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 the latest episode of the Alternative Allocations podcast series. I'm thrilled today to be joined by Jeb Belford, CIO of Clarion Partners. Welcome, Jeb.
Jeb:
Thank you very much, Tony.
Tony:
So today we're going to talk about commercial real estate, and we probably need to address the elephant in the room. There's certainly been a lot of headlines around the office sector, but as you and I have talked about in the past, offices represent a shrinking piece of the private real estate pie. But let's talk a little bit about offices. What's your views on offices and how has it changed over the last couple of years?
Jeb:
Well, first it might be worth starting with a point you just made, which is what portion of our sector is really allocated to office? And then we can talk about what's really happening inside the office sector. Historically, office made up a very large portion of our sector, at least as far as what was in the real estate indexes, represented between 35 and 40% of all of the institutional real estate holdings. That has dwindled now to only about 20%, which is a significant change over the last six or seven years. And it's continuing to decline, in our view it will likely continue to decline, and going forward will represent a much smaller piece of our overall real estate pie than it has in the past. That being said, it is, of the major property sectors, the one that is the most challenged as far as operating dynamics on the ground, that's fundamental leasing and operating dynamics.
A significant element to that has in fact been COVID. That did in fact, change the pattern of how we all go to work, think about work, the way we're using our office space. It's really resulted in much fewer people actually going to the office. That gets measured, and those that measure it are calculating that we're about 50% to 60% of the actual people going into the office on a daily basis compared to where we were pre-COVID. And that's being taken as a relatively negative sign for the overall space. We don't seem to be able to get beyond that 50% to 60% level.
The second big element is that we are paying very close attention to what are tenants really doing when they need to make space decisions, when they're either renewing their lease or moving to other locations? How much space are they taking relative to what they had before? And this is a very big, broad average, and it's certainly not the same market to market or building to building, but as a broad average, tenants are actually taking 15% to 20% less space when they make new decisions compared to what they had before. And that's certainly a negative sign for the overall sector. That means that vacancies have risen dramatically and stay elevated. When vacancies rise dramatically, you have no pricing power as a landlord, rents at best stay flat or fall, and we've seen falling rents in most markets. And it's not obvious what set of dynamics is going to change that picture.
We have a relatively strong resiliently, strong employment picture in the country that has put the balance of power more on the employee than the employer. And even though employers want to get people back into the office, it's been very difficult. And the go-forward outlook for employment is that it's going to continue to stay relatively robust. So, it doesn't seem like there's an obvious catalyst for those dynamics to change and therefore the fundamental outlook for the sector going forward is pretty weak and we're extremely cautious as to new investment in that sector.
Tony:
So, thank you because again, I thought it was important that we address that up front. But as you've kind of framed, that is a shrinking sector and then they're growing sectors and opportunities in areas like industrials and multifamily. You have a way that you're thinking about allocating though, which I think might be instructive to think about, which is you have these big macro themes which inform the way that you're allocating capital. Maybe if you can hit the big themes first and then we could go through the themes, each theme individually, one by one.
Jeb:
I'll start there by saying that our mindset is as a long-term investor. We're trying to identify themes going on in the economy, in the world that will affect our space over the long term and therefore determine where and in what we would like to invest. And at the moment we've identified five major themes that we think are playing out across all sorts of asset classes, including real estate, that are extremely important. And the first one is demographics. And simply put, there is where the big age cohorts. What are they doing and how are they affecting the economy in all sorts of different ways. And we are relatively fortunate that some of our biggest age demographics, the millennials and the Gen Z's, are in their prime spending household formation, coming out into the workforce phases, which is generally an overall boost to the economy and a boost to real estate. At the same time, we have the baby boomers, the former largest generation, that's moving off into retirement, that also is having a profound effect on the economy and various types of real estate.
Number two as a theme would be technology. We've all seen the incredible pace of technological change over the last 15 or 20 years that continues where that is changing our world and in what overall industries and sectors does have a very significant effect on real estate as well. Big things I would call out there would be change in overall life science and medical technology, which is having an effect on the length that we all live, the treatment and medicines that we need, and back to us, the companies and industries that support that. But just a basic technological change that we may take for granted now is just the rise of ecommerce and how that has had such a profound effect on how we shop and how we get goods and where those goods flow through real estate.
Third big theme would be we'd call out now as deglobalization. We've had a long period of globalization, In our view, we are having at least some period now of an adjustment back the other way and how we manufacture goods, where we manufacture goods, our supply chains, where that all happens, also has a very profound effect on lots of different industries but real estate as well.
Number four would be housing shortage. This is not just a U.S. issue, but we've focused a lot on the US lately here. But over time, perhaps as a backlash from the global financial crisis, we have underbuilt the amount of housing that we typically need for all the people that we know are coming out, forming their own households day to day, year to year. So, for over a decade we have significantly underbuilt our housing stock in the U.S. That's all forms of housing that's for sale housing, that's rental housing and think at all price points. And we are now sitting with what people estimate is a housing shortage of three to five million units. And it's very difficult to see how we can build enough, which we're not doing anyway, but build enough to close that gap. So that is a, we'll get to it in a minute, but that's a very strong driver for all things housing.
And our last big theme is climate change that plays out across our entire space and obviously across lots of other asset classes and sectors. And it has various different elements to it. There's the ESG green element to it and the health of buildings and making buildings healthier, that's of increasing importance to tenants. So, if you want to have real estate that is as leasable as possible to the maximum array of tenants, you're going to want to pay attention to the characteristics that those tenants want. And one of those things are healthier, greener buildings. But it also has a climate weather element to it in the sense that we've seen an increase in the level of natural catastrophes over the last decade or so and that desperately creates an impact on how we think about investing and where, and what characteristics of the buildings that they should have depending upon their location. So, all those five themes which we think are big, long lasting in our view, themes are going to have an impact on our space for a long time to come and that's going to lead us to where or where not to invest, in our view.
Tony:
That's fantastic because yeah, I think those are long-term and kind of make sense probably to everyone who's listening to the podcast. So, take us through that. So, demographics make sense. What are the opportunities that come out of that. How do these macro themes translate into opportunities, invest capital?
Jeb:
Well, maybe I'll twist that slightly and say where I think those themes lead us property type wise. And it's usually not one theme leading to one property type, it's two or three different themes together that are driving something in a positive direction.
Tony:
Would seem like there's some natural overlaps. That's kind of what I was getting at as well.
Jeb:
So, the one that's combining the most is really the industrial property sector. In industrial property sector, think commercial warehouses that goods flow through between being manufactured and then getting to your house. And that's a combination of demographics. The more we're spending and buying things, which relies a lot on the big spending generations, which I talked about a second ago, the better for retail sales and therefore industrial space. The other sector driving that, as I mentioned a second ago, was technology. Just the whole rise of ecommerce, the basic rise of ecommerce and the trajectory of that, the positive trajectory of that is not expected to change anytime soon, is a big driver for the industrial sector. And lastly, as a driver, deglobalization. So, to the extent that we're more worried about our supply chains, we're more worried about having goods manufactured or stored near or on shores so that we can deliver those goods to ultimate consumers. That's also a big positive for the industrial sector.
So the industrial sector has got three of those big picture themes that are driving it and likely to drive it going forward over the intermediate to medium to probably longer term. A combination of two others is really driving the housing sector and one of them is housing shortage. So that one is probably relatively obvious in the sense that with a shortage of housing that's going to drive the pricing and/or rents – all kinds of housing. So that's a big positive tailwind. But demographics are a key there too. So again, with the bigger population groups coming out and forming households, getting married, having kids, taking bigger forms of real estate, that's a big driver of the housing sector too. So you've got two big tailwinds there that are combining, that are great drivers of that sector. And again, it's not obvious, at least to us, that you can build enough to really satisfy the normal day-to-day demand, let alone cut into the shortage gap. Those are long lasting, hard to change themes and therefore the housing sector should be a very positive space going forward for a long time to come.
Something like demographics and technology are also combining to drive one of our smaller property sectors, which is life science. So, the technological advances in medicines and the aging baby boomers and the large aging baby boomers in this country and therefore driving a need for new medicines and treatments has created a big boon to what we call life science space. Life science space used to be considered a subsector of office but is now recognized as its own group. And there are buildings that are specially configured and oriented towards life science companies and think there that half the space is real lab space where lab work is being done. That lab space has very significant characteristics and requirements. And the other half the space you would think of as sort of the more business side of those organizations which would look more like traditional office. But that's been an extremely strong sector, a growing sector, a combination of big pharma companies and all sorts of smaller startup incubation-type companies. Vacancy rates are very low in the places where life science base exists which are relatively small number of clusters around the country.
But those two big picture factors demographics particularly the aging part of it and technological advance are really driving strongly the life science sector. And we think that's got a good long runway to it too. So when we're looking out there at property types that we think have amazing forward fundamentals, three of them rise to the top, all based on some of these themes. A surprising one though maybe would be retail space. We've mentioned a couple of times that retail has been hit hard to the benefit of industrial. But we found that, just like all the other property sectors, not all is equal within each of the sectors. And so parts of the retail space have been struggling pretty significantly and parts of the retail space have actually been pretty solid to are actually benefiting.
And one of the big picture trends we've seen is what we think of as necessity-oriented retail. There think more suburban, grocery anchored or non-grocery anchored necessity retail centers where people go to do everyday things, has been much less affected by ecommerce than either mall real estate or what we call “high street real estate”, so that's real estate sitting inside cities that are catering to everyday needs. But that subsector of retail, sort of that necessity gross re-anchored part, has been performing quite well. It's been quite resilient to ecommerce, all during a period when we've basically built none of it. So, quietly vacancies have become very low; rent growth has come back to that space pretty solidly. So there's a portion of an overall sector which has had a challenge, which is now looking pretty solid to strong, and we actually think has a pretty good long runway ahead of it. So, one of the places where we are recommending strategies invest would be in that necessity retail space because the fundamentals are good, and again, that's actually being driven by the demographics, the large groups of people spending. So, we're tying it right back to one of those very important themes.
Tony:
Really good stuff and very helpful I suspect as people are kind of thinking about the diversity of the opportunity set. You made the comment about “it's not all real estate created equally”. I think geography is a big determinant, right? Because we're sitting here in New York where we're surrounded by big office buildings, but yet more and more people are moving south and southwest and areas. So geographically, where are you seeing the opportunities and how does that interplay with the way that you think of these macro themes?
Jeb:
The macro themes are easier to talk about when it comes to the property types but they're playing out geographically too. So when we tend to think about strategy, long term strategy, there's the property type half and then there's the geographic half. And it's equally important. And I would say probably the theme that, well there are a couple of themes, but the theme that probably dominates the geographic story is really demographics. Where are people moving? Why are they moving there? Where are jobs being created? Why? That is a huge determinant of growth of places and it's ultimately that growth is what attracts us investors. We want to be investing where there's growth and we tend to be cautious where we see lack of growth. And those are very long-term trends and have been prevalent in our space for quite a long time. So some of the parts of the country that are benefiting today have been benefiting quietly for decades. So, places that we continue to see that really strong growth are what everybody's calling the sunbelt, right? The Carolinas, Nashville, Atlanta, Florida through Texas through sort of like the Southwest, those are all high growth people moving to job creation areas that drive demand for all sorts of real estate.
So all things being equal, we're attracted to those areas that have that driving growth. And there are parts of the country for a long period of time that really haven't exhibited that. The Midwest is a big region, as a case in point, there has been very tepid growth there for decades and therefore we, and most of our peers, are significantly less invested in the Midwest than we are in other parts of the country. The coasts, particularly the West Coast, has been a high growth area for a long time, even though it's very high cost. And we've obviously seen some challenges post-COVID with parts of the West Coast, notably California. But the ultimate desirability of those places as places that people want to work and live is still strong and we expect that those areas will generally thrive going forward notwithstanding maybe some short- or near-term challenges. The Northeast Coast with its big major cities New York, Boston and Washington, which has always been a huge driver economically of the United States, has also seen kind of flattish growth over the last several decades. So we're more cautious about the trajectory of those cities compared to other parts of the country. But that doesn't mean that you don't want to invest there. Of those three, Boston seems to be the one at the moment that has the best overall combination of industries, growth story and attractiveness to younger people. So we're a little more bullish on Boston than New York or D.C. But with all the major metro areas, it's very tempting to paint them with one brush, like it's tempting to paint almost a region or a property type with one brush. And you really can't do that. There are all sorts of stories inside them. There are total differences between locations and submarkets. There are differences between different segments of a property type and you've got to really pay attention to all that in order to figure it all out.
Tony:
So Jeb, I'm going to ask you to put on your crystal ball. We're clearly in a changing rate environment. There's headwinds and as you've described, there's some tailwinds. Where do we think the opportunities are? Not just in the coming year, but maybe five years from now? What's your long-term outlook and are there things that you're really excited about?
Jeb:
So I would say that when we're going five or more years out, stick with all the things we just talked about. Stick with the fundamentals, stick with the themes, stick with the drivers, stick with the property types and the geographies that you're going to think will thrive over a long period of time. So I would say nothing different as far as strategy, with respect to the longer term outlook. Shorter term, we've seen heightened interest rates that we haven't seen in a long time. That has slowed our space down very dramatically and I think it will stay slow until we all are feeling more comfortable. We sort of see where it's all going to settle out, where interest rates are going to settle out, where the economy is going to settle out. We've seen a tremendous amount of volatility. Our expectation is that that volatility is not going away in the next few minutes. So, we're likely to see, until that volatility settles down, a continuation of being a little bit of a slower market for us as far as transactions and commitment of capital. As far as near term opportunities will there be some good properties in good property types that need to get sold or recapitalized as a result of some of the volatility we've seen and the disruption of the capital markets. There will. So there will be opportunities with things that you'd like to own long term, spring up, or at least in our view, spring out in the next 3, 6, 9, 12, 18 months. And you've got to keep your eyes open and be ready to pounce when you see those, because notwithstanding it being relatively slower out there, there's still plenty of people that are eyeing the same thing and will try to do the same thing. But, there will be opportunities if you keep your eyes open.
Tony:
Jeb, thank you so much. We've covered a lot of ground. I really like the themes – demographics, technology, deglobalization, housing shortage and climate change. I think those themes clearly will be with us here for the foreseeable future. I appreciate you painting the long-term picture, and I also appreciate you addressing the challenges. And the challenge in the headwind with offices is not something that's going away anytime soon. And I appreciate you addressing that in a very open and candid fashion. I think people will appreciate that. But I do like your views on the long run, which is you're likely going to see some opportunities. Not all real estate sectors are created equally. Industrials, multifamily, life sciences, and select retail seem to fit within your five themes and may provide attractive opportunities. Thank you so much for your time today, and I hope that our listeners got something out of our session.
Jeb:
Well, thank you very much for having me.
Tony:
Thank you.
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