Confidence

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Confidence (noun)

o??the feeling or belief that one can have faith in or rely on someone or something.

Example of use in a sentence "we have every?confidence in?the underlying data”.

o??the state of feeling certain about the truth of something.

?o??a feeling of self-assurance arising from an appreciation of one's own abilities or qualities.

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Similar:

Trust – Belief – Faith – Credence – Conviction – Reliance - Dependence

Opposite:

Distrust – Scepticism

"In investing, what is comfortable is rarely profitable."?— Robert Arnott

There are many inputs that go into building a state of confidence. Perhaps the most important is infallible knowledge of the operating environment, underlying fundamental macroeconomic factors, and the capacity and preparedness to act in a manner that delivers a successful outcome even as conditions change.

Confidence is also a reliable indicator of inflection points in markets, over the long term.?Group consensus is a powerful market moving force both at the top and bottom of long-term trends. ?Some well chronicled real estate booms and busts evidence what happens when large pools of capital chase the same corners of the market.

-???????High risk opportunistic investments in BRIC[1]/EM countries pre-GFC, 2004-2008, mostly ended poorly.?Investments in China were a notable exception.

-???????The frenzy of buying overpriced premium commercial real estate in key gateway markets in the run up to the COVID pandemic as yields flattened to ~4%. There was strong confidence that central banks would keep rates low forever, rents would continue rising and inflation would remain contained long term.Refinancing for many assets purchased during the 2016-2019 ear is today is a huge challenge.

-???????The BoJ (Bank of Japan) will hold YCC (Yield Curve Control) forever.?Via the adjustments in Dec 2022 and now, the BoJ has clearly signalled the need for more flexibility in the face of rising inflation and wage growth lagging productivity.

-???????Leadership change at the RBA (Reserve Bank of Australia) prompted by late signalling of how fast and rapid interest rates would rise for consumers.

-???????That long term liquidity provisions (LDI) could be managed in the UK pension system via derivatives despite deteriorating value of the bulk of such collateral, i.e. UK gilts.

So where are we now?

-???????Consensus that the US Federal Reserve is at or near peak hiking levels and swaps pointing to a 75-100 bps cut over 2024.?Will Powell pull off a miracle as some leading publications now speculate?

-???????China’s reflation of the economy will succeed delivering growth at or near pre-pandemic rates and support global growth leading into 2024. This has been a consensus since Q4, 2022 and didn’t exactly play out as expected over H1 2023.

-???????The global energy shock is over, Europe has successfully moved away from reliance on Russian oil and gas imports.?Question to ask - Why is the OPEC cutting production rapidly if economic growth is accelerating?

-???????Transition to clean energy will happen as planned for the magical years of 2030-2050-2060.

You can be both right and wrong about current economic conditions.?The confusion arising from current economic data and signals can be summarized as follows; if economic activity reflects the pressure of high interest rates, how sustainable is current level of ?high nominal growth given tight labor markets. And what does that translate into for wage growth, strength of consumer demand, corporate profitability, stated purpose of slaying the inflation demon and continued relative ease of financial conditions? What gives and when? Given real estate is a long tenured asset class, these are important questions answers to which will should guide the pace of investments. In the current phase of this cycle, the signals vary from country to country and between the choice of different strategies.

Some charts for consideration below to facilitate our discussion on what the evolving macro conditions mean for real estate investing.?Bonds markets are an inflection point.??If LEI (Leading Economic Indicators) continue to push at 30-40 years lows, a deflationary economy may lead to cuts in projected rates as currently being priced.?Else, if manufacturing and advanced order ISM indicators pick up in the next few quarters, the high interest rate regime may persist thus testing both business and consumer resilience. ?

Summary: the worst seems to be getting behind us and recovery will take some time.?It could be erroneous to confuse improving asset pricing with emerging intrinsic value or to expect conditions favouring a ramp up to historical returns generated in the past decade.

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In an operational sense, Confidence manifests itself in behavioural traits of market participants and over time, astute observers of the market can parse the language from leaders in the business to judge and differentiate between Confidence and Hubris[2] with surprisingly great accuracy. Herding amplifies the exaggerated moves, drives FOMO[3] as markets peak and at cyclical bottoms paralyses engagement despite evidence of improving market conditions for those who do not follow a strictly data driven approach to investing.?

Sample a few recent instances from the commercial real estate industry in Asia (paraphrased);

§?Q3, 2022 - CEO of an Australian fund manager at an industry conference “… we have built market leadership by being completely aligned with what our investors want and how do we deliver best risk-adjusted returns for them” .?This was a fund manager actively buying office assets in Sydney and Melbourne then when industry workplace surveys pointed to over 35% employees in both cities stating intention to quit jobs if employers insisted on them turning up to office all 5 days/week.?

Current situation: Less than a year later, the fund manager was forced to gate some open-ended funds as requests for redemptions piled up.

§?2016-19 – CEO of a large Indian alternative fund manager at every possible forum or investor meeting “…we are the only credible competitor to HDFC[4] and growing at a much faster pace, we are often the lender of last resort... our risk management and speed of decision making are key reasons behind our success…”

Current situation: ~40% of the loan book is stressed, the ‘emperor’ of alternative real estate lending has many loans being sold cents on the dollar via bankruptcy and asset reconstruction schemes.

§?“Although escalating Sino-US trade conflicts will affect China’s GDP, the domestic housing market is still driven by local supply and demand so it is unlikely to change course in the short term,” – head of China research for a leading property consultancy, Sep 2018

Current situation: China’s housing property sector got bust and now limps along aided by targeted government stimulus.?An estimated $2 trillion of equity value has been destroyed and it was the only major housing market in the world not to benefit from the post pandemic housing boom.

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"Know what you own, and know why you own it."?— Peter Lynch

Mitigants to delivering sustainable returns

Risk Management

The simplest investing rules are the most difficult to consistently adhere to.?

Blackstone recently made headlines as the first alterative asset manager to breach $1 trillion of AUM[5].?Almost all articles tracking Blackstone’s phenomenal rise since the early 2000s narrow the narrative to citing a few landmark transactions as evidence of their acumen.?What goes under emphasized in the case of multidecadal successful firms, such as Blackstone, are;

-???????Duration risk management.?Reluctance to take high value, lumpy greenfield construction risk, too many unknowns for a long duration are often judged not worth the risk.

-???????Big positions on compelling business opportunities and demographic trends.?Sizing for capital allocation on deep conviction bets matters in a diversified portfolio.?Market leadership in sectors and categories also attracts the best talent and directs market participants to engage with such investors.

-???????Diversified portfolio, heavily concentrated in very select markets.?The role of market selection is grossly underplayed in the popular narrative.?For the same length of time that others have been involved in exciting, albeit market limited by scale, such as Vietnam, likes of Blackstone and Brookfield have successfully deployed billions of capital with high profile exits across many sectors in markets such as Australia and India.?

-???????Recency bias and avoiding legacy concentration risks.?As investment firms succeed and grow big in a specific or handful of legacy markets, there is a strong internal bias to keep raising capital similar strategies for the same market often at the cost ignoring that chosen “home” markets may have perhaps shifted in terms of fundamental characteristics.?The ability to tap new sectors, markets, and position to ride structural changes in demand is important to build long term longevity and remain relevant to the investor base.?Take the example of leading PE firms currently reweighting away from Greater China or the recent herding effect for Japanese real estate exposure.

-???????Talent and partner development is key to creating Confidence to deploy meaningful capital. Many large institutional investors, including those who claim to be “active”, keep decision making heavily concentrated in remote hubs and lagged in the effort to import local expertise or empower it sufficiently to making impactful market engagements.?Often decision makers choose to fly in and out or rely too heavily on just a specific legacy partner.?

Supplying into long term structural themes

If office user demand – historically the most homogeneous global real estate category- is undergoing structural and experiential shifts, especially in liberal developed economies, and retail continues to be upended by e-commerce, where do investors seek relatively long-term uncorrelated growth and returns? The simple answer seems to point to where the spend is shifting to.?Recent successful fund raises are evidence of where increasing consensus seems to be concentrating.

-???????Residential

The large real estate category has finally woken up from many decades of slumber for institutional investors.?

o??Multifamily/ BTR[6]: 30 years of secular decline in interest rates has made housing largely unaffordable for new entrants in most large cities.?Renting is often the only option.

o??PBSA[7]/ Student Accommodation: Largely concentrated in big educational markets, with a significant component of foreign students, the ability to provide safe communal living conditions to what hereto was a demand catered to by mom-and-pop establishments.

o??Senior living: The colour of the world is increasingly silver.?Affordable housing which releases home equity from primary homes for use in the sunset years and in proximity to healthcare facilities has a multidecade tailwind behind it.

-???????Digital Assets

o??Data Centres: Secular spending for hosting enterprise and public data is increasing 12-15% per annum off a broad base.??New technological developments – Edge, 5G/6G, AI[8], Automation & Robotics, Virtualisation – are all fuel to the spend.?The trifecta of accelerating computing power, improved data analytics and renaissance in hardware development has the potential to upend every corner of the global economy. Consider this - the “boring” data centre powered shell is getting disrupted at hyper speed.?Those purpose built to dense AI computing needs now boast 6.5-7.5 metres clear celling height, 50-70% higher flood loading and 75-100% denser cooling needs.?Construction costs are up 30-40% and operators are happy to pay for it.?Watch this space for an explosion in capital expenditure if for no other reason than to obviate future technological obsolescence.

-???????Delivery centres

o??Last mile delivery centres, neighbourhood hub-n-spoke parcel storage facilities, custom built facilities for food/ medicines/ perishables and other innovations are expanding the total addressable market.?Automation in large warehousing and logistics facilities is a proven durable competitive edge.

-???????Lifesciences

o??Geopolitical rifts continuing from the pandemic experience translates to most countries wanting to take control of some of the primary and tertiary value add in the basic drug manufacturing cycle; generics, API[9]s, testing, et all.

o??AI powered data science is enabling drug discovery faster than ever imagined.?High end lab spaces needed for very specialised biotech and pharma companies is in very high demand.

o??Legacy pharma companies have tens of billions of assets on their balance sheet that need monetising and upgrades.?In an increasingly competitive industry, shareholder capital is scarce and best deployed in the core business.

-???????Private Credit

o??Financial history suggests that once Inflation reaches high levels, it rarely comes down to deflationary levels in a jiffy.?The “longer for higher” environment is already pushing corporate defaults higher, triggered a banking crisis in the US, depressed home mortgage applications and auto loans globally, and unsurprisingly crowded duration exposure in the fixed income market to the short end of the curve.?Medium to long term flexible capital is relatively scarce and expensive.

o??In the venture and innovation space, the fallouts include a massive dip in reported valuations and the highest mortality rate of start-ups since the tech bust of 2001-02.

o??Never have conditions in the credit market been so favourable for lenders since the Greenspace Fed started pumping gas in the early 1990s in response to deflationary fears.?Vast majority of current investment professionals have no experience of investing and managing portfolio risk in a persistently high inflationary environment.

-???????Sustainable real estate

o??Will the hyphenation of real estate and infrastructure, the very crossover of “real assets” style of investing, be best evidenced by large real estate owners and operators building Sustainability capability to create resilience in long term portfolio values? Or will third party solutions evolve sufficiently and be available at scale for the entire industry to benefit? This is an existential question for exit values in the future.?In the near future, broadly in the 2030-2035 time frame, exit values of properties that fall short of institutional grade compatibility on sustainable parameters will find their values erode precipitously. On both sides of the table, whether you are an investor or a fund manager, what does it mean for the underwriting for pools raised today with a life of 10 years?

o??Sustainable self sufficiency will take many initiatives to come together from the current focus on less use of natural resources in building (say water and energy) and ultimately evolve to captive storage of excess renewable energy for use during off peak production hours. Some other infrastructure plays to complement real estate portfolios is investments in new age materials used in construction and possible vertical integration with renewable energy production sources.?

Coming off a decade long boom in all asset classes, including commercial real estate, it is not hard to empathise with GMO’s forecasts of returns over the next decade being lower relative to the recent past.

These mega demand drivers call for strategic capital allocation capabilities, eclectic operational skills and deep understanding of local asset markets under pinned by unprecedented shifts in cost and availability of capital.?Identifying the right sector, teams, and external partners to deliver the execution coupled with a flexible capital allocation strategy is the best recipe to deliver above market returns.

(views expressed are strictly personal)

[1] Acronym for Brazil, Russia, India and China - attributed to then Chief Economist of Goldman Sachs, Jim O’Neill

[2] Definition:?excessive pride or self confidence

[3] Fear of Missing Out

[4] Erstwhile Housing Development & Finance Company, India’s largest housing mortgage company and rated by global institutions as arguable one of the best governed companies.

[5] https://www.reuters.com/business/finance/blackstones-quarterly-earnings-slump-39-asset-sales-plummet-2023-07-20/

[6] Built to Rent

[7] Purpose Built Student Accommodation

[8] Artificial Intelligence

[9] Active Pharmaceutical Ingredients