US Commercial Real Estate Equity with Invesco’s Dan Kubiak

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Stewart: Welcome to another edition of the podcast. I’m Stewart Foley, I’ll be your host. Welcome back. It’s nice to have you. We are talking today about US commercial real estate, which is a fantastic topic and super important right now as we’re seeing questions abound, particularly around office real estate. We’re joined by Dan Kubiak, who’s the managing director and portfolio manager at Invesco Real Estate US Income Strategy, a role he has had since 2013. Dan, welcome to the program.

Dan: Thank you. Great to be here and looking forward to doing my first podcast ever. So hopefully that’ll be entertaining for everybody.

Stewart: We’re thrilled to have you on. I’m glad that this is your first podcast. Hopefully, we’ll have some fun and we’ll learn some things along the way. But before we get going too far, how about your hometown, your high school mascot, and what makes insurance asset management so cool?

Dan: I’m not sure which one of those is harder. My hometown is a small town, Santa Fe, Texas, often confused with Santa Fe, New Mexico, but it’s a small town in Galveston County right by the coast, which I guess might make me a pretend expert in wind insurance and hurricane risk, although I won’t act like I am one. The mascot was the Indians. And I guess this is really top of mind right now, I mean, because I guess not only is real estate top of mind, but obviously insurance has been almost as big a topic this year as real estate’s been from a number of different angles. So I think hopefully this will be pretty timely.

Stewart: That’s fantastic. So let’s talk about the big picture here. Lots of concern about commercial real estate valuations, what’s happening in the commercial real estate market today?

Dan: Yeah, I mean maybe to rewind just a little bit, obviously, we’ve had an ultra-accommodative monetary policy for quite some time, and then post-COVID it was even more accommodating. And then we had a really abrupt shift in that. So I think anytime you have a very rapid shift in the macro environment, you can see some choppiness in the markets. We saw that the global financial crisis within about a month’s time period, October ’08. And then we saw it literally play out last summer to fall with interest rates increasing from a widely historically low level to something that’s probably just a little bit more normal.

So I think it’s going to take a little time for the real estate markets to adjust to this. And I think situations where capitalization of real estate investments and funds that were not in such a risky position should be fine, especially with higher quality investments. But maybe some of the ones that were maybe put together a little bit more risk to them might encounter a little bit more volatility as they adjust to just the higher cost of capital. And that’s the capitalization side. And then on the fundamental side, largely the real estate fundamental side is still relatively positive, albeit not as positive maybe as it was post-COVID where it was in a real boom mode. Albeit there are several sub-sectors that have struggled post-COVID, most notably office, which I know we’ll probably get into.

Stewart: Yeah, it’s interesting. So I think that’s where a lot of folks are focused. And I guess the simplest way to ask this is, are things as bad as the headlines suggest? My mind goes to, what about trophy assets – are they investible today? Can you talk a little bit about how you read the office market?

Dan: Yeah, I think my short answer to the question on the headlines, the short answer is probably yes, unfortunately. It’s not overblown, it is legitimate and it’s still relatively early in that story. I think the analogy I like to make is that some of the listeners may know that the retail sector around five, six years ago went through a fairly similar situation where it was the penetration of online sales, and shifting consumer behavior made it feel like bricks-and-mortar retail was, “dying”. So there was a period of time where the retail sector was somewhat uninvestable, it was viewed negatively, but then things kind of slowly shook out. People realized that there would be winners and losers and you could see that in asset level performance. And then you had other helpful attributes happen in terms of just less new supply coming online, increased consumer spending. And now retail is actually one of the better relative performers within all of the sectors of real estate. And I think office is likely to play out somewhat in the same manner where right now it’s still in that initial phase of shock to the system. And it’s really hard right now to tell which office assets will be the winners and losers. And I think the one thing we certainly know is that unfortunately post-COVID there will be more loser, “office buildings” and there were pre-COVID. And so I think that similar to what retail went through a few years ago, that’s still shaking out.

Stewart: And we did a podcast on CRE, I don’t know, come maybe two months ago. And someone mentioned a chart that graphed basically lending tightness by banks. And that person said valuations won’t find a floor until that chart reverses course and banks begin to be more accommodating themselves. Do you agree with that statement generally?

Dan: Yeah, yeah, generally speaking, yes. I mean, real estate valuations tend to be a function of both fundamentals performance, cashflow performance of the asset, and sentiment behind both equity investors and debt investors in the space. And right now, we’ve seen the headlines that banks in general don’t have a lot of capital to lend right now. The capital they do have to lend is somewhat expensive and has some terms and conditions that aren’t ideal. So that is impacting real estate broadly, albeit in some of the more favored sectors such as the industrial or logistics sectors or the residential sectors, there is somewhat available debt capital and that’s helping transactions continue to happen at a much more moderate pace. But yes, in the office sector, a number of lenders either feel like they have too much exposure there already, that’s not where they want to allocate capital, valuations are uncertain. So there’s really not a lot of available debt capital for that sector right now, unfortunately.

Stewart: So I think that COVID is the catalyst for this stress in the market because of work from home. I’ve spoken with somebody in the last week that’s 100% remote. I’ve spoken with folks who are hybrid, and I’ve spoken with some folks who are five days a week in the office in New York. What do you think is next for working from home?

Dan: Yeah, I guess I agree with your premise that more broadly COVID served as an accelerator of a number of secular trends that were maybe already in place such as work from home or online shopping or more mobility in our society. And it really served as a great propeller of those trends that might have played out over 5 to 10 years, playing out over 2 to 3, which puts a lot of stress on the system, so to speak. Within office, there’s a lot of speculation, but I think it’s very clear that things are not going to go back to the way they were pre-COVID. There is going to be more flexibility built into how we use office space, the way we do it, in the manner we do it.

Office is not dead, it will not die. That was a headline with retail as well. It’ll not die, it’ll not go away, but it’s being transformed, and it’s being consolidated. And I think right now is the time to try to figure out which buildings will be the ultimate winners within this. And there’s potentially some tactical investment opportunities there at some point. It’s probably a little early. And frankly, which buildings are not, and I think trying to avoid and get away from them because I think even firms like ourselves that have come back to the office generally 4 to 5 days of the week, we even have additional flexibility built in, and we’re probably utilizing space more efficiently. So our aggregate space demand is probably going to be flat to somewhat down. And so I think you need to take all that into account.

Stewart: So let’s shift our focus to the international markets. What are you seeing in commercial real estate in Asia and Europe today?

Dan: Yeah, definitely, I’ll start by saying I’m foremost probably much more versed on the domestic side here in the US, but I think there are a couple things really to point out across the globe. One is, generally speaking, we tend to see a little bit more growth in the Asia region than the European region, which I think is fairly intuitive to people, albeit there’s still are opportunities there. But two, kind of piggybacking on the office sector conversation we’ve been having, we’ve generally been seeing a quicker return to the office and more office utilization occurring outside of the US versus inside of the US. And that’s been an interesting phenomenon.

I think there’s a number of reasons people might speculate on that. I guess one of which being that living quarters tend to be a little bit smaller in some of the European markets or Asian markets. So it’s a little harder to consistently work from home so people actually have that desire to leave the residence and go to the office. I think maybe there’s some other maybe demographic issues relative to large millennial, kind of Gen-Y population here in the US that is in that 30s to 40s seeking to move out to the suburbs, so to speak, and get a home. So the commute times are farther. There’s probably a lot of reasons for that, and you could probably have a good argument about it, but I do think it’s something worth noting that some of these other regions tend to have had a little different recovery.

Stewart: That’s really helpful. So Dan, when we think about real estate capital markets, what’s going on there? Are there transactions getting done? Is anything getting financed? What are the current market conditions in the real estate capital markets?

Dan: Yeah, things are getting done. There is a propensity for… Newspapers and magazines sell because they write headlines that lead you to want to buy them. So I think there is a focus on some of the negative, but there are some positives going on out there within sectors that I know we as a firm and within our strategies really like on the residential side, the logistics side, especially sectors relative to self-storage. It’s absolutely moderated from the last year or two, but admittedly those were record levels. So it’s a little unrealistic to think those would continue.

But it’s more in those favorite sectors that are still seeing positive fundamentals that back to your earlier question that lenders have an appetite for and can help facilitate transactions relative to the debt part of the capital stack. Although, you still see a lot of capital out there to the point where a number of buyers that may be over the last year or two might have used leverage on their investments aren’t using it now. They’re just buying them all cash and they’re waiting to finance at a later date, but they really like the asset and the basis that they’re getting in on and don’t want to miss that opportunity because it’s probably at a much better pricing level for them relative to where it was maybe a couple years ago.

Stewart: So as a real estate investor, how are you investing in these markets right now?

Dan: Yeah, I think some of it goes back to what we’ve talked about on the sectors. And there’s certain sectors that I think we have a positive forward viewpoint of both near term and long term relative to just secular changes in demand, residential relative to just demographic changes within population ages such as the millennial generation-wide demographic we talked about before. It’s the largest grouping. It’s at that age in life where they’re consuming, they’re purchasing homes, they’re forming households. So the residential side we think has a lot of drivers to it. Correspondingly, logistics as well in terms of just continued transformation, supply chain system, online retail sales. Onshoring, so to speak, as we’ve seen operations move maybe from global locations back to domestic locations. So those are some of the sectors that we really like and that you’ll see a real emphasis within our portfolios.

Stewart: That’s really helpful. And one of the things that is always a topic of conversation on a podcast is the impact of rising rates. And rates went up dramatically last year, and we’ve got a little bit of decline of late but still significantly higher than levels that you mentioned at the top of the show. Can you walk me through how those rising rates are impacting this market right now?

Dan: Yeah, I think what you’re seeing is the ability for strategies within this environment to differentiate themselves if they have premium income levels that can somewhat match where the cost of financing’s gone. So we really like strategies that feature premium income as well as growth of income, which is a little bit of what I’ve been talking about on the sector side relative to sectors that have forward growth fundamentals as well as market focus. Maybe some of the markets that we all know right now that are maybe in the southern and western United States and the Sun Belt region tend to have more growth characteristics because that’s really the best way in a somewhat higher rate inflationary environment to combat that within your real estate portfolio is having a premium income level in the first place and then also having an income stream that can really grow through that in a well-managed balance sheet.
So I think those are characteristics we look for in our strategies to help guide us through the near term with rates being a little bit higher for a little longer, albeit we think they will probably moderate some at some point here over the next year to two.

Stewart: Thank you. I often say that I learn the most on these podcasts because I get to talk to subject matter experts like you and I get to ask questions that I simply don’t know the answer to. And so this is one of them. So when we’re talking about real estate… I mean, I’m a fixed income geek. So when we’re talking about fixed income, I know what these terms mean, but it helped me understand what core, core plus, and opportunistic mean in real estate terms for the description of different strategies.

Dan: Yeah, I’d say they’re all characteristics that I think are needed within a well-balanced portfolio whether, as you mentioned within the fixed income world, they have their own terminology for it within the equity stock side of the business, they have their side of it, whether it’s growth stocks, value stocks, there’s a balance there. And that’s really what those terms all seek to achieve is diversification within a real estate portfolio, complementary aspects where you can have a core portfolio that maybe features, like you mentioned earlier, maybe some trophy buildings with really low-income returns to them but a lot of perceived durability and quality. So maybe a little lower returning total return, but a lot of safety to that.

And then you kind of go up one step to core plus where maybe the total returns are a little higher, you’re taking a little bit more risk in a smart way in terms of going maybe a broader set of markets, a broader look at sector weights that you might utilize, maybe utilizing a little more leverage but not a dramatic amount and further emphasizing those total returns and maybe premium income returns as well that fits very complimentary with your core approach.

And then lastly, opportunistic. Obviously, these are typically non-stabilized investment profiles that don’t have income returns, but the potential for really strong total returns, albeit at a riskier level. So they all kind of complement each other in terms of risk level income orientation, or honestly lack thereof quality, market breadth and depth, sector weights. So that you’re building something that’s fairly durable that can go through cycles like what we’re going through now and have some really all-weather attributes to it.

Stewart: That’s really helpful. So we’ve kind of gotten ourselves to this buy, sell, or hold segment, Dan, and I guess it goes something like this, what types of asset profiles do you like as a firm? What are you avoiding and why?

Dan: Yeah, I think maybe starting with the avoiding part of it, I guess I would say clearly the office sectors we talked about, not that we don’t think there will be some winners out there within the office sector, but it’s fairly early innings on that right now. I think it’s not overly transparent as to which ones they’ll be, but at some point, they’ll present themselves, but it’s still a little early on that front.

I’d say the other thing that we’re avoiding is, I think there still are some owners and sellers that are, even on attractive assets, maybe locked in into yesterday’s valuation, so to speak, at really low cap rates or income returns that frankly, even if interest rates do settle out a little bit, still don’t make sense in terms of where the true cost of capital sits. So conversely, that kind of helps me answer the other side of it in terms of what we talked about before, premium cap rates, premium income levels that can help better match where the cost of funds has gone and sectors and markets that we think have growth characteristics to them we think can really demonstrate well through both the near term and the long term.

Stewart: Thank you. And Invesco manages a significant amount of insurance assets. What are some use cases for insurance general accounts? How are they using real estate in their portfolios?

Dan: Yeah, I think a lot of investors, I think first and foremost, they really value the income generation that comes from it. It can serve as a little bit of an inflation hedge as we’ve talked about. So the income component can help balance out some more of the more volatile areas within their portfolio. It can generate income today that can go to use however they see fit, it can diversify their portfolio, again, lower their volatility within their portfolio. And I know there’s been certain regulatory changes over the last year or so that have made the viewpoint of real estate within the insurance business a little bit more favorable relative to reserve requirements. So I know we’ve seen a number of clients that have approached this over the last year or so that now that things are a little bit more amenable to real estate and realizing some of those benefits that I talked about, we’ve been seeing a lot more activity from that side.

Stewart: That’s great. And so it’s just kind of a little bit of a wrap question. When you look at the commercial real estate market today, what are you most excited about on a looking-forward basis?

Dan: That’s a great question because, and you’ve talked about it, I think there’s a lot of negative headlines right now, and I think sometimes we can get lost in that and not really see the opportunity. I can tell you that a couple years ago when there was a lot of capital flowing and cap rates were around 2.5%, 3%, 4% on certain investment profiles, it was really challenging to invest in the right profiles that could get the right growth at the right cap rate. I mean, everything was really aggressively valued. And now valuations have come off that a little bit, and it’s a little bit easier to buy, frankly. There’s a lot of good opportunities out there. And so, frankly, I’ve been here at Invesco for 20 years, I’ve invested through a number of cycles, these are the parts of the cycle that honestly leave me the most excited because that’s where the most opportunity is and the ability to really differentiate.

And that’s a lot of what we’re doing now is capturing opportunities that previously were just priced well beyond us. So I guess I’d say that while we’ve seen valuations back up a little bit, it’s always really hard to precisely time the bottom of something. And to the extent, you see a portfolio or a strategy, you think really makes sense for you long term and you generally think we’re getting close to an inflection point, I guess I would just advise clients not to try to time it too perfectly and really try to think more long term in terms of what they get into.

Stewart: Great advice. It’s been a pleasure to have you on, and I’ve got questions on the way out that you have an option you can do either or both. You ready?

Dan: Okay.

Stewart: Who would you most like to have lunch with alive or dead, or what’s the best piece of advice you’ve ever gotten?

Dan: Well, being a native Texan, I might pick Sam Houston is the person I’d like to have lunch with. This very dynamic individual, if you go back and look at his biography. And he was a contrarian on a number of items historically that I think proved him right. So I always find characters like that fascinating.

And then also, I guess I’d say the best advice I got was really to look at situations where you are broadening your experience level and your responsibility levels. And it’s advice I give some of the younger folks in our office all the time because if you’re doing those two things and you’re not necessarily getting lost on what that specific role is and then maybe how long you’re in it, if you’re broadening your skillset, you’re getting more responsibility, you’re generally going to end up in a much better position in the future. And I know that’s something that’s put me in the position that I am today in terms of having to know a lot about a number of topics. And so being able to have a variety of roles and experiences really put you in the best position to have all the context you need to make good decisions.

Stewart: Very good advice. Thanks for being on. We’ve been joined today by Dan Kubiak, managing director, and portfolio manager at Invesco’s Real Estate US Income Strategy. Dan, thanks for being on, and thanks for listening. If you like us, please rate us, review us on Apple Podcasts or wherever you get your podcast content. My name’s Stewart Foley, and this is the podcast.

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Invesco is a leading independent global investment manager, dedicated to helping insurance investors achieve their financial objectives. We understand insurers have unique investment needs, from optimizing capital efficiency and yield, to managing reserves and reporting. That's why we offer specialized solutions across a broad set of asset classes and vehicles. With $1.6 trillion in total assets under management, and $51.2 billion on behalf of insurance general accounts,* we strive to understand your distinct capital requirements, accounting tax treatment, and risk factors. (*As of December 31, 2021)

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