Delving into the world of commercial real estate, Madison Realty Capital’s Managing Principal & Co-Founder Josh Zegen joins Joe Richter to discuss how the firm got started, and why it’s strongly positioned to succeed in today’s lending market. We also covered timely topics, including the secular decline of physical retail, the hospitality sector, WeWork, crowdfunding, and more:  

Joe Richter: Before delving into timely market topics, it would be great for you to give us some background on your journey and how you started Madison Realty Capital (Madison).

Josh Zegen: When I graduated college, I went into investment banking at Merrill Lynch and Salomon Smith Barney. I then got my dream job around 2000 at a venture capital firm. Unfortunately, the timing wasn’t great because the market crashed in March 2000. 

The firm basically laid everyone off, so unfortunately – or fortunately – I was forced to reinvent myself. At the time, I was around 26 years old and moved back home, basically trying to figure out what to do next. It was a very tough time, companies were making lots of layoffs, and it was hard to find a job. 

I’ve always been an entrepreneur and have been starting businesses since I was a kid. So I co-founded a mortgage brokerage company in 2001, and started facilitating commercial real estate bridge loans. This opened up a huge opportunity for me, as I came to the realization that there was a real need for flexible and fast capital. It was very mom-and-pop, and I brokered a number of deals. 

Joe Richter: And I guess this brings us to around 2004. 

Josh Zegen: Yes. I got together with my college roommate Brian Shatz and pitched him on the idea of starting a fund around bridge lending. His first job was at BlackRock and then he joined a hedge fund where he was able to build a Rolodex of investors. At the time, there was almost no one in the real estate lending business. It was highly fragmented and not institutional. We saw the opportunity and decided to start a fund around this.

We launched with $10 million of LP Capital [limited partner capital], and completed our first deal in 2005. It grew from there. That fund ultimately became a $300 million fund. We created a large global investor base and started lending. We were very early, the word private credit didn’t really exist back then, it was a mom-and-pop business that we set out to institutionalize.

Joe Richter: And then a few years into Madison’s history, the industry is of course confronted with the great financial crisis. How did that affect the firm?

Josh Zegen: Our growth was accelerated by the global recession in some ways because banks changed their business completely. We were often identifying deals that were special situations or quick closings and finding opportunities that banks couldn’t act on between 2005 and 2008. We were well positioned to lend at a time when no one was lending. 

It was a very challenging period too, because we had to make sure that we preserved our investor’s money. Obviously, the markets were very illiquid in 2008-09, and it was very hard to raise another fund. We really had to figure out how to manage best with what we had. At that point, we recognized the importance of becoming a vertically integrated company. We realized that we needed to bring in asset management, property management, and construction management because our track record was going to be dictated by how we managed that vintage.

It put us in the next vintage in 2009-10, and while we were in between fundraising for a new fund, we set up a joint venture with a hedge fund to buy loans in the New York area and make loans as well. We weren’t just a loan originator, but we were buying loans from banks. 

Joe Richter: That seems like a pretty exhilarating stretch in a company’s infancy! 

Josh Zegen: The DNA of Madison was created in that period of time, as a vertically integrated firm that can tackle all kinds of opportunities from direct lending to buying loans, to restructuring loans, to owning real estate. We started buying real estate at that time in 2010-11. That got us to Fund II where we raised $350 million, and then almost $700 million in Fund III; and $1.35 Billion in Fund IV. 

Joe Richter: That’s a great story. As you know, everyone in the market is trying to get into the lending business. With all your experience, what would your advice be to them? I think there’s definitely a misnomer out there, with people thinking lending is as simple as a standard equity deal. Right now, there’s so much liquidity out there and I was wondering what your thoughts were on the landscape and how this evolves in the next few years?

Josh Zegen: There’s another lender that pops up every day and the reality is that most of these new entrants to the market have not seen a true downturn – what we saw in March 2020 wasn’t even a downturn. The liquidity that’s been pumped through the system rescued a number of firms and a number of mortgage REITs. 

Generally, none of the firms out there started on the credit side and then added equity. Most came from equity and then added credit. So, the experience we’ve had over 17 years, and our track record of $14 billion plus in business is really what sets us apart. Being able to close on small, medium, or very large deals quickly with flexibility. We also service all of our loans in-house.

The way we’ve set up our business as a vertically integrated firm, allows us to tackle deals that are complicated or require a unique understanding of the market. Our focus is not on the commodity part of the lending business, which is the case for most debt funds out there.

We’re creating more customized financing solutions, which leads to many value-add deals. We can both buy and originate performing or non-performing loans. We also make new loans, which is a substantial part of the business.

The number of repeat borrowers is a testament to the fact that we can control everything in our process. We’re not syndicating or bringing in different investors. We’re not closing subject to leverage. This allows the whole loan solutions we’re providing to be very flexible, efficient, and valuable to our customers.

During the last year, we launched another product, which we call our income product. It’s a fund where we provide lender financing to other lenders. So while alternative lending has grown like crazy, we think there is more of a need for flexible financing to lenders in the business, whether that be through loan-on-loan, A-note financing or lines of credit. The typical credit sources to other lenders (i.e. the alternative lending universe) are very rigid, it’s not as customized, and we can offer a lot more flexibility.

Joe Richter: Is there anything in the lending universe that you see as a red flag?

Josh Zegen: The mistake that I see being made is the lack of downside protection – your last dollar exposure. Unfortunately, the big mistakes that cause firms to blow up in our business are repeated. They go high, leverage up the spectrum in terms of the capital stack and people aren’t really being paid for risk, especially with so much liquidity in the market. The second problem is levered lenders – the way people leverage today through warehouse lines, CLOs, and repo – unfortunately, every few years you have a blowup in the market and that’s what we saw in March. People don’t necessarily learn their lesson and they do the same thing.

It’s worth noting that most of the new lending arms out there don’t have discretionary capital. Madison did $1.6 billion of transactions in the pandemic because we had capital and conviction at a time when no one was doing business. We didn’t have leverage issues or some of the portfolio issues some others had. We were able to play offense big time last year. Now, all those debt funds that were sitting on the sidelines are trying to play catch up. 

Joe Richter: Now that we have some background, I’d love to get your perspective on the current market. I want to first discuss the supply gut we are seeing in the Manhattan condo market. I know Madison has been pretty active in the space for the past few years. 

In 2018, you invested in 111 West 57th, and then a couple of months later you did Ian Eichner’s condo inventory loan at 45 East 22nd Street. And last week, there were 47 contracts in Manhattan for deals over $4 million, which extends the record-breaking streak of more than 30 such deals to 11 weeks in a row.  

And with the national, general housing market the way it is, how do you view the condo market shaking out in the next year or so? Gary Barnett recently said that he’s only expecting to make money on three out of his six active projects. So I was just wondering what your outlook is for that market. When will the supply gut be absorbed? Are we headed for some distress?

Josh Zegen: We are seeing a substantial amount of absorption across the board. From luxury properties to the middle and low-end. Pricing was already going down in March before the pandemic hit. Generally we are seeing somewhere between 5% to 15%, with an average of 5% to 10% off of March pricing.

There has been a huge kind of absorption in the first quarter, which we identified in the fourth quarter as well. Basically, as soon as the vaccine was announced, we started to see a huge pickup in momentum. People started to feel like they were missing out on something, such as empty-nesters, who couldn’t sell their homes in the suburbs, and they always had a dream of trading into New York City. With all of the renewed interest in the suburbs, people were able to sell their homes and get a bargain in the city. I saw a lot of tech executives from the West Coast look to buy units in New York City. It was families trading up to get substantially more space for a lot less than what it would have been pre-pandemic. We are also seeing foreign buyers – a number of investors in Israel and South America are interested.

Joe Richter: Even without them being able to travel, you’re saying they are just buying virtually.

Josh Zegen: Yes. What’s hurting the international buyer is that the world isn’t vaccinated at the rate we are here in the U.S. and it will hold back some of the market. It has been holding back the hotel industry and the condo sector.

Joe Richter: 100 percent. I know you have a few projects in South Florida. What are you seeing there?

Josh Zegen: We have three major projects there: Monad Terrace, the Four Seasons Hotel and Private Residences Fort Lauderdale, and The Residences at Mandarin Oriental, Boca Raton. All three are substantially sold and continue to sell every day at record prices.

Interestingly, going into the pandemic certain parts of Florida were strong, but Miami was weak because of condo unit overcapacity. That started to change as the housing inventory narrowed and people started to renew interest in the condo market, and anything that’s available for sale is selling units every week.

Joe Richter: So do you think when everything gets back and running in New York City, we could see the same type of thing happen in that market?

Josh Zegen: I think so. I believe that the inventory available is another 18-months out. Renewed interest in condo inventory loans in New York City, which we are participating in, has just begun. We are looking at whole loans for inventory, but also looking at leveraging other lenders in inventory loans. In those cases, we’re competing with banks that are providing A-notes or loan-on-loan financing. We’re seeing that as a very big opportunity where we may not want to take the last dollar of exposure, but where someone is, we can lend to them.

Joe Richter: We recently published a survey with KayoCloud, which was featured in the New York Times. One of the interesting results was on the question of which asset class will see the most bankruptcies in the next 12 months: Interestingly, 48% said hotel, 42% said retail, and 10% said office. Based on what you’re seeing – you guys are at the front lines – where will we see most distress in the next 12 months?

Josh Zegen: The distress is more around retail. In terms of hotels, it depends on locations because obviously the business traveler creates a big question mark as to how that comes back regionally.

Joe Richter: Yes. Demand for leisure travel should really spike.

Josh Zegen: Business travelers can say for now I’m okay on Zoom for the first meeting and maybe the second meeting. There may be less business travel because you can accomplish a lot through video conferencing platforms, but it doesn’t mean that the first handshake isn’t valuable. That all being said, we have someone on the fundraising side and as he says, he can be in seven countries in one day.

Joe Richter: There’s an efficiency that didn’t exist previously.

Josh Zegen: From a hotel perspective, the major question is how quickly will the world open up? Meaning, how quickly does Europe and the Far East get vaccinated, which will determine some of the tourism industry in the U.S., and around the globe for that matter. 

From the retail vantage point, it is a more binary business. We learned a major lesson from a bad mall loan we did in 2007, it kept us out of retail lending for the most part for the last 14 years.

Joe Richter: That seems like a good mistake to have made.

Josh Zegen: Yes. We had a number of tempting deals along the way, but we didn’t like the risk of co-tenancy. If one anchor goes bankrupt all of a sudden, then the mall can turn into major distress. We just stayed away from malls and from a lot of retail because we were very worried about the asset class in general. We basically had no major retail exposure, other than in mixed-use assets where there’s an apartment building with a little retail in the base, so nothing major there.

We also had almost no hotel exposure. Other debt funds and mortgage REITs had a lot of hotel exposure going into this crisis with generally 15% to 30% of their portfolios were in hotel loans, because they were able to get a little more yield for hotel lending.

We never viewed the risk worth taking because hotels are operating businesses and just have more binary outcomes in times of distress. That doesn’t mean we don’t think there’s an opportunity today, especially with distressed hotel investments, preferred equity, and providing note-on-note financing.

Joe Richter: It sounds like you’re still shying away from retail because of e-commerce and the macro trends. Are you looking at retail deals now or more on the distressed hotel side?

Josh Zegen: We are still shying away from retail, though there’s some opportunity for us financing others that are buying distressed retail and turning it into something else. There’s a lot of interesting business plans around taking a mall, for example, and turning it into single family rental housing, multifamily, or distribution. 

We’re also seeing that business plan in distressed hotels where people are taking hotels in the Southeast and Texas and turning them into multifamily. There are a number of interesting business plans where we can be very relevant from a flexible capital perspective, not just a lender, but as someone who can understand a lot of moving pieces. There’s a void there, which presents an opportunity for us.

Joe Richter: Would also like to get your perspective on WeWork and the co-working space in general. If you guys were looking at a building where a co-working company was the anchor tenant, how would you approach a potential deal? 

Josh Zegen: Fortunately, we also avoided that pitfall going into the market. We didn’t have any exposure to WeWork on any co-working. We were actually looking at one deal where WeWork occupied the entire building and we looked at every one of those co-working deals the same way, which is basically what happens if that tenant blows out. What would that mean in terms of our time to lease up, cost to lease up, and the rents we can get if that took place. Generally none of those deals penciled out for us to be able to make a loan because there was such a drastic difference in value if that happened.

While we stayed away from co-working, I still see the concept as a valuable business plan in the future. Let’s say we wanted to test out opening an office in Seattle without locking ourselves into a 10-year lease, this model would be very valuable for someone like us. Meaning, let’s take 3,000 SF and be a presence there, and have a one, two year, or three year lease just to get going.

Joe Richter: Yeah. I think flexibility of office leasing in general is the lasting impact WeWork and its competitors have on the industry. 

Josh Zegen: The business plan was flawed amongst a number of the co-working companies, there was too much competition, too many commoditized products, and not enough of a value proposition to the tenants and the landlord.

It’s being reinvented and it’s here to stay because there is a value proposition, but only the strong will probably survive.

The same thing is true with a lot of these co-living companies, including Stay Alfred or Ollie, as expenses were too high at the operating company level. The expenses were just crazy, and it was always just about growth, and it was never about how to grow smart. There was too much money being thrown at the space.

Joe Richter: Yeah, they were flawed businesses. I mean, on the office side, look what happened to Regus in the last downturn. The business model was faulty from the start. And I think the partnership model is what will survive. The question obviously remains what the margins will look like and the profit it can generate. I’m not really sure, but that’ll ultimately be the arbiter.

Josh Zegen: I do believe that experience and technology are integral for the business. The less commoditized the product, the better. Just like in our business, the lending world. So much of the debt fund business today is based on everyone trying to do the same exact thing. What keeps us relevant is that we don’t do the same thing. We’re able to create opportunities.

Joe Richter: I wanted to get your thoughts on crowdfunding for commercial real estate deals. The space is definitely making strides and has gotten some more publicity because of what’s going on with Robinhood. 

Cadre, CrowdStreet, and Fundrise have been at it for years already with mixed results, and some like Prodigy Network have gone under, which shows the complexity at play. The truth is that it really started with Blackstone and Starwood when they raised from smaller investors with a minimum check of $2,500 for non-traded REITs. And I guess it’s evolved now where Jamestown is out there raising a $50 million fund concentrated on small investors. So I was wondering on the lending side, do you think there’s an opportunity to go ahead and raise from smaller investors? Or do you think this is just a small fad?

Josh Zegen: There’s an opportunity both from an equity and debt standpoint. The problem has been that there’s been negative selection thus far.

These crowdfunding groups are not getting the best deal flow because it is a process and a lot of uncertainty dealing with them. The most established will survive, and there’s a value proposition to both the developer and to individual investors out there that couldn’t access deals because they don’t have the capital. 

The key is to find the best sponsors and have repeat business. I’m a believer that there will be a handful of these groups that really make a mark and become big and there’ll be consolidation because there’s too many players out there.

The negative is when you have a real downturn and recession, which again, we didn’t see last year. COVID-19 was very different, as it was a health crisis not a financial one.

In times of uncertainty, investors put in money and then I don’t know how much more bandwidth they have from a capital call perspective. It wasn’t tested the way it was during the global financial crisis. At that time, you had years of not getting financing, years of working through deals, years of more capital that had to be put into things, I don’t think it would have survived that.

Joe Richter: It was a very short blip and everyone had forbearance agreements and there was so much liquidity in the system. So who knows what would have happened had it lasted for longer and the federal government had not taken such bold fiscal action. 

Josh Zegen: The model hasn’t really been tested –– individuals are the first to just say I’m not writing a check. I’ve seen it in deals. Unfortunately, that means the sponsor who’s going to be subject to completion and carry guarantees is really going to be exposed.

The plus is that it is a real way to raise capital. There is a business plan there that could be a major source of capital globally. The negative is that unfortunately in times of uncertainty, investors may not know what they’re buying into, and that may create a lot of risk for a sponsor, rather than coming in with a big JV equity partner. It doesn’t mean the JV equity partners can’t just walk away and leave a sponsor exposed, but there’s a little more certainty around it.

Joe Richter: Yeah. There’s the sponsor’s reputation at stake in contrast to a fragmented crowd-funded deal, which is pieced together from like 7,000 investors online. So there’s definitely a distinction. 

Josh Zegen: I’d say that’s an opportunity for a business like Madison Realty Capital. We’re seeing deals where equity investors aren’t ponying up money and there’s an opportunity to come in with preferred equity and restructure the debt in place. Our experience also means that we can tackle opportunities from many different lenses. That might mean making a loan, buying a loan, or restructuring a loan. It may mean coming up with some other way of tackling the situation through preferred equity and restructuring the debt. We are a creative solution provider.

Sponsors really appreciate that we look at a deal through the same eyes that went through the GFC (Global Financial Crisis), in addition to our investors appreciating the ability that we have to drive better returns because we can understand a deal in so many different ways.

And I just wanted to tell you, Joe, I really appreciate what you’ve done with the Real Estate Daily Beat. You’ve created something where there was a real void in the market. It’s probably one of the first things I look at every morning, because it sums up the news in a really nice way. 

Joe Richter: Thanks Josh. Really enjoyed chatting and very much appreciate your kind words. 

 *The interview has been edited and condensed for clarity.