The REIT Renaissance

Speaker 1 (00:08): Hello and welcome to your Thriving Practice. I'm your host, Dan Corcoran.

Speaker 1 (00:13): As we continue our look at the future of the 60/40 portfolio mix, financial professionals are looking for new, more innovative and diversified approaches when advising clients on their portfolio allocation. One such diversification option is private real estate. That's what we'll talk about today, how to access private markets and how to compare public versus private real estate. We'll also talk about non-listed REITs, the history of non-traded REITs, and then get into the nuances around the macro market. Joining us today is Stephen Morello, who's a principal at KKR within its client partner group. So Stephen will look at one piece of a potential portfolio, real estate investment trusts or REITs, as a way to inject an element of stability into a volatile market. Stephen, thanks so much for being here today.

Speaker 2 (01:02): Thanks so much for having me.

Speaker 1 (01:03): So we all know that the 60/40 allocation has been a typical diversified portfolio for a while now. This portfolio construction strategy worked well for individual investors until last year. And while we can debate the validity of the 60/40 going forward last year, certainly caused many investors to be open-minded to different alternatives. One of those alternatives is real estate. So Stephen, let's start with your perspective coming into 2023, and then let's dig into real estate.

Speaker 2 (01:34): Absolutely. So to your point, the 60/40 was initially constructed to really be the optimal allocation for individual investors to achieve the best risk adjusted returns. And in theory, this was because stocks and bonds should move opposite of one another, or they should be uncorrelated to one another and ultimately be a stabilizer when one goes down, the other goes up. Ultimately in 2022, what happened, you had a very challenging year. What you saw was C P I ultimately hit a 40-year peak. And what ensued after that was the Fed went through a very hawkish tightening cycle. They raised rates seven times for a cumulative of 425 basis points. In that environment, the 60/40 performed poorly. The S&P 500 was down about 20%. The AG was down 13%. But what was more important than the actual negative performance of stocks and bonds respectively, was that actually the performance was correlated. And that correlation in traditional investments has ultimately what made people more open-minded to alternatives.

Speaker 1 (02:40): So let's dig into that just a bit further now. What are the key takeaways in comparing public and private real estate?

Speaker 2 (02:47): First off, real estate is actually the third largest asset class in the us yet if you think about the 60/40 portfolio, that does not include real estate. And I think the main reason for this is most individual investors are just unsure how to actually access real estate. But at the end of the day, I think there's some tangible benefits to real estate out there. One, inflation hedge. Two, they provide uncorrelated returns to traditional investments. And three, there's an element of of tax efficient income. Now, I think for the individual investor, when you think about ease of access, the easiest way to access real estate tends to be the default option of of publicly traded REITs. Now these, for individuals that need daily liquidity makes sense, and that can be looked at as a benefit, but that daily liquidity stems from the exchange traded nature of the product, which causes outsized volatility and reduces the diversification benefits that investors are searching for with a real estate allocation. Now, for wealthy individuals who can write a large check, you could invest in direct real estate. So that would be investing in, call it a secondary investment property, maybe an apartment complex, but there as an investor, you would have to manage that property and that can ultimately turn into a full-time job. So if you want to have private real estate without public market exposure, beyond direct real estate, there is private real estate funds, which gives you the true fundamental exposure of real estate without that public market volatility.

Speaker 1 (04:24): Let's backtrack just a little bit. What has the historical return experience been between public and private REITs?

Speaker 2 (04:31): So if you actually look at the difference in annualized performance of public and private rates, it's been very similar back since the early 1990s, both have delivered about 8%, and I'm talking about really the MSCI U.S. Reed Index and the NA CREF Odyssey. But the difference has really been the difference in volatility because ultimately publicly traded REITs are highly correlated to global equities. The actual correlation back over the past 20 years is about 0.7. And then on top of that, if you actually look back since 2010, publicly traded REITs have actually had 10 price swings of 15% or more in a 12 month period. And private real estate has had zero similar volatility experiences. So while they've achieved the same annualized performance over a multi-decade period, I think how you've achieved that performance and the emotional experience that that could cause to investors matters. And that's why I think there, there's value in private real estate's performance stability,

Speaker 1 (05:35): And how can investors actually use private real estate investments as part of their portfolio mix to achieve elements of stability in their portfolios, for example. So,

Speaker 2 (05:46): If you look beyond publicly traded REITs and direct real estate, private real estate funds is really the first thing that that comes to mind. Then I would say traditional private equity slash private real estate funds were almost synonymous in a sense that there was a multi-year element of illiquidity, there was capital calls, there's distributions, but over time there's been what we call in the industry democratization of private real estate. And what that means is ultimately creating structures that actually align to the needs of individual and institutional investors that would like more liquidity than the traditional multi-year illiquid vehicle. Now, one specific example of that would be a non-traded REIT. A non-traded, typically from a structural perspective, maybe have monthly or quarterly liquidity, and they're not traded on an exchange. So there's no public market volatility, and you get access to institutional quality real estate without that multi-year illiquidity. And in addition to that, they produce a level of consistent income.

Speaker 1 (06:54): And as with any financial product, there may be misconceptions here. What are some of the misconceptions that investors may have about non-traded REITs?

Speaker 2 (07:03): If you think about non-traded REITs, they actually originated in their first form back in the early two thousands. And at that time, they were marketed to unsophisticated retail investors by non reputable firms. And what they were doing at that time in that call it non-traded re 1.0 structure, was that they were charging a very high upfront fee, something like 10%. So as an investor coming into the fund, you took a 10% haircut immediately. And in addition to that, they had non-standardized opaque valuation processes. And what happened when you went through the global financial crisis was that many of these non-traded REITs went from, let's say a $10 nav, one quarter to a $0 nav. So a lot of people actually lost a lot of money. So for any financial professionals or end clients that actually invested in one of these, I'll call 1.0 non-traded res, there may be some inherent skepticism around the structure or just the general terminology of a non-traded reit.

Speaker 1 (08:09): And that skepticism is is tough to shake even years later. So Stephen, how exactly has the non-traded REIT business evolved since the global financial crisis?

Speaker 2 (08:19): Yeah, so there's been a a fair amount of evolution post G F C, and that has stemmed from, I would say, one regulation because ultimately coming out of the global financial crisis and the many lawsuits that ensued, regulators stepped in to regulate one compensation. Now two post gfc, I'll call it, in the mid 2010s more well-known sponsors came in and really institutionalized the space. And what does that mean? So they standardized valuation, there's new structures put in place, and within that valuation, there was a level of third party oversight that added protection for individuals and investors alike. So at the end of the day, I would say where we are today is that we've seen a 2.0 version of a non-traded re and even a 3.0 version of an evolved structure that typically when you think about what that structure actually is, it's one you can come into the fund typically monthly or daily or quarterly, depending on the vehicle. And then there is typically monthly or quarterly liquidity. And then as I mentioned, there's a level of consistent tax efficient income as well. So

Speaker 1 (09:30): With the evolution of the non-traded REIT, how does illiquidity play into that?

Speaker 2 (09:35): Illiquidity is a really important part of any investor that's looking at any private market product, but in particular, non-traded REITs, they do not have daily liquidity. And I think from some investors' perspective, they may look at that as a negative, but in reality, non-traded REITs are offering you true exposure to private real estate. And if you think about a building, for example, like a commercial real estate asset, it actually takes multiple weeks if not months, to actually go through a sale process or a by process of that specific asset. So to offer a fund that gives you true exposure to real estate wouldn't necessarily be synonymous with a true exposure because buildings are not liquid on a daily basis. Now, at the end of the day, what do these funds offer in terms of liquidity to investors? Typically, they offer a percentage of the funds, fund's NAV on a quarterly basis, and they do this to not have to sell assets suboptimally at pricing that would be detrimental to investors.

Speaker 2 (10:37): So for example, what does that look like in terms of liquidity around these vehicles? Let's use an example where 5% of NAV V in quarterly liquidity is offered. If you take a fund that has 2 billion in NAV, that would mean that the fund would have about a hundred million of NAV offered if there was more demand for redemption out of that fund. Typically what you'll see is a probation back where investors don't get all of their money out, but maybe a percentage like 60, 70%. And then ultimately what happens over time is investors in the vehicle can get their money out over multiple quarters. So I think what's important here is for potential investors, you have to be committed to having real estate as a long-term allocation. And these products shouldn't be looked at as short-term trading vehicles because you can't trade in and out of them, and it has to be a long-term investment.

Speaker 1 (11:28): Now, a moment ago you mentioned tax efficiency. Can you talk about that a bit more?

Speaker 2 (11:32): Absolutely. This is a really important topic and one of the main attractive points of real estate in general and non-traded reads. So as I was saying before, like these funds are investing in actual hard assets, they're investing in buildings. And what from a fund perspective these funds will do is they will ultimately depreciate those hard assets from an accounting perspective. And what happens then from an investor experience standpoint is the benefit of that depreciation is passed through to investors and materializes on an investor's 1099 in the form of something called return of capital. And that's sometimes shortened for R O C or rock. Now what that means is that a percentage of the income is actually tax deferred, and this can be a really meaningful benefit to investors in the fund because that percentage can actually be a very high percentage of the income on an annual basis.

Speaker 2 (12:30): And it's not uncommon to actually see that be a hundred percent. And now I think just to frame that in terms of an after tax experience standpoint, if you think about a corporate bond or the tax equivalent yield of a non-traded REIT, that would be yielding 5% on a nominal basis with a hundred percent return of capital, the tax equivalent yield there is actually about 8%. And then in addition, anything that's actually not deemed return of capital receives another benefit under the the jobs and tax Act of 2017 of a 20% discount from your ordinary income tax bracket. So the entirety of the distribution of a non-traded read is actually tax efficient or more tax advantage than your ordinary income tax rate.

Speaker 1 (13:17): So now let's get a bit more specific on today's real estate market. With the prevalence of work from home or hybrid work, we've seen pictures of just empty downtown office buildings and lower rents, et cetera. So how does that affect commercial real estate markets today?

Speaker 2 (13:33): It absolutely is affecting commercial real estate markets, but I don't think it's affecting them exactly how it is perceived. I would say one, the the work from home trend I think most people can agree is here to stay. And I think we are not necessarily in a work from home full environment, but more a hybrid work environment and it's causing companies and rightfully so to rethink their office footprint. So what you're seeing happen is you're seeing these companies actually consolidate their office footprint and actually downsize into what has really been new tech enabled highly amenitized prime locations of office buildings that are near transit centers. Now they're doing this because they actually still want their employees to come to the office. They don't want their employees to have any excuse to stay home five days a week, even if it's just a few days a week.

Speaker 2 (14:23): Companies still by and large want their employees to come into the office. So what you're seeing is this consolidation into newer office buildings, but candidly, the office stock out there is actually largely older office buildings that are built in the mid 20th century. So the total demand for office has actually come down fairly significantly. And an office that is older in a non-prime location may be looking at vacancies of 50% or more. So going forward, older office buildings, which are the majority of office buildings in the United States will be affected negatively. But there actually is this resurging demand for new tech enabled office buildings in prime locations.

Speaker 1 (15:08): So let's talk about, if we can, Stephen, what does the city and also real estate in the future look like to you? What do you see?

Speaker 2 (15:16): Yeah, so this concept of what does the future city look like, I think is, is on the minds of everybody. And rightfully so because most office buildings are in downtown locations. And while I mentioned before like office demand for tech-enabled prime located assets is still high. The majority of cities called like 90, 95% of the office buildings in the US are older. So this has caused many people to think about, okay, well what can we do with that vacant office space? And one of the things that has constantly been in the headlines recently is the potential for office to multi-family conversions. And this is a really interesting topic, but if you actually look at the validity of that going forward, I would say there's a couple things that consider many of these older office buildings actually have really large floor plates that don't necessarily align with the typical structure of a multi-family asset.

Speaker 2 (16:09): They also typically don't have enough elevators that a normal multi-family asset would actually have. But the floor plates issue, I think is one that's more prevalent and more prominent because you have space within that floor that isn't rentable and then it's wasted space. In addition to that, you have other things in cities like New York where each actual bedroom has to have a window. So if you think about that large floor plate, it becomes very difficult then to ultimately create a profitable office to multi-family conversion. And then on top of that, what I would say is that we're also in an environment, as I mentioned earlier, where the cost of financing has gone up significantly. The Fed has hiked rates through 2022 into 2023. So the cost of financing is not what it was 18 to 24 months ago. And many of these developers that come in to do an office to multi-family conversion, they're not just using equity, they're also using financing from banks.

Speaker 2 (17:09): And therefore, because of that, it's harder to achieve a level of profitability because these are levered developers that are coming in to ultimately do these office to multifamily conversions. Now, in saying that, I think if you look at the future of the city going forward over the next decade or two, I think we are gonna have less office. I think we are gonna have more housing because there's still demand, especially from young people to be in cities where there's restaurants, bars, and other entertainment. But ultimately, I don't think it's all gonna happen today. I don't think it's all gonna happen in the next five years. I think it's gonna happen over a multi-decade period.

Speaker 1 (17:46): So Stephen, in this environment, and you described it so well, how does real estate credit play into all of this?

Speaker 2 (17:52): So real estate credit is is an important topic, especially in the environment that we're in today, where the cost of financing has gone up so significantly because of the hawkish fed policy that I mentioned earlier in the fact that interest rates are at a far different place than they were 18 to 24 months ago. There's risk out in the marketplace for uh, borrowers who have in place floating rate financing, being unable to actually pay their mortgage interest stemming from rent, and because of the increased cost of that floating rate financing. Now, in addition from that from a different perspective, it actually creates an opportunity to act as a lender as opposed to a borrower. And we're in an environment where the cost of capital has gone up, one from interest rate policy, but two, because of the lack of financing available from traditional banks and from regional banks.

Speaker 2 (18:47): And due to the recent regional banking crisis, there's been more of a pullback from traditional lenders. So this has created an opportunity for non-traditional lenders to step in and originate loans or buy real estate credit securities in a way that can ultimately generate, in some cases, call it low double digit, gross contractual yields in an environment where it's actually very difficult to generate similar returns on the equity side. So it becomes a really interesting opportunity where you can originate alone, have deep equity subordination beneath you and can generate a return that's in excess of equity. So it's a really interesting time for real estate credit and real estate lenders in general.

Speaker 1 (19:30): So big picture here, how does all of this come together from an asset allocation perspective?

Speaker 2 (19:35): So from an asset allocation perspective, I would first say that every investor will have different needs. Every investor will have different abilities to take on illiquidity. Now, one thing that we've looked at in terms of contrasting the 60/40 portfolio with a different idea for investors that can handle semi-liquid illiquidity is a portfolio that's 40, 30, 30. And ultimately what that portfolio has is a 30% allocation to alternative investments. And within that broader portfolio, 10% of the portfolio is in private real estate.

Speaker 1 (20:12): So what would some of those alternative investments be?

Speaker 2 (20:16): Yeah, so there's many different private market asset classes that would fall in the alternatives bucket. We've talked about private real estate, but in addition to that, you have private credit, you have private equity, and you have private infrastructure. So those are just to name a few that would fall within that 30% alternatives bucket. And what we did in testing that portfolio from a return experience standpoint is we back tested it verse the 60/40 portfolio over a multi-decade period. And ultimately what we found was that the 40, 30, 30 actually produced about 150 basis points of excess return. But more importantly than that, it actually produced a volatility profile that was about 300 basis points lower than the 60/40 portfolio. So it didn't just only outperform, but it did so with far less volatility. So we think it matters for end investors and financial professionals alike, not just in achieving excess performance, but achieving that in a way that creates a far better return experience that's far less emotional for the end investor.

Speaker 1 (21:19): Such important information. Stephen, thank you again for joining us for sharing your insights on private real estate and REITs. I know I learned a lot today, and I'm sure our listeners did too.

Speaker 2 (21:29): Thanks so much for having me.

Disclosure (21:38): The opinions, beliefs, and viewpoints expressed by the guests on this podcast do not necessarily reflect the opinions, beliefs, and viewpoints of Global Atlantic Financial Group. Global Atlantic Financial Group, global Atlantic is the marketing name for the Global Atlantic Financial Group LLC and its subsidiaries including for Thought Life Insurance company and Accordia Life and Annuity Company. Each subsidiary is responsible for its own financial and contractual obligations. These subsidiaries are not authorized to do business in New York.