has any type of debt whatsoever, be it a loan, a bond, et cetera, they are our potential clients.
[04:42] Kevin Choquette: I know you guys primarily in the context of real estate. I’ve been tuned into you for a long time in terms of tracking your weekly newsletters and things like that. But what percentage of the businesses focus on the real estate operator, if you will, versus other larger.
[04:59] Well, I’ll just say different economic concerns.
[05:04] Jim Griffin: Probably about half is focused on maybe a little less than half as focused on real estate, but sort of another slice to your question is a good 70% of the business is focused on interest rates, with the remaining 30 focused on say, currencies or foreign exchange as we call it.
[05:26] So yes, you’re right, Kevin. We are heavy and very deep into commercial real estate and very deep into managing interest rate risks across many industries. But obviously commercial real estate is one of our biggest industries that we operate in in that context.
[05:44] Kevin Choquette: Yeah. And look, since COVID there’s been plenty of interesting movements in interest rates and you know, future values of cash flows. What’s happening in the business right now? What do you guys, what are you seeing?
[05:57] Jim Griffin: Well, in commercial real estate specifically, it would be no surprise many of our clients had borrowed floating, say two, three, four years ago, maybe are now looking at an asset that’s underperforming to business plan and is having to extend their existing loan or hoping to having, you know, few or if any refinance options.
[06:26] And in concert with the loan extension, they’re having to also extend any interest rate hedge that they happen to engage in. As part of that floating rate loan.
[06:37] So a day in our life today, I’d say a good percentage of it, probably half of our day is devoted to clients in that situation.
[06:45] But maybe surprisingly, we are seeing new debt being offered and contracted on a pretty regular and increasing basis.
[06:56] And that’s frankly from all financing sources in commercial real estate, be it banks, life companies, bridge lenders, et cetera.
[07:07] Of course, it’s nowhere near what we saw, say a year and a half, two years ago, before the Fed started hiking interest rates. But it’s probably more than we would expect at this point in the cycle.
[07:18] Kevin Choquette: Those extensions that you mentioned, that guys are on floating rate debt, those are just rate caps they’re having to buy to keep their debt service low enough that the property is covering or close to covering.
[07:31] Jim Griffin: A lot of them, yes.
[07:33] Also a lot of them are bank loans where there was an underlying interest rate swap or an interest rate swap as part of the whole financing package, if you will, that they’re also having to deal with either amending or extending as part of that loan extension.
[07:50] So, yeah, Kevin, it’s a combination of non bank lenders that were lending floating, requiring some type of hedge like an interest rate cap and having to extend those, as well as that bank financing dynamic that I just described.
[08:07] They’re both about equal right now.
[08:09] Kevin Choquette: Okay, and what opportunities are you seeing for borrowers in this space? I mean, both of those are kind of like, well, I’ve got to extend and probably my existing lender is the best option.
[08:20] So they’re just, you know, I suppose they’re choking down the expense of extending the cap. But are you seeing any opportunities out there for borrowers in this interest rate environment?
[08:31] Jim Griffin: A lot of them are, Kevin, but frankly, we do all that we can as a firm to avoid the borrower having to extend, let’s say, that interest rate cap and suffer that expense.
[08:45] Of course, that reduces our business or reduces the fees that we would charge for trying to get that done for them. But we too do try to do that out of the box as much as possible.
[08:56] So depending on who the lender is, specifically a bridge lender and that bridge lender’s financing source themselves, some of them can allow the borrower to be a little more creative than, say, those bridge lenders that are financed with a large warehouse line from, say, Deutsche bank or someone, or a bridge lender that securitizes that loan and really has to force that borrower to stick to the letter of the loan agreement and extend the cap.
[09:27] But there’s Some bridge lenders out there, a handful that keep those loans on balance sheet and obviously are or can entertain some flexibility oftentimes as suggested by us. So what do I mean by flexibility?
[09:41] Well, maybe that’s eliminating the need for an interest rate cap entirely, you know, at this point forward as part of the extension or eliminating it with the condition of, you know, they’re putting cash into the deal in terms of equity or they get to an agreement with the borrower such that that borrower is putting up a percentage of the cash that would be spent on extending that interest rate cap, you know, with maybe some renewed business plan associated with that.
[10:14] So of course it’s very easy for that borrower to just say, okay, I’ll go ahead and extend the cap at this strike and suffer that several hundred thousand dollars expense.
[10:25] But it’s really important to sort of have someone on the side for that borrower or some advisor, no matter who it is, to just let them know that there could be alternatives and to see if there’s any desire or appetite to try to negotiate those alternatives with the lender.
[10:41] Kevin Choquette: So let’s go into a. For instance, say somebody’s got a cap that’s holding them at a 10% rate where if they, you know, if the cap expires they might go to, I don’t know.
[10:52] So for 550 they’d be at 10.8 or so. For 600 they’d be at, you know, 11.2 and the loan’s not going to do one of 100 debt cover. How do you approach the lender and say, hey, we shouldn’t do a cap here, Are you asking for them to accrue or how do you, how do you go about that?
[11:13] Jim Griffin: There’s a couple scenarios to look at in a case like that.
[11:18] Really none of them are desirable. If there’s some real debt service coverage issues right now that exist and there’s no hope really of those improving at any point in the near future.
[11:32] That often results in a scenario where the lender is saying there’s gotta be some kind of cash in in some way here. Then it’s just a question of what form does that cash in take.
[11:43] One form that it could take would be a buy down of the strike and the interest rate cap. Where let’s say the existing interest rate cap strike is, I don’t know, 4%, let’s say, just to pick a number out of the air, and the lender is at least considering or evaluating requiring that borrower to pay more to extend that interest Rate cap.
[12:08] And part of that extension is reducing the strike from say 4% to 3.5% or 3% to improve the debt service coverage in the deal overall.
[12:19] Sometimes that’s more palatable to the equity investors such that they are seeing the direct allocation of the extra cash they’re putting into the deal, meaning they can see that, okay, this is what we’re doing with the money specifically and here’s how the deal mechanically is penciling out, meaning the improvement of the economics by buying down that interest rate cap strike.
[12:47] So there’s really no silver bullet in a situation like that, Kevin, as you would imagine, there’s not some magic that the derivative can perform to just suddenly improve the situation with little or no cost.
[13:01] That doesn’t exist. Economics are what they are.
[13:05] But it’s just a question of how is that extra cash going to manifest? Meaning in what form is it going to take in the deal? There’s going to have to be some.
[13:17] And how are we allowing it to manifest itself?
[13:21] And again, buying down the strike in the cap or just cash into the deal overall, increasing the debt equity ratio of the overall deal.
[13:29] Kevin Choquette: And have you seen any of the lenders pick up a partial accrual like they still think the assets money good, they know that the coupon’s too high, they can’t get there.
[13:40] It’s probably more the portfolio lenders to your previous comment, not the guys that are doing clos or repo or warehouse lines.
[13:47] Jim Griffin: Correct.
[13:48] Kevin Choquette: Have any of them said, hey, I know we’d be at 11, 2, why don’t you pay us a 10 current, we’ll accrue the balance and instead of putting up, let’s just make up numbers.
[13:58] $350,000 for a new rate cap. Give us 200 and we’ll accrue the balance.
[14:05] Jim Griffin: Yeah, we have seen that. Again, we don’t see it every day or all the time, but we’ve definitely seen it. As you can imagine, Kevin, and I know you probably see this yourself, you know, just depending on the asset and the sponsor, lenders are kind of forcibly to consider alternatives rather than just to the letter what the loan agreement says and what it requires of the borrower at this stage of the game.
[14:29] So yes, we definitely see that and we absolutely see more open mindedness on the part of most lenders these days, just given the environment and really trying to avoid taking the keys at the end of the day.
[14:42] Kevin Choquette: Yeah, look, and I didn’t know we’d get into it this quickly, but you’re such an expert and I honestly think that a lot of real estate operators, at least the ones that are in my orbit, and I would also include capital advisors.
[14:54] We’re, we’re part of a group that’s like 17, 18 member firms and our use of derivatives and, you know, the caps come in because the lenders require them. But there’s lots of other things out there that I don’t think people use.
[15:08] And candidly, I’m not sure people really understand some of the language that you’re using. So let’s, let’s slow it down just a bit. And this will partly be a masterclass for me.
[15:20] But if we’re saying it’s a 4% strike, that’s the underlying index over which you’d have a spread. So if you bought a 4% SOFR strike, you’re 130 basis points below the current SOFR.
[15:33] Jim Griffin: That’s correct.
[15:35] Kevin Choquette: Okay, cool. And we should just state for the record, it’s August 16th, so if you listen to this, in 2025, you’ll have to go back and figure out the indexes.
[15:44] Are you seeing any distress? I mean, I’ve, I’ve got a bunch of equity guys we talk, talked to, are saying, like, well, we’re really out looking for distress. And I’m aware of this scenario that you’ve, you know, just spelled out where especially guys doing value add stuff that was underlying floating rate, but they put a cap, so it kind of ended up being fixed or sort of having to deal with, hey, are we going to keep chasing this by putting more money in the deal?
[16:08] But we haven’t seen a lot of distress. And even the equity guys that are telling us they’re looking for it aren’t seeing it. I’m wondering if that’s, if you guys might have a different view.
[16:18] Are you seeing much distress?
[16:20] Jim Griffin: We really aren’t, no. I mean, other than what I read in the Wall Street Journal, like, you do, you know, some of the big guys. But no, we really aren’t. So, you know, what does that say, right, Kevin, about the state of the industry right now?
[16:36] From my perspective, it tells us, as I mentioned before, that many lenders are just being a bit more flexible now than you thought they might have been before all of this, which is a good thing.
[16:50] And there’s just meaning the fact that they’re entertaining these alternative, say, hedging or financing scenarios and not labeling it, say, a workout, if you will, I think is a direct feed into the lack of defaults that I see on a daily basis or hear from or Hear about, because I just don’t hear about many at all, frankly.
[17:15] We are seeing, you know, we’ve seen some sales, you know, obviously at some sale prices that may not have been as desirable to the sponsor as they had hoped going in.
[17:26] But you know, I haven’t heard very many nightmare scenarios, frankly, so I’d agree with you.
[17:32] Kevin Choquette: Yeah, very much the same here in, in the business you’re in. What do you think is required to be kind of amongst the best? I perceive derivative logic is, you know, at the top of the game with a few other names.
[17:48] What, what do you guys think is required to be a good advisor in, you know, whether it’s foreign exchange or, you know, my world is more the. The rate caps, the swaps, the forwards.
[18:02] Jim Griffin: Well, if you don’t mind, I’ll give you a little history of how I got here.
[18:05] Kevin Choquette: That’d be great.
[18:06] Jim Griffin: And I say that because a lot of the folks that parlay this advice or this expertise every day, we all came from kind of a similar place.
[18:17] So my personal background very quickly is I came from a life insurance family, specifically life insurance sales, believe it or not, and I did that up until my almost mid-20s, having a father that was very deep into that his entire life.
[18:37] So what that means for a person like me, and this has nothing to do with understanding derivatives, but I became just a very adept salesperson at a really early age.
[18:49] I’m not tooting my horn, but you can imagine it takes a lot of courage and whatnot at the ripe age of 19 or 20 or 18 even, to go door to door in Chicago in the winter selling life insurance.
[19:03] Right, Yeah, I can imagine, with leather shoes and a briefcase in your hand and all of that. So that was sort of where I cut my teeth through college and shortly thereafter.
[19:15] But frankly, it was pretty boring and predictable and formulaic. So I kind of felt that once I got it to a certain level of what I called skill, or for lack of a better word, skill, I developed an interest in financial markets.
[19:33] That whole trader Persona back in the early 90s, late 80s of the phones and the screens and people yelling and all that was extremely alluring to me. So over, geez, probably a couple of years, I just poked around that and tried to find a way in frankly wanting to leave selling life insurance door to door.
[19:56] And what I found was, is foreign exchange, which again, this is not the topic of this podcast, but I’ll just mention it in this light briefly. And it’s essentially advising companies on their management of exchange rate risk.
[20:12] As I Explained much earlier on your podcast and how I manifested that was I worked for basically a, essentially a brokerage in foreign exchange where I was cold calling companies all day long, stealing their foreign exchange transaction business from large banks who were asleep at the wheel.
[20:35] Just based on my background in doing that and comfort with cold calling and selling, it was very easy for me. I was pretty successful pretty quickly.
[20:44] But at that brokerage I learned that I wasn’t going to make any money there of any significance. And I learned pretty quickly that I would have to work for a bank and probably a large one to make any kind of reasonable income.
[21:01] So after a couple false starts, I ended up at a regional bank in Southern California and frankly found when I got there that I was surrounded by a lot of nerds, economists, people that looked at charts all day long, most of which weren’t really comfortable sticking their neck out in their conversations with the banks hedging clients.
[21:28] Kevin Choquette: Wait, a banker who doesn’t want to stick his neck out.
[21:31] Jim Griffin: There you go.
[21:34] Exactly.
[21:36] It was pretty easy for me to succeed. Frankly, it wasn’t difficult at all. It was just work. Right, I know you know what that is. So as long as I came to work and actually worked during the day and tried to prospect and sell and had some kind of sales strategy and acumen, it was pretty easy to succeed.
[21:55] Kevin Choquette: And that was focused on foreign exchange, it was okay.
[21:59] Jim Griffin: So after a couple of moves I slowly started to do more interest rate type of consulting and basically ended up at bank of Tokyo Mitsubishi in Los Angeles. Talked into really big customers and all kinds of industries.
[22:16] I focused a lot on energy and movie productions and manufacturing and stuff like that.
[22:23] And it was great because in that capacity you get sort of a backdoor into a lot of these companies operations, their strategy, their business plan, you know, if you’re asking the right questions.
[22:32] And it was, frankly, it was fascinating and I learned a lot and then ended up at Wachovia and had a front row seat to their demise and failure.
[22:45] Then Wells Fargo, obviously, that’s who bought Wycovia. And then after that UBS in New York. But the point I’m trying to make in this history is that being on those large trading desks, talking to those large clients, interacting with pretty high level market analysts, economists, traders, I just learned a lot, frankly, learned on the job, all this stuff and also how derivatives works and how they’re priced and you know, so on and so forth.
[23:13] So without boring you to tears with my personal history, I sort of knew all along it was a pretty esoteric skill set that even though lots of people could understand it as much as I do, and you certainly could, Kevin, if you and I spent a month together in a room, or maybe less, it’s just most of the business folks I dealt with at that time, or even you right now, there’s just no point in you learning it to this level, knowing that, say, you as a lender, sponsor, etc.
[23:44] Can sort of hire the talent when you need it on an episodic basis and not have to have it full time all the time. That’s obviously what our clients do here at Derivative Logic.
[23:55] We’re sort of like the crane that’s used in construction. They hire it when they need it and then jettison it when they don’t. And it’s sort of a smart arrangement that way.
[24:08] But having built businesses and built big books of business for banks for, geez, almost 20 years, upon seeing, say, what UBS did with a lot of their peripheral businesses after the financial crisis, meaning they chose to jettison a lot of them or restrict people like me in the ability of transactions, hedging transactions I could do with clients, meaning the compliance, regulatory load that a lot of these large banks had to shoulder via Dodd Frank after the financial crisis, it made the job of people like me extremely uninteresting pretty quickly.
[24:53] So during my last time at ubs, I started to plan for my exit with the idea of starting an advisory company, frankly, because my clients were begging me for things I could no longer give them, but I knew I could probably give them if I wasn’t an employee of a large bank.
[25:10] And that’s exactly what happened.
[25:13] So I think really the skill set, and you know, you do this every day in your work and lots of people do in industry, but it’s just explaining what seems to be a really complicated topic and different dynamics with multiple variables that are moving around all day long every day and are driven there by human nature, that is financial markets and being able to synthesize all of that in a way that people understand and can understand quickly that that’s the skill set.
[25:49] Right?
[25:50] Kevin Choquette: Yeah, well, that’s why you’re on the podcast, honestly, because I do the same thing all day and I feel like, you know, we might be walking on a 4 inch wide slack line, 6 inches off the ground saying, hey, like this is what this class of capital is.
[26:09] These are the remedies, these are the things you need to be thinking about.
[26:13] And I feel like we’re pretty effective, you know, bringing some, hopefully some degree of acumen to Their decision making, just advising, but what you guys do. And I’ve, you know, I’ve gone into this wormhole fairly deep.
[26:29] It’s, it’s much, you’re on the tightrope, you’re 60ft above the ground, trying to explain to people like, no, you just come up here and you do it like this. How do you package this up in a way that the layperson, and by that I mean real estate operator can understand?
[26:47] You know, when do we call derivative logic? When do I start looking at, you know, some of the swap executions, the swap shins, the corridors? There’s a, there’s a myriad of tools, but you pretty quickly get into like this.
[27:02] Like our conversation could go so technical here that we might lose the listener. And I’m sure that’s something that you are like wrestling with on a regular basis. So how do you construct a message and get to the marketplace in a way that people go, hey, let’s, let’s go get a crane.
[27:20] A crane would be great right here. Let’s go get a derivatives advisor and bring them into this deal. Because there’s probably some, you know, risk mitigation or upside and optionality, maybe even some free optionality by doing some of these executions.
[27:35] How do you get the average real estate operator to start understanding and thinking about this as part of their execution?
[27:42] Jim Griffin: Well, Kevin, it really comes down to the cash flows of the deal.
[27:47] And it’s really important for someone like me and like you, frankly, not to be product focused.
[27:55] Meaning interest rate cap, interest rate cap, interest rate cap, or swap. Swap. Swap, Swap, swap. Does that really matter to a sponsor or an operator? No, it really doesn’t. What they respond to is how the cash flows perform given a certain transaction or no transaction.
[28:16] That’s really what it comes down to at the end of the day. So it’s really trying to achieve the goal of allowing that borrower in whatever form, assisting them in developing kind of a long term debt management strategy.
[28:37] Forget derivatives, forget interest rates for a second.
[28:41] Meaning the goal of that borrower really over a long period of time should be to create the longest stream possible of known interest expense across deals and to drive the cost of borrowing down over time across deals or as a portfolio of deals.
[29:04] Right.
[29:05] So I can tell you many, many of our clients are deal focused, project focused. How do I make this particular project work given X economic environment or myriad, you know, operational variables, vacancy, cost reduction, things like that.
[29:26] But really the best practice is to focus on interest, expense or cost of debt on the entire portfolio. And it really takes a sort of a larger mind on the part of the sponsor, let’s say, to even consider that because it’s obviously more work, takes longer, but that’s really the best practice.
[29:47] How many of our clients actually do that on a consistent basis? Very few. Especially given this rate environment. Right. Meaning there’s some panic going on in different corners.
[29:58] So that’s the best case. But it doesn’t happen very often, frankly.
[30:05] Kevin Choquette: So if you’re looking at a portfolio of an operator, and I don’t know what your typical client profile is, but one of the client profiles that we like is a single operator who owns and trades real estate to continue to grow their wealth.
[30:22] But they might have deals that are land going through an approval process or a covered land play. They may have deals that are just coming out of the ground. They may have deals just starting lease up and then they own a bunch of other deals that might be stabilized.
[30:35] How would you look at a portfolio like that for the totality of all of the interest rates, all of which have different terms and different, you know, there’s a whole bunch of externalities on every project and start to go, okay, hey, let’s look at this whole thing.
[30:48] And we could probably do the following. And I know it’s probably hard with a purely fictional thing, not concrete, but I don’t know how you guys would think about a portfolio that’s got that kind of diversity.
[31:02] Jim Griffin: It’s not easy and difficult, which is part of the resistance. And looking at it that way, I mean, for sure, but it can be done to an extent.
[31:14] The clientele that we have, and I won’t bore you with a detailed sort of client definition, but they tend to mean be not that diversified in asset class, frankly.
[31:26] Meaning they either mostly are all multifamily or maybe all are mostly warehouse, industrial, et cetera, et cetera.
[31:35] Not that they have to be all one single asset class, but the diversity you describe is unusual in our client base.
[31:45] If there is multiple asset classes in the portfolio, it’s maybe two, maybe three. And which makes it a lot easier to do that.
[31:55] Also, as you would know, there’s different investors on different deals, of course, meaning not all single investors invested in all of their deals, which makes it also difficult for them as an operator to manage it on a portfolio basis.
[32:11] But we do that where we can as much as we can.
[32:15] If that’s, if it’s not possible, then obviously we resort to just doing it on a project or deal basis as much as we can. But that proves kind of inefficient over time, frankly, if they’re in the business.
[32:28] Kevin Choquette: Are some of your clients like really large asset owners, whether it’s the Blackstone Blackrocks or smaller REITs or big family offices, like what, where they’re holding mostly stabilized assets?
[32:44] Jim Griffin: No, most of our clients are in what we would call mid market. And the reason why Blackstone isn’t my client is because Blackstone has me on staff as a full employee.
[32:55] Basically, they don’t need me.
[32:58] So there’s no need for us with a Blackstone. However, one rung below that, there absolutely is a need for a firm like us or one of our competitors.
[33:10] And that’s where we get hired, frankly, in a scenario like that.
[33:14] Kevin Choquette: So without going too deep, which I know could be tricky, but take, take a more prototypical client profile that maybe owns all multifamily and has, I’ll just make it up 14 assets, different interest rates, different maturities, what kinds of things would you look at with the collective cash flows and interest rate exposures to try to say, okay, hey, here’s some of the tools that could be employed here to reduce some of your volatility or maintain your cash flows.
[33:45] Jim Griffin: So mind you, some of those assets are going to have required hedges on them in the case of say a three or five year bridge loan where the lenders forcing that borrower to buy an interest rate cap to close that loan and to maintain it over the life of the loan.
[34:02] Others would have different or no hedge requirements.
[34:06] But it’s really a scenario where that borrower is being more proactive rather than reactive to changes in the financial marketplace and frankly the commercial real estate marketplace and has established a scenario where they can be strategic in terms of layering on or taking off layers of interest rate derivatives to help them achieve the outcome that they’re desiring.
[34:37] So that could be anything. It could be interest rate caps or swaps or all the things you described earlier, corridors, collars, things like that.
[34:45] But oftentimes the management of these organizations, they really don’t know much at all about derivatives. And in order for that, say CFO or VP Finance or treasurer to raise their hand at a management meeting and say, I need a million dollars in our budget this year for interest rate derivatives.
[35:07] Meaning give me some money to allocate two derivatives to help us achieve our desired outcome, oftentimes as a laughing stock because no one understands. What are you asking? No way, we’re never going to do that.
[35:21] Or it’s so complicated that the answer is no, you don’t have A derivative or hedging budget, Mr. Or Mrs. Treasurer. So it’s a stretch out of the gate. And frankly, one of the things we do is really educate, just like you do, Kevin.
[35:37] Meaning that’s what we spend most of our time doing here at Derivative Logic is educating really everybody. Attorneys, lenders, pension fund managers, borrowers, their investors, things like that, to get them in a position to where they can be strategic as much as the organization will allow them to be.
[35:58] What do I mean by that? Well, it’s obviously a budget to spend, say on interest rate caps as an example.
[36:06] It’s something like a risk management policy internal to that organization, assuming it’s big enough to warrant something like that. What is a risk management policy? It’s a living document shared by management that basically addresses how the organization deals with interest rate risk in different scenarios, products that they’ve approved for use in managing interest rate risk.
[36:34] Who’s responsible for making the decisions in managing interest rate risk? Who signs off on it? Meaning, is it the CEO? Cfo, controller? Who is it?
[36:47] It’s all great and no one cares about this stuff. You know, when the interest rate environment is pro progress and more and more deals.
[36:57] But it becomes critical or extremely important when things go the wrong way and either a decision was or was not made or a transaction was or was not done, and the fingers start to get pointed at different folks in the organization.
[37:13] Why didn’t we do this? Why did we do that? And you could imagine a document like that becomes extremely valuable in that scenario, right?
[37:23] Kevin Choquette: Yeah. So in this scenario, we’re just this fiction, right? 14 different assets, lots of different rates, lots of different requirements in terms of caps and swaps and things like that. With a document that’s sort of your risk management protocols, you guys might say, hey, there’s three assets here that you could actually make a trade on and capture a bunch of cash.
[37:46] We can leverage that cash into those three, plus two more, extend out your durations on your caps, maintain a positive cash flow or a known interest rate for longer than we would have if we let these things just kind of go independent.
[38:03] It’s that kind of a thing that you start to see by having a proactive management approach.
[38:09] Jim Griffin: That’s exactly right, Kevin. But that is only formed by someone like us, or at least someone in charge at that organization, having that comprehensive view of the deals, of the projects and of the debt, inclusive in those, and how best to manage that debt.
[38:27] Because remember, there’s really two types of interest rate risk.
[38:31] Whether the underlying debt is fixed or Floating, obviously, if the underlying debt is fixed rate, who cares about interest rate risk? It’s fixed. But that loan is going to mature someday, right?
[38:45] And chances are it’s going to have to be refinanced in some form. Probably. Well, where are rates going to be at that point?
[38:53] And what can we do today to try to take some of the potential sting off of that refinance? If rates are higher than what we would prefer or like? Right.
[39:04] That type of risk, the refinance risk is not in getting the financing in the first place. But what are rates at that moment of refinance?
[39:13] That is a risk that I’d say the vast majority of commercial real estate firms do not address.
[39:20] The second type of interest rate risk is again, that deal by deal risk. Are we borrowing fixed or floating?
[39:28] If so, if it’s fixed, why is it fixed? Why isn’t it floating? Or vice versa?
[39:34] If it is floating, do we feel we need to sort of mitigate the potential movements of that floating rate over the life of the deal? If so, how? How do we do it?
[39:45] Things like that. That’s the more common interest rate risk that’s managed. But frankly, that’s not the best practice either. The best practice is both that refinance risk and the deal specific risk on floating rate debt.
[40:02] Kevin Choquette: So this will sound a little bit funny, but is the industry just kind of missing the plot and how much money. I know the answer is, it depends, is being left on the table.
[40:16] I mean, it seems like you’re. And do you feel like a crazy person sort of jumping up and down, going like, hey guys, like, you could do a lot better if you just put some of these tools to work.
[40:26] I mean, it strikes me that that’s what’s at play here. But how does that all land for you?
[40:31] Jim Griffin: That’s true, Kevin, it is, but it’s been that way forever since I’ve been in derivatives.
[40:38] And we tend to see that kind of behavior, meaning that inefficient behavior. That’s how I would describe it. Meaning not really hitting the peaks it could with correct management.
[40:50] It’s in commercial real estate, right. Just because of the localized nature of commercial real estate, the sort of spectrum of sizes and histories of the operators within it, as opposed to say middle market or large public companies, where things generally are a lot more established in terms of overall risk management of that public company’s business.
[41:16] The point I’m trying to make, you could imagine, if it’s a public company, let’s say they make $200 million in revenue a year, pretty small for a public company. But even still, they tend to be a lot more efficient in how they manage risks.
[41:30] When compared to, say, an operator that has seven different assets scattered across the United States, or In your example, 14 different assets, they’re smaller. They don’t have the expertise. Their expertise is elsewhere, managing the properties, attracting the investors, things like that.
[41:51] Managing interest rate risk is just not their first skill set, which is why we exist, frankly. But that’s why it’s different. It’s just commercial real estate. It’s the nature of the industry.
[42:01] Kevin Choquette: Yeah, and you’re right. It’s not that they’re not lacking expertise. They just have expertise in other places. And what’s interesting is this isn’t. And it’s not beyond anybody’s capacity to sort of, I would imagine, unpack it and be successful here, but it’s, you know, there’s a lot of other things competing for their time and energy.
[42:23] The local politician, the NIMBY neighbors, the rent control, the, you know, property tax assessor, the utility bills, the property manager. This probably just falls back burner.
[42:35] Jim Griffin: It absolutely does. Absolutely does. But I would encourage all managers of those types of organizations that. And most of them do, frankly. But the order, number one is to really analyze and understand the impact that interest rates have or will have on the firm’s bottom line, obviously.
[42:58] But do that also in different interest rate environments. If rates go up, this is what we look like. If they stay the same, it looks like this. If they go down by this much at this time, it looks like this.
[43:09] And that’s when you start to be able to sort of bleed into that more strategic interest rate risk management. Because really, Kevin, sometimes the right decision is, hey, we’re doing great.
[43:20] We don’t need to hedge anything. It’s looking good. Maybe that’s the right decision and that’s okay.
[43:26] Obviously, no transactions could hurt my or my competitors, businesses and advice.
[43:35] But if that’s the right advice, then that’s the advice we’re going to give, is you shouldn’t hedge rate risk on these assets at all because of X, Y and Z.
[43:44] Your strategy for the firm, your strategy.
[43:47] Kevin Choquette: For the assets, that’s worth highlighting. It sounds like us. You guys are paid on the transactions, not the advice that doesn’t lead to a transaction, which is to say you don’t engage on a retained basis and provide ongoing consulting.
[44:04] You work when there are. It’s the crane, right? You’re the rented crane that comes in to work on the job.
[44:10] Jim Griffin: No, that’s not Correct. It’s just the opposite, Kevin. But I understand why you, why you would have it that way.
[44:17] Kevin Choquette: Yeah.
[44:17] Jim Griffin: So I would say if you look across the spectrum of firms, like derivative logic across the country, there’s probably four or five of us that are solid, if you will, meaning the principals have decades of experience.
[44:34] We’ve been operating a long time in the space. We operate among multiple industries, not just commercial real estate, because there’s a fair amount of experiential value that comes with operating in multiple industries.
[44:50] Some of those firms are paid on the transaction itself.
[44:55] Most are, but there are some, including us, where the scenario could be either or, meaning there’s many client engagements that we have where we’re just on retainer, frankly, which is preferred because I can give the most reasonable advice available.
[45:14] Because again, that vibe.
[45:17] Correct. There’s no conflict of interest. That advice might be do not hedge at all. You shouldn’t use derivatives at all at the moment in this specific scenario. So we try to give ourselves freedom to do that and not have a conflict of interest with our clients.
[45:33] That’s critical to the business.
[45:36] Other times, many of the listeners would know this bridge loan, three or five year term loan, the lender requires an interest rate cap, meaning there must be a transaction. There is no, no hedge sort of possibility, even though that could be the right thing to do.
[45:57] You shouldn’t buy a cap. But then when the lender is asked, hey, do we have to buy this interest rate cap? The lender says no, so there must be a transaction.
[46:05] Then of course, our fees and whatnot are paid based on that transaction. So my point is, bottom line, it’s a little of both here at Derivative Logic. It just depends on the client and what, what the debt is and what’s being driven by that debt and that lender.
[46:21] Kevin Choquette: So going into this middle market client, I think for the most part we have a lot of overlap in our client profile that the guys who might do one or two deals a year, they might own three to six assets that are for duration and they’re constantly working to grow up that portfolio over time, which, which is to say it’s not the public company, it’s not somebody who has a, you know, risk management document to reference.
[46:50] What are some of the applications that you guys see now in the tool chest that you bring to a middle market operator and find that you can unlock some value for them?
[47:06] Jim Griffin: Well, based on the current environment that I described earlier, it’s definitely trying to soften the blow of that loan extension and the interest rate cap. Around that loan extension, meaning that it’s still required of the borrower.
[47:22] And it’s the ways that I describe Kevin, I won’t repeat those unless you want me to, but I’ll just do a high level it’s maybe raising the strike on that required cap to reduce the cost of that interest rate cap replacement or extension.
[47:37] It’s doing our best if the business warrants it. Eliminating the requirement for the interest rate cap completely at loan extension.
[47:49] That’s rarer, of course.
[47:52] Probably a third scenario that’s more common than it has been in a while is while avoiding that requirement for an interest rate cap, meaning instead of that, having the borrower post some funds in escrow that are some percentage of the cost to extend that interest rate cap on escrow with the lender and allowing that borrower to avoid replacing that interest rate cap as a result.
[48:23] So the borrower is not going out and extending or replacing that cap at $340,000. Instead, they’re agreeing to post funds in escrow every month of a certain amount in lieu of that interest rate cap.
[48:37] Kevin Choquette: Requirement and hope the rates are going to come down. And then they would have saved a bunch of cash for not having bought the full duration interest rate cap.
[48:47] Jim Griffin: Yes, or that gives them more cash to operate with and more time to look for other financing or a buyer or, you know, things like that. It just gives them more room to operate.
[49:02] Kevin Choquette: Thanks everyone for listening to part one of the podcast with Jim Griffin. Look forward to seeing you on part two.
