Platt dives into factors that may be causing certain sectors to either suffer or survive this crisis as well as the ways these industries may be able to adapt. Why is commercial real estate experiencing a hit while data centers thrive? How may federal monetary policy be helping or hurting these sectors? This and more in this episode of Non-Beta Alpha.
Ryan Morfin: Welcome to NON-BETA ALPHA. I’m Ryan Morfin. On today’s episode, we have Russell Platt, the CEO and Founder of Forum Partners, a global real estate firm that invests in operating companies and property companies globally. He’s here today to tell us about the future outlook of global real estate post the COVID crisis. This is NON-BETA ALPHA. Russell, welcome to the show. Thanks for joining us.
Russell Platt: Thanks, Ryan. Good to be here.
Ryan Morfin: We know you’re calling in from London and we appreciate your time. Wanted to pick your brain about what the global real estate market, where it was headed prior to this exogenous shock, and what’s happening now. Would love to hear your perspective.
Russell Platt: Good. Thanks. There’s a lot to say. Just set the context, maybe set the table for a minute. If we go back to late 2018, early 2019, the recovery in real estate and the economy in general was pretty long in its tooth. I think we can all agree with that. We also saw a pattern of interest rate rises, particularly in the US and also the Fed, simultaneously, beginning to shrink the money supply by burning off that big portfolio of treasuries and other assets that have been accumulated during the GFC. That was beginning to put some pressure on real estate, because cost of funding is absolutely essential in our industry and as well, cap rates are the initial yields that an investor earns on every dollar invested in real estate, those yields were coming down as well. That was really compressing the spread between the return on investment and the cost of funding.
Then we got to the latter half of 2019 and the Fed begins to ease for reasons that, I think, we were well aware of and, actually, we began to see just a little bit of a rebound in the property market. Things actually, coming into the end of 2019, were quite good. Demand was good. Supply in terms of new construction was muted, except for a few areas, high-end residential in San Francisco, in New York, et cetera. But otherwise, conditions looked pretty good.
Then we had a massive demand shock. What’s interesting about our business is, in the old days, and I am old enough to remember this, problems in real estate began on the supply side. Simply, there was too much capital into the industry, we had too much building access to the demands for housing or for commercial assets, and that caused a shock, and that shock rippled through the banking system and, therefore, from the banking system into the rest of the industry.
The last cycle, we had a bit of overbuilding, certainly in residential but not broadly in commercial assets, and it’s really a demand shock. This time, it is purely a demand shock. This has nothing to do with some exceptions which we can talk about with supply. It’s purely about a collapse in demand, we hope one that is temporary and one that’s offset by government relief or stimulus, but nonetheless, it’s had a pretty sharp impact. The impacts have been very diverged across geographies but, more importantly, across property types. It’s leading to a fascinating situation if one were simply an academic but, for us as investors as well, an opportunity to reposition and pivot towards the opportunities that are emerging as a consequence of this whole thing.
Ryan Morfin: I know commercial real estate is one of those asset classes where short-term volatility doesn’t really impact the cash flow streams because they’re long-dated in nature, like the debt 10-year debt, typically long-term leases. Typically, there’s credit on the leases so they’ll typically not default on the rent often. But as we start to see the short-term volatility in this demand shock turn into earnings issues, this next quarter, we have earnings season, I’m sure there’s going to be tremendous downward pressure on public company earnings. Some estimates, over 20% to 30% of GDP will be reduced in this quarter. How are property companies preparing for this, if there’s anything to prepare for, a weakening credit market?
Russell Platt: The way we look at the business is to think about a matrix. There are two axes that’s called the vertical axis, the sensitivity of a particular sector within the real estate business to broader economic growth. At the upper end of the axis, you have a high sensitivity to economic growth, in other words, it’s very cyclical, and at the low end, you’ve got a low sensitivity to economic growth. It’s more of a secular demand driver.
Then another axis would be a horizontal axis, and that is the intensity or the impact of COVID on that particular property type. On the left-hand side, you would have fairly low intensity. On the right-hand side, you’d have maximum intensity. Again, the upper right-hand quadrant is where you’ve got the biggest impact, economically sensitive and COVID sensitive. The lower left-hand quadrant by contrast would be low economic sensitivity, low COVID sensitivity.
Let’s talk about how things are shaking out. That upper right-hand quadrant, obviously, that’s the one that is really getting hit fully with the storm from the coronavirus. At the very apex of that would be hotels. I was speaking to a fund manager the other day who has four hotels, New York, Chicago, San Francisco, and LA, so very business-focused, very conference-focused. He said his portfolio went from 81% occupied on average on the first of March to zero on the 31st of March. That’s high beta. Bad for corona, and hotels also get on in terms of the economic impact as well.
Not quite as high up but certainly in the same quadrant would be retail. I’ve heard from companies that we’re working with and, anecdotally, through others that we’ve been speaking to, that rent collections for this current month will run in the range of 10% to maybe 20%, 25%. That is an incredible hit to cash flow for owners of shopping centers and malls. Obviously, those shopping centers that are anchored by grocery stores and where they drive most of their income there will do better. But remember, most shopping centers make most of their income from things like hair salons, services, food delivery. A lot of those are shuttered right now. Those are small businesses that may not come back.
The grocery stores are fantastic but they don’t pay much rent. They pay a fairly low rent per square foot. Just because the Whole Foods or the Krogers or Albertsons is open doesn’t mean the shopping center is doing well. You go to the malls. What I found interesting in my discussion just today was that the national chains, that oftentimes are the backbone of these regional malls, have sent out a directive that they will not pay any rent anywhere, no rent anywhere. It’s ironically the local shops and the regional shops in the malls that historically have been viewed as the poorest credits, they’re actually the only ones paying the rent. Because for them, this is mission-critical space. They need to have it. But the big national stores are simply saying, “We’re not going to pay it all and we’ll sort it out in the end.” Bad news there. We’ll talk about maybe the silver lining in a minute.
At the other far end on that lower left quadrant, low COVID sensitivity, low economic sensitivity. You’ve got things like cell towers. You’ve got things like data centers. Those all look very good. Great secular growth. In fact, they’re probably seeing more demand right now for Internet connectivity than they were beforehand, and ecommerce is clearly a big driver there as well. Then somewhere in the middle, well again, more towards that left quadrant but not quite as good, are industrial warehouses. Obviously, very important in driving the fulfillment for the ecommerce business, although there’s clearly a prioritization around some types of deliveries like food over beverages, food over durable goods which are coming much more slowly. We hear, again, from our two portfolio companies there that they’ve had virtually complete rent collection. They’ve had one or two folks who’ve been opportunistic.
Then somewhere in the middle, we’ve got office and multifamily or rental residential. Office generate longer leases. If they can stay open, they’re getting their rent collected. So far, first part of April seems pretty good for our office portfolio. Multifamily’s an interesting thing. On the one hand, it is absolutely the essential service today in the residential businesses. As you know, we’re all being asked to work from home, unless we have an essential service to provide. Therefore, for those who can work from home, home is now the office and it’s also the sole area of entertainment and the place, of course, where we put our head down at night for sleep.
The problem is some communities have said, “We’ll put a stop to foreclosures and evictions.” In those jurisdictions, New York would be certainly on top of that list, there’s an opportunity for those who can afford to pay but simply don’t want to pay to skip out for a month or two on rent and, eventually, this will catch up. This will be dealt with a broad written moratorium. The place where I’d draw contrast is over the past couple of years, there have been two or three niches within the multifamily area which have become quite popular and, ironically, all three of those have really suffered.
One is workforce housing, so we’re talking about renting to folks that are really the working class folks that might be at the type of establishments like restaurants or bars or service areas which are now shuttered, and they are living paycheck to paycheck, call it that type of housing are suffering. Second would be microliving. By that, I mean places where typically young folks, folks that are zero to five or six years out of college, can live together in proximity with others of their contemporaries. They might share living space. They might share kitchens. Those types of areas are really badly hit because of the distancing issues and they’re not typically family members. Those folks have now moved home.
The third is the area that’s probably been the strongest subsector within residential over the past few years, and that’s student housing. Student housing is an asset class that really is coming to its own as an institutional area for investment over the past decade, certainly here in the US. It was emerging as a investable asset class for pension funds in Europe, particularly in the UK and, to a lesser extent, in Asia. Student housing, of course, has been decimated.
Those students have now gone home, unless they’re unable to really live at home, and that has led to a dramatic fall in rent collections among student housing operators. Many have had to offer rebates to extend if they had year-long contracts and exactly how they address the return to school in North America, in particular in September, is one that’s going to be very, very tricky. Student housing has gone from king to pawn in literally the last 45 days.
Ryan Morfin: That’s all interesting. Do you think that there’s going to be a return to school in the fall from the student housing companies you’re talking about? I know they’re optimistically talking about that, but do you think that’s an actuality?
Russell Platt: It’s a $64,000 question, and for the folks that are in that business, it’s a $64 billion question no doubt. I’ll just tell you, anecdotally, we received notice from my son’s college a couple days ago that while they intend to start in September, they are making contingency plan, really reflecting two things. The first is will they be able to teach on campus or not and, clearly, to the extent they can’t, schools are going to face a real issue around tuitions and collections. That’s absolutely on the on the table.
The second is that colleges have suffered the most dramatic fall in endowments, probably on record, faster in terms of decline in valuations, certainly in the GFC, and that put a big dent into the wallets of the major institutions. Those that were already on the cusp, I think, are in bigger trouble. I go back now a year to a conversation I had with a major student apartment owner and operator, and he had already begun to pair his portfolio of properties in what we’ll call tier-two and certainly tier-three schools. What he was particularly concerned about is schools have become increasingly dependent upon admissions from international students because they all typically pay a fuller ride, less access, if any, to financial aid than the domestic students.
Then you can imagine what’s happening now. With the clamp down on tourism and inbound traffic from Asia, which was the biggest single driver of this international student demand, it’s going to be very problematic for not only those residential halls that depended upon cash paying, full rent paying international students, but also for those schools that have become dependent upon that as a source of their financial viability. It’s going to become a time for real selectivity, and out of that will come some very interesting buying opportunities, no doubt, but I think that the shakeout there is one that has another chapter or two to be written.
Ryan Morfin: That’s fascinating. You’ve been part of these conversations with boards of public companies in the past. How does a large national company make a decision saying, “We’re just going to default on our rent obligations holistically across the country”? Because they have good legal departments and they can fight the fight in court, but that’s going to put some pressure on some landlords that maybe don’t have the wherewithal or the rent roll to survive that type of pressure.
Russell Platt: Yeah. I guess I’d put it in two columns here. One is what’s the extent to which the broader federal response and, here, I think, not only of the fiscal response but importantly of the monetary response. To what extent will that bridge us to a period of greater normalcy, and normalcy should be put in quotation marks because we don’t really know what the new normal is going to look like. We hear about this $2.3 trillion plan from the Federal Reserve is now including basically a laundry list of assets that the Feds can buy.
As Jerome Powell said the other day, basically, they can do whatever they want. They can buy literally whatever they want and, for the first time, we see the US Federal Reserve buying equities in the form of ETFs. Japan did that 10 or 20 years ago and, at the time, we were horrified that the stock market would be supported. But in fact, Hong Kong did that not so long ago in the last crisis. Japan did it. Now we’re doing it. We’re also seeing CMBS on the menu, and exactly how that’s implemented, through what routes they do that, and how broadly based that is is something that we need to see, but that is clearly important. At some point, we need something systemic done just to simply lock in place existing financial relationships.
I had a conversation, I shared I think a little bit of this with you, earlier today with one of my portfolio companies. He said if he had access to his business interruption insurance, if that now can be deemed applicable to the current COVID pandemic, then all of his properties and his local operations will be fine. Now it would pose a systemic crisis for the insurance company. In some ways, what you’d like to see is the Feds simply say we’ll underwrite the insurance industry, allow them to conduct the role for which they’re meant to play, which is helping businesses through disasters, business interruption of all sorts, understand that this is a government mandated disaster and deal with it that way.
Ryan Morfin: We had TRIA back in 2001, so this is not an idea that is too farfetched.
Russell Platt: No, absolutely. We’ve done this thing before as a society. Obviously, the political machinery, whether it’s regulatory or in terms of spending moves slower than we’d like, some certainly slower than the new cycle but we are still only in terms of the impact on the US. Obviously, globally this started as early as December or some folks are suggesting even earlier. But in terms of the US impact, it really has only been the last 30 to 45 days. We’re not that far into it.
I think the second thing, and this is a bit trickier to understand, is the extent to which this will allow tenants to take decisions that might have already been in the works. I think back to our discussion, Ryan, about the national chains that are simply saying, “We got to stop paying rent anywhere.” Then once the fog lifts, they can step back and say, “Okay, which installations for us, which stores, which outlets were really vital to our franchise? Which ones had the foot traffic and the profitability to really work?” This could be in some ways, for them, a golden jubilee where they get to write back almost as if they would in a judicial bankruptcy or foreclosure, those assets that are no longer relevant.
I think the same could happen in other sectors. Clearly, there’s a lot of discussion about what happens in the office sector. It’s fascinating, if you think about the two key trends in the office business over the past let’s call it half a dozen years, Ryan, there’ve really been two. One has been what we call densification, the reduction in the amount of square feet that each employee enjoys in his or her place of work. That number has come down from 150 to 200 square feet per employee. In fact, if you go back 20, 30 years ago, it was 300 to 350. That number come down closer to 100, 110 square feet per person. We are packed very closely.
The other trend was sharing. It was the whole sharing economy. Uber, Lyft, Airbnb, and we work in other shared office services like that where we really pack people in like sardines, but we gave them flexible, cool, if you will, interesting, common space to share with other tenants or co-workers. I think we’re certainly going to see a dramatic shift in the shared office sector. Again, speaking to a peer of mine in the asset management business, his shared office tenants provided zero collections for April one, zero. Not a single one paid, and this is a large portfolio. I think they’re going through a state of shock there.
On the one hand there, they can’t ensure compliance in terms of safety, that they’re safe environments in which to work. Secondly, their tenants are, by and large, small, mid-sized enterprises, those that are targeted for relief under the Payroll Protection Plan but who haven’t yet gotten the benefit of that because the dollars remain clogged in the system. That’s big. That’s a major change. I certainly expect to see someone like WeWork with a withdrawal support from [inaudible 00:22:36] really hit the wall here pretty soon.
The second is this densification, and we clearly think there’ll be a change there. People are going to demand some level of social distancing, so whether that means, as a number of companies have seen, that we put people in shifts and shift A comes in on odd days and shift B comes on even days or whatever the case may be, or we simply begin to spread those cubicles out further apart or people begin to drift back into their own offices so they have their own space where they can have compliance around the safety and security of that space. Either or both may happen and it will have profound implications for corporate users, but it could actually help office landlords. That’s something we’re discussing with our portfolio companies in that arena.
Ryan Morfin: That’s fascinating. Yeah. It seems that WeWork is going to have to convince people it’s safe and that they’re doing something above and beyond what was perceived as normal in the past. One question.
Russell Platt: One of our portfolio companies is focused in the facilities arena. It’s basically cleaning, maintenance, modest capex. One of the new services we’ve rolled out is disinfection, with certification of those who are doing the work so they’re properly licensed and compliance so that we can actually ensure and demonstrate to a landlord that, in fact, certain services, particularly those that are high touch, having them cleaned. We’re now working with two nationwide vendors of cleaning solutions to find a way to deliver those in real-time so that landlords can ensure tenants when we do begin to open up for work, whether it’s in two weeks or two months, that those facilities, those mission-critical facilities are actually safe in which to carry on vital work.
Ryan Morfin: I guess one question back to retail is that even though some of the national retailers are saying, “We’re done paying rent until we get certainty here,” is this not going to … The only retail that’s continuously working right now is essential retail, grocery retail, Costco, and all the major grocers. Is this going to give them a lot more leverage, do you think, in the next set of rents conversations when they renew rents, that they were the only ones paying during something like this because-
Russell Platt: Yeah. It’s an interesting question. As it is, typically, those firms operate on very low margins. They depend upon volume to make money. They make money typically not on durable goods, but more on the fresh produce, meat, fish, veg, fruits, et cetera. There’s not a whole lot of room to take those rents down, frankly. Perhaps they’ll get some adjustments to covenants. But what’s interesting, at least in this immediate maelstrom that we’re in and, again, the situation, no doubt, is going to be quite a bit different in three months and we’ll look back and draw some conclusions, is that the supply chain for fresh food is pretty fragile. It’s difficult and it may become more difficult as we go into the spring and summer season.
I was speaking to someone who’s a business partner and he also was a farmer, and he said there’s a critical shortage of farm workers unavailable to pick fruits and veg, which if you leave them there for too long on the farm will rot. He said he can’t get labor in right now because of social distancing to actually pick his crops. That is a potential catastrophe in the making. On the other hand, what’s interesting, of course, about the last few weeks and I think the hysteria is abating.
Certainly, I think it’s crusted in some of the places where I’d spend my time, and certainly has here in the UK, was really the sudden rush for durables or, well, I’d say consumer non-durables, but things that the grocers were tending now to begin to push to online sales. There, I’m talking about infamously the toilet paper, which became a mini crisis for a week or two, and cleaning supplies, and all these other things. These are the things that grocers had decided. We talked to a senior guy, one of the top two nationwide grocers, about this not too long ago. They had decided to fundamentally change their business model and move those goods from the store, where they occupy a lot of space and they’re fairly low margin and fairly homogenized, to online shopping.
Suddenly, these grocers have realized those are vital goods and can come into short supply during a crisis. I think grocers are probably going to be sitting back and saying, “Okay, what’s our role? How do we best fulfill this,” both in a time of a relative stability but, importantly, when we’re the lifeline at a time of crisis when Amazon Prime is no longer delivering on a 24-hour cycle and suddenly your lifeline to vital food and consumer non-durables is that local grocery store, and I think that’s going to be a fascinating discussion that’ll play on boardrooms here over the next 6 to 12 months.
Ryan Morfin: Especially the fact that we’re probably going to have several waves of this ripple through the global healthcare system and then, secondly, the densification of cities and urban centers is only going to probably make virus and pandemics, disease pandemics, probably more prevalent in the 21st century and something we’re going to have to get better at living through, for sure.
Russell Platt: To take that from a real estate perspective again, Ryan, sorry, the big push coming out of the GFC a little bit over 10 years ago was that we’re not going to get … Generals, as they say, always fight the last war and investors also fight the last crisis. They said, “We’re not going to get fooled again. We’re only going to park ourselves in the highest quality assets in the handful of global cities,” cities that really are thriving in this information economy, which are part of this globalization that we’re seeing this connectivity with other similar cities in other parts of the world.
It really meant Tokyo, London, to a lesser extent Paris, certainly New York, Boston to a lesser extent, certainly San Francisco, LA certainly up there in that list. Those are the big cities and then, of course, the Shanghai, Beijing, Guangzhou, Singapore, Hong Kong. Those were the places to be. The thesis was they would thrive in this connected, information-driven economy, and as well, they had the greatest defenses against overbuilding because they were crowded. Simply, literally their crowding, their densification made it difficult to build new space.
I think that we’re now seeing that that thesis was flawed for two reasons. One is simply while they are crowded, there’s always more land or you can knock down a building and put up something else in its place that is higher, taller, fits in more people whether it’s an apartment building, an office building, or shopping center. In the case of New York, we had an entire new downtown constructed in the Hudson Yards Project, the 10 or 20 million square feet of space, so literally built an entire town in the densest urban environment in America, certainly one of the top ones in the world. Therefore, we saw supply overtake demand, particularly in high-end residential and other space over the past two or three years, and we’ve seen the wave crest there in terms of per square foot pricing.
The second thing now is I think we have to rethink this issue of density and connectivity. It’s that connectivity with infected people in Wuhan that caused problems on hotspots like Lombardy in Northern Italy, problems in New York, in Kirkland, Washington, outside Seattle, and elsewhere. That thing that was the strongest bond supporting these markets now has become the weak link and, ironically, there’s places in the flyover country, in the middle of America, that seem to be doing best, and there may be a whole variety of factors for that. But I think people will think about that, again, when they decide, “Where do I want to open my new office, my new distribution center? Do I want to be in Northern New Jersey or do I want to be out in Omaha or Nashville or Austin or someplace like that?”
I think this really could help tilt things back to the interior of our country, and we’ll see similar impacts, no doubt, in other countries as they sort through, in some ways, how to protect those connections, how to disconnect, or how to put firewalls on those connections so that if this thing has a flare up, which I agree with you, it probably will, we’re able to hit the shutdown button and pull back and safeguard ourselves.
Ryan Morfin: Yeah. I think it has a positive impact for, call it, tier-two markets, class A office. Great locations in tier-two markets because I think some companies are going to probably revisit the fact that, hey, we have way too many people in Chicago or New York or LA. It doesn’t really hurt us to have somebody in Reno or Scottsdale, Albany, New York, for instance, look at some of these other tier-two markets where you can still have quality labor force but not be so compartmentalized and one single point of failure market [crosstalk 00:33:26].
Russell Platt: We have conductivity like you and I are having today. I think there are certainly limitations. You and I know each other well. It’s easy to have this conversation. It’s a little tougher to do this if it were an introductory conversation but, nonetheless, we’re going to, at the margin, find ways to utilize this to have more decentralization. We certainly saw that after 9/11. You don’t want to have all of your senior executives in a single building in a single city, and I think this is going to have a similar impact diffuse across the economy.
Ryan Morfin: Industrial seems to be doing well, but there’s probably a tale of two cities there, right? There’s the fulfillment industrial and then there’s flex and some of the small business industrial. Could you maybe talk a little bit about what you’re seeing on that side?
Russell Platt: We had seen that what was bad for retail over the past decade was good for industrial. The whole ecommerce revolution led to an attrition of demand away from traditional bricks and mortar retail towards ecommerce and, therefore, to logistics. We saw that the demands and the specifications of logistics users, and Amazon, of course, comes to mind, really led to more and more complex smart buildings, larger, smarter. One of our portfolio companies built a 2.5 million square foot, five-story building for Amazon just on the ring road that surrounds London, for example. That’s indicative of how that was evolving.
I think what is probably as important, if not more important, for the next 5 to 10 years really is the whole last mile, and there’s been a lot of talk about it. Ironically, Ryan, I think actually that bodes well for some of those property types you just talked about to the extent that the change in specifications, the need for more complex and higher automated racking made some of the older industrial buildings, those with 12-foot clear heights or even 18-foot clear heights, which would have been perfectly satisfactory back when I started my career. Those had become outmoded. They couldn’t really adapt to the needs of the third-party logistics providers, the FedExs, DHLs, the Amazons of the world.
Now, ironically, a lot of those because they’re older and therefore more likely to be in infill locations closer to population density are best able to adapt themselves to the new needs of the last mile logistics. What is important in a big logistics box is how many big semi-tractor trailers can you get in to that space and unload off an 18-wheel truck a large amount of goods. Now, what’s important really is how many small vans can you pull up next to a building that is within 10 or 20 minutes of major population so you can fulfill same-day service.
The flex buildings, those older 12 and 18-foot clear high industrial buildings, which is really had suffered, now suddenly looked much more valuable, and we hear anecdotal evidence that close to major cities such as London or Chicago or Philly or New York, those buildings now are commanding premium rents, rents much closer to office because, frankly, the incremental cost of the rent relative to the number of van loads that Amazon can run for their daily deliveries is really not particularly meaningful, and commanding those spaces so that you can promise and deliver on a 24-hour basis is absolutely key to these ecommerce giants.
I think it’s actually a fascinating opportunity. The tricky part is that these are small assets. Oftentimes, they have to be retrofitted. You’re dealing with cities so you’ve got more regulation. But folks are looking at this and saying, “We’re bringing vitality back.” Think about even Long Island City for example, which was some would say a pretty grotty industrial neighborhood in New York but now, its proximity to Manhattan and those older, largely brick industrial buildings are suddenly now quite valuable. I think we’re seeing that play out certainly across the US. As well, here in London, certainly we hear that, and I’ve no doubt it’s in other major urban markets from around the world.
Ryan Morfin: How far are we from drone delivery now that people are probably not wanting to see the delivery guy or shake hands anytime soon? Do you think this accelerates some of the leaders in the retail space like Amazon to really try to fast track with government work, government approvals, the ability to start doing call it short distance drone delivery?
Russell Platt: I think it may. I have questions around capacity there. Also, some of the areas that are most demanded immediacy in terms of delivery don’t have the ability to land the drones. There’s a lot of talk around rooftop space and how are we going to allocate this. In the past, we might have talked about putting up a cell tower on a roof or putting up side hinges as source of ancillary income. Now, we’re really trying to figure out how do we use these literally as many airports, and which rooftops are acceptable for this and then, also, once it’s on there, how do we get it into the underlying tenants. I think we’ll see more of it. Again, there’s so much talk over the past several years about automated vehicles and the demand that we put on our infrastructure and the risk it posed to traditional real estate. Obviously, I think we’re seeing that that’s maybe a bit further into the future than perhaps we had dreamt or feared.
Ryan Morfin: The last food group I’d ask you to comment on and it’s probably the most devastated is the hotel industry. What’s your outlook for the hotel industry? How are they going to come back? A lot of people are mothballing hotels and furloughing all the employees, because it’s an expensive operating business to maintain and with zero occupancy, you can’t make sense of it. What’s going to happen in the hotel industry, do you think?
Russell Platt: I certainly think that the conference business is certainly knocked out for the summer. It’s probably knocked out for the entire fall. Then once you get into the winter, it’s a less popular format, generally. It’s going to be very difficult for the big urban hotels that really depend upon conferences to make them work and, certainly, the resort business. There may be some limited benefit this summer to the extent that folks are staying close to home, the staycation where they don’t travel far and, therefore, may use a motel to the extent that they’re staying within a fairly short drive.
Even then, I think the same issues that we’ve talked about before in terms of how do you certify to a guest that the room is absolutely clean and sanitary, a sustained issue that Uber is facing now with ride-sharing and other uses. I think it’s going to be very difficult for the next few months. I think there’s certainly going to be some shift in inventory in two areas. One would be, and Ryan, you and I talked about this the other day, towards hotels or overflow capacity for seniors or others who need a residential environment and their current situation doesn’t support it.
I also think we may see, again, where applicable, some transition of inventory from lodging over to residential. We saw this really in major urban centers in the transition from older office properties, particularly those with fairly small four plates, lots of windows, I’m thinking about downtown Manhattan, but it is something we’ve seen really across the board in the US, that transition to residential. Residential became the highest in best use. Some of those buildings architecturally are fantastic and, in fact, they can be repurposed for residentials grade.
One’s not going to think about any Red Roof Inns or Motel 6s being architecturally distinctive but, nonetheless, there may be some where that becomes a good source of more workforce housing. Again, that’s a value that’s greatly diminished from that to which was intended, and we’re going to see a lot of value destruction in the hotel business, no doubt. I had someone pitch me yesterday on an investment strategy that had among its areas of focus picking up some values in hotels. He spoke about the cap rates or the yields they might be able to achieve. Of course, the big question is yield off of what level of income, and if there’s no income, there’s no yield even at a very, very low price.
As we look at things right now, we think if you’re a king of your own castle, then your apartment or your single-family rental home really is now becoming more important than ever. Aside from temporary dislocations due to overzealous mayors who want to score points by allowing rents to not be collected, that’s going to go away pretty quickly. We still like office. Actually, we think office could be strangely a beneficiary. We certainly like areas of secular growth like last mile logistics, data centers, other things associated with the information, the sharing of information, not face to face necessarily but electronically.
We think cities outside those three or four key coastal cities here in the US, and the same would be true to some extent elsewhere in the world, those should be continued beneficiaries cyclically, but also from a secular standpoint. That gives us a lot of things to look at. Then retail, either now the Fortress Properties which are those that are maintained by grocery centers or those that now the final shoes dropped, they’re no longer viable in their current format and there’s an opportunity for repurposing well-located land that can be dedicated to other uses.
Ryan Morfin: You’re suggesting take some of that corner through a land that had a bunch of strip malls in it and maybe scratching that and redeveloping it into something higher, better use in the future?
Russell Platt: Yeah. If you think about the great mall entrepreneurs, Jacobs, Taubman, The Barlow, Simon, they picked the best locations at the intersections of major ring roads and major interstate highways in the ’60s, ’70s and to the fading extent, in the 1980s, and built fortress smalls of 750 to 1.5 million square feet. These became the new town centers for these cities, largely in the interior of the country. That’s now infill land. Housing came and surrounded that, and there are fantastic opportunities due to the transportation connectivity to turn those into smaller but more lifestyle-oriented retail, certainly residential, senior housing, medical office, office, really mixed use centers, because they’re large enough that you can actually build some critical mass. With some of these malls now in deep financial distress, you can actually buy them for land value, and land that you now can’t recreate, given the growth and the sprawl of those cities.
Ryan Morfin: Yup. Just a hypothetical question, but the financing markets and the transaction volumes, they seem to be all arrested, if you will, and a lot of transactions are pumping the brakes on pause. Can you talk a little bit about what you’re seeing as it relates to that and what’s driving that trend?
Russell Platt: Yeah. Clearly, there’s uncertainty about two things. One is folks are hoarding cash, so if they have cash, they don’t want to let go of it. The second is they don’t really know how to price risk because the guidance from the government literally is changing on a day by day, if not a week by week basis. That will change. The biggest, I think, factor there is that the Fed is flooding the zone. They’re literally flooding the zone with trillions of dollars of cash, and all that cash has got to go someplace. It will find risk assets.
Right now in what could be a very short window, we’re seeing some opportunities. One of our portfolio companies has an opportunity potentially to buyback a tranche of its debt, which has been put into a CMBS, and certain investors simply have to sell and we may be able to repurchase that at yields that approach 20%. That’s fantastic. That’s a very creative investment for one of our companies, and we hope to participate as a shareholder in that business. That thing isn’t going to last for long, particularly if the Fed’s buying up all those CMBS they can.
Now, we are monetizing our debt, and that has its own issues in terms of the moral issues and the long-term economic consequences but we will see credit restored. I think probably, and this is a question I posed to an industry thought leader a few days ago, we look back at the first crisis of my professional career was in the mid-1980s. The SNLs blew up on too much investment into real estate, particularly development real estate. That was fixed through the RTC in 1991, 1992. That was a pretty novel device used by the government to force the repositioning of all this bad real estate.
Then we had the crisis in ’07, ’08 and the TARP funding began to address some of those issues and allow banks to hold on to assets and not dump them into the market, and that took about eight months to get done. Here, we’ve seen a reaction by major global governments, some faster than others, but within a matter of weeks. It’s really unprecedented. I think it really defines two things. One is there’s a much lower tolerance for exogenous shock that really hits Main Street and not just Wall Street, so money’s being pumped out very quickly.
Two, it’s an understanding that this kind of financial and credit market dislocation has real-world consequences. People’s lives are shortened through to poor health, stress, loss of income, and it actually causes damage to the fiber of the economy. We see this no place better than with small restaurants, businesses, bars, et cetera. With that in mind, we’re seeing the money flood in to a much greater extent, and we’re now all quantitative easers. What Japan did 20 years ago, which seems so unprecedented now, we don’t, again, bat an eyelash, too.
Ryan Morfin: Do you think we’re at risk here globally of the entire … What that means is over five trillion of cash so far pumped into the global economy. Do you think we’re globally at risk for going into a Japanese style growth environment and negative interest rates going across the board?
Russell Platt: Yeah. No, I think that’s a real possibility. I was reading some interesting work out of the FT, Financial Times, this morning and it spoke to what’s happened at time of war. This has been declared by the US administration a time of war. What has typically happened, the circumstances is that there’s actually deflation following that, with all this money sloshing around. We clearly are monetizing the economy and certainly, our national debts, not just here but in Europe and in East Asia.
The other thing, interestingly, is it’s not necessarily apropos to this conversation but one that I thought you’d be interested here, which is that you begin to see a change in the distribution of wealth and income following this. Actually, it’s less good for those who’ve done so well the past 10 or 20 years, that is the top 1%, as Bernie Sanders would say. It tends to lead to a broader distribution even though the consequences right now are being felt most acutely by those in need that are in the working class. Over time, it tends to lead to a redistribution away from that very top of the pyramid. We’ll see how that plays out. But certainly, this monetization is either going to mean we inflate away our debt and we simply just leave all of our debt in the hands of the federal government and effectively is washed away as an accounting exercise anyway.
Ryan Morfin: Interesting. Two final questions. Public markets have been hammered recently and the beta coefficient with a lot of these equity REITs have shown that we’re somewhere down between, call it, 23% to 25% from the beginning of the year in terms of where the indexes are for real estate. At what point does hard asset valuations have to catch up to what the public company valuations are? Meaning, if I have an industrial property I could buy at a seven cap but I’ve got an implied cap rate in the industry right now, maybe an eight cap because of the delta of the valuation drop in the public markets. Is it better for folks to be thinking about comping those two private versus public investment opportunities, and how do you think about that?
Russell Platt: That’s a great question. At some point, an asset can exist in either the private or public markets. The asset really doesn’t care. The question is, what do the owners of the asset want to do. Where do they see best value for that asset? Should it be part of a REIT, just to use that phrase, or should we own privately in a partnership or sole proprietorship? There’s a friction cost to getting an asset from the public markets into the private or vice versa, and investors do have choices but decision-making takes some time, particularly it’s longer in the private markets.
As customers, we’ve historically seen a lead/lag phenomenon where the public markets tend to lead in the recovery and they also lead in a downturn. That lag really can vary depending upon the cycle, but it tends to be six to nine months at a minimum, and that’s how long it takes for the weight of capital and assets to reflect the change in fundamentals. Right now, if you want to buy real estate, absolutely the very best values are generically in the public markets but we’re seeing this seize up in credit and capital beginning to effect some private assets and there’ll be some good values there.
Again, I think the big issue really is how quickly does Fed money either directly, through the purchase of ETFs and many of these ETFs are comprised of companies including REITs so that money is going to be going into REITs, and half of it is indirectly because there’s a spillover hedge fund sell there, the assets that the Fed is buying, bonds and CMBS and ETFs solos and put them into other risk assets in a desire to rebalance their portfolios and make money. I suspect that that disequilibrium may not be around as long as it has been in prior cycles just because the Fed is being wholly unconventional in its approach to as a wholly unconventional issue that exists largely outside of the boundaries of conduct in real estate business day to day.
Ryan Morfin: If I’m looking at buying an asset and it’s one of those situations where for the private market, what kind of repricing or retracing of price should I be thinking about while I’m looking to maybe close in the next six months on a transaction, given where fundamentals have shifted away and cap rates, no doubt, have gapped out? What are your thoughts on that hypothetical [crosstalk 00:56:47]?
Russell Platt: I think we’d go back to fundamentals. A good place to start is replacement cost. It’s a simple benchmark but one that was pounded into us by our mentors, my case, Morgan Stanley, and yours as well or elsewhere. What does it cost to build and maintain the building, and if we can buy something systematically at a discount to replacement cost, then that’s a good thing. Then the other really is structure. Generally, we focus first and foremost on the unlevered cash flows from the asset. What do we get paid just in terms of rental income divided by value, and we look at that number.
But ironically in today’s environment, debt becomes both a liability but, in some cases as well, and asset. Imagine that you’ve got very flexible long term debt on an asset and you’re able to buy it for a higher unlevered yield. Suddenly, that debt, which you might not be able to replace in today’s uncertain credit environment, becomes something of real value. We’re seeing people think about the option value of have having access to debt because it’s tied to an asset. Also, you have the opportunity when things return to normalcy to pay down that debt.
I’ll be engaged in a conversation later on this evening with one of our portfolio companies. We’re looking at buying a portfolio at a pretty big discount to replacement cost. It comes with debt attached to it. The spreads are okay, not great, but that debt actually is something we couldn’t replace today. We also know, touch wood, within the next 18 to 24 months, we can then probably refinance that debt at lower spreads and reduce our cost of capital, increase the spread of return that’s going to our equity shareholders. There’s some very interesting stuff going on, and it requires some patience and thoughtfulness.
Generally, I think these are what I call mini headed problems. In other words, a single investor, on their own, may not be able to think through it, but if you get into the same room or on the same Zoom chat with two or three or four very smart men and women, you can look at the problem from multiple angles and usually figure out how to unlock the value in it. That’s why I think this next period of time is going to be probably the best buying opportunity we see in the real estate asset class, certainly in the past decade. It’s painful to go through it. In a lot of ways, we were hoping to put off the inevitable as we came into 2020, see another year, year-and-a-half of smooth sailing and then take our medicine. Instead, we had it shoved at us basically in a six-week period, the sharpest fall in stock prices since 1929, the sharpest rise in unemployment since the 1930s.
That being said, if we do see liquidity return to the market, there’ll be some very interesting buying opportunities. As well, the thing I tell all my colleagues is that the way, the manner in which we conduct ourselves and our businesses today and over the next few months is going to be critical to how we’re able to conduct business as we come out of this. There are undoubtedly some people who are perhaps not handling this in a manner where they will look back in a year or two and think they did the right thing to all their counterparties, and as we’re coming upon week of Passover and the week of Easter, perhaps that a little bit of sermon from me is one that won’t fall completely on deaf ears.
Ryan Morfin: One final question. You’ve got a global perspective. You travel around the world more than anyone I know. What are you hearing on China and how do you think this crisis will impact foreign capital flows back into China once there’s a new normal?
Russell Platt: I think that’s two different questions. I think the question of capital flows is it’s hard to see investors really, at least Western investors, absolutely jumping on the China bandwagon anytime soon. There’s going to be a lot of political backlash, I think. You didn’t ask me that question, and I think that ultimately filters down to decision-makers predicate the big pension funds. It’s hard to imagine one of the big US pension funds saying, “Oh, yeah, we want to throw a fresh billion dollars of capital into investments in China.” That’s not going to play very well in state houses around the country.
That being said, our data providers, and we’re spending a lot more time with our research providers, one, because they’re being more generous with their time, too, because we have more time to listen to them. Say that, and maybe with some note of irony, that East Asia could come out of this reasonably well. The reaction time there has been quicker. That’s not just for China but for Hong Kong and perhaps for Korea and Japan as well. In some ways, the area that’s least prepared to deal with this is Europe. The area best prepared to deal with this is Asia, and the US is some someplace in between.
That may not be something that we want to hear. That may not be the resolution that we prefer from a normative perspective but it could very well be the outcome that we see, and which is why we’re continuing to at least think about how we might reenter some of those Asian markets. We’re certainly active in Australia. We’ve historically been active in North Asia. We’ve been quite active historically in China, as you know. While we’re not rushing back to mainland China, we have to accept the fact that that part of the world may actually come through this better than parts of the West.
Ryan Morfin: Yup. Russell, we thank you for your insights and your time today, and wanted to really say thank you for being part of the show. Russell, we’ll talk to you in the coming weeks ahead, we assume.
Russell Platt: Good. No, it’s been my pleasure. It’s great to really vet around some of these ideas and issues and impacts, and I certainly look forward to speaking to you again.
Ryan Morfin: Okay. Thanks a lot.
Russell Platt: Thanks. Bye-bye.
Ryan Morfin: Thanks for listening to NON-BETA ALPHA. Before we go, please remember to subscribe and leave us a review on Apple Podcasts or our YouTube channel. This is NON-BETA ALPHA, now you know.
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