Show V/O:
This is Alternative Allocations by Franklin Templeton, a monthly podcast where we share practical, relatable advice and discuss new investment ideas with leaders in the field. Please subscribe on Apple, Spotify, or wherever you get your podcast to make sure you don't miss an episode. Here is your host, Tony Davidow.
Tony:
Welcome to this special edition of the Alternative Allocations podcast. We recently hosted an episode live from the New York Stock Exchange where Clarion Partners hosted a client event. I had the chance to sit down with Jeb Belford, CIO of Clarion Partners, to discuss the state of private real estate and opportunities in the asset class. I hope that you enjoy our discussion.
I know you and I have been having this discussion, it seems like, for the last year. But coming into the year, we're both feeling pretty constructive about the opportunities for real estate.
Valuations had come down. Clearly, there were opportunities which were troubling, offices, but great opportunities, industrials and multifamily and life sciences and all. How did we start the year?
What was the view that you had? And how has that changed over the last several months here?
Jeb:
Well, I'm going to start by a couple of things you just said. We've come off a period of readjustment to new cost of capital and debt rates. So, in our space, we've lost about 20% of value from the peak in 2022.
That has brought values down to below replacement cost. And that's a big deal in our world, when you can buy assets at below replacement cost, knowing that it's very difficult to build new product accretively, you can kind of ride rents and NOI up until the point when construction becomes more viable.
So you usually have a pretty good period of returns ahead of you if you feel like you can actually get it in a pretty good basis. So we were feeling like that was a pretty good spot to be in. We were feeling like the economy was in pretty good shape from all sorts of different measures, from the consumer measure and the corporate and GDP and employment. All those were looking pretty solid at the beginning of the year. Real estate is correlated with the economic posture in the country. So, generally when the economy is solid, real estate is pretty solid.
And if the economy gets a little weaker, we get a little weaker. So, we're also feeling pretty solid about that. We're also feeling very solid about something you alluded to, it's the fundamentals in our space.
When we talk about the fundamentals in our space, we're really talking about how the properties are operating on the ground. Is vacancy low? Do we have the ability to raise rents? Is our net operating income, after subtracting off expenses, rising? Is supply in an OK place? Is demand solid?
All those things that make the operating of the properties important. We were in pretty good shape there, too, in most of the property types in which we invest. Now, there are a couple that are weak. And office is one of the places we could talk about that. But for most of the places that we invest, the fundamentals are good.
Inflation was coming down. The Fed had started to move rates down. Transactions had started to pick up. Transactions in our world had started to pick up.
The transactions that were happening were supportive of the values that assets were valued at. So all those building blocks were forming and made us feel like this year could probably be the year when the market sort of inflects and starts to go back to a more normal capital flow transaction market and start kicking off a new cycle, so to speak. And usually, when we kick off a new cycle in real estate, the returns for the first three, four, five years are very nice.
So that was the posture that we all felt coming into the year.
Tony:
And if we think back, and it was just a couple months ago, you're exactly right. Coming into the year, we thought this would be a more pro-business administration. Rates had started to come down. I think we collectively didn't anticipate as many rate cuts as others. But clearly, that was somewhat baked in. I think you talked about the office sector. And we're not going to dodge that. We'll come back and revisit it. But because of the office sector and the concerns, valuations had come down quite a bit.
So, we were feeling good about real estate coming into the year. I'll remind everyone here what has happened recently. On April 2nd, the Trump administration announced what they refer to as reciprocal tariffs.
We could debate all day whether they're reciprocal or they're just resetting the trade agenda. Obviously, that caused a shock to the market. The market was down pretty precipitously for the first couple days.
April the 9th, a week afterwards, he reversed his position, essentially saying, well, let's pause for 90 days to think about it. Immediately afterwards, I was talking to Jeb and Indy. And we're thinking about this and trying to think about how we could communicate some of these changes to you.
And I don't think we've made substantive changes in our outlook. But there were some little things that we thought could be different if we're thinking about reshoring, bringing things back here. Maybe give kind of a current view in how we're looking at the world today.
Jeb:
Let me start by mentioning something I mentioned earlier to a couple people in the room, which is we're generally a slow-moving space, right? It takes us three months on a good day to do transactions, right? And we're thinking about investing over the long term.
So we're thinking about dynamics. They're going to make real estate investments, whether it's property type fundamentals or whether it's geographic fundamentals or where's the fundamentals of individual assets. We're trying to make judgments on which of those are going to provide great returns over five, seven, ten years, right?
So we tend to anchor ourselves in what are the big economic and structural drivers that really influence our space? And where are they going? What is the long-term trajectory of those? And where are they going? And therefore, where do we want to invest? So when something like this happens, you sit there and say, well, is what's happening likely to change those long-term fundamental drivers and/or our view of what could be good and not so good, right?
And I would say really big picture, those long-term fundamental drivers, which are things like demographics, things like innovation, things like a persistent housing shortage, are not the kind of things that are likely to get really upset by a little near-term uncertainty and volatility. So, our fundamental long-term view probably hasn't changed a whole lot. That being said, you immediately go into, well, if things play out in different ways, what effect could that have on the economy and on our space?
A very near-term one is that there's a uncertainty, but I think a general view that the possibility of weaker economic performance of the country or a recession is a much higher probability. And as I said before, real estate is correlated with the economy. So if we go into a little bit weaker period, that should have a somewhat negative effect on demand in our space. So we'll get a little lower rent growth and a little lower NOI growth for a little while. Is that a dramatic or a disastrous change? I would say no.
But we will definitely have, if we get a weaker economy, that will affect us too. It'll be a little longer before we come out and start the new cycle, or we'll have a little rough patch. But again, it doesn't really change the long-term fundamentals of our space and our long-term view.
Since what's happened has been so focused around trade and tariffs, you immediately start to think, well, what effect could that have on our industrial sector? Because the industrial sector does take in goods from all over the world. It does take in lots of goods that are produced here too and distributes them.
It's been an excellent performing sector for the last 15 years. It's likely, in our view, to be one of the best performing sectors going forward. A lot of that's driven by the pace of e-commerce and the continued rise of e-commerce, which seems relatively relentless and positive.
But nonetheless, if we have a big shift in trade patterns and the way goods move around, what effect might that have on our space, our industrial space, and what effect might it have on different markets inside the industrial space? And to the extent, for example, we do end up getting more near-shoring, on-shoring, friend-shoring, those are words that are now thrown around, which is basically the manufacturing and creating of goods much nearer to home and closer to get into us. And to the extent that we get more manufacturing in this country, which has already started happening, it seems likely, those are actually positive things for the industrial sector, right? They create demand for industrial space. So, the fact that we're having some bumps in the road, probably in our view, doesn't affect the trajectory of the overall industrial sector as a whole.
Now, I'll give my last little near-term example would be a lot of the focus is on China. We know we get a lot of goods from China. It's one of our largest trading partners and a lot of the goods from China flow across the Pacific Ocean into our West Coast ports. So knee-jerk reaction is, well, oh my God, like if we have a big problem with China, is that going to crush our West Coast ports in favor of some of our other markets?
You know, in fact, when you really look into it, in Trump 1.0, we had increased tariffs with China. And since then, China's share of trade to the U.S. has dropped from the mid-20s to the high teens. It's lost about seven or eight percentage points, which is a big deal.
So in theory, that should have made the West Coast ports weaker if that was the only place the goods were coming from. But what's picked up slack of that reduction from China has been Southeast Asia. And the Southeast Asian goods come the exact same way as the Chinese goods. So actually, over the last six or seven years, the West Coast ports have actually strengthened. And Mexico has been a big beneficiary. So the goods coming from Mexico has increased dramatically.
And the markets that come through, which is not just border markets, but markets like Atlanta and Dallas, because those goods are coming up and then getting distributed over a whole bunch of places, have actually been very strong. So, the pattern of trade has already been changing for the last seven or eight years. It's actually had, we think, a net positive benefit so far. And our gut and our analysis leads us to say, this actually might end up being better for industrial as opposed to bad.
Tony:
I'd love for you to maybe go back and talk a little bit more about your macro themes. You started that discussion. And I think that's such an important foundation because you've got this long-term view. We can make subtle changes as the market environment changes, but your long-term view is a five-year, six-year view as opposed to one month or two month. And maybe it'd be good for this audience to maybe frame that a little bit better for everyone.
Jeb:
So we really have five fundamental driving factors, themes. And the first one, and probably the most important one is demographics, right? And the way demographics is playing out in our country and other countries, both our country and for the importance of this discussion, where is the population really increasing? Where might it be staying the same? Where is it actually declining? That's an age thing.
It's also a geographic thing. But the two big, the really two big developments there that are actually very well-known is the boomers all getting into their very end stages of their lives. That's a ginormous increase in the amount of elderly people in this country. That comes with ginormous demand. That's demand for everything healthcare. That's life science space, medical lab space. That's senior housing.
The innovation, which is another big theme in that whole healthcare field has also been driving that. So the healthcare sectors are being driven by the demographics. They're being driven by innovation and the pace of innovation.
But the other big increase demographically is right in the middle. Like it's the millennials and a little bit of Gen X before them are in prime earning household formation, expansion, consumption years. And that's a big growing group. That's a big growing group for the next at least six to 10 years. And that consumption and that behavior benefits a lot of our sectors.
It benefits retail, necessity retail. It's benefiting the industrial sector because it's the goods moving through the system. It's benefiting almost every housing type because those people are forming households and expanding their households. So almost everything housing and everything industrial is being driven off a demographic story. So, I've spent a little more extra time on that but that is such a fundamental driver of our space.
Innovation, I mentioned number two, a very simple example there is the rise of e-commerce that's benefited industrial. It's actually hurt parts of the retail spectrum. That was a pretty dramatic change in our space. That started happening a long time ago but back in 2016 or 2017, you started to see a dramatic bifurcation of the returns in the industrial sector which became extremely strong and retail, which were somewhat weak.
And those kinds of bifurcations in our space makes it so important to allocate your investment to the right places and away from the wrong places so important. And so our suspicion is the pace of innovation is not going to slow up. It's going to have a dramatic effect on our society and we need to be watching where that's going to benefit and hurt. When we get to the office discussion, I would say innovation has actually hurt the office sector.
Number three is we have a persistent housing shortage in the country. This one's a relatively simple but powerful theme that we've built up after the global financial crisis. We now have what most people estimate to be three and 5 million units of all kinds of housing, everything short of what we should have. That is an incredibly powerful positive driver of all housing, for sale housing, for rent housing. It's almost impossible to fathom a case where we can build enough housing to solve that problem in our country with all the things that line up against it.
So all housing, we think, has a very powerful tailwind behind it and that excites us. You couple that with affordability issues, the affordability issues that we all know of and that drives you to, wow, rental housing has a strong driver.
Shifting trade patterns, our fourth theme, we're living that out right now. We've talked a little bit about that but how goods move around, where they're produced, where they come into the country, where they go out of the country is a big deal. We actually think that's a positive for the industrial sectors now but it's also causing us to think about which markets might be better and worse.
And the last one is resiliency and when you use that word, what you immediately think of is kind of the ESG-type resiliency and that's part of it. That's a very important part of it. Climate and ESG and the characteristics of buildings are very important to tenants, and they are important from an investor point of view and we definitely try to orient our portfolio that way.
But when we talk about resiliency, we're talking about two other things that are also equally important and one is structural resilience and when I say structural resilience, that's, are the buildings of equality that they're going to attract tenants? Are they in the locations that are going to attract tenants? Do you have a resilient piece of real estate for the demand that would normally come into it? Because ultimately we want to stay as well leased as possible at the highest rents possible.
And then there's also what we call economic resiliency. Is the resilience of demand in that market strong? Like are you in a weak place where if you have a little bit of fall off on demand, it's actually really going to be a bad day?
Or are you in a location or a market that is always going to have strong demand drivers and therefore going to funnel basically tenants into your assets? So, we've been underwriting real estate forever thinking about that economic and structural resiliency without really calling it that. But if there are two super important components of the themes going along with the ESG portion to create this sort of resiliency package that we think is so important to investing in any kind of asset. So those are our five big themes and they're big and long lasting.
Tony:
And what I like about the themes is if you understand the themes, and these macro themes are again, five years, six years down the road themes, it points to where the opportunities are. And a couple of times you mentioned industrial benefit from reshoring, industrials benefit from e-commerce and all of the things going on. So if you understand the macro themes, it's easy to understand that discussion.
And I've long argued when we think about real estate, the problem is we shouldn't think of real estate as a monolithic investment. Those sector allocations, where you deploy capital and where you avoid deploying capital is so important and really probably the biggest determinant of success and failure. So let's talk about the elephant in the room and that's office sector.
And if I can, I'll indulge you with a little bit of a story. I was telling a couple of you earlier, I get a little nostalgic being in this building. I was a young lad on the floor of the exchange in the 1987 market crash. I did pricing volatility studies when there were actually people on the floor of the exchange. And now I look at it and it's a museum. It's a great museum. It's got a great history here.
So, I wonder how the office sector ends because I don't know here if people go back to the office like they used to similar to the exchange or is there another story that could be told, which is maybe it gets retrofitted for housing or some other means of taking advantage of the physical space.
Jeb:
We can go on for hours on office, but really big picture. The office fundamentals are very weak. Vacancies climbed very significantly. And the two things that we pay attention to the most are how many people are really going back to the office. And that obviously was very low in the middle of COVID or the start of COVID and it gradually increased, but it kind of stopped increasing a couple of years ago. And it sort of stuck in what people sort of think of as sort of the 50 to 60% of people normally going to the office on a day-to-day basis are doing so now. And it really hasn't improved much in two years.
And I think that's a negative sign. I think it's a sign that we've changed our behavior likely permanently. What will tell us that for sure though is if one day we get to a weak employment market and where the balance of power kind of shifts back to the employer versus the employee, we'll have to see what happens then.
But so far it's been very difficult for a really big picture companies to get people back to the office five days a week. But the more important thing we watch is like what are tenants really doing when they choose to either renew their space or move, which happens in the office sector, you know, every five, seven, 10 years, that's the typical length of leases. So in one sense, we haven't seen the whole playing out of that because we're only sort of four or five years in.
And anybody that had a lease that's longer than that at the beginning of COVID probably hasn't started to deal with that decision yet. But there really isn't great news there. You know, when you look at the average, the overall average of what the tenant decides to take for space, whether they stay or move compared to what they had before, it's about plus or minus 20 to 25% less. Like that's a really big deal.
That's why vacancy is so high. And we really haven't seen a lot of evidence or a lot of evidence in many markets that that's changing either.
So, we believe the fundamentals in the office side are gonna stay weak for a long time. Now, once you dive into the office sector, like everything else, they are winners and losers. There are a certain number of buildings in every market that are the very, very, very best markets. And they're doing just fine. In fact, they're probably doing better than they used to. They're attracting tenants. They're staying well occupied. They're setting record rents. So, for a handful of buildings, and let's call that the top 5% of the buildings, that's not very much. Those are actually probably in very good shape. I suspect that whoever owns them is probably never gonna sell them because they're pretty good.
So, we believe the fundamentals in the office side are gonna stay weak for a long time. Now, once you dive into the office sector, like everything else, they are winners and losers. There are a certain number of buildings in every market that are the very, very, very best markets. And they're doing just fine. In fact, they're probably doing better than they used to. They're attracting tenants. They're staying well occupied. They're setting record rents. So, for a handful of buildings, and let's call that the top 5% of the buildings, that's not very much. Those are actually probably in very good shape. I suspect that whoever owns them is probably never gonna sell them because they're pretty good.
It is not easy. A simple solution would be convert them all to residential. That would be what everybody would love to do, but it's very hard to do that. They're not configured right. It's super costly. You're providing housing to make it work where it works, you're going for the very top end of the market and generally places, cities would rather see more affordable housing added as opposed to top of the market, top end housing. So, I think you're continuing to see some buildings get converted to residential. That is a good solution.
Are there other uses that could be dreamt up for some? Probably. But it's very, very hard to do. And if it was easier, a lot of it would have happened already. Like in the last 15 or 20 years, this is not a new idea. So, I just don't think that's going to be a magic solution.
Tony:
I've asked that easy question to Rick multiple times and he's given me the same response. It's much more complicated than it seems.
Jeb:
And he's an architect, so he kind of knows how hard it is.
Tony:
Let me ask one more question. Again, we're talking about a lot of material here. I want to go back to the beginning of the year when we wrote our market outlook, which kind of looks at all the opportunities across private markets. Two of the macro themes that I had identified, which I think are pertinent to your space, are we believe there's a big difference in putting capital to work today versus putting capital to work in ‘21, kind of peak valuations.
And then the other macro theme is we think there's going to be a larger dispersion of return between the winners, those managers who have actually managed through good times and bad, versus those who were newer to the space who maybe lacked the depth and the resources. I would love for you to maybe jump in on that because I think in your space in particular, having the ability to look forward and say where you want to allocate capital versus if you had invested in ‘21, you likely would look very much like the market, which probably would have had a much higher allocation to offices.
Jeb:
So again, if we're trying to take a view out as to what we think is going to work the best over a long period of time, let me talk about timing also as we come to this. You stick with the big fundamental themes, you stick with the property types you think are going to benefit from that. You would then allocate in a perfect world your portfolio across the places that you think, in a diversified way, in the place you think are going to perform best.
So, when we do our model portfolio, the housing sectors are a big component, a little over a third. The industrial sectors, not just industrial warehouses, but what we call IOS, which is industrial outdoor storage, that's an alternative industrial property type, is another third plus. So a big chunk of what we think is going to be the best part of our world, you know, call it 75%, is going to be in housing and industrial type sectors, right?
And then self-storage has a component, data centers have a component. Healthcare is probably the next biggie. Well, retail and healthcare are the next biggies.
In retail, you still want to have a healthy chunk there because like parts of the retail spectrum are totally in excellent shape in what we call a necessity part. Think grocery anchored centers and community centers that are catering to sort of everyday needs. They're very smooth, consistent performers, and they get to like a 10 or 11% chunk of our model universe.
Office has a teeny tiny slice, no surprise because we think the outlook is relatively poor for office. That's less than, you know, it's 4 or 5%. So we try to orient the portfolio, or an ideal portfolio, around the themes and around where we think long-term performance is going to be.
Tony:
Can I just interject though? But the difference is, if you have capital today to put to work, you can actually see where the opportunities are. And my comparison, and I suspect many of you who might've allocated capital to managers in ‘21, you probably would look pretty different because ‘21 was a different environment and you likely would look-
Jeb:
Yes, so in ‘21, we didn't yet know what was fully going to happen to office. Office has always been a very big component of our portfolios and indexes, right? So, it was the biggest. It was always 30 to 35, even topped out at 40% of the overall index. And that's notwithstanding everybody knowing that office is very capital intensive and actually doesn't produce the same long-term positive returns, as good a long-term positive returns as things like housing and industrial and retail. It was the poorest of our major sectors performers, but nonetheless, it had the biggest weighting.
So, in ‘21, you wouldn't have known. You still wouldn't have known how things were going to play out fully. And you probably would have had a much bigger segment to office because the outlook then probably wasn't as bad. That's changed dramatically since ‘21 until now, which is your point. But our suspicion again, is that the fundamental themes are the important drivers.
They should lead you to what kinds of property types and geographies you should be investing in and over-weighting and under-weighting. And we think the themes are long-term persistent themes. And therefore, not that near-term bumps in the road aren't important, you gotta watch for them, but they're the drivers. So, I would suspect it would be less likely that three years from now, we would have a dramatically different view than we do today.
Tony:
I hope that you enjoyed this special edition of the Alternative Allocations podcast series. As always, please rate and review and let us know if there are future topics you would like for us to consider.
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