Real Estate Investing in the Wake of COVID-19

Stewart: Welcome to another edition of the Insurance AUM Journal podcast. My name is Stewart Foley, and I'll be your host standing with you at the corner of insurance and asset management with David Roth. Welcome, David.

David: Thanks, Stewart. Nice to see you.

Stewart: David is a partner and the head of US real estate, private equity at Ares Real Estate Group. David, I don't know of another asset class that has been talked more about in terms of COVID impact than real estate, right? It's been a tumultuous year. It's likely to have a lasting impact on this market, but I think there's probably more hysteria than truth out there. What's your view on this market?

David: Well, look, I think when you think about real estate, we're impacted by the economy and of course the economy is being impacted by COVID, but perhaps more than a lot of other sectors we create, we own, we develop space that people use for the most part. And so in a world where we are worried about being closer than six feet to each other, clearly there are going to be impacts across the real estate sector. So, the thing to remember is that there are a lot of different types of real estate.

David: And this downturn, if you will, this inflection point, this moment in time that we're in, it's not characterized by negative impacts across the real estate sector. There are certain sectors that are being helped in certain sectors that are clearly being challenged. It's worth noting that we're, we're talking today when Pfizer has announced that they think that there's a 90% efficacy rate on their vaccine, obviously to the extent that this COVID crisis extends longer, as opposed to being shortened by something like the introduction of a vaccine that will have more impact on the psychology of consumers and businesses. So today's announcement is actually a critical piece in the puzzle and something we've all been wondering when it might occur.

Stewart: It is amazing of all of the non-economic or the exogenous things that are going on in the market. And it's your job, and thankfully not mine, to discern all of that into a view on by sector. And you talked about sectors just a minute ago. Can you go into some of those sectors and how you think they're going to be impacted? Because I think I'm reading into this, but clearly not all equally, right?

David: Yeah. Look so start by giving a little bit of my background. I've been investing in real estate for about 30 years now. I started out when I was in college. The reason I mentioned this is that a lot of our businesses about pattern recognition. And so this is now my fourth inflection point, if you will, going back to the late eighties, and you're always trying to think, "How is this the same? How's it different? How did the different sectors respond to different impacts from the economy or from other exogenous shocks", and the last downturn, frankly, during the GFC, there was sort of a widespread decrease in value as all parts of the real estate sector really were being hit at the same time. What's been different this time is that there are certain sectors here that have actually been helped.

David: And so you can go through the different, what we would call main food groups, and then some of the, what I would call more niche sectors. And you could think about how they've each been impacted. Some have been winners, some have been losers, and some are sort of in between, and time will tell. So if you think about the winners, I mean, obviously one thing that's happened with COVID is historical trends towards the use of e-commerce has accelerated. So, that has made a big, big winner out of industrial assets. The need for industrial assets has gone up as e-commerce has really accelerated into this. And now there's a view here that the pace of acceleration is going to continue, even if we have a vaccine. I think people who were perhaps not inclined to use e-commerce through this COVID crisis have really learned of what it's like.

David: I know that my wife has, although she knew going into it. So the industrial sector is something that we've spent a ton of time in over the years, we've owned 111 million square feet or so of industrial assets over the years. And we've only accelerated our pace of both buying and developing into this strength. Another area that we think will continue to show resilience and has done remarkably well, are residential real estate in particular markets and particular types. So we think long term the residential sector, which is an area that we've spent lots of time in, in the past, we'll continue to do well. There are some geographic differences. The cities like New York, San Francisco are being hurt right now, as people think about dedensification and have moved in many cases home with their parents. Obviously, if we have a vaccine that will reverse somewhat the longer this takes, the more likely that people will continue to migrate out of those kinds of places.

David: But in terms of multifamily, we continue to develop assets into that sector. We spend a lot of time historically in the Sunbelt which are markets that benefit from dedensification. The losers, if you will, are obviously the hotel sector which went from, and this never really happened in history went from being well occupied to being 0% occupied. And the hotel assets actually cost money when they're under occupied. So, that sector is being hurt in ways that we've not seen before. And really almost every asset today is distressed. Now, long-term we think there's going to be opportunity because we think the hotel sector is going to recover over time, certainly for certain assets and certain markets, but that is a sector that's certainly being hit hard right now, the other obvious answer is retail.

David: And the difference between retail and hospitality is that we were somewhat oversupplied in retail, in this country going into this crisis. And as a result we've had acceleration to e-commerce that has continued to hurt retail, but even when we recover, we don't necessarily think it will be as fast or as stronger recovery as hospitality, let's say. This is all generalizations. Every asset is a specific asset. Every situation has idiosyncrasies and you have to analyze the market and the assets specifically, but these are generalizations. And then in between those winners and losers, you have the office sector, which is harder to figure out because the use of office space, time will tell how quickly we all go back to the office. I would say at Ares, and my personal belief is that the office sector is not going away.

David: We've found great success through Zoom, and we can talk about that aspect of how we all do business if we want, but long-term, it's hard to maintain a culture onboard new people have a collaborative culture and be productive, I think if you're working from home. So, we think that long-term, there's clearly going to be a need for office, but in the short intermediate, and even in the longterm there's dedensification, which potentially helps in terms of the number of square feet that you need to manage the same number of people, but opposing that is remote working. And so there's a push and pull here and we'll see over time, how that plays out.

Stewart: It's interesting. You mentioned, you just kind of touched on your background. You've been at this awhile, right. You've been at Ares not as long. So can you just kind of give a little sense of your background? And I mean, I know that you're steeped in the real estate, but maybe everybody else doesn't know.

David: Yeah. Happy to give you a little bit of background and you try not to take our entire time because I certainly can just talking about myself. I've been in real estate now for upwards of 30 years, I started buying apartments in college back when you could do things, sort of no money down if you recall those days.

Stewart: I do.

David: And I ended up in a partnership that when the first downturn in the market occurred, which was the late eighties, early nineties, resulted in me selling my interest to one of my partners and going to be an attorney. And I went to NYU Law School and ultimately I became a corporate M&A attorney at Wachtell, Lipton, Rosen, & Katz, never wanting to be an attorney. I'd never really planned on being an attorney. And I did it for about a year and a half and promptly left. I did a move that very few people I think have done before, or since. I left Wachtell to go move to Santa Fe New Mexico and joined a real estate startup and went back into the real estate industry in 1993, I was with a company called security capital group where, which was basically, it was a private equity firm focused on real estate operating companies. I was with them for a number of years in Santa Fe, opened up an office in Chicago, ultimately moved to London and became CIO of Europe for them.

David: Soon, at some point I came back and I joined a group called Walton Street Capital. This is condensing a much longer story. I was with Walton Street Capital in Chicago. It's an opportunity fund that's run by Neil Bluhm who's the B of J&B. I was there for about four years. And then I got a call from a headhunter and ended up joining Blackstone in late 2005. And I went to Blackstone and was a partner there ultimately was there for about a dozen years. Ultimately, I ran Latin America and at some point had a desire to come back to the US and an opportunity came up to, to join Ares, to head the US business. And I took that opportunity and I haven't looked back since.

Stewart:

Yeah, that's where I was headed, right? Those sounf like very interesting roles aside from the attorney part. I'm with you. I'm not sure I would've made it a year and a half. I'll be honest with you. But why Ares? Why did you make the move? That's not their largest block of assets. It takes some courage to make that move and what's the rationale behind that?

David: No, obviously I haven't had problems in the past changing roles and always had a pretty entrepreneurial background. And when I wanted to come back from Latin America the opportunity to help this. And I think there are things about Ares that are unique and attractive for me. And when I try to hire people, I explain this to them. And frankly, when we talk to investors, I try to explain it as well. Ares is a tremendous corporate platform, right? And the benefits of that from information flow to relationships, to deal flow, to ability to raise capital. These are all things that I knew about from my experience at Blackstone. The difference, though, is that we were investing in, we are investing much smaller pools of capital a billion to $2 billion pools of capital. And so I was excited about going back to that part of the marketplace.

David: I also thought that that would be an interesting place to be during what I thought would be a coming inflection point, which we've now experienced. Nobody had any idea COVID was coming, but we were long in the tooth on a long dated economic cycle. And so I liked the idea of being in a smaller, more nimble place and having the ability to bring the experience that I've had to bear, create the culture that I wanted to create to help grow this business. So super excited about it. And I think our, really, approach, which we have three different offices around the country. So we're always very close to on the ground. We have to know our markets and our assets very well and be nimble investors is something that really appealed to me.

Stewart: Yeah. It's interesting you say that because it just seems like in that smaller market, you can create more value from applying more of your experience maybe than you can in the megas. And it makes sense to me. What areas, this sounds so weird, it's an odd question, but do you see growth anywhere out there in the real estate space?

David: Yeah, for sure. Look, there are real winners coming out of this post COVID environment, obviously what's happened from a personal standpoint. I was very sick in March, by the way. So I've actually experienced it.

Stewart: Oh, I'm so sorry.

David: And so I feel for everybody who's involved, but I mean, there are certain sectors that are being helped. As I mentioned in the industrial sector, some of the sectors like the single family to rent market that has benefited from dedensification and people wanting to have their own space and have a place to work as they're having to work from home. Obviously life science is something that has benefited from this and there are geographies that are benefiting, right? So, some of the less dense markets around the country are going to benefit whether it's Atlanta or Nashville or Charlotte, or Austin or Phoenix or Denver, they seem to be benefiting from a migration from the denser larger cities to the less dense environments. So there clearly are areas that are doing well, that are, you would call that our growth areas for sure.

Stewart: And we talked a little bit about the real estate equity, real estate debt. Do the two teams collaborate, how are they on the capital stack? Can you talk a little bit about that?

David: Yeah. First of all, give you a sense of Ares, which we really didn't talk about, and probably we should. We are part of $165 billion in assets, alternative asset manager, publicly traded company. The company started as a middle market lenders. So it has a very large credit business, probably the largest direct lender to businesses. That's where a lot of the information flow comes from other parts of the firm, in terms of understanding markets and industries and tenants. It's very helpful for us, but there's over 110 billion of assets under management and credit. There's about 25 to 30 billion in assets, under management in a private equity business that has been very successful for a long time and real estate's about 14 and a half billion. And in our real estate business about a third of that is in mortgage debt.

David: So we have an origination platform. We have a publicly traded mortgage rate that we manage, and then we have a number of SMAs that we manage. And then the balance of the equity is split pretty evenly between the US and Europe with in each region, currently we have two strategies closed end funds that manage in the case of one opportunistic capital, where we're looking to generate a high teen type returns and then a mid-teen type capital source for what we call value add. So we in the US have about 53 or 54 investment professionals now between the equity and the debt business. We have offices where we all sit where we have individuals from both sides of the house, both debt and equity in New York, LA and Atlanta. And then within the debt business, we have additional offices in San Francisco and Chicago.

David: And so we have people pretty well situated in most of the major markets that we operate. We operate I don't know what the right phrase is, but hand in hand with our partners, we're sitting on investment committees, I'm on the debt investment committee. The partner who runs our debt business, Brian Donahoe sits on my equity committee and we are within the same offices sitting next to each other. And so we're very much linked in, and this has tremendous benefits from us, from everything from information floated, direct deal flow. So I'll give you an example. We have a deal that we just put under contract to buy a student housing deal, and I'm in a kind of a large student housing market. And that student housing market is one where we, on the debt side, have made loans to several other properties in the neighborhood, right in the same area, same school.

David: That's an example of one way that we, on the equity side benefit from our debt business. On the debt side, giving an example of a deal where we were selling the asset that we owned, the property that we developed in Chicago, and that resulted in an opportunity for our debt business to provide a loan to the buyer. And since we obviously knew the property well, and we knew the situation, we didn't control who the lender was going to be, but they had the opportunity to pitch and win the business. So there's a lot of synergies between the two sides. I would say.

Stewart:  David, if we turn just for a minute to our specific audience, why do you think real estate should be a part of an insurance company portfolio? What type of an insurer talk about the liquidity aspects, whatever you want to talk about, but the insurance industry is screaming, crying, for yield. And how does this asset class, and based on your experience work in this industry?

David: Well, look, obviously, real estate has been an important asset class for insurers for a long time, particularly life insurers. The idea of match funding with their liabilities requires cashflow streams that are long dated, that are secure. And in the best case scenario that grow at some inflationary or better growth rates, so lots of different types of real estate. And of course the real estate industry is not one size fits all. There are certain industries that are a 20 year lease to an Amazon is one thing, and then there's assets that are like hotels, right? And so the type of collateral matters quite a bit. And I think one of the things that I think the insurance industry is grappling with today is that perhaps in the past, there was a focus on CMBS for CMBS sake, but not as much focused on the underlying collateral and in a world where the collateral types are sort of dramatically performing in a differential way, I think this is going to be increasingly important to them.

David: But again, going back to the main points, insurers have invested in longer duration, fixed rate, commercial mortgages and core type real estate for a long time. As insurers are thinking about how to match their liabilities, match their funding needs in the future in a close to 0% interest rate environment, I think they're increasingly focused on that five or 7% bucket of alternatives of which real estate is part of. And I think we can provide incremental yield in a, really what I think of as a good risk adjusted way compared to some of the other alternatives for insurers.

David: On the debt side, obviously there's been a historical focus on longer term, either CMBS or RMBS shorter term floating rate loans to like transitional properties that can offer like sector diversification, additional yield for life insurers, but really requires, I think, high quality managers. And that's one of the things we're trying to provide for insurers. And then our other strategies, which are on the equity side value add and opportunistic real estate. This also allows insurers in insurance investors to seek additional return through property improvement. And again, the choice of who you pick as managers really matters on that.

Stewart: And I know that you being Ares, partner with insurance companies, can you get into any specifics on any of those mandates?

David: Well, I've been told that I'm not supposed to talk specifically about each of our funds and either how they've performed. And there's lots of requirements around that, but I would say this, insurance clients have invested across the Ares real estate platform, debt and equity in both the US and Europe. And given this need to enhance income, given the low interest rate environment on investment grade, fixed income portfolios we've noticed a heightened interest in strategies that both distribute income, but also have some growth attached to them. Certainly for debt investors, including life insurance companies we have been a provider of sourcing of shorter duration, transitional lending, which obviously can create different exposures and provide incremental yield over time. We've worked with separately managed account clients to make sure that our loans are pledgable to FHLB, which I know is important to insurers. And if they participate in the lending program, which I assume many do...

Stewart: ...that's a no brain deal. Absolutely. I think that's a really big deal for them.

David: Yeah. Yeah. And most, I think, do. And we offer transparency on our commingled vehicles to facilitate the best possible capital treatment. So by partnering with somebody like an Ares, we think insurance investors can gain exposure to high quality, well managed portfolios of shorter term floating rate loans, loans on transitional assets, and basically incrementally help with yield. And then for the insurers that are comfortable with value ed real estate returns are opportunistic as a small component of what they do. We think we provide strategies that have a proven long-term track record and can really help meet the return requirements that they're looking for.

Stewart: I want to ask a question and you don't have to answer.

David: My favorite type of questions.

Stewart: This is great. Yeah. I teach, right? I teach college students.

David: Where do you teach, out of curiosity?

Stewart: I teach at Northeastern Illinois University and I used to teach at Lake Forest College. And now I teach at Northeastern and,,

David: ....my wife's from Highland Park.

Stewart: Is that right? Yeah, right down the street!

David: I spent a ton of time in that area. And my mentor when I was younger was a guy from Lake Forest.

Stewart: Oh, is that right?

David: Yeah.  A guy named Tony Mano. I don't know if you've ever met him.

Stewart: I didn't but what has happened outside of COVID impact on the real estate market is COVID its impact on the job market and internship market for students. Right. So you and I have both been out here for a while. I'm winning the gray hair race, but nevertheless, the question I guess I have is you are walking across the stage of your college graduation at the ripe old age of 21, and you take your mortar board off, you give it a fling and you meet yourself today. What would you tell that 21 year old David Roth, given the current environment for opportunities and internships and full-time jobs?

David: Yeah. I mean, look, I think that, that's a great question. I get asked these kinds of questions all the time. And what's interesting, I mean, of course this environment I'm sure is more difficult than some and cyclically we have these moments where it's more difficult to find the right job and to find any job. And those are always tough times. The answers I tend to give are more generalized in this specific moment, which is find something you do that you like. That's the most important thing. If you like what you do, you will do it better and you will enjoy it over time. So I give people that advice for when they actually find a job, my advice is be a learner, be a learner, be the person who says I will do that.

David: I will try that. I will expand myself and take risks. Find ways to make yourself indispensable to the person you work for. That's how you will get ahead. Take on more responsibility than even you think you can handle. Put yourself at risk. That's what I think is the best thing that young people can be doing when they're in the work environment. As for other advice that I would give somebody in this particular time period I think you just have to make a job, if you're out of work, of getting a job. You just have to talk to as many people as possible. Because in my experience, oftentimes people don't even know they need you as an employee until you've spoken to them. So find a way to talk to as many people as you can. Not in a way that makes it look like you're begging for a job, but just in informational ways. And I'll put myself at risk saying this, but somebody reaches out to me and says, they want to talk to me, I generally say, I'll talk.

Stewart: Yeah. It's really, I think it's sort of one of these deals where we need to pay it forward. Right.. Thank you for being on. You've been a great guest at the [crosstalk 00:30:22].

David: That's appreciated.

Stewart: The thing that people can't see is I can see you and I, and you have a better podcast set up than I do. And I thought that I... I've been referred to as the Joe Rogan of insurance asset management podcasting, so man, you've raised the bar.

David: This is actually his, Joe Rogan's setup here.

Stewart: That's awesome. I love that. That's great. Thanks for being on man. We've really enjoyed you being on.

David: It's a pleasure. It's really the most important thing for us at Ares is our clients. And a lot of them are insurance providers. And so it's great to have this opportunity to talk to them directly.

Stewart: Thanks to our audience for joining us. If you like us, please follow us on all the major platforms. We'd love to hear your suggestions for future podcasts. You can reach us at podcast@insuranceaum.com. My name is Stewart Foley, and this is the Insurance AUM Journal Podcast.

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Coronavirus and Public Health Emergency Risks

As of March 17, 2020, there is an outbreak of a novel and highly contagious form of coronavirus (“COVID-19”), which the World Health Organization has declared to constitute a pandemic.  The outbreak of COVID-19 has resulted in numerous deaths, adversely impacted global commercial activity, and contributed to significant volatility in certain equity and debt markets.  The global impact of the outbreak is rapidly evolving, and many countries have reacted by instituting quarantines, prohibitions on travel and the closure of offices, businesses, schools, retail stores, and other public venues.  Businesses are also implementing similar precautionary measures.  Such measures, as well as the general uncertainty surrounding the dangers and impact of COVID-19, are creating significant disruption in supply chains and economic activity and are having a particularly adverse impact on transportation, hospitality, tourism, entertainment and other industries. The impact of COVID-19 has led to significant volatility and declines in the global public equity markets and it is uncertain how long this volatility will continue.  As COVID-19 continues to spread, the potential impacts, including a global, regional or other economic recession, are increasingly uncertain and difficult to assess.

Any public health emergency, including any outbreak of COVID-19 or other existing or new epidemic diseases, or the threat thereof, and the resulting financial and economic market uncertainty could have a significant adverse impact on the Fund, the pricing and fair value of its investments and real estate assets and its subsidiaries, and could adversely affect the Fund’s ability to fulfill its investment objectives.

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All unrealized performance information, investment strategy, and targeted returns presented throughout this presentation were prepared as of the dates indicated.  Such information was prepared at such times in good faith based on a number of fundamental assumptions as of such dates, including assumptions relating to the broader economy, macro and applicable micro economic conditions, the geopolitical landscape, interest rates, availability and pricing of credit, liquidity and depth of transactional markets, health, population, and the environment, etc.  With the unprecedented (and to date uncurable) advancement of COVID-19, most of those assumptions at the current time appear to be materially off or in a state of suspension.  Consequently, all unrealized performance information, the portions of the investment strategy which related to targeted returns, and valuations of current investments held within or warehoused for the Fund are at the time of this writing indeterminate, but presumed to be materially lower than those last presented.  While in the medium to longer term the Manager believes the Fund should see attractive opportunities consistent with its larger investment themes and strategy, it will likely take some time for the markets to recover.

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REF: RE-01551