Ever Wonder What $114 Billion of Investable Private Equity Real Estate is Thinking? I Went to a Conference in New York to Find Out. Part II of II

I know this isn't New York. It's a metaphor! Source: stolen from our friends at Butler Photography.

I know this isn’t New York. It’s a metaphor! Source: stolen from our friends at Butler Photography.


This is Part II of a conference summary. The first one was titled “The Cycle is Trying to Age Gracefully” or “What the Heck do I do with my Money Now?” Part I of II

There are a lot of investment observations in this long blog, almost all made by other people. I am not making any investment recommendations here, and have no financial interest in the success or failure of any of these speakers, though I may in the future, and many of the speakers are friends, or professional acquaintances.

Note: many quotes are approximate and may even qualify as alternative facts.

There was so much good stuff here that I cut it into parts. Keynote in Part I, rest of speakers right here.

After the keynote speaker, the panelists covered a very wide range of subjects and views that I have mashed into a few categories.

Housing (as opposed to just multifamily) is looking good because (i) jobs and population continue to grow but total annual new supply (including single-family houses) is down 30%, (ii) homeownership is now 62% vs. 69% at past peak, so there is more demand for multifamily, and (iii) broadening the definition to include senior housing – one speaker claimed this is the first year that there are more grandparents than grandkids. Another claimed 80% of the senior housing stock is more than 10 years old (which I don’t doubt. I was part of the crowd that got pulled into this product way too early almost twenty years ago).

Buy B multi near good schools where people who can’t afford to buy can instead rent, or multifamily where there is a wide rent gap between A and B, or buy new product in great markets from opportunity funds that have to exit because they are out of time (so apparently LP reluctance to vote to extend fund lives has replaced interest rates as the shot clock in institutional real estate, see Jim Grant discussion in Part I)

But the multifamily view that was more down the center of the fairway was delivered by a multifamily investment manager with hundreds of thousands of units: nationally, annual rent growth is slowing: high-2’s% to 3% expected in 2017 following 3.7% in 2016, with multifamily supply holding steady in 2016 and ‘17 at 350,000 – 375,000 units, and with single family still way below peak. Rent growth can be expected to accelerate again a few years out as sparse construction lending crimps supply growth, and after working through excess supply in certain markets: Houston has a supply demand imbalance, while San Francisco and New York have supply problems.

(After hearing that discussion I realized New York is a pretty good microcosm of the national picture, but more extreme: certain hypergrowth submarkets in Queens and Brooklyn look like crane-farms in mainland China during the boom-times and some prognosticators are a bit negative as a result; however, some researchers forget that (a) permits and press-releases do not equal starts and (b) construction is effectively illegal in New York and permitted on an exception basis, both exacerbated by effective withdrawal of construction debt from the NYC market – as in many other markets around the country – plus City vs. State jostling over 421(a), so in a few years New York may see something close to zero multifamily deliveries.)

General Angst focused on:
– “overcrowded” core
– net leases are tricky because of interest rates
– rising rates in general (Rates were at 2.4% at the time of the conference following a pretty steep run-up, and are still 2.4% as of this writing.)
– value-add
– end of cycle was cited frequently
– and investment management fees.

More than one investor announced they were net sellers in 2016, but some were active buyers and plan to be again in 2017. Investor concerns were further exacerbated by the reported $225 billion of dry powder in private equity real estate vehicles. Some of this overhang is due to an expansion of the definition of a fund: it includes core funds as well as private debt funds so like-to-like comparisons over time are tough.

Investment Vehicles Investing directly rather than through funds to reduce fees

Ex-US Investing Some like Brazil. Emerging market is where the growth is. But another investor felt that someone other than investors is capturing the growth: with government debt at 12%, core real estate has to return 20%, but that’s equivalent to an 8% on a risk adjusted basis because of country risk and interest rate differential, so stay home.

On Europe, there are still opportunities there because resolutions are slower there than here (the keynote speaker’s shot-clock analogy notwithstanding). A large fund manager pointed out that Europe has €2 trillion of “core” non-performing loans and banks will be selling €50-100 billion a year. European focus has shifted from Germany and the UK 3-4 years ago to Spain, especially addressing urban housing shortages and broken residential deals. People are also getting excited about Italy, but a foreclosure can take six years there. UK and London will face uncertainty for three to four years because of Brexit, which will make leasing tough because corporate occupiers hate uncertainty (though another speaker mentioned that he had just signed two leases in London). Another speaker likes UK industrial, but not office. On pros and cons of Europe, one manager active there concluded: “The cycle is trying to age gracefully.”

On the other hand one large manager ($1B Fund) has only 4% outside the US in his debt fund, and only 25% in his equity fund in spite of a 50% ex-US cap in his funds: “US is still the best risk-adjusted return.” Another investor comforted the audience that nationalism is worse in Europe, and that the US “is the best house on a bad block” (meaning planet earth???)

Office Two panelists agreed that suburban office is a value trap: obsolete product (and locations and access?), short leases, no growth. {one thing I think about is that the definition of “urban” is expanding with improved transport, increased safety (despite our President’s alternative stats), spread of non-Starbucks coffee venues and Whole Foods, and even people’s willingness to think of new places as urban because classic urban is just too expensive: so Tysons Corner is to DC what Brooklyn & Queens are to Manhattan – we called them “Bridge and Tunnel” not that long ago — and what Raleigh is to New York. Not saying these speakers are wrong, but need to think about definitions.}

Retail Pretty broad agreement that future retail is going to be unrecognizable because of e-commerce, and that it is basically game over for Class B malls. A particularly colorful image was the “sucking squid” invoked by one speaker when referring to Amazon, which he said would do to Wal-Mart what Wal-Mart did to the rest of retail. Investors like grocery-anchored retail. Some brick and mortar retailers are adapting: half of William Sonoma’s sales are on-line, and that starts early when couples register for their wedding gifts. Counterintuitively, brick and mortar sales are increasing for books made of paper, cardboard, and thread – and for records made of vinyl. Traditional retail locations are getting new uses: everything from nail salons, haircuts, food, and movies to showrooms for Sonos and Teslas (retail use reflecting our increasingly unequal distribution of disposable income and wealth). One hopeful note is that these evolving users need a lot of space: it takes 1.2mm sf of real estate to generate $1 billion in online sales, but three times that much for service retail. The supply chain is becoming more like a permeable wall. As the differences between industrial and retail start to blur, percentage rent may become a thing of the past as actual point of sale becomes impossible to determine (Store? Showroom? Phone? All three?).

And boring old hinterland Industrial is getting downright edgy, techy, and urban: Industrial is now competing with other property types for infill land in urban centers, both as the last way station for last mile delivery and because so many alternative uses are targeting former warehouses.

Meanwhile, getting away from urban industrial: ever wonder what it costs a drone to make a rural delivery? We heard 5 cents a mile, which gives me the opportunity to refer you to the recently published Berkshire Hathaway annual report, in which Buffett reminds us that his railroad (BNSF) had revenue in 2016 of 3 cents per ton-mile, which sets up a pretty interesting question about whether we define progress as seeking increased efficiency: BNSF can move a literal ton of goods 10 miles for all of 25 cents (factoring in a profit margin). Assuming a drone could safely handle 5lbs at a time,it would have to make 400 such trips (800 of course since it is going back and forth) at a total cost of $200 to move the same ton 10 miles. Score: Buffett 1, Bezos 0. Just sayin’. (On the other hand, the drone can do it in 30 minutes, the train…..? On the other other hand, if the trip is eleven miles, or the package weighs six pounds…..)

Risk Profile Now Value add has to show value creation in one year, not two or three, which is a change for that panelist from just 18-24 months ago. Core + may be best if we are at the end of the cycle and rates are rising

Debt as an investment and a business Debt was a popular investment option. Repealing Dodd-Frank is not a threat to private equity debt funds, said more than one manager of such funds. A later panelist cautioned that investors in leveraged debt funds might not fully understand the risks they are taking. Other issues are regulatory change and the after-loss track record. But others like the equity-like returns in a defensive strategy.

The Rest One speaker likes life sciences office. Here’s a link to a public company that has been doing this for a long time if you want to learn more about it, or just invest (NOT a recommendation!!!! I haven’t looked at this company in years.}. One of my former employers was an early indirect backer. Downturn may be less severe in certain idiosyncratic demographic-driven property types like student housing and medical office. But another panelist pointed out that these strategies are necessarily a small part of an overall institutional real estate portfolio, which in turn is a small part of the overall institutional multiasset portfolio… and therefore may not be worth the brain damage.

Many investment managers would benefit from that full-field view of an institutional portfolio that many institutional investors are always considering.

Here is a last link to Part I.

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