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Capital Allocators – Inside the Institutional Investment Industry
John Khoury – Asymmetry and Opportunity in Public Real Estate at Long Pond (EP.474)
00:55:42
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- [00:00]
A
Real estate is cheap and it's great risk, but it's not loved. The only gics sector in the S and P that's still materially down since 22. The GIC and REITs is down almost 20% while the S&P is up 40. What do I look forward to in the next two years? Not swimming against a current. I'm excited to stop talking about it and watching it happen.
- [00:27]
B
I'm Ted Seides and this is Capital Allocators. My guest on today's show is John Corey, founder and managing partner of Long Pond Capital, a $3 billion hedge fund that specializes in publicly traded real estate securities. After 15 years in the business, Long Pond is one of the few remaining firms in the niche. It recently launched an active ETF ticker, lpre, which invests in the most attractively priced stocks from Longpond's list of the highest quality real estate businesses. Our conversation covers John's pat to public real estate investing, changes in the investable universe, and the impact of passive flows and pod shops on the sector. Return to Longpond's investment process focused on identifying and exploiting asymmetry, and cover John's perspectives on the major real estate subsectors. We close with a discussion of Long Pond's new actively managed etf. I hope you enjoy the show and if you do this week, why not reach out to that friend of yours? You know the one I'm talking about. There's someone you've known for and trust and love so much. You probably only see each other maybe every year or two these days, but whenever you get together it's like no time had passed at all. Go ahead, reach out to them and just say hi when it comes up. What inspired you to reach out? Just tell them you thought of them while listening to the Capital Allocators podcast. And maybe they want to have a listen too. Thanks so much for spreading the word. Capital Allocators is brought to you by my friends at WCM Investment Management. WCM has the courage to back future histories not evident today. Informed by their unrelenting focus on moat trajectory and elevated by insights on corporate culture, WCM's deep roots in public markets set the foundation for its approach to private investing. They didn't just want to enter the private markets, they wanted to improve the investing model itself. Build something better, aligned, more thoughtful and truly long term. As a firm owned by its people and grounded in Laguna Beach, WCM is built for alignment and independent thought. Rather than chasing a scoreboard, WCM invests with a partnership mentality to build meaningful relationships with founders reimagining their industries. They show up earlier, stick around later and let value compound over years. WCM's style is their edge, authenticity over formality, two way learnings over checklists and stories over slide decks. To learn more, visit wcminvest.com this testimonial is being provided by TED sites and Capital Allocators who have been compensated a flat fee by wcm. This payment was made in connection with Capital Allocators testimonial and production of podcasts and does not depend on the success or level of business generated. The opinions expressed are solely those of Capital Allocators and may not reflect the opinions of others. Investing involves risk, including the possible loss of principle. Past performance is not indicative of future results. Please visit wcminvest.com for WCM's ADV and further information. Capital Allocators is also brought to you by Ten East, A private markets investment platform built for sophisticated investors, Ten east offers institutional grade access to private equity, credit venture and real estate without the complexity of building your own family office. Led by Michael Lefell, former co head of Distressed Investing at Davidson Kempner, Ten East's team sources underwrites, builds conviction, invests meaningful personal capital and provides transparent reporting. I've known Michael for about a decade and after becoming impressed by the quality of Ten East's offerings, its research process and high quality investment team, I became an advisor to the organization, shareholder and investor in multiple offerings. Join investors and executives from leading global firms already co investing through 10 East. Learn more at 10 East Co podcast. That's the number 10 East Co podcast. This testimonial is being provided by Capital Allocators who has been compensated a flat fee by 10 East. This payment was made in connection with Capital Allocators newsletter, testimonial and production of podcasts and was not tied to an investment, performance or business generated. The views expressed are solely those of Capital Allocators. Private market investing involves significant risk including possible loss of all capital and past performance is not indicative of Future results. Visit 10East Co for our adv and other important disclosures. Please enjoy my conversation with John Corey John, great to do this with you.
- [05:09]
A
Great to be here. Thank you.
- [05:11]
B
Take me back to your background that led to real estate investing.
- [05:16]
A
I grew up in eastern Canada in Fredericton, New Brunswick in a real estate family. My father was a Lebanese immigrant who came to Canada in the 50s with no money and a lot of siblings, 10 brothers and sisters. He was a typical immigrant story. He put himself through school, bought the house he was renting, rented out a room. Next thing you know, he owned a couple of apartment buildings in town. His immigrant ethos is the way our household ran when we were young. We were working. When it snowed, we were shoveling snow outside those apartments. We were mowing lawns. And then when you got older, you got to lease apartments. It was always in my blood to be a real estate investor. Ultimately, I ended up going to Wharton, where I studied the Zell Lurie Center. My first job was in the real estate investment banking group at Lazard.
- [06:05]
B
What did you learn at banking as that foundational ground before you turned to investing?
- [06:10]
A
I joined that group in 1999. REITs were the antithesis of what anybody wanted to own. So the most impactful thing that I learned at Lazard, having been the grunt guy running all the models in advance of the CEOs coming in to complain to my managing director why their stocks all traded at 70 and 80 cents on the dollar, was saying, here you are, it's not complicated. You have $100 of apartments trading for 80 cents. You have $100 of industrial real estate trading for 75 cents. At that point, I thought I was going to use real estate investment banking as a stepping stone to real estate private equity, which I ultimately did. That was the first moment I said, this seems like an interesting way to exploit valuation differentials between the public and private.
- [06:58]
B
How did you then go from the private side to the public side?
- [07:03]
A
I had offers from both Lazard and dlj. Investment banking was training for private equity, and private equity was going to be the career. I went to Lazard. I had summered there. While I was there. An associate that I work closely with went to the same group that I didn't take an offer from at dlj. And he was there for a week and called me. He's like, you know, everything you're going to learn in banking, you should come over now. I went to re interview with them. I really like them. It was a great group of people. I wanted to do private equity. I moved over.
- [07:31]
B
What did you find in the private side that eventually led you to switch over to the public side?
- [07:36]
A
I wish I could give a really thoughtful answer here. The truth is, it all happened by happenstance. I was working at dlj. I was enjoying it. I liked it. I was on this path. I had this thought in my head from my Lazard days of the interesting nature of public versus private markets. But there was no one in my cohort from Wharton who was entering the public business. One of my mentors early on was Keith Barkett at Angelo Gordon. He had been instrumental in starting their real estate business. My brother worked there and Keith invited me to his 40th birthday party. I met this guy named Art Ruble, who had quarters prior, less than a year before, launched what was then one of the first hedge funds focused on real estate securities. I spent the entire party talking to Art and what he was doing, and I found it really interesting. He reached out to me afterwards, said, why don't you come over to the office and we'll have lunch. He laid a path for me, which was, all your friends from Morton are in the private equity business. Be the one guy who's doing something. Use the same analytical capabilities, but express your view in public markets. Public markets are going to grow. If you believe Sam Zell and I had come from the Zell Lurie center. And his point was, this space is going to grow. I'm going to be an early person doing it. I literally don't have an employee you can get on the ground. If you want to do something entrepreneurial, this is for you. It really resonated for all those reasons. I got off that private equity path and went to a building right across the street from this one, went to work with him at the beginning of 02.
- [09:06]
B
If you go back around that time, what was the public real estate investable universe then?
- [09:15]
A
It was about $300 billion. So it wasn't huge. It was much more concentrated by subsector. They used to call it the four major food groups. Office, industrial, retail and residential. And those companies accounted for over 2/3 of the entire REIT index. The entire space was more correlated. Real estate really moved together. Certainly some subsector had more supply than another and you had to normalize for that. If you were an analyst covering apartments, you could pretty easily cover the office space as well. From then till now, you've had two things happen. You've had the introduction of secular risk in real estate. We learned that with office and Covid. We learned that positively for industrial, negatively for malls with E commerce. I'm sure that's not the last of it. We'll see more of that in real estate. That's been a big factor in the old days. If real estate went down, you could buy it and just wait and generally it would come back over time. And that's certainly not true anymore. The second thing that's happened is as the public market has proven to be an efficient place to own and hold assets, more and more subsectors have Come to the public markets. Data centers, towers, cold storage REITs, single family for rent REITs, gaming REITs. That's led to more dispersion within the space. In short, the absolute space has grown, the correlation is less and the menu of options to express a view is higher.
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B
Within that idea that there's secular risk that didn't perceptually exist 20 years ago, that does now. What are some of the other changes in the nature of the real estate investment opportunity set in the public markets?
- [10:56]
A
Real estate is still dominated by the private market. 90% of real estate in this country is owned outside of the public market. So you've got 10% of the market that trades publicly. You've had two large movements of capital to market participants since I got in the business. The first is active to passive and the second is the advent and success of the POD model. When you break down who's investing in real estate today, you still have active management on the mutual fund and long only space. They're not trying to do much more than outperform an index by a very modest amount. For them, taking a bold stance is having an extra a hundred basis points in prologis versus the index. They're doing something very different than we are. Passive by definition, cares about nothing other than recreating the passive index. There's not a lot of thought as capital moves around there. And then the POD model, which has been an incredibly successful model, but is a model that does something incredibly different from what we do. And they're hyper short term focused. 80% of the returns of these pods are generated on quarterly earnings or the day after quarterly earnings, which means they are looking out for 1/4. Then at the bottom, left over is us. There used to be few firms doing what we do. Now there are very few firms doing what we do. We take a different approach. We look at everything through a two year IRR paradigm. Given the dynamics of this market, the majority of players effectively playing a different game than we are, the output of that can create interesting opportunities. When we launched the fund, the first three years of the fund's existence versus the last three years of the fund's existence. The average move in the REIT space is literally 2x today than it was then. That's consistent throughout the top 10 movers are two times broader than what they were then, which creates an opportunity for us.
- [12:56]
B
Oftentimes when you look at that preponderance of money, either passive or very short term, where do you see their inefficiency? Or in your perception, mistakes that Other people are making.
- [13:09]
A
I want to be clear. I don't think they're mistakes. These guys run great businesses. The passives run ten jillion dollars or whatever the largest number you could imagine is. And the pods have grown 4x since Long Pond has existed. They're doing something different. They're playing hockey, we're playing basketball. The fact that they've grown has outputs that benefit us, and that's where we're focused. We have one key thing we're looking to do. The way we've done it has changed over time, and we've adapted in how we execute this. But we have a view that our job is to identify and exploit asymmetry within publicly traded real estate securities. Asymmetry defined as a disconnect between intrinsic value and stock price. We have another view that volatility and asymmetry tend to hang out together by points of volatility. There's probably more opportunity for firms like ours who can take a little bit of duration and be looking out through a longer investment horizon than others. If we back up and say, well, what's the output of all these players? If the output is that the average move on earnings is two times what it used to be, but the average change in earnings is the same, then what we're seeing is larger disconnects from intrinsic value that we can seek to exploit. Our coverage model and our process is designed to put ourselves in a position to play offense. There's more volatility. Valuation doesn't matter. This is something that's taken us a while to really appreciate. We have a couple of analysts who work here, used to work at pods. Then it blew up again on earnings and, by the way, blowing up for a read. I'm talking about missing earnings by 1 or 2%. But in each of these instances, the Stock was down 8, 9, 10%. We felt like the inflection for this company was much sooner. The stock had collapsed. We took advantage of it and we bought a large position. And I happened to connect with a friend of mine at a POD who owned the stock into the quarter. And I said, we're shareholders. Along with you now. He giggled. I sold my stock today. The story's broke. He's good at what he does. I had scratch and I explained to him why we liked it. His response was, you only like it because of how cheap it is. I took it as a compliment. When I hung up the phone, I only realized later that day that it was a dig. Valuation is not enough for us. It still is enough. We want to make sure that we're seeing in the market over a reasonable period of time or over our holding period will lead to that asymmetry compressing or us reaching our irr. Oftentimes it feels like we're one of the few players left who cares about the fact that stocks can get really cheap.
- [15:39]
B
You talked about joining Art Ruble. What led to you to forming Long Pond on your own?
- [15:44]
A
It's a classic example of I worked for somebody who was a great person who gave me a ton of rope, got me to a position in my career where I felt comfortable running my own business. I reached a point in my career where I had a vision and a desire and a burning urge to run something in 100% my own vision. That's when I decided to part ways and launch Longpan in 2010.
- [16:07]
B
When you went out to start Long Pond, what was that vision or investment philosophy you wanted to pursue?
- [16:14]
A
I wanted to create the best version of the firm I could create. Seeking to exploit asymmetry in publicly traded real estate securities. I felt like controlling a culture, an investment process, an investment philosophy would allow me to systematically look at this space, analyze this space, and exploit the asymmetry or that disconnect between stock price and intrinsic value that existed in the public markets.
- [16:42]
B
So let's walk through the different aspects of how you go about doing that. We can just fast forward to today. How do you think about your investable universe, the different companies you're looking at to potentially invest in?
- [16:53]
A
When people think about real estate, they naturally gravitate to REITs. And REITs is not the only thing we do. There are a lot of companies that are not REITs that are 100% real estate companies, hotel management companies, home builders, real estate service providers like CB Richard Ellis or Jones Lang LaSalle. I would define everything we do as full 100% real estate companies, just not solely REITs. Both spaces have evolved, REITs have grown a lot and there are more options on the menu to exploit a view. But there's been a lot of growth and evolution in the non REIT side of the business too. When you look at home builders or hotel companies, the way many of these business models have evolved, they're not acyclical businesses, but they become much less cyclical than they once were. When you compare a home builder pre GFC with a lot of land on its balance sheet and a lot of leverage and a business model that forces you to invest your free cash flow while the cycle is getting hot and then ultimately the cycle stops and you're writing down book value and you're having problems. That's evolved to almost 100% asset light models, in some cases, no leverage, real free cash flow generation that's used to shrink the float. So these have become much better businesses. And when you look at the hotel business, it's not dissimilar. There's been splits of the cash flows that come out of a hotel. There are Hotel REITs which in our opinion are not great businesses. They're generally price takers. Then there are hotel management and franchise businesses which themselves are not REITs. Hilton, Marriott, Hyatt, Accor, Wyndham, these are companies that are going to grow earnings from Revpar. They've also got a net unit growth story which comes with basically no capital invested. These business models you've got Revpar, you've got net unit growth. Then with a little bit of operating and financial leverage and share repurchase, you're growing earnings 15% a year compared to the hotel REITs. Basically growing, not at all, or in some cases shrinking pretty meaningfully.
- [18:58]
B
When you add up that traditional REIT business, the four flavors you mentioned earlier and all these new business models, how big is that universe today with market cap and number of companies?
- [19:10]
A
REITs are just under a trillion and a half. And the non REIT side is actually larger than that. The companies are generally much bigger. In aggregate we cover about 325 companies in our coverage model.
- [19:24]
B
What is it that you're looking for to add to the portfolio when you've got quite different business models from a traditional hard asset? And then some of these asset light.
- [19:33]
A
Businesses, we attempt to boil everything down to the best risk adjusted return, the best asymmetry. The first tool in that process is something that I've worked 15 years on honing, which we call the asymmetry ranker. So every analyst, whether we own a security that you cover or not, has an updated model on this company and a expected irr. That expected IRR gets discounted at different rates depending on what the business model is. A levered hotel REIT gets a much higher discount rate, not surprisingly, than an unlevered apartment reit. Then we have a qualitative overlay. How good is the management team? How is management incented? What is the history of this company's capital allocation? What the asymmetry ranker does is it takes those cash flows and models them out. We have a terminal value, we discount it back at what we think is the appropriate discount rate and that gives the long pond warranted value of that individual security today, which is often not where it trades in the market. We rank those companies in our asymmetry ranker by the delta or the difference between stock price and what we deem to be the fair value. We don't plug that into some quantitative model and it trades securities. It's an idea generating tool. We use that to decide where we're going to allocate our firm resources and where we believe the best return on invested time will be. The things that ultimately are the great long pawn stocks, things we really like. They're stocks that are disconnected from intrinsic value. There's something happening in the universe in that individual company in that sector that has led people to dislike this company or not like something material enough for this company to get cheap, cheap by old school standards, cheap to liquidation value, cheap to intrinsic value. What we also want to see is a path. Now this isn't a path this month, this quarter or even this year. Sometimes it's a reasonable mosaic, as we call it, where we've put together what we believe is the highest likely outcome of a series of facts that will play out for that disconnect to compress during our holding period or for us to realize our irr. In the best instances. These are companies that are generating material amounts of free cash flow and shrinking the float so that as time passes, if the stock's flat, it's getting better and it's getting cheaper. Things we try and avoid are misaligned incentives, management teams with poor track record. We're looking for cheap stocks today that are growing earnings with conservative balance sheets and a path over a two year period that we think will lead to a compression or an expansion in multiple for us to realize the irr.
- [22:25]
B
So you've gone through that process and you have your asymmetry tracker, you've added all the qualitative inputs. How do you then take what comes out of that to make decisions in your portfolio?
- [22:36]
A
It's did a change in a security in the public markets. Did a change in that price or a disconnect to intrinsic value. Was it of a magnitude enough that there is something within the portfolio that no longer meets that same risk return or asymmetry? A lot of times that can happen pretty quickly. We think of our process as geared towards speed with the desire to allocate with duration. We're doing three management meetings a day on average. In our process. The models are being run whether we own a company or not. That's all being done so that we're ready to allocate when an opportunity presents itself internally. We often say we want to be allocating capital while the next guy is sharpening his pencil. But we're not allocating it because we think it's going to go up tomorrow. We're taking advantage of the ability to allocate quickly in periods of volatility. But for duration, we want to take advantage of short term market reactions in order to allocate capital to 2 year IRR investments that are asymmetric. It doesn't always lead to a two year hold period. It's a paradigm of how we allocate. If we allocate to something and that stock goes up or we get it wrong and the facts change and it's less good than we thought, it doesn't mean we're going to own it for two years, but the willingness to own it for two years is really what differentiates how we're allocating capital in those volatile periods of time.
- [24:05]
B
Over the course of time, how does that translate into portfolio turnover?
- [24:10]
A
It's episodic. In Liberation Day, we're moving a lot of capital really quickly. Cyclical securities got hammered across the board, good and bad ones. Our experiences, often they all go down at a similar level in those periods of time. So you get a chance to buy the really good ones at great prices. In the case of Liberation Day, a lot of what we did was sell stocks that were down a little to buy stocks that were down a lot that had these compounding characteristics, like Hyatt. Other times, when the world's a lot less volatile, the turnover can be de minimis. We can go weeks without doing much. It tends to be fairly episodic, where we may do very little or we may be very patient. Oftentimes when one opportunity presents itself, it's in an environment where many present themselves.
- [24:59]
B
If you looked at it as just a quantitative exercise and took your asymmetric ranking and you said, hey, that's a portfolio we could buy quantitatively. How different is what you end up putting in your portfolio from just what the numbers would tell you?
- [25:14]
A
It's meaningfully different. And it can be different for a whole host of reasons. One is portfolio construction and risk management. I've had the indignity of having had this. And experience is what you get when you don't get what you want. In 15 years of running a hedge fund, every year does not go exactly as you want it. Very few do. One of the big things that differentiates between what the asymmetry ranker spits out and what the portfolio looks at is the asymmetry ranker doesn't care about factors. It doesn't care about correlations, it doesn't care about any of that stuff. We're not a factor neutral fund, but we respect factors. We have lived in environments where we owned too much of a cyclical factor. All individual securities that turned out to be asymmetric, that generated their IRR over a reasonable period of time, but were very similar from a factor perspective. And on the short side, short. Many securities that were challenged, had credit issues, had problems, but were all very high on the defensive factor. And when you're long a lot of cyclical and short a lot of defensive and 4Q18 happens, you learn you have to respect factors. And the asymmetry ranker doesn't think about those kinds of things.
- [26:23]
B
What are the most important factors that you see influencing a portfolio of real estate securities?
- [26:28]
A
Momentum. Value are really the two big ones. Real estate oftentimes being more value than momentum, which is not always a great thing in today's world. Those are the two that present themselves the most defensive. Certainly.
- [26:42]
B
What does shorting look like in this sector?
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A
It's funny, people often say it's hard to short REITs because they pay dividends. If you go back to who the market participants are today, if you've got a significant amount of passive capital, which the REIT market now does, and a passive capital doesn't really care about anything, oftentimes securities can trade at levels that are higher than they otherwise would be because they're paying dividends that they can't afford, or have low integrity or have risk of being cut. The short book breaks into two categories. There are the alpha driven shorts. These are shorts that on their own we're expecting to make a lot of money. When the world sees what we see over some reasonable period of time, we're much more catalyst focused on the short side than we are necessarily on the long side. Another portion of the short book are the means to be longer. Something on the long book. In the depths of Liberation Day, we bought a lot of Hyatt. Hyatt's an amazing company. It's a company know very well that got massively repriced to a level that we felt even if we went through a recession, you were going to make a lot of money. We didn't know for sure you weren't going to go through a recession. There's a lot of unknowns happening around Liberation Day. It's not uncommon for us to say, okay, what are the lowest quality hotel REITs that are not going to grow the same way Hyatt is going to grow, where the delta and performance between those two companies will be large enough to warrant the gross exposure, but where the risk can be mitigated by having this low basis underperforming short on the other side of something we love.
- [28:20]
B
When you put your portfolio together, roughly speaking, what does the composition look like?
- [28:26]
A
30 longs by 30 shorts, with the longs almost always being larger.
- [28:31]
B
How do you think about position size in this sector?
- [28:33]
A
I like to run concentrated. One of the nice things about real estate is you can oftentimes know very well the risk you're taking. If you're looking at an apartment REIT and you can see every single asset they own, you can see every single secured and unsecured obligation that they have, you can see the incentives of the management team. You can understand the private market value. You might lose money in that stock, but you can quantify the risk. You can really understand through hard work and disclosure the risk that you're taking. There are times when high quality real estate with solid balance sheets and great management teams for short term reasons get absolutely dislocated. And my view is that's not supposed to be a 5% position. We run with 12% positions. We don't do it all the time. It's reserved for special situations. If we really love something and we think it's incredibly downside protected and the passage of time works in our favor and we're comfortable in the case of an apartment reit that there isn't this secular boogeyman living around the corner, we're still of the belief that buying a lot of something you love is a good way to allocate capital.
- [29:46]
B
How do you think about position sizing and duration on the short side?
- [29:49]
A
Much smaller. We all know that when a short goes against you, it gets bigger, not smaller. In today's world, we're learning shorts can do things from a volatility perspective that was less common or completely uncommon pre gamestop. We have the benefit of dealing in REITs. We're not dealing with companies that are generally doing those kinds of things. For us, a short being a 3% position is a big position for us.
- [30:14]
B
You described how some of the pot activity at times can create opportunities on the long side. How does that play out on the short side?
- [30:22]
A
Not dissimilar. The volatility is both ways. The volatility is to the up and to the down. That can create opportunities for us on both sides of the book. Broadly for both sides of the book, reits disconnect from intrinsic value in a wider way than they used to. If a REIT traded 125% of NAV, that was Wall Street Journal news. Today it's the norm. While value matters to us, we need to be respectful of the disconnects that can exist longer or wider than they have historically.
- [30:54]
B
How do you organize your team to cover the more subsectors in the space?
- [31:00]
A
It used to be that one analyst or two analysts could cover REITs. The four major food groups covered 2/3 of the space and they were correlated and there was no secular. Today that's not the case. Whatever you know about office is completely irrelevant when it comes to what's happening in the industrial space or the retail space. We have a coverage model. Each analyst is responsible for 40 to 50 securities. Those all flow up to that asymmetry rank curve. The ability to cover more than that amount of stocks is a thing of the past.
- [31:32]
B
I'd love to dive into your perceptions of the different subsectors. Probably the hottest people are talking about that touches your space is data centers and would love to get your sense of what you see in the public markets in that space.
- [31:45]
A
Data centers, they're one place in real estate where the better opportunities are in the private. There are two large data center companies. Both of them have large existing footprints. The most exciting thing about data centers today is the development economics. You don't really get that as a percentage of enterprise value that you're buying very meaningfully in the public. That's something that we're doing very little of. The jury is out on what terminal value of these assets will be. I understand why there's a lot of capital going to them and the math is very powerful. There will be a lot of these built. There will be people who want to sell them. What cap rate or what multiple a 10 year old data center with a 5 year remaining lease term will be will be an interesting outcome. Not something we think a lot about because we don't have a lot of that exposure in the public. The most interesting thing is the value available today to the highest quality secularly winning real estate subsectors. Apartments, industrial and self storage. They all suffer from a similar problem. It all rests in pre 22. Real estate went one way for a very long period of time coming out of the gfc. Rates went lower, cap rates went lower with it. We came through Covid a lot of these asset classes really over earned during that time period while interest rates basically went to zero. You had this confluence of macro factors that Led high quality public and private real estate to trade at cap rates that would have been real head scratchers 10 years ago. They were there for logical reasons. Money was free, they traded at spreads and they had some growth. Then in 22 we know what happened. Rates went from 0 to 5, multiples expanded and it was pretty painful. In real estate if you entered a change in cap rate environment at a 4 cap and you went to a 6 cap and you had no leverage at all, your value went down by 33%. That was a multiple repricing for the industry began in 22. Now interestingly, what the best industries had was a second problem that was relatively unique to the highest quality secularly winning asset classes was they now had a supply problem that we had to digest for the next three years. We had a supply problem because everybody wants to build the best type of real estate. When money's free and cap rates are going lower and incomes are always going higher, it's very easy to pencil development. The problem in overall real estate is while we had a multiple repricing that was very logical and would have happened anyway, we now had to deal with the fact that we were getting the deliveries of all of these assets that were started in 20, in 21 and in 22 when money was free. Real estate deliveries are never reflective of current capital markets. They're reflective of capital markets from three years ago in industrial, in apartments, especially the sun belt and in self storage. While you were losing multiple you couldn't grow earnings. There was always someone putting a new one up across the street. Now you combine that with our view that the public markets has become much more short term oriented. If every participant is looking at 1/4 and this quarter is going to be bad, then it creates an interesting dynamic. And the Sunbelt apartment REITs, which in aggregate are the largest exposure of the fund today we're buying These companies at 6 and a half to 7% implied cap rates while the private market is close to 5, 5 and a quarter in 25, 30% discount to net asset value. Companies like this with modestly levered balance sheets, they don't trade at those levels in a sustained period outside of the gfc. This is unique pricing stuff. What's interesting to us is when you rewind, 26 minus 3 is 23 and in 23 we stop building stuff. So the output of that is in these secularly winning real estate asset classes. Some belt departments, industrial and self storage, that supply starts are down depending on market subsector 60, 70%. We think you're not only buying incredibly cheap securities here, or they're very cheap in the public markets, but you're at a point where the inflection's on the horizon. The issue for many market participants is we don't know if the inflection is starting next Friday or a year from now or two quarters from now. Which makes it, if you're a short term focus, very difficult to time that. But if you have a reasonable holding period, the IRR is available in the public market for this high quality, secularly winning real estate asset classes is exceptional.
- [36:40]
B
I'd love to ask you about the office space. Felt like there could be secular headwinds coming out of COVID How has that all settled out?
- [36:49]
A
That's been a fun one to watch. Yes, in the depths of COVID we were never going to use offices again. Everyone was going to work from home. That has certainly reversed itself pretty meaningfully. Not 100%, but that has led to a lot of these markets that were left for dead coming back viciously. The supply and demand for space in New York City is excellent. San Francisco is bouncing back in a way very few thought it would as recently as 12 months ago. This all office is left for dead today seems highly unlikely. And the private markets and the public markets quickly got back to a point where they are willing to ascribe capital at lower cap rates than people would have expected a couple of years ago. The supply and demand for space is much better, which led to supply and demand for capital to be much more fluid. One still has to differentiate between A and not A office buildings. The best stuff is where you're really seeing capital go and values go. What you're seeing is the best, most profitable companies. The expense of office is de minimis. And people want their employees back and they want them to have a great experience. They're willing to pay a lot of money for the best. You're seeing that play itself out. The less than the best stuff remains dicey. Depends on location, depends on market. The office business, it's never been a great business. It's a hugely capital intensive business. 25, 30% of the income from an office building is going into repairs, maintenance, capital expenditures on a recurring basis. And when you think of a self storage facility, that number is de minimis. You have one person working there and you paint the little walls every now and then. It's not a great generator of free cash flow over cycle relative to other asset classes. That's where the state of the world is today. Much better than it was. You have to really think about what the impact of AI is going to be on office. Highly unlikely to be super good. I can understand why in some markets it's good now with AI tenants taking space. That space that AI tenants are taking will be dwarfed by the magnitude of vacancy that they create over time. We'll see. We don't really have exposure today in the long side in terms of garden variety offices. We believe it's a dicey space.
- [39:11]
B
Been a lot of change in housing now housing's delivered. Single family rentals mentioned change in the business model. Home builders. Where do you see the landscape for the various subsectors of housing today?
- [39:24]
A
As dicey as ever. We have a housing problem that I think is leading to political outcomes that are going to lead to hopefully somebody finding a way to deal with this housing problem. But single family homes in America are too expensive for Americans, full stop. The home builders have done better than many expected them, including us in some instances to do in this environment because they've leaned heavily on these rate buy downs. They've gone to consumers and said if you want to buy an existing home, which by the way, nobody wants to sell because they have 3% mortgages and mortgage rates are at 7. So you have this frozen existing home market. But if you could find someone to sell, you've got to get a 7%, 7.5% mortgage. Depending on what timeframe we're talking about, the home builders will say, I'll buy down your mortgage to a 5% mortgage. It might impact my margin by 4 or 500 basis points. If I'm an Roe machine, I'm still paid to run my machine, generate cash flow, shrink my float, and maybe I'm generating less cash flow, but cash flow is better than none. We'll see how long they can do that. As rates have come down recently, there's been very little elasticity of demand. The consumer is stretched. The low end consumer. Low end homes are not in a place where they're transacting in a way where there's any element, we believe of health. Certainly there's some markets, but it's difficult. I don't believe that means every home builder is uninvestable. Valuation matters, Business model matters. Balance sheet matters. For apartments, that problem in housing is a good thing for you. If it's really expensive to leave an apartment building, then your people are going to leave an apartment building. If there's been rent growth back to that whole supply thing. Rents have been flat or down in many of these markets. For these sunbelt apartment REITs. But incomes are growing quietly, which is a really important metric that people don't talk a whole lot about. Rent to income in the sun belt has been going lower and lower and lower every year. So once you get back to equilibrium, we're of the view that it's not going to be, oh, we're back at equilibrium, we're going to grow a little bit. You're back on equilibrium. In the case of many of these markets, a healthy rent to income is about 22%. In these publics, you're down to about 19%. Not only are you going to get the normal growth, but you're going to get this 19 to 22% catch up. You're going to put operating financial leverage on top of that. We think the dynamics of both what's happening in the oversupply of multi and the expensive nature of single family is going to potentially lead to some significant rental increases once supply and demand normalizes for apartments.
- [42:08]
B
How about the retail space? Something you alluded to for a while has had, at least in certain areas, secular pressure from online businesses that trade is over.
- [42:20]
A
There was a period of time pre Covid where there was a belief that the physical retail experience was unnecessary. I'm exaggerating a little bit, but multiples compress massively from all companies today. Simon Property Group is one of the better performing REITs this year. They've called their portfolio retailers have figured out that they can't do everything online. They need an omnichannel experience. While we don't have a lot of exposure in retail today simply because we think there are better alternatives elsewhere, the idea that we don't need physical retail in America or that multiples for these assets need to compress meaningfully, a lot have closed. Nothing was developed. The combination of those two has led to a normalization that is a much healthier market.
- [43:03]
B
How about hotels and other lodging assets?
- [43:06]
A
We like hotels. What we really like about hotels is we feel the opportunity created in many of these management and franchise companies. If you look at the difference between expressing a view on hotels, between a management and franchise business and a reit. Blackstone orchestrated the separation of Hilton and Park Hotels. Park Hotels became the reit. They owned all the real estate. Hilton became a fully management franchise business in 2017. Interestingly, both of those companies did $2.19 in free cash flow in 2017. This year, Hilton is going to do over $9 in free cash flow. Park Hotels is going to do less than the 219 they did in 2017. Over that time period. Hilton has been a four bagger. Park is down 30%. I can't go back in time and buy Hilton, but there's a lot of there there because what happened for that to happen is not going away. It's a separation of cash flows and a development of an amazing business by taking the assets out of an asset intensive business. One of the things that we frequently do is buying the companies that are in the process of going from asset heavy to asset light. Hyatt, when they came public, they owned 70% real estate and generated 30% of their income from management and franchise. Today it's 80% management and franchise and 20% owned and leased. That evolution oftentimes leads to interesting opportunities to buy something that looks like an asset laden business. When you're looking out two to three years and seeing that 70 go to 80, go to 90 in MNF in the compound earnings in conjunction with the warranted multiple expansion that we think will come, we think it's a really interesting space. As a specialist, it's one of the spaces that we like participating in. Like everything else, the underlying fundamentals in the hotel business today are noteworthy. The super high end, there's ostensibly no price that is too high of a price. And the low end, we're seeing negative revpar that you typically don't see outside of real recessions. That's creating opportunities in stocks. There's a real discrepancy right now in how hotels are performing based upon what chain scale or revpar level they're at.
- [45:32]
B
What are some of the other subsectors that you find interesting today?
- [45:37]
A
Manufactured housing. Sam Zeller created a manufactured housing company called Equity Lifestyles. This is a phenomenal business. This is a business that's grown earnings in 99, 2000-2001-2007-2008, you name the year, it's grown earnings. And their business is simple but incredibly safe. They own the land underneath manufactured homes. They don't actually own the homes. It's an incredibly stable stream of cash flow. It's a cash flow that can grow. They have high quality, many times age restricted communities where you're able to push those rents because they are such an affordable alternative. Those kinds of high quality companies have gotten interesting in the public markets. We're spending a lot of time on the cold storage space, which has been a really interesting space. There's a public company now called Lineage, which was a private darling that came public a little over a year ago at high 70s a share quickly went to close to $90 a share today. It's at $35 a share. These are just numbers. It's nothing to do with valuation. There's a handful of things that have happened in that space, like other real estate spaces that have great fundamentals. They got a lot of supply. They've been digesting that. Their customers who are the distributors of food throughout the country got a lot better at running their businesses through Covid. So occupancies ticked down a little bit. Sadly, people are realizing there's more economic sensitivity to food consumption than the general investment community appreciated. That trifecta has led to the reason why this company has gone from 90 to 35 is quarter after quarter Mrs. Guide Downs. Today the company trades at, we believe, around 12 times free cash flow. Its competitor Americold, we believe trades a couple turns lower than that. We think good longer term businesses that are probably trading at $0.50 in the dollar to replacement costs today. That's one where we believe with duration you're going to be paid to take some risk. That is an interesting place for those with duration.
- [47:59]
B
Underlying the assessment of almost any of these is free cash flow and supply and demand fundamentals. How have you thought about using AI as a mechanism to speed up the assessment of those two things?
- [48:15]
A
We use it in the table stakes form. There's a lot of information that we can slice and dice in a way that we were not doing two years ago. It can get to a lot of the data that you're referencing, what that data means in a lot of ways that we hadn't looked at it before. It's necessary to remain competitive for a long time.
- [48:35]
B
You've run just a hedge fund. 10% of the assets are in the public markets, 90% in the private markets. Have you thought about whether to participate in where you originally thought you were going to take your career into the private real estate area?
- [48:48]
A
It's a much different skill set than it looks like. If you from the outside you say, well, if you can buy an apartment reit, you should be able to buy an apartment asset and generate a great irr. I don't think I can look investors in the eye and say because we've run a hedge fund focused on real estate securities for 15 years and I worked at DLJ for one year that I'm going to go make great returns for you. There are talented people who do that. It's a different skill set. The opportunity cost is high, the return on invested time is low. I have a couple of things that are important to me in running this business, which is why We've never launched another product until recently is if I'm not going to be the largest or amongst the largest investors in a product that we're doing, I don't want to do it for the opportunity set I see in the public markets today. I don't want to put my money in the private market because I think the public's so much cheaper. So I'm not going to ask other people to do that. But we are doing something new, which we're really excited about and we've launched an actively managed etf. This is a space that is incredibly interesting. The structure is incredibly interesting. Our view is that institutional investors will adopt actively managed ETFs. We backed up a little while ago and we said half of every potential investor meeting I've had in the last 15 years ends with will you do a long only fund? And for all the reasons I stated, I didn't want to put a lot of my own money into it because I like what the hedge fund does for a living. We generally said no. Publicly traded, high quality real estate is so cheap. Today that calculus has started to change and the understanding of the benefits of the ETF structure put us in a position to have a great product for those who want to be long real estate. If you've chosen that you want exposure to real estate, you've got a pie of capital. I sit across from you and I say, I have a product. And this product can do the following things. It can give you daily liquidity at net asset value, not at a premium, not at a discount, and not liquidity only when you don't want it. If the public markets are open, you can come in and out at net asset value. Transparency. Every single dollar that you're invested in in this actively managed long pond etf, you can see where that dollar is. If we make a trade on a Monday, you see where that money went on a Monday. We're not marking that book. Bloomberg is marking that book, which is something that's valued amongst real estate private equity investors. The fees are very fair. It's a 1% flat fee. There's a incredible benefit from a tax perspective. If run properly, the underlying investor is not taxed until they sell the etf. For those who want long term exposure to real estate, the power to compound that way is incredibly powerful. As a firm who has a 15 year track record of generating alpha in the space, we should do that on the long side just as well as we've done it on the long short side. And these companies are generally under to unlevered companies. So the risk associated with them over a holding period we think is quite good. What we did was we said, look, we're going to create a product before seeing if it's a good business. I want to create what I would deem to be the most shareholder friendly or investor friendly way to gain access to long exposure. Let's do that and then let's figure out if there's a business. Then we said, we think there's an interesting business here. What we've done is we've taken the data that we have over the last 15 years of analyzing these companies and we've said there are 80 high quality real estate companies. These are secular winners, compounders like Hilton. That will be the investable universe for the ETF from an active perspective. We are going to own the 20 to 25 cheapest of those companies at any given point in time. The beauty of this for the firm. We do all of this all day, every day anyway, unlike launching a private business. We have an amazing team, we have a great process. We have our asymmetry ranker already. We cut out the illiquid stuff or the stuff that needs hedges that exists in the hedge fund and we keep it only to the high quality companies. We think there's a huge space in the market for this. It's a product that is for now, without competition. You can go buy the VNQ, which is the passive index. They've got only 30% of the companies in the VNQ that we deem to be high quality companies. There's another half of the companies in our ETF investable universe that aren't even in the vnq. Hilton, for example, isn't in the vnq, but you can get parc. It's never going to grow earnings, but we'll take the one that's compounding 15% a year in ours. It's a really interesting product. We're really excited about it. The return on invested time for the firm makes a lot of sense for those who want long real estate exposure. It has all of the characteristics that I think the investment community will like. We are one of the first hedge funds to launch an actively managed etf. It'll take some time. Those characteristics speak really well for themselves and over time I'm optimistic with what this can do.
- [54:04]
B
How different does the ETF look from your hedge fund long book?
- [54:09]
A
It's about a 50% overlap at any given point in time.
- [54:13]
B
What was the process like for getting an ETF launched?
- [54:17]
A
Much easier than I thought it would be Anthony Famiglietti, our cfo, took the lead on that. And there's some great advisors out there who can help you walk through it, making sure that the process for each product is set out in stone prior to trades being made. Outsourcing a lot of that. So the trades on the ETF don't even happen on our desk. So there's a lot of things that we needed to put in place to make sure that it was run correctly.
- [54:42]
B
What excites you? In addition to this ETF launch over the next couple years, you're talking to.
- [54:48]
A
Somebody who's investing in the only gics sector in the S and P that's still materially down since 22. The GIC in REITs is down almost 20% while the S&P is up 40. We've now, since the beginning of 22, underperformed the S&P by 60%. I believe there's no other gig that's even negative anymore. What do I look forward to in the next two years? Not swimming against a current. We've done well. We've generated more alpha in the last three years than we have in the history of the fund. So we're proud of what we've done in this difficult environment. Real estate is cheap and it's great risk, but it's not loved. We're not as popular as we once were. Coming through this, looking into the next couple of years, I'm excited about fundamentals inflecting for Sunbelt apartments, fundamentals inflecting for industrial. The characteristics that exist right now in publicly traded real estate in real time are shifting. For our business to be swimming against a current to with a current. The stocks are cheap. The credit markets are friendly to real estate. That 90% of the capital that exists thinks real estate in the public market is cheap. The output of that is. In the last short period of time, we've seen six public processes for sales of real estate companies to the private market, all of which seem to be happening at large premiums. If we're right, earnings are about to inflect. That's generally a pretty good cocktail. I'm excited to stop talking about it and watching it happen.
- [56:18]
B
All right, John, I want to ask you a couple of closing questions before we finish. And before that, a quick advertisement. Our closing questions are brought to you by Oldwell Labs, or Owls. Owl is the very best software I've seen for allocators to find and track managers. And I've seen a lot of them. If you haven't seen owl check them out at oldwell labs.com ted that's o l d w d l l.com ted and trust me, it'll be worth the look. All right, John, what is your favorite hobby or activity outside of work and family?
- [56:51]
A
With three young kids and a hedge fund to run, free time is fairly limited. We play basketball as a firm every Wednesday morning at 7am We've been doing that for the last decade. Absent a short period in Covid outside of my family, it's the most fun I have every week. It's a great team building exercise. I grew up playing basketball. I love basketball. Your phone is put down for a period of time.
- [57:13]
B
What was your first paid job and what did you learn from it?
- [57:16]
A
So my brothers had paper roots. We all worked when we were very young. That was just something that happened in my family and my older brothers had paper roots and I was young and I wanted to be a part of it. My first job was delivering papers on their routes for them. What I learned from it was the power of operating leverage. When I went to get my own paper route, I realized that for every dollar I was making, my brothers were keeping a dollar, which I respected. I didn't resent, but it taught me the benefits of operating leverage.
- [57:43]
B
All right, John, last one. How has your life turned out differently from how you expected it to?
- [57:47]
A
I grew up in Fredericton, Canada. I now live in New York City. That wasn't on the bingo card. I thought I was going to do real estate, private equity. I apparently run a hedge fund and an etf. Now the only thing that's gone as I expected is I married a Canadian, but I met her in New York and married in New York. Very little, I would say, went the way I expected when I was growing up.
- [58:08]
B
John, thanks for this exploration of real estate.
- [58:10]
A
Thank you. It was a lot of fun. I appreciate it.
- [58:12]
B
Thanks for listening to the show. If you like what you heard, hop on our website@capitalallocators.com where you can access past shows, join our mailing list and sign up for premium content. Have a good one and see you next time.
- [58:28]
A
All opinions expressed by TED and podcast guests are solely their own opinions and do not reflect the opinion of Capital Allocators or their firms. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of Capital Allocators or podcast guests may maintain positions in securities discussed on this podcast.