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Current Opportunities in Real Estate
Where does real estate fit in an investor's portfolio? The experts in this Masterclass answer that question and offer their views on where we are in the real estate cycle and where current risks and opportunities lie.
Scott Brown, President, Cornerstone Real Estate Advisors
M. Jason Mattox, Executive Vice President and Chief Operating Officer, Behringer
Brian Nottage, Managing Director, U.S. Real Estate Research and Strategy, J.P. Morgan Asset Management
Duration:
00:51:55
Transcript:
Masterclass: Real Estate Oct. 2nd
Evan Cooper: [0:01] ...Today's master class, we'll be discussing real estate and providing ways to hold it and where it's going and what it's doing. Welcome, gentlemen.
[0:11] Let's start with an overview of interest rates and their impact on real estate. Everybody's expecting the interest rates to rise so far they haven't. But it's coming, theoretically. Let's start and see the impact of what that might be.
[0:30] Scott, we'll start with you. Tell us a little bit about where you think interest rates, effect it will have on real estate going forward.
Scott Brown: [0:37] Happy to. First of all, predicting interest rates is not the perfect business to be in, in the first place. There is a well thought out camp that says they're going to rise.
[0:50] I think they will rise over the long term into 2015 at some point, not necessarily in the shorter term as the quantitative easing comes off from the FOMC.
[1:04] But with regard to real estate, there's a relatively low R squared between interest rates moving and cap rates in real estate moving.
[1:14] My expectation is that, once interest rates do start to move, for equity real estate ownership, there's enough of a spread between where the risk free rate is currently and where cap rates are currently, that that spread will come in and there'll be a de minimis effect on cap rates in short to medium term.
Evan: [1:35] Brian, what do you think?
Brian: [1:36] I think I guess to be fair, we have had some rise in rates. If you talked to our colleagues in May of last year, they were panicking. They received a reprice this fall. I'd say that private real estate largely priced completely through the little interest rates moves that we've seen.
[1:52] For all the reasoning Scott's talked about, the spreads were wide. Real estate incomes were rising appreciably and continue to, and that's been supportive of real estate pricing evaluation as it is.
[2:03] In our view, a world that gets to a 4 percent treasury, which is what we think we go in the medium term, is a world where today's pricing which is unleveraged or without leverage basis for high quality real estate is about six and a half.
[2:20] You throw a little leverage on that, you're in the seven and a half to eight percent range. That's consistent with historical spreads and we think that that can persist.
Jason: [2:29] I would just add that I think from a nuts and bolts standpoint, with your underwriting, given the uncertainty surrounding interest rates, we're all just a little more careful.
[2:38] Sensitivity analysis makes...there's a larger argument about that in the investment committees, I believe, just concerns about long term holds and how much growth will be there.
[2:49] I suppose the overall impact of interest rates should actually be a positive one. If indeed they begin to rise, perhaps that suggests that there's continued economic growth. Real estate is designed to accommodate that.
[3:00] I think I agree with a lot of the commentary they've offered. But for us, it's something that you just have to make sure you've sharpen the pencil thoroughly.
Scott: [3:08] Certainly, with regard to exit cap rates, we then perform a sensitivity analysis. There will always be expansion in cap rates currently big which I think is what you're referring to.
[3:19] Interestingly on the public side, I think the expectation of interest rates have started to affect valuations. The expectation of interest rates going up has pushed valuations down somewhat slightly different across property sectors.
[3:37] But the interesting part about that is that most of those companies on the public side have their interest rates, their debt fixed almost consistently across the asset class. It's a very interesting anomaly taking place, expectation versus reality in some of those balance sheets.
Brian: [3:56] I think there's another twist, too, that you can think about the dangers of high rates. I actually think that where we are today, there's actually a slightly bigger [inaudible 04:04] rates stay too low.
[4:06] What we're seeing across real estate space particularly in the course of high quality, well leased properties because their bond in a way, you have levered investors who see a return that's very attractive and they compete in that space.
[4:23] I think that that makes pricing, in some cases, feel very full and very competitive and perhaps even a little bit frothy.
[4:29] In our view, I think the bigger risk at a 2.5 percent treasury rate is not then going up as them staying as low as they are.
Evan: [4:36] Jason give me the point. Obviously, if the economy improves and rising interest rates are sign of that, then typically rents will come up. When does the increase in rents generally get felt? What's the lag in terms of seeing that...?
Scott: [4:53] upon the asset class. With a hotel, you can take there at almost instantly. With an office investment in downtown Chicago, it's going to take a while because if we have a lot of long term leases, that will reflect the disability we're looking for when you made the investment.
Scott: [5:08] I think that's fair. It's happening already. We haven't seen widespread inflation across the CPI indices and other measures of inflation. Rents in commercial real estate, in gateway cities, and frankly in some of the other less gateway cities, rents are starting to move. As referred to, the length of a lease is an important piece.
[5:35] A one day lease versus a five or seven year lease matters in a way that average lease expiration of a particular asset or of a portfolio matters quite a bit in how you're pricing and how you're expecting potential increases in rents to affect your NOI and the value of the property.
Brian: [5:51] Certainly, here's adding, rents are rising really in every property subsector at this point. I think a number that's important to look at, and we're talking about cap rates. Cap rates are net income over a property value.
[6:05] Net operating incomes for the typical institutional property on average, they arise in plus or minus 5 percent. That's rent increases, that's occupancy gains, that includes expense gains.
[6:17] It is very hard to get price declines with interest rates rising in a world where operating incomes are going 5 percent. That's a pretty ubiquitous result in more and more markets across property sectors.
Evan: [6:30] Let's talk about those sectors. When you talk about commercial real estate or institutional quality real estate, what are we talking about specifically? Is it all office buildings? We mentioned hotels. Give us a view of what that is.
Scott: [6:41] It's multifamily. It's industrial, office, retail and then the fifth and...sometimes those four are considered the four groups or whatever you might want to call it. Then hotels are certainly a mainstream property sector as well. Those are the five.
[7:01] There are other property sectors that would be referred to as niche property sectors. But, those five are the primary US commercial real estate property sectors.
Evan: [7:13] How are they doing? Let's get a view of how those five are doing.
Scott: [7:17] Multifamily is doing exceptionally well. Through the GFC, there was agency financing available the whole time. Household formation went down.
[7:29] As we've come out of the GFC, the millennials and other generations have started to form more households, which has begun to push rents which has begun to push development, but supply is meeting demand. It's a very healthy market with relatively low vacancy and opportunity on this.
[7:47] On the supply side, I say we've seen some development opportunity and we're taking part on that. Some of the other property types that we've seen, industrial is quite interesting mainly in the 10 major markets, port type markets across the US.
[8:05] Rents have risen there. They haven't risen as much as in multifamily. There are opportunities for development in major ports like LA or Oakland or Houston. But there is an opportunity for rents to continue to grow there in our view.
Evan: [8:23] Let's have Brian [inaudible 08:24] at some of the other sectors. Brian, what else do you see in the other commercial sectors?
Brian: [8:28] Sure. I'm just talking about apartment, it's fascinating sector because you look nationally, it's very strong and then you look at markets that were covered earlier and softening a lot of where we are. The Northeast, the Mid Atlantic are soft. The Sun Delta's great.
[8:42] The Pacific Northwest is great. It's a very differential market by market, submarket by submarket story.
[8:48] We like the office sector particularly talking about millennials moving back downtown. There is a room to run in central business district offices and ways to think about that. If you look at the apartment market for instance, rents are well above where their previous peaks were. Affordability is being pushed. There are some risks there in terms of supply coming into it.
[9:12] If look at the typical office market in the country, you have rents that are 10 to 20 percent below where they were previous peaks. You have rents that are broadly too low to justify construction.
[9:24] You have a lot of these central cores in Manhattan or Boston where creative types are gravitating. We think that's really an opportunity that still has some room to run.
Jason: [9:36] I would also agree with that point. I would say that from our perspective, suburban office seems to have more opportunity today than central business district. Again, there's not one universal or one national market. It does vary from place to place.
Brian: [9:49] It's a great contrary.
Jason: [9:51] Yes, but I would say what stands out also, I believe, is hospitality. Part of that has almost more to do with capital flows and the fact that it's a little bit slower to return because I think other parts of the world hasn't viewed our business and travel clientele as being as firm a demand as it really has become and it's truly back.
[10:10] There hasn't been as quiet as much interest and there's still yield opportunities there. We think hotel has a nice runway ahead of it as well.
Scott: [10:17] Yeah, I would agree with that. Particularly the upper up scale and then the limited service. In particular urban and suburban markets. With regard to suburban office, I agree with your comments about CBD office.
[10:29] I like suburban office, but we have a tendency to be very careful in suburban office. We look for suburban CBDs, which goes back to the work, live, play.
Jason: [10:38] Downtown suburban.
Scott: [10:39] Right.
Brian: [10:40] So they're walkable, they're transit oriented.
Jason: [10:41] Right. Right. Exactly.
Brian: [10:43] Although there is, I think, a great case to be made, you know, everyone is very down on the suburbs today. It's that everyone wants to be downtown. That's just not the reality. In our view, CBDs will outperform suburban markets. I think they're oversold. The suburban markets are oversold.
[11:02] The challenge is you can get a very high yield in a suburban market and your total return starts there and falls, because you have a tough time keeping it leased. That's I think the challenge in the suburbs.
[11:12] The suburbs that we think probably make most sense are suburbs where when they grow, so markets where they grow. You can take an Atlanta or a Dallas. These are markets, they do have, certainly core downtowns, but when they grow, they grow in the Alpharettas of the world.
[11:26] That's when corporations start moving and that's where you see, I think, some opportunities. But it's a lot more of a tactical timing play than a for the ages play.
Scott: [11:34] Yeah, absolutely. Absolutely.
Jason: [11:35] You really have to be careful to avoid just pure commodity plays out in the suburbs.
Evan: [11:39] And what about the whole phenomenon working from home and never going to work and telecommuting? Is that scary?
Brian: [11:46] We've been talking about it for 20 years. I'd say the thing that we've seen most have an impact on office is not telecommuting, it's densification.
[11:56] It's that you have corporations that have really said let's stuff as many people into as little space as we possibly can. That really has been something where if you looked at office job growth versus how much space we have absorbed, we've under absorbed because of that in part. That's been a much bigger...
Evan: [12:15] Phenomenon...
Brian: [12:16] Story, than I think telecommuting.
Jason: [12:17] A recent survey, it used to be 250 square feet per employee, now it's down to about 170 for modern, open office. And that's what most companies are going to.
Brian: [12:25] And they're trying to get lower.
Jason: [12:26] That's right. That's right. And it seems to me that all of the lessons of the recession are still being held by those large corporate users. They learned how to, outsource.
[12:34] They learned how to use part time workers. And they've also learned how to be efficient in so many ways, including their office space.
Evan: [12:39] But have we reached sort of the maximum they can squeeze out of the space? Unless we sit on each other's shoulders, I mean, how many more people can we get in to one space?
Brian: [12:46] Well, you're preaching to the choir there personally. [laughter]
Evan: [12:50] You're on the side of a little more space for everybody. OK. Certainly.
Brian: [12:52] Yeah, I mean, what I think you find is interesting. You know, we talk about how little construction there is, for instance, in the office market.
[12:58] With older buildings, so if you think of Manhattan, a typical building was built maybe in the, you go along 6th Avenue, was built in the 60s maybe. Big floor plates that people are a little skittish of.
[13:12] But you also find that they don't have enough elevators or bathrooms to densify. So you have this interesting sort of true physical dilemma where corporations can't densify to the extent that they perhaps would like to. So you end up with some push back.
[13:25] What you also end up with, New York's a great example, where you have some pockets of new construction. So in your case out west at Hudson Yard, some downtown, where a corporation that wants to pay a little bit more in rent perhaps, is able to get space they can densify a little bit more. But the buildings actually have physical constraints on how dense they can actually get.
Scott: [13:47] It will be interesting to see how it evolves from here. The job creators have been the technology, energy, health care. Those types of sectors, if you will. And those types of sectors have absolutely densified.
[14:01] Financial is a little bit behind. We'll see if that particular user is able to adapt to the work, live, play densification collaborative space movement. It will be very interesting to see as time goes...whether it goes from 250 to 170 to 125 will be interesting.
Jason: [14:18] But obsolescence is a much bigger deal as well. Just have buildings that are falling out of inventory because they simply don't work any longer for the modern office.
Evan: [14:25] Sorry. Much as it's weird for me to say as a New Yorker, but what about the rest of the real world?
[14:30] Cities like Cincinnati or Saint Louis or others where there's not...New York isn't an unusual a city because of the international aspect of it all. But what about in those cities? Is there a glut of office space?
Scott: [14:43] I wouldn't say there's a glut, but I would actually say there's an opportunity. So in the sectors that we mentioned that are growing, there's still occupants, there's still occupancy increases, there's still rental increases.
[14:54] They might be smaller, but there's also buildings that are older that create an opportunity to potentially come in and modernize the space and create a core asset from what might not have started as a core asset.
[15:09] There are opportunities in these types of markets, in the CBD areas of some of those cities. To create core, or manufacture core, from a value add start.
Jason: [15:20] It depends on how far out on the spectrum you're willing to go. The definition of a primary market versus a secondary or tertiary is important here.
[15:27] We have a couple of holdings in one of our related funds that has, you know, Cleveland, Cincinnati and indeed Columbus. Their rents are actually still rolling down in certain instances.
[15:39] You are top of the market or you are class A landmark asset there, signed deals a number of years ago at very high rates. And unfortunately, the recession recovery has not impacted those markets as well as it has, Dallas or New York or other places. Right?
[15:54] It's a tougher argument to make, but I certainly believe there are certain areas. You have to be very careful, but you can find those opportunities.
Brian: [16:01] Yeah, I think, what I think you find for particularly institutional investors, is that the trade that's worked for the last 20 years has been, broadly, high quality major markets. And certainly if you're holding core investments.
[16:18] More and more markets increasingly have fallen off the radar screen. So that's, I think, an opportunity. But it has to be very carefully underwritten. It has to be the right type of property.
[16:30] But, there are jobs in other parts of America. And there are markets like Pittsburgh, for instance, that 10 years ago, or 15 years ago, you were saying wow, what's going to happen to Pittsburgh? And you can certainly see with health care, with tech, what's happened to the downtown.
[16:47] People want to live there again. That there's, selective creative opportunities and they're around the country and they're going to be higher yields than New York. But it certainly takes a lot of work to find them.
Evan: [16:58] You mentioned Brian, when institutions went on automatic pilot, bought a great office building and that was it before. What are they looking for now? What is of interest to them? What kinds of real estate investments are appealing?
Scott: [17:11] It depends on their legacy portfolio. It depends on their risk tolerance. We see institutions in the US and internationally still looking for yield from their investments. So we still see core.
[17:28] We still see opportunities in the US for core real estate to be attractive to investors. But some with risk tolerance are starting to move up the risk profile, if you will. More into the value add and some into the opportunistic space.
Evan: [17:43] Define what that is, for example. I think it's worth going over like what does opportunistic mean in value?
Scott: [17:49] Opportunistic is finding a situation where there might be an arbitrage. So finding a situation in which you might be able to take a piece of land that is all ready entitled, perhaps. Usually, institutional investors won't take a piece of land that's not entitled. It's got a plan. It's entitled.
Evan: [18:06] Entitled means that they can build something on it.
Scott: [18:08] Correct. Which has a plan which has a density already approved by the municipality. To go through the building and lease up process in that situation, the building development process, you can create quite a bit of value.
[18:21] You're taking on some construction risk. You're taking on the leasing risk, and then you're taking on the stabilization of the asset risk, all of which professional investors like ourselves can do.
[18:33] Development is really in the opportunistic space. Moving down that from there, value add would be an existing asset, normally, either with significant refurbishment requirements or a significant re tenanting or leasing requirement. It might be completely vacant. It might be completely vacant and need some significant work to it.
[18:57] You can also get into a fourth category, which would be between value add and core, which would be core plus.
[19:03] That might be a stabilized building that has a very close lease expiration, which you're willing to take that risk and re tenant that particular space in the future and make a little bit more from your investment to take that risk.
Evan: [19:14] You're saying the institutions are going up. Some of them are getting interested in taking a little more risk.
Scott: [19:20] Because the market's giving it to them. Because the market in the US is attractive, because there's wind in the sails, if you will. You need to be prudent. You need to be careful.
[19:30] You need to do your homework before you make an investment, obviously, in every situation. Yes, because the market's giving it to professional investors, some investors are willing to move up the risk profile.
[19:43] [crosstalk]
Jason: [19:44] I think the interesting thing is a lot of this also has to do with capital flow. There's so much capital seeking the safe harbor of the United States that they're, in some ways, in my opinion, being forced to look for more risk.
[19:55] If they want some kind of yield, they're just having to move beyond because there's so much competition for that. What would have been right on the fairway, the class A office building right along the coast in one of the four major markets in the country, it's not necessarily an option.
[20:07] Some other institution has probably just picked up that asset where they could deploy a significant amount of capital in one fell swoop. Now, you're looking at portfolios in other markets. You're inviting a little more risk for a value add play, which, I think, fortunately, all the economic signs seem to justify that kind of theory.
Brian: [20:22] It works, I think, in the US case. In, say, a European case, it's a lot tougher to execute. There is a portion it being forced a little bit up the risk spectrum and also working. You are seeing these interesting arbitrages to just in...
[20:39] There's a term that I think a lot of investors use, "Build a core." What that is is you go, "I don't want to buy an existing asset. I think that I'm not getting fully compensated, perhaps. I'll take a little bit of risk building it, but I'll hold it." It's a slightly different approach.
[20:54] What it's getting at is that in the apartment space, for instance, most apartment properties, virtually anywhere in the country, will trade for more than it costs to build. Replacement cost is a metric that real estate investors use.
[21:08] You can create some embedded value by building an asset like that. If you build it and stabilize it, meaning it's fully leased, you immediately create some value, and then you hold it.
[21:19] You've got a core holding that's modern, and you've got a little bit of extra boost at the front end. That's, I think, a between core and core plus value add. That's, I think, been a popular approach.
Evan: [21:31] Before, they might not have held it? You mean they would...
Brian: [21:32] As opposed to if you're a core holder, just buying and holding, that there are some more opportunities. Obsolescence creates some of that as well.
[21:42] What I'm able to buy may, in fact, not be something I think is competitive for the ages. I can build something, get a bit of an arbitrage, and I can ensure that the tenants are actually going to be here ten years from now.
Scott: [21:54] In particular, it's generally irreplaceable real estate. The location is so good that if you build it, it's a shame to build it, then realize the transaction, and then watch somebody else hold it for that period of time.
[22:09] There are two investment decisions involved, but the decision's made at the beginning of the process that we're going to build and hold.
Jason: [22:16] The construction risk, at least with the market so hot, at least early on, didn't feel so bad. Now, you're actually competing for subcontractors and that sort of thing.
[22:24] It's become a little more challenging to get things done on time, within budget, but it still has been a very attractive play and had to be because multifamily has been so hot.
Scott: [22:32] Absolutely.
Evan: [22:33] In terms of what institutions own in real estate, what percentage of their portfolios would you say is real estate? It's considered, I guess, the original alternative. Is it an alternative now, or is it just considered this is one of the things that we have to own in addition to equities and bonds?
Brian: [22:50] I'd say, in the '70s, really is when institutions said, "I'm moving," '60s and '70s, "from stocks and bonds to real estate." A typical institutional investor, a typical, say, pension fund, would hold 8 to 10 percent in real estate.
[23:06] Really, what institutions are doing today is going beyond real estate into other alternatives. It's infrastructure. It's timber. It's energy products. I'd say eight to ten percent is largely the allocation.
[23:21] If you looked at commercial real estate as a share of the US economy, it's somewhere around 12 to 13 percent, so that's not a particularly large underweight. I think that's where we've seen people shake out. Certainly, individuals don't have really any of that.
Scott: [23:37] Within that 8 to 10 percent, they may hold a relatively smaller portion in public equities to maintain some liquidity.
[23:47] Usually, institutional investors are attempting to get the benefits of private equity commercial real estate investment through whichever, diversification, another source of income for your portfolio, an inflation hedge, and sometimes, yield enhancement on the opportunistic side.
Evan: [24:04] Of course, they're less concerned about liquidity than the individual investor might be.
Scott: [24:07] Yeah, that's absolutely right.
Jason: [24:08] They're trying to capture that illiquidity premium
Scott: [24:09] That's right.
Jason: [24:10] ...that real estate delivers.
Scott: [24:11] Exactly.
Jason: [24:12] It is worth mentioning just the fact that the individual investor, I think, would be well served by looking at the institutional model. It's worked for so long now. It's proven.
[24:21] Your individual home that you occupy is not quite the same investment that stepping out and being a part of a REIT or other type vehicles that you might choose to participate in... [crosstalk]
Scott: [24:31] You're starting to see some of that. We're starting to see some of that in the defined contribution market. As we move from a defined benefit world into a defined contribution world, there are life cycle funds that will be able to invest into real estate periodically.
[24:44] Certainly, the public side, the public equity side, is the beneficiary initially, because there's a daily pricing mechanism. The private equity side of the industry has begun to solve the daily pricing.
[24:55] There are a number of vehicles in which you can daily price inside a life cycle, inside a defined contribution plan. Some retail investors can get access periodically, depending on who their 401K is with and whether or not they have real estate as an option, but we're seeing more of it.
Jason: [25:13] That's right. There are plenty of retail investors that have chosen the non traded REIT vehicle to actually get exposure to commercial real estate.
[25:21] What's rather telling is, just for example, one of our funds raised most of its capital from individual investors, yet I had a co investment partner that was one of the world's largest pension funds that joined right alongside within the same portfolio.
[25:35] Going side by side, into a Class A, good strategy...This happened to be within multifamily...seemed to make sense. On the one hand, the institution was partnering with someone who had ready capital that was provided when most institutions were not putting capital into the market.
[25:50] As we were in the depths of the recession, despite the fact that Freddie and Fannie were there, there were a number of institutions that still pulled back. The individual investor still wanted exposure.
[25:59] They were able to pair up with a partner that had capital during that time, and that individual investor got the comfort of being with the institution. It was a very nice marriage in that situation.
Evan: [26:06] What other ways can an individual, just to bring that up...How could they mimic the best of institutional world, given they have fewer choices? Perhaps they have different choices. I couldn't say fewer.
[26:18] While an institution can buy an office building directly or get a share in it, an individual can't do that. What should they do that would use the best practices of institutional real estate investing?
Scott: [26:30] It depends on the size of their wealth. Ultra high net worth folks that have family offices, they can invest into real estate like an institution. They are institutional investors, essentially.
[26:40] Smaller investors have to come through partnership vehicles. They can come through a master. They can come through a non traded REIT. They can come through a DC. Those are generally...
Jason: [26:51] Or public REITs, right? [crosstalk]
Jason: [26:52] ...exposure that way. It's a little different, much more exposed to the market, correlates much more with the market, which is not exactly what they're looking for.
Brian: [27:01] You get volatility, and you have correlations that are closer to financial or small cap stocks.
Scott: [27:05] It's a good way to go global, for sure.
Brian: [27:07] It is.
Scott: [27:08] In other words, a private investor of a lower size wealth may not have the opportunity to buy a real estate asset or even a partnership that's investing in Asia, that's investing in Europe.
[27:22] Through the REIT markets, the public markets, they can get that exposure, but it is more highly correlated, generally, with small cap stocks, so you have to look at the proportion of small cap stocks in your portfolio before you make that decision.
Brian: [27:35] I do think that what every advisor is working on is increasing ways to get retail investors to be able to get the benefits that institutions have gotten, which are diversification, which are lower volatility, which are yield enhancement.
[27:53] There's a fundamental mismatch in that we're offering daily liquidity for things that are not daily liquid. [laughter] [crosstalk]
Brian: [28:00] The structuring of that is something, so we've done that through a defined contribution, through a target date fund that gives daily liquidity, but the choice of allocation is usually held by a fund manager, not by an individual.
[28:15] It's very hard to make a mutual fund with true, ungated daily liquidity for investors and not hurt the other investors who are in there. I think that that is where the industry...The industry is moving toward vehicles that let individuals do what institutions have done.
Jason: [28:34] There are closed end funds that an individual investor could choose to participate in, which have pluses and minuses, and then even some niche investors are choosing Delaware statutory trusts.
[28:43] If they have an appreciated asset maybe sitting in their family for a number of years, they may sell, do a tax free exchange via the 1031 exchange opportunity, defer taxes, and find themselves into at least a diversified portfolio of some assets. That's also happening. [crosstalk]
Evan: [28:57] I was just going to say that, of course, liquidity, which comes up constantly...Is that liquidity isn't free and that the advantage of real estate is its illiquidity, which, of course, means...
[29:10] The analogy is if you're a homeowner, you can't sell your house in five seconds. It takes a little longer. It's the same kind of thing with an office building. You just don't sell it in two minutes.
[29:19] Let me bring up a point that Scott was talking about, that we should go into. It's a good segue into international. We are, as Americans, typically focused on America.
[29:29] What about international real estate opportunities? The world is booming, especially the emerging markets. Many of you are involved in international things. Tell us about the opportunities internationally.
Scott: [29:37] Sure. We are global. We have a big footprint in Europe. There are a number of opportunities in Europe that we're seeing at this point.
[29:46] I would say, with the baseball analogy, we're somewhere in the second, third, maybe the top of the fourth, but it's early days in capitulation with a lot of the non UK European banks. There's an opportunity there, but there's also already a lot of capital that's been raised to buy NPL portfolios off of the balance sheets.
Brian: [30:09] Loans that are going bad.
Scott: [30:11] Yeah, loans that have gone bad, that are non performing, NPL, non performing loans. It's a great investment, if you have large buckets of capital that you can point at it and you have the contacts with the bank.
[30:22] Downstream from that, a lot of those assets don't get attention. They don't get the capital that they require. They don't have good news money, which is tenant improvements, leasing commissions, and the like to re tenant a building.
[30:35] We think there's an opportunity downstream, as capitulation continues, for the value add opportunity to take place, where you're buying well located assets that need some love and attention, turning them into stabilized core asset overtime, and then sell it into the market.'
[30:52] In addition, we think because that value add play, if you will, exists, we think there will be additional mezzanine opportunities in the marketplace on the mezzanine debt. Not a first mortgage, but a second mortgage between the first mortgage and the equity.
[31:07] The yields on that have been, the spreads on that have come down recently because transaction volumes have been relatively low.
[31:15] As transaction volumes pick up, we have a theory that those spreads will start to blow out a little bit and there will be a continued opportunity in the mezzanine space across the European markets.
Evan: [31:26] You're talking specifically what countries?
Scott: [31:28] Well, we just bought a company in Germany. We're very bullish in Germany. We're still bullish on the UK. We've been doing light industrial and office redevelopment in the UK, in London specifically. Those are our two primary focuses at this point.
[31:45] We also have been focused on retail in some of the Nordic countries. There's an opportunity given some of the geopolitical situations and what that's done to retail spending in Finland, in Sweden.
[31:57] We're actually doing some development in Sweden on the retail side and we're focusing on expansion of our company into Madrid, Milan and Paris. We're really building out our footprint given the opportunity in Europe as we see it developing.
Brian: [32:14] I think in Europe the debate has been, do you stay in core countries and do riskier strategies, for instance?
[32:23] Do you stay in Germany, in the UK, but not do the absolute safest thing and get some yield that way? Or do you do a Madrid or a Milan or a Barcelona, is that the way to go?
[32:34] I think it just illustrates that much different than the US, there's still a restructuring opportunity through the debt and the equity space.
[32:43] Our main European focus has been on opportunistic, which is that there are broken capital structures that need to be reworked. That you have buildings that have not had capital that they need.
[32:56] Then eventually as corporate users come back they're going to want a new space that the previous owner didn't have the capital health with. Those are opportunities.
[33:06] It's ironic. People talked about the wall of debt in the US market, so there were a lot of refinancings that had to happen. The wall of debt has really had I think virtually no impact on equity pricing in terms of being a headwind.
[33:20] If you look in the European case, they really haven't fully solved, they really haven't solved any of the problem of the restructuring we've had to do in banks and real estate debt. That's going to go on for a while and I think that's an opportunity.
Jason: [33:34] Our most recent exposure in Europe has been central Europe, actually retail and logistics properties, which has been an interesting play. Setting aside geopolitical risk, it seems like it will probably work out fairly well.
[33:48] Then also interesting place in German office, which we like very much. Then I'll say on the other side of the globe in Australia, we think logistics and some housing place there actually have a lot of likes for now.
Brian: [34:00] The thing that I think I'm hearing a lot from investors is is there a way...We talk about core in the US. Core at some point in Europe.
[34:11] I think a lot of investors would like a way to have core in Asia and perhaps a pan, a global core strategy. We were talking earlier, certainly in Asia that's hard to put together.
[34:23] But I think that what we hear from a lot of people is, "I would like a diversified income producing global portfolio that you can give me." So I think putting together safe buckets of assets in the US, Europe and Asia.
Evan: [34:41] Where in Asia would they consider safe? Tokyo?
Brian: [34:43] Safe and non yielding, for the most part. But you would do Australia, you'd do Singapore, you'd do Hong Kong.
[34:54] I think the jury's perhaps out on whether you would consider mainland China. The extent to which you say their core, true core holdings in mainland China. That's I think up for debate. There will be, and I think people will start to add that.
[35:10] There's a lot of core real estate. It's just harder, you have to have local relationships and local offices, really, to get that to.
Scott: [35:19] But it's a key point, because Asia's hard to ignore. It's an emerging region. If you look at the investible universe, the institutional investible universe of real estate today, Asia is predicted by most researchers to double and or triple over the next 20 to 30 years.
[35:39] That makes it impossible to ignore in your portfolio construction with regard to a global real estate investor.
[35:47] It's an interesting market. I agree with everything that was said, but it's certainly an interesting place where you have to pay attention and study your options and be patient in order to get it right.
Evan: [36:01] What about the currency risk? The risk of that element of hedging it or not hedging it in terms of the return. How do you handle that?
Scott: [36:09] My view on that is institutional investors should look at currency as an asset class.
[36:16] Therefore when they're looking at real estate, when they're looking at fixed income and they're looking at global equities, publicly traded global equities, they should look at where they are based on their fundamental analysis and their fundamental portfolio construction.
[36:30] But they should also look at currency and say, "Where does that have exposure wise and opinion wise, where do we want to be?" At an overlay level...
Evan: [36:38] They can divorce the two.
Scott: [36:39] Across the portfolio, they should make their overweight and underweight on currency to get away from where they're invested on their asset classes.
Brian: [36:49] Absolutely. Our funds are unhedged, so we allow the institutions to decide how they want to handle that for that reason.
Jason: [36:59] We haven't been consistent in that way, I will say, because some of our international exposure was small within the portfolio.
[37:04] Again, we have had portfolios that have been dominated by individual investors. We've had some of those positions just trying to lock in so that the equity exposure is what they expected it would be. We rise or fall on purely the real estate from that protected position, if you will.
Evan: [37:20] We talked about this a little earlier. Internationally let's talk about areas you think where the growth will be. What's coming up over the next couple of years. They have their own economic issues to deal with in Europe, especially maybe going into another recession, or certainly not climbing out of the last one too well.
[37:41] What do you see as opportunities there, both in Europe and in Asia?
Scott: [37:49] I named a couple earlier in Europe. I think the one I didn't have an opportunity to speak about, we also like German office quite a bit. I would echo and agree with that. But hotels are quite interesting. It's a different structure.
[38:05] It's still the one day least, it's still a lot of operating leverage on the way up and a lot of operating leverage potentially on the way down if you get caught, so you have to be careful.
[38:13] There's a master lease structure that takes away some of the risk with the operators of hotels. If you look at situations like Greece, which still has a dire situation on its hands fiscally, and macroeconomically for that matter.
[38:31] But there have been quite a few investments in the resort type touristy hotels and that the tourist market is actually starting to come back in Greece, not surprisingly, because it's a beautiful country with economic problems. There's a contrarians play there to be made, for example.
[38:47] But generally we are still operating in the UK, in Germany, in the Nordics, and we're going to go into the southern periphery, but carefully and smart and try to make the money on the buy in the southern periphery countries.
Evan: [39:03] Do you see, sort of analogous, maybe, to what's happening in manufacturing in that in the past the idea of recessions came when there was overproduction and they had to layoff till the economy caught up.
[39:16] Real estate use to have cycles too of overbuilding and then speculation. It seems that forever reason, maybe you can go into it, you're the experts in this, that doesn't seem to be the case anymore.
[39:25] There's very little speculative just boom times where there's just empty office buildings hanging around.
Jason: [39:31] Certainly in the office market there is very little spec construction. If you looked at the last 50 years, we never had, certainly at this point in the cycle this little office construction. I'm going to be very positive on apartment construction but it's not speculative.
[39:44] Even in the industrial market, which has been strong, we have less construction at this point in the last cycle.
[39:50] I think that you have some more disciplined debt. I think it's harder to get financing for a lot of that, and I think equity investors have been chastened.
[40:00] I think that there were, to the extent that people did spec offices out you were typically doing this later cycle. You were approving a deal in 2007. You're delivering in 2009, which was not a pleasant thing to do.
[40:15] With long lead times what you find is, particularly in a market like the office market that hasn't come back so strongly that it's much harder now. There's much more reticence to go speculative. That's a good thing for the market, and that's I think what you're seeing.
Jason: [40:30] Then again, there is no national market, though. Market by market you can still find pockets where if all of the all buildings that have been announced actually delivered, you might have a real supply problem on your hands.
[40:41] It's still possible. Developers are I think well capitalized because there is so much capital chasing these opportunities. There really are. But relatively speaking, it's a very nice environment over the long haul for that.
Scott: [40:52] It's sector by sector, multi family there's a lot of capital available. Office wise there's less capital available. Offices take two to five years to deliver. Multi family takes one to two years to deliver.
Brian: [41:04] And a warehouse you can put up in nine months. [laughs]
Scott: [41:07] Nine minutes. The financing availability has been what has been driving that. The availability of development finance I guess post GFC, one burst, twice shy.
[41:23] However, we have looked at that as an opportunity. We have a large lending business. We have a large core mortgage business. We have a large alternative investment or high yield business.
[41:33] We have been making development loans in markets where we see good demographics, good tail winds from a job creation point of view and very good locations and very, very, very strong borrowers or sponsors of the projects of the projects.
Evan: [41:47] Even if those office buildings don't have tenants, you'll still loan then money.
Scott: [41:50] I didn't say that. [laughs]
Scott: [41:54] Usually some level of preleasing, particularly on office. Office is an interesting product sector, property sector in that the performance history of office has the largest standard deviation or volatility over time.
[42:10] It's very difficult to be a tactical office investor, so that's why you see most institutional investors gravitate toward gateway cities. There's better demographics there, there's better liquidity there and the like, so if it's a safer office bet, so to speak.
[42:27] There will be pre leasing requirements on any development, period, but particularly in the office space.
Brian: [42:34] From the equity perspective, because there has been so little building, we've actually been doing office construction in select markets, taking advantage of the fact that there isn't much. That people want to densify and they want modern space, but they've been in very select markets.
[42:48] They've been in Manhattan, San Francisco is another example. Early stage in Washington, DC. Very few select markets that we've done development in.
[43:01] Part of what you're seeing is there are some markets where you have the arbitrage you see in the apartment markets. So in San Francisco, for instance, which is a very heated office.
[43:09] It's a very heated everything market, really. But we know, for instance, that we can build an office building at $650 a square foot and once done you can sell it for 850 a square foot very easily. There is that delta right there.
[43:25] You do have to least it, though, so you have to pick the right market. It's a great theory as long as you can actually lease it.
Jason: [43:31] Just like Scott was saying, we had a pretty significant mezzanine program specifically multi family development.
[43:37] I think that when it feels as good with the demographics the way that they were for that particular property type, you can feel confident that you're part of a wave that probably hasn't gone out too far yet.
[43:49] Now retail and some others, a different feeling there. But I do believe that we're not nearly in the same place we were when there were tax incentives and other non real estate driven motivations for supply to be added or other disincentives where too much exposure was created.
Brian: [44:08] You mentioned retail. Retail is interesting as well. That just like we don't have a national market, we don't have a national retail market, and we don't have a single market.
[44:16] Everyone talks about the Internet destroying retail, when you talk about development.
[44:21] One of the things that we're very bullish on is the high end mall space. We said, well gee, that's people are all doing stuff online.
[44:29] What you find is that higher end malls have done very well and that what they do is they increasingly transform into delivery mechanisms for experiences and services and restaurants.
[44:40] We've actually done a lot of retail construction, but not of new retail centers. But of taking existing malls and adding lifestyle and service components to them.
Evan: [44:53] Were they already premium malls and they just made them more premium? [crosstalk]
Brian: [44:56] You're able to do that, so you're able to upscale the retailers, that's one thing. But you're also able to increase stay times by saying, "I'm going to have niche restaurants. I'm going to have a movie theater. Here's why. I'm going to have a retailer that lets you try out the faucets, the high end faucets that you want and you'll actually be able to get the water to come out." It's those sorts of things.
Evan: [45:20] A Tesla dealership.
Brian: [45:21] When you do a mall, so you have two ways to report sales. You have to report them ex Apple and now ex Tesla. [laughter]
Brian: [45:30] Because Tesla sales are the so large that the per square foot numbers get skewed. We're very much, we don't like the big box power center space. That is I think what the Internet kills, that commodity retail. But we're very bullish on high end malls, particularly ones where you can reinvest in, make them more experience.
Scott: [45:51] I would agree with that. We also see necessity retail as very interesting at this point in the cycle.
Evan: [45:55] What's that?
Scott: [45:56] It's shopping centers, grocery, so to speak. There are opportunities to come in in certain situations. As long as there's not too much in line space, in line or the non anchor, non grocery anchor tenants that are in line next to them.
[46:17] As long as there's not too much of that, based on the population, the income, and the area, there could be opportunities to create synergies and almost make it a lifestyle, make it more experiential and a lifestyle opportunity. We have done that as well, and I agree that retail is interesting.
[46:35] Retail has been the slowest to recover out of the four primary food groups. It is an interesting opportunity in the core space, in the value add space, and maybe in the opportunistic space. But I don't think we need a lot more malls [inaudible 46:47] .
Jason: [46:49] One part that hasn't really lagged though is single tenant net lease retail. That has been on fire for a while.
[46:55] We have a significant demand for that within our investor base, so we have had to work very hard to get ahead of developers and others. Trying to get ahead of retailers where they want to be so we can partner with developers to be there on time when it completes so we have some product to deliver for that audience.
[47:10] You have to be very careful in that part of the retail sector.
Evan: [47:14] What's an example of that?
Jason: [47:16] A CVS or a Walgreen's might be a good example of a single tenant net least retail play.
[47:21] A long term lease backed by credit that, especially, again, an unsophisticated investor or institutions that are able to cobble together enough a large enough portfolio of it may have some interest in that exposure to that credit.
Evan: [47:34] This is purely anecdotal, but you're here so I'll ask you all this. There seems to be an explosion of drug stores all over the place. Is that flooded? Is it because of the health insurance stuff? There's like a drug store on every corner, practically.
Jason: [47:46] Part of it I will say is also there's ready capital to build those. Walgreens, CVS and others know that they'll have no trouble not having that real estate exposure because someone will be there waiting to buy that once that lease is signed.
[47:58] I also think that the consumer has changed their demand. They get it online and they get it from Amazon immediately. They want to have access to all of those necessities immediately, and that's why they have to be on all the corners.
Scott: [48:11] Some of the drug stores you might be seeing might be smaller footprint where you can get to a neighborhood, you can get to a high density neighborhood, so it's a quicker opportunity to shop. Particularly in communities likes Manhattan.
Brian: [48:25] The other thing that a lot of drug stores are doing is more service delivery. This is a theme. You go to the drug store, you get a flu shot. You go to the drug store, there's a doc in a box, so you can actually get healthcare delivery at drug stores.
[48:38] I think that's the theme. Small footprint, more service delivery, more convenience to being close to where you live.
Evan: [48:46] We're reaching the top of the hour, so let's get some takeaways. What should institutional investors and some retail investors who are watching and advisors who want to know about real estate, what should they come away with knowing?
Scott: [48:58] We're at a unique point in the cycle, I think. In interest rates matter, but they may actually help real estate investment as opposed to hurt it. There's a global opportunity. US rolling into Europe, rolling into Asia, rolling into emerging markets as the expansion develops.
Evan: [49:18] Brian.
Brian: [49:19] Real estate I think is, in 2010 it was cheap. It was an obvious place to be and you were going to get I think unusually high returns.
[49:29] I think today you can buy good quality real estate or funds with good quality real estate, and with a little bit of leverage I think you can expect that if you look back over 10 years you will have earned a seven or eight percent return. That's what real estate should really be giving you. I think that that is a good, safe starting place for people.
[49:48] I think that globally there are a lot of opportunities, and there are a lot of opportunities in the US. The extent to which we have growth means that there are lease up opportunities, there's opportunity for limited development that I think are perhaps unappreciated that you can do right here.
[50:04] I think the US space from the levered core perspective feels pretty good. I think taking a little bit of risk I think feels even better right now.
Evan: [50:10] Jason.
Jason: [50:12] I think that it's important, sponsorship matters. I think that you have professional real estate investors sitting around this table that institutions would be comfortable talking through and understanding their strategies.
[50:22] I think that competition is fierce for the products that are out there or making the right decisions on development properties. It matters, it really, really does.
[50:30] I think that an evaluation of the marketplace will show plenty of opportunities, but you have to make sure that the opportunities are matched with the right group.
[50:38] From my perspective, having a pipeline of transactions that you can execute on, you can deliver to them will lead towards the right outcomes. I think that's the critical takeaway.
Evan: [50:48] We'll send everybody's interest to you three guys. Gentleman, thank you very much for your insights on real estate. Thank you for being here with us in this master class. For Asset.tv, this is Evan Cooper.
Scott: [51:01] Thank you for having us.
Jason: [51:02] Thank you.
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