Private Real Estate: From Uncertainty to Opportunity

Private Real Estate: From Uncertainty to Opportunity

Anu: Private real estate can be a compelling component of a well-diversified portfolio, potentially offering attractive returns through income and appreciation, but also providing a potential hedge against inflation. With rate cuts and moderating inflation, along with a tough fundraising environment, private real estate presents unique opportunities and challenges, particularly in today's economic climate.

To help us navigate these complexities, I'm pleased to welcome Justin Hakimian, Investment Committee member of Neuberger Berman's Almanac private real estate team. Welcome, Justin to Disruptive Forces.

Justin Hakimian: Great. Thanks, Anu. Great to be here.

Anu: Now Justin, it's been around a year since we had someone from your team, the private real estate team, which we call Almanac, on the show. Catch us up. How has the private real estate space evolved over this time?

Justin: For folks who've been tracking it over the past 12 months or longer, I would say on some days feels like Groundhog's Day. The same set of challenges, the same set of headwinds that persisted about a year ago still persist today. There's definitely signs of improvement. I'd put those generally into two buckets. There's an operational bucket and a capital markets bucket.

On the operational side, COVID had a very meaningful effect on certain types of real estate in particular. Think office and the work from home trend. Think seniors housing. Think about hotels and hotels in certain markets in particular. We've seen improvements fundamentally in those asset classes over the past 12 months, but still some challenges remain.

The other operational challenge, more widespread, is inflation. Much talked about out there and definitely no surprise, but the pressures it's put on, things like insurance costs, real estate taxes, labor costs, especially for more labor-intensive real estate assets. Again, think hotels, senior housing. You've seen some margin compression that has started to improve, but some headwinds continue to persist.

On the capital markets side, the headline there is interest rates. We had nearly 0% interest rates for a while there. We saw a meteoric rise in rates. They've come down recently. They're back, the five-year and the 10-year are back up a little bit. That has put a lot of stress into the marketplace. As a result of that, 12 months ago, transaction activity was very, very slow. It's picked up a little bit, but for the year, you're probably going to be down 60%, 70%. Then similarly, that leads to a very challenging fundraising environment, which again, we're starting to see improvement over the past several months, especially as compared to a year ago. You can put that into the challenges and the headwinds of the capital markets bucket.

Anu: Yes, sure. 60% to 70% down on transaction activity. That's an interesting stat. You mentioned the challenging fundraising environment. Could you just explain what are some of the key factors that have contributed to that and what effect do you think that's had on private real estate investments?

Justin: Yes. There's a couple of points I'd make there. One is there's just been heightened uncertainty out there in the marketplace. Are we going to enter in a recession? What type of recession, if at all? Interest rates, I mentioned inflation. Investors, to a certain extent, it's not the absolute level that they're targeting, it's the volatility and the uncertainty that's very difficult to underwrite, and so that has affected fundraising out in the marketplace.

I think number two is just time and effort. We use the phrase mindshare all the time in the office. Folks have challenges in their portfolios, and that can be, can go back to operational challenges with certain assets that can be driven by the capital markets side of the ledger, maybe a, debt refinancing that's challenging. I think folks are, some more than others, probably a bit distracted by asset management of their existing portfolios.

The next point I'd make is to put money out. When you're an investor, you need money coming in, and slow transaction environment, maybe distributions aren't what you expected, has led to less capital allocations and more challenging fundraising environment.

Lastly, a phrase you hear in the institutional world often is a denominator effect, which is where your allocations to certain product types, think real estate, get over-allocated, under-allocated, and we saw some of that as well. Again, like the first question, I think all of that has improved over the past 12 months and is improving, and there's an expectation for it to improve into next year, but that has all led to a very challenging fundraising environment.

Anu: Yes, I'm sure we know, and as you said, distributions have been a challenge for many private market investors, and you talked about the volatility and uncertainty. That's really been keeping investors a little bit on the sidelines until we get a little bit of clarification. On geopolitical issues, elections, et cetera, there's a lot of uncertainty right now. I guess the big question is, why now? Why should investors really be thinking about private real estate at this juncture?

Justin: It might be easier to start with the why not now, and there's always a reason not to. It's the beginning of November. We're approaching the election. Think about tax policy, regulations, foreign policy, how folks are going to manage deficits, again, that's uncertainty, and that's going to take a while to get some visibility too.

There's geopolitical issues around the world, Russia, Ukraine, Israel, Middle East, China. That can take things in a lot of different directions. The recessionary fears that I mentioned earlier, are we going to have a soft landing, a hard landing? I learned a new phrase recently called a K-shaped landing.

Anu: I think you have to explain, what is a K-shaped landing?

Justin: Where different industries end up in different places.

Anu: Winners and losers, depending on the market.

Justin: Yes, exactly.

Anu: Okay.

Justin: That's uncertainty. Real estate is often acquired with debt, to various degrees, but debt remains relatively expensive, especially as compared to the prices that one needs to pay to acquire them and the types of yields that folks are generally trying to achieve. There's lots of reasons to feel a bit uncertain out there in the market. The question of why now, I think, one is you generally want to invest when others are not investing. The challenging fundraising environment can very much lead to that. You're also seeing some forced selling out there in the marketplace and favorable seller circumstances can lead to very favorable buyer circumstances. Fundamentals in real estate, I wouldn't say they're great, but they're good and they're stable. We have a very seemingly resilient US economy here.

Acquisitions today can generally be had at meaningful discounts to replacement costs. Always a great barometer. You've got a generally favorable supply-demand outlook, and this is, again, a very general statement, but especially on the supply side, development is very hard to pencil. Construction costs remain elevated. Construction debt remains pretty expensive. Equity remains pretty skittish for development deals, and so you're buying into an environment where you probably won't see an onslaught of supply enter your market, your product type over the next couple of years.

Higher level and more thematically, I would say, the why now question is COVID either established or accelerated certain trends. Think about work from home. Think about student housing, where pre-COVID, the question was, why do these schools exist? Kids can just learn from behind their computers. COVID happens, and what you learn is kids want to be on campus. It almost debunked a fear that existed before COVID.

Investing along those lines, and then technological advances, AI is in the forefront of everyone's minds, real estate or otherwise. I'm personally of the belief it's going to really change the way we do things. Being able to invest along those themes. Data centers is a big one you hear about, but there's other product types as well. All in all, the next couple of years, it should be a great vantage and with a greater margin of safety than what you had just a couple of years ago.

Anu: Sure. Thank you. Justin, you spoke for a second about the resilient US economy. Just wanted to hear a little bit more about that, the US versus the rest of the world in terms of those private real estate opportunities. When we're thinking outside the US, are there similar factors that come into play when you look at the opportunity set?

Justin: Yes, the factors are definitely similar. The evaluation is very similar. I would say international markets have a place in portfolios, real estate or otherwise. At Almanac, we've gone internationally and not say we never would, but when we look back at the US, we come back to very similar points. One is you've got good demographics here. You've got a growing population. You've got a growing economy. You've got a very clear rule of law. It doesn't always exist in foreign countries.

We're fortunate to have friendly neighbors and protected by oceans in a world of geopolitical issues. We're a country with constant innovation and always room for improvement. It's always amazing to see what's being innovated out there. Lastly, it's just a very deep real estate market. It's hard to exactly quantify, but $15, $20 trillion, maybe 10% of it is in public markets. It's an incredible opportunity set in terms of being fragmented and the depth of what exists in the US real estate markets.

Anu: Sure. On that note, we had Archena Alagappan on recently, and she was discussing publicly-traded REITs, maybe with that in mind, could you share some differences between your space, private real estate, and maybe the clients that you tend to serve? Is this something that retail investors can also take part in?

Justin: Yes. The beautiful thing about real estate is we're all just surrounded by it. You work in it, you live in it, you travel in it. It's such a big part of the fabric of our lives. As an investor, individual or institutional, you have so many ways to access it. You've got the public markets and private markets. On the private side, you've got closed-end funds and open-end funds. You've got joint ventures. You've got syndications. Banks and wealth management platforms often have feeder accounts, feeder vehicles to invest in various products. An incredible access point into the product type.

We at Almanac primarily manage capital via closed-end, long-lived discretionary funds. Predominantly today, and more so even looking backwards, is for institutional investors. Think about public and private pensions, endowments, sovereign wealth funds. We're almost five years here in partnership with Neuberger Berman, so increasingly individual investors do have access to our funds and lots of funds that Neuberger sponsors, not just across real estate. Retail investors can definitely participate in private real estate, and there's a whole host of ways to do it.

Anu: Terrific. Justin, you've spoken about the value proposition, the why now, as well as the why not, as well as access to private real estate. What are some of the key factors that you think are important for investors to consider?

Justin: Yes. I'm going to sound like one of those mutual fund commercials. Part of it is very general. What's your timeframe and your hold period? What are your liquidity needs? Because fundamentally, real estate is not always liquid. Are you looking for income or appreciation? What risk tolerance do you have? A stabilized asset are very different than a development asset. Tax and tax considerations are enormous in the real estate space.

Then things like transparency and control and even volatility. There's all those considerations, regardless of what type of investor you are. More specifically to real estate, there's a few things I would flag. One is to assess the functionality of the building you're buying or investing into. That goes back to the comments about COVID earlier today. The functionality of an office building today is different than it was 5 years ago, than it might have been 10 years ago. With that comes major capital expenditures often. Being able to take that into consideration. What is the finance-ability of the asset that today has evolved over time, post-COVID in particular?

For someone who doesn't plan to own an asset or make an investment in a perpetual timeframe, what are the exit opportunities for that asset? Very similar set than you would evaluate any investment opportunity. similar set that you'd apply to real estate.

Anu: Terrific. I think the only other thing our compliance people would say if you're doing that commercial is, and past performance is no guarantee for future performance. Justin, as we wrap up here, I'd love to just hear where this space, private real estate, really evolving over the next 12 to 18 plus months and any other thoughts about investors getting access to the market would be great too.

Justin: Yes, taking the latter question first, I mentioned some of the access points, public versus private and syndications and what have you, but to go a little bit deeper there and taking those considerations that I mentioned earlier, such as timeframe and liquidity needs, think about, debt versus equity. There are ways to invest in real estate mortgage debt and mezzanine debt versus equity. Think about whether you're more interested in development opportunities, more consistent with your objectives and say acquisition opportunities.

Again, we at Almanac have a very specific approach managing our funds and we generally invest in real estate platforms or companies and so that's a niche of the world. With respect to the next 12 months, my personal belief is we won't really see widespread, massive selling and distress. We saw that in the '90s around the RTC. We saw that after the GFC, but there's a lot of stress out there in the marketplace. Again, that can come from the capital stacks of owners, that can come operationally, as a result of ownership.

I think personally what's going to happen is that stress is going to just be relieved over time with a dribbling out of assets and a lot of force selling. Sometimes that's selling your winners to generate cash to deal with your losers. Sometimes that's selling your losers so you don't have to deal with a debt maturity or funding shortfalls, but all of that should create great buying opportunities, which we're obviously super excited about.

I'd say more thematically over the next 12 months, I'd watch, the innovation technology, AI. Again, I go back to, I think it's going to impact the way we do things and that, in effect, impacts the way, real estate is run. The force selling that I mentioned earlier, I think is going to lead to some opportunities to acquire very high-quality assets that would otherwise be acquired by public REITs or core funds. We call it core on sale and hopefully done at a wider margin of safety.

Real estate debt remains a really interesting opportunity over the next 12 months. Again, different risk-reward, but you can achieve good current yield through real estate debt and there's ways to access that both publicly and privately. Lastly, I would say development can make sense very selectively, a very high bar, but you're going to have less competitive new development in the next couple of years. To have new products, two, three, four or five years from now in the marketplace can hopefully provide for some outsized returns.

The last thing I'd say about the next 12 months, we talk a lot about real estate, a lot about the bricks, a lot about the physical structures, but real estate at the end of the day is run by people. You walk into a hotel, you're greeted by folks, you walk into an apartment building, you're greeted by the leasing staff. It's a great time to be building and expanding an organization right now. The labor market was incredibly tight a couple of years ago. It's loosened up the ability to hire the right people in the right seats. I think that's going to be something that folks don't always talk about when they're thinking about real estate investing, but can really lend itself to a great opportunity.

Anu: I think ending our conversation on the importance of terrific human capital is excellent. Thanks, Justin, for all of those comments today. I can't let you go, though, without one last bonus question. If you could design your dream home anywhere in the world, where would it be, and what are some of the unique features that it would have?

Justin: Wow.

Anu: I figure we're talking about real estate, so here's your bonus real estate-related question. [chuckles]

Justin: Yes. I would say a couple of things. I would say, view. To have something with a beautiful ocean view, water view, would be something pretty magical to wake up to every morning. Sometimes you see these homes with floor-to-ceiling glass and beautiful ceiling heights, and I would put that high on my list. The technology is also changing the way that homes are built today and the technology inside of the homes, and so being able to incorporate some of that into the home as well would be quite special.

Anu: Yes, that is excellent. Thank you very much for sharing. Justin, it's been great to have you on here today to share your insights on private real estate. I wanted to highlight, I think, one of the key points that you made here was really about how forced selling can create buying opportunities. We've spoken about that a lot on the podcast, how being a liquidity provider is so powerful at this time.

Again, with your comments that there may be stress in this environment, and for those who are able to be nimble to take advantage of that, there's great opportunity. Thank you for those comments as well as all of your comments today, and we hope to have you back on the show soon.

Justin: Great. Thanks for having me.

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