Alternative Access August 2019

LOOKING BACK AND LOOKING FORWARD, PART 2 Reflecting on the Real Estate Crisis of 2009 and What to Expect Next

In the July newsletter, I covered several viewpoints related to opportunities within institutional real estate and how the current cycle might unfold. This month, I have a few more viewpoints I want to share. Read on ... So, you are saying to continue buying real estate today because inflation is around the corner? Well, I’m saying there’s a bit more inflation today than we actually measure; illiquid supply-constrained real assets provide investors with a unique portfolio benefit that offset the risks embedded in liquid paper assets. Inflation is already here, but we pretend it’s not. The best part is that real assets also win in low-inflationary environments because, by definition, if the increase in costs to construct new competitive supply exceeds the rate of core inflation, then you have a built-in arb

another definition of making money. And, of course, you are more supply constrained than you might otherwise think.

we will often warehouse whatever portion they have not syndicated, giving them 90 days to take us out after we close. We stand by as a resource at all stages of the deal, sometimes looking over their shoulder and making suggestions. But I bet on people and expect them to run the deal their way. In exchange, they give us a first look and a significant piece of the GP. The downside is that, sooner or later, a small operator becomes a big one and no longer needs us. But that’s okay. Same structure, but more selective on the buy. I’m not afraid of vacancy, especially in a well-located suburban office. We’ve seen success in turning traditional suburban offices into medical offices, and that can be a great play. I think the best office executions today are fairly capital-intensive. It’s similar in the retail sector, but I’ll only do it with an operating partner who has decades of retail relationships and understands the new realities of getting people to part with their money offline. Industrial and storage assets seem picked-over, and those are only opportunistically attractive. I’ve continued to stay away from ground- up development as I think there are myriad unacknowledged risks, like the impact of tariffs on the final construction cost. At this stage of the business cycle, I would rather redevelop than develop. Having said that, I am evaluating a number of interesting opportunity zone deals, especially in Hispanic neighborhoods, with operators I know and trust. What about other property types?

So, going back to apartments … What does this mean for execution?

Deal flow is everything. I look for structures that drive compelling deal flow from great managers into my inbox. I execute via operating partners who have defined expertise in specific markets. I’ve been an advocate of secondary and tertiary markets for 30 years because the growth dynamics are exciting and at least as predictable as large markets. I like multifamily operators who fly under the radar, especially in the middle market. I’m attracted to operators where our capital is strategic to their growth, and we can forge programmatic JVs that deliver expertise in a few select markets, sometimes only one market. The bigger you are, the tougher it is to source deals. In our industry, sometimes economies of scale work against you, and with deal flow, that is an unfortunate reality. If you are in 20 markets, you cannot know them as well as someone who is in two. Too often, the big guys have cost and incentive structures that force them to do deals that they might otherwise pass. My ideal

on rent versus buying power. That’s just

structure requires more work but is repeatable once we’ve underwritten the team, their operations, and track record. We pledge half of all GP and LP capital under well-defined

investment parameters, so our operating partners still must raise money for each deal, but they can count on us to cover at least half.

So, you are still bullish on real estate?

And they need the certainty of close, so

Yes, and for all the reasons mentioned. Deal flow is just as important as execution, and the big difference today is I think a lot more about JV structures that provide the right incentives to maximize deal flow.

I see a fair amount of opportunity today, but investors need to be flexible and nimble, looking at a

range of strategies, operating partners, and geographies to source the best opportunities.

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How people use space is constantly changing, and the pace of that change may increase. Outperforming requires more work today than yesterday, and deal flow is critical, but not at the expense of execution. It takes far more work than running a stock or bond portfolio. In that context, I think the call for lower fees by investors, similar to what has happened in liquid assets, is disastrously misplaced. This is an operating business of wildly heterogeneous assets. We’re not picking stocks. We’re running businesses.

What is the biggest single risk you see?

State and municipal budgets are strained. Taxing authorities view real estate as a piggy bank and have become very aggressive in reevaluations. Whatever your pro forma assumes future taxes will be, it’s probably too low.

THE NEW REALITY

Any final thoughts?

Institutional real estate investors may be best served by evaluating their opportunity sets into the two broadest possible categories: liquid and illiquid investments. Technology, access, and the regulatory environment is changing both areas, but they are doing so in different ways. Surprisingly, some of the big changes are happening faster in illiquid assets, like real estate, than in liquid assets, like stocks. From my vantage point, illiquid assets are more attractive long term than liquid assets. The advent of crowdsourcing platforms, the emerging “democratization” of real estate, and even real asset-backed cryptocurrencies will push more individual investors into real assets, and this trend is only just beginning. Remember that equities really took off after the 1981 IRS ruling allowing the funding of 401(k) plans from employee salaries. It’s been a great ride, but success always breeds its own destruction. Most stock portfolios are not diverse, simply because they are all diverse in the same way. When everyone uses the same techniques for diversification, what I call “copycat diversification,” then nobody is really diverse. And this creates far more volatility in liquid markets than people have historically assumed. Volatility is a risk, and liquid assets will continue to have more risk over time. REITs aren’t real estate. I like buying and owning stuff I can’t easily sell, and I think the benefits of illiquidity will soon become widely available to anyone with a 401(k). Every share of a listed stock is the same. But every private real estate deal is different, and good managers have the potential to create value every single day. I don’t experience the ups and downs that come with owning liquid securities that I can sell at the push of a button. Liquidity is neither good nor bad; it is cheap or expensive. You should know what you are paying for.

A LOSS OF PURCHASING POWER

Here is a fact for you: Retirees today are poorer than retirees back in 1979, thanks in large part to the persistent lack of purchasing power that has developed over the years. The declining strength of our currency has impacted every retiree in America. It is time to calculate a real interest rate by subtracting this ongoing inflation! Prices continue to rise as your purchasing power has plummeted all the way up to your retirement. The simple fact is your dollar is buying less, and your savings are not growing at all. With an interest rate of virtually zero, for every year that passes, you lose your life savings. Any wise pensioner has already realized that something needs to be done. Back in 1979, the average pensioner with $100,000 in savings earned enough to support a good middle-class lifestyle while maintaining their capital integrity. Now, a million dollars in savings does not earn enough in real interest to pay so much as a gas bill. To lead a middle-class life on this kind of equation means that you would need $100 million! With hyperinflation, the price of capital has gone up 1,100 times in just 35 years. Capital, therefore, is no longer producing for conservative investors. Saving is sitting down, and in this volatile market, you need to stand up and take riskier actions to secure your financial future. More to come ...

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CLOSED-END FUNDS: A PRIMER

A closed-end fund is typically an investment vehicle that is public and raises a fixed amount of capital. The fund is then structured, and shares are sold like stocks on a stock exchange. In a closed-end fund, the fund manager raises capital during an initial phase of capital raising. This can take six months to two years, depending on the manager. Once this initial phase is closed, no more shares will be created. At that point, the only shares available for purchase will come from existing investors selling their shares.

held for extended periods of time. Because of this, you will find the bulk of institutional real estate funds are, in fact, closed-end funds.

Investors tend to enter a closed-end fund during the capital raising period, before any investing has taken place. Then everyone purchases shares at the same price. The typical buy-in for these funds can be $5 million, $10 million, or even $20 million each. Immediately after the allotted fund raising period, the investment phase kicks in. At the end of the investment phase, which is also predetermined — say, after five years or so — the fund will be liquidated. On that day, every investor will get their pro rata share of the proceeds. However, fund managers will sometimes choose to leave the investment period open-ended, with no predetermined end date.

Share prices will fluctuate and change because the market value of invested assets will change over time.

In the wide world of real estate,

If investors in a closed-end fund want to liquidate their investment, either partially or fully, they will need a willing buyer.

closed-end funds are a lot more common than other types. This is particularly true in high-cost property

A closed-end fund gets its name because of its distinct phases of investment. Once the initial allotted shares are sold during the capital raising phase, the fund moves to the investment phase and is basically closed to new investors. Buying and selling of existing shares, however, can still take place.

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