Coordinator: Welcome to the Center for Investment Excellence, a production of JPMorgan Asset Management. The Center for Investment Excellent is an audio podcast that provides educational Insights across asset classes and investment themes.

(Katherine Pasqualone): Welcome everyone. We appreciate you taking the time to be with us here today. My name is (Kathryn Pasqualone) and I’m a client advisor with MP Morgan's North American Institutional Business. I am delighted to be joined by two of my colleagues, (Bob Culver) and (Kevin Bedell) from Security Capital Research and Management.

For those of you who don't know the team, Security Capital is JPMorgan's boutique all-tranche and targeted regroup based in Chicago. So (Kevin) and (Bob) are both lifelong investors in both real estate and REITs. (Kevin) is the cofounder of Security Capital, head of company and market research and member of Security Capital's portfolio management team. (Bob) is Head of New Strategy and Client Service and began his career in direct real estate in the mid-80s.

So (Kevin), (Bob), thank you both for joining us.

Man: Thank you.

Man: (Unintelligible).

(Katherine Pasqualone): Absolutely. So we're going to be discussing what's going on in the REIT market. Like many aspects of the capital market, it has certainly been an interesting year. So with that, (Bob), I know we heard from your team in June, but can you talk to us about what's changed in the REIT since then?

(Bob Culver): Sure, thanks (Katherine). Yes, this is a follow up to that call, June 17. We had that titled the State of the REIT market. That's available as a podcast on the JPMorgan Center for Investment Excellence channel and you can access that on iTunes and Google Play. So I'd encourage today's listeners to listen to that playback for more background on Security Capital and our all-tranche and target investment approach which is so well suited for the current environment.

Many of the market themes, risks and opportunities we discussed then continue today and certainly (Kevin Bedell), my colleague, is going to talk about that more in a moment. Certainly, now we have greater perspective and clarity. So an update is appropriate.

Since we spoke in June, the REIT market is up about 5% and real estate property sector performance remains highly dispersed. As in June, we continue to identify opportunities and for those interested in these opportunities, we continue to advocate for active investment. It's really critical now to understand the companies in the most granular way possible.

One-by-one, property-by-property, understanding balance sheets, maturities, tenant turnover, cash flow management teams, this is what we always do, but now understanding shifting demand patterns is critical to determining future value. And deeply understanding companies is critical to assess the companies' ability to get to this future. This is not a time to index. This is a time to (unintelligible) and highly targeted portfolios and do consider cash and senior securities and returning capital (when) opportunities abate.

Experience is also important. Long tenure is really critical now, certainly a history of working together as a team has been very helpful as we work remotely in the pandemic, but also the experience of having navigated other challenging markets as a team, backed by the resources at JPMorgan. 

We have managed through 9/11, the GFC. This experience and discipline and valuation concerns led us to return over a billion dollars of capital to clients pre-GFC and similarly led us to pre-COVID positioning with 40% cash and then our multi-tranche strategies overweight to more conservative REIT preferreds and REIT debt.

All of this is driven by fundamental research. These qualities have served us well in the past and are certainly doing so again now. Our 800 to 1300 basis points of excess returns suggest this is all working. 

Since June we have continued to reposition separate account guidelines and strategies for existing clients. We've also been entrusted to manage new capital. Interestingly, all of these investors are targeting return-seeking strategies focusing on offense. Certainly maintaining an awareness of risk but asking us to take advantage of the price volatility and identifying opportunities driven by fundamental research.

Together these new and repositioned mandates total nearly a billion dollars year-to-date out of our total $4 billion (unintelligible). Back to you (Katherine).

(Katherine Pasqualone): Great, thanks (Bob) and I know we're going to get into how we think about positioning today within portfolios later on in the discussion. But before we do that, (Kevin) maybe you can give us an update on REIT performance and contrast that with both private market valuations as well as performance during the GFC.

(Kevin Bedell): Great, thanks (Katherine) for hosting us today. I'm happy to be speaking with all of you and I hope all are well. To your question, as always the public markets respond to change with speed and emotion. They're always forward-looking. They're often prescient. But sometimes they're just emotional.

As of Friday, the overall REIT market is measured by the Wilshire Real Estate Securities Index which is US common is off about 17% to the COVID period which began February 21 or about 11.6% year to date. This is off a bottom of 40% down in mid-March. So the rebound has been pronounced as it's been in the broader equity market.

A couple of observations, first, 161 days into COVID, this is a lot better experience than the GFC when the REIT market bottomed out almost down 70%. A couple of reasons for this, balance sheets are a lot better. Not only is debt lower, but we have interest rates that are a fraction of what they were which serves to magnify coverage. 

Credit markets with very aggressive early action by the Fed are highly accommodative and the property mix in the public markets has migrated over time and we have a lot more property segments oriented towards growth areas of economy that are actually doing okay.

Second overall point is very little movement so far in the private market indicators. It was usually the case in major disruptions. Price discovery is virtually nonexistent in private real estate markets for some time. As of the second quarter numbers, Odyssey total return is modestly negative for the year as appraisers fly largely blind without transactions. This compares to the Odyssey being lost over 25% at this stage during the GFC.

So public and private real estate markets are both doing a lot better this time around. And the functioning credit markets are the major factor there. We now await additional info with the third quarter release of Odyssey results which can be expected any day.

Finally within REITs as (Bob) indicated there's a substantial amount of performance dispersion both across and within property types. For example, relative to the overall market since COVID started down 16.7%, the traditional core property segments has reweighted to reflect Odyssey weights are down about 700 basis points more or 24% since that period.

Broad brush retail, hotel, office are down in the 30 to 50% range year to date as compared to industrial data, single-family rental which are in positive territory. (Katherine)?

(Katherine Pasqualone): Great, thanks (Kevin). I think that's a really good description of kind of what's going on in some of the market dynamics taking place. So maybe if we could, take a bit of a layer deeper. Can you help us to understand the landscape in terms of significant property type trends?

(Kevin Bedell): Sure, I think I can safely say that the US real estate landscape is transforming more rapidly today than at any time over very long careers that we've had in the business. Traditional bedrock property segments like office, retail, residential, and lodging faced stiff obsolescent headwinds. The geographic hierarchy of cities is shifting, both between cities as well as within them. And we got entirely new property segments emerging to support the new realities and demands of a very different economy.

Now the pandemic didn't really create this transformation. But it served as a powerful catalyst. The real drivers are rooted in technology and demographics and in urban stressed both fiscal and social. And the impact of these forces are both interactive and reinforcing. I really want to say that again because it's so important. Technology, demographic and urban stresses together are driving a wave of change and obsolescence in real estate the likes of which we've never seen.

Technology disseminates brick and mortar retail business models over the last several years while driving unprecedented growth in industrial logistics. There are many retailers large and small often saddled with debt and legacy store (front) formats. Pandemic-related shutdowns have been really the last straw. Now we see mandated work at home demonstrating for employers and their workforce the value and convenience of working from anywhere. 

Maybe not everyone and not always but enough to meaningfully impact the office business moving forward. Demographics is another huge force now channeled and shaped by the pandemic. The peak demographic age in the US is now 29. Many are married, starting families holding onto an experiential urban lifestyle that favors renting close to work. 

For this cohort, the move to suburbia was probably already on the radar screen, but not pressing until the pandemic really transformed urban living from a paradise to a jail cell. The millennial workforce is in demand by employers and like they had with online shopping, millennials will embrace the flexibility and lifestyle benefits of work from anywhere capabilities.

And finally, we haven't even begun to see the fiscal fallout from the pandemic on cities particularly large, older urban markets like New York or Chicago. Already reeling from aging infrastructure, crime, weak public schools and stressed budgets, older urban centers may present a very different cost-benefit proposition for businesses and employees moving forward in contrast to the urban golden age of the last decade.

Now all these forces drive demand for technological infrastructure, things like data centers and cell towers. Demand for industrial logistics and for what I'd call lifestyle transitional real estate segments like self-storage and single-family rental housing. 

Nowhere are the signs of this transformation clearer than in the public real estate markets. Over the last five years for example, retail real estate has fallen as a percentage of the US common equity index from about 24% to about 8%. Over the same period, warehouse industrial and datacenters have grown from a combined 10.6% of the index to over 30% today.

Traditional core real estate segments comprise 50% or less of the public indices. So we're really seeing this change which is akin to what we're seeing in the broader equity markets with tech really eclipsing so many other areas. As investors we need to understand these trends, chart their progress as we underwrite the future in our cash flow models.

(Katherine Pasqualone): That makes a lot of sense. And some of those statistics are very staggering. So I guess given the dynamics that you just laid out, can you talk to us about how security capital is navigating this transformation from an investment standpoint?

(Kevin Bedell): Sure, a colleague of ours often observes three factors that shape our sense of opportunity. He's always saying it's supply, demand and price. And this is the same whether one is buying a property in the private market or investing in a public security representing a portfolio of real estate. The important distinction in the public market is that price can play a much bigger role because it moves around a lot. 

Six and a half hours a day, five days a week, 300 days a year, and this price volatility is magnified by the active role played by non-real estate investors in public markets. Think hedge funds, opportunity funds, index funds. You've got Japanese dividend investors and not only their large footprint as investors in the REIT market but also their ability to employee derivative strategies. Shorting, for example which can be a major force today.

This is an important dimension of public real estate markets to recognize because it necessarily shapes investment strategy. A dynamic allocation to the market, one that moves up some periods and down in other periods and the ability to concentrate holdings are true key elements that can materially drive performance when investing in REITs. 

But both are often overlooked in the traditional mandates fully invested, diversified index relative approach. So by embracing this approach in our strategies, we've effectively started COVID period already on second base in our targeted and multi-tranche strategies. We had 40% of our clients' capital in cash or senior securities as (Bob) mentioned and our investment positions were concentrated in life science, SFR, datacenters and self-storage. 

And in our targeted strategies, we held no investment in retail, healthcare, hotels. So when we take a minute and put the supply, demand, price paradigm to work in the context of how we're seeing the real estate investment landscape today, among the 12 to 15 property segments, we view that there's really three flavors or buckets on the supply, demand, price spectrum. Let me talk about each.

Bucket 1 are the haves. These are property segments where the supply, demand profile is strong, where cash flow outlook is visible, transparent, growing, but where pricing is not really dislocated. We would include data, industrial, life science, and single-family rentals in this category.

Now of note, just because these companies aren't dislocated doesn't mean that there's not great value opportunities in Bucket 1. Spending just a minute on the single family rental business, for example, the value proposition has two important drivers. One is demographics and the other is industry fragmentation. 

The demographic argument is straightforward. Millennials are starting families. They're thinking about schools. They're less enamored with urban life, but may not yet have the means to buy a home or they just prefer the mobility of renting. But the industry fragmentation argument isn’t clearly compelling. Single family rental is 13% of a total US housing market. That’s homes, apartments and everything (unintelligible).

But until the housing bust, there was little if any institutional role in the business. The opportunity to bring scale efficiencies, professional management, purposeful product for the first time to this huge part of US housing market is important part of what’s happening in this business and some of the building movers and some of the scale players are in public market.

Now shifting to the other side of the equation, bucket trade includes property segments that face serious structural headwinds impacting demand where pricing has been hugely dislocated but where forward cash flow visibility, so key to underwriting, is almost nonexistent.

Here would include hotels, malls and shopping centers, there could be a mirage of value for these segments but the road to realization is treacherous. So today we believe is an example that public hotel portfolios are implicitly trading at about 50% of replacement cost.

Sounds attractive but with negative cash flow and operating under short term forbearance agreements from lenders, value could really be a mirage. We believe the next round of forbearance discussions in 2021 will focus on the companies being overleveraged after surviving the burn rate environment and new capital may provide diluted to existing owners.

We recently feasted on a new perpetual preferred offering for one of the hotel REITS priced at 8-1/4%. We saw this as rehabilitation capital and due to risk reward is more palatable than equity. The hotels recover will earn 15 plus percent. 

But if not, and we’re senior in the capital staff with significant coupon. We expect to see more of this sort of hybrid issuance among the bucket three companies. And this is one way we can really make sense of the risk/reward of this segment of the real estate market today in the public markets.

Just a brief word on malls. We’re all familiar with the headwinds this format faces. But there really is a difference with premiere venues where in North Park in Dallas or Valley Fair or King of Prussia outside Philadelphia. And these venues will require capital to repurpose boxes and fend off competition, but they’re a different species than the traditional mall that so often comes to mind that needs discussion.

And then finally to bring it to the center, bucket two is where things get interesting. This group includes office and apartments in the (main) and they face notable structural headwinds -- technology, demographics, geography -- and they present dislocated pricing.

But importantly forward cash flow while not necessarily growing, is fairly visible and transparent. This is the group where a .7 treasury and leverageable cash flow could be highly relevant in thinking about value, particularly for private capital looking for opportunities. Today, we’re viewing apartments at the most investible in this group, since there are still so many unknowns that we see in the office business. 

High quality apartment portfolios are trading in the mid fives, NOI cap rate in the public market versus odyssey valuations in the low fours and (unintelligible) asset values probably somewhere in the middle but hard to know yet. Translate this discount to a leveraged net figure and there’s lots of room for a profitable public/private arbitrage among the apartment companies.

This strategy been wider for high quality office which is intriguing and keeps us very focused. Because as a I mentioned, there are still so many unknowns in that business, it’s difficult to jump.

(Katherine Pasqualone): Thanks (Kevin). Sounds like a lot of different things happening within the market. A lot of themes that we definitely heard across different investment teams here at JPMorgan. So, I think if you can, just talk to us a little bit about your investment posture today given some of the points you laid out earlier.

(Kevin Bedell): Yes. Our targeted dynamic strategies, which probably reflect the edgiest part of our nervous system, have pulled back investment levels to 75 to 80% after the substantial rebound in pricing we’ve seen from the bottoms.

With our investments concentrated entirely in bucket one and increasingly in bucket two, but with really only minor preferred holdings in the bucket three area, our cash flow models in aggregate suggest that market wide pricing is fair to full. The strongest bull case comes from the huge pricing and performance spread to odyssey for the traditional property segments. That’s a very power (unintelligible) if one can execute. Though you still might not make money in REITs, it’s hard to know.

There’s also a positive signal on leveraged expected returns. The power of a 2% borrowing really can’t be overstated. So those are two things that jump out on the bullish side. The more bearish perspectives relate to more traditional pricing indicators, multiples, cash yields, unleveraged expected returns. All of those are modestly adverse.

Bottom line, we see the market priced to deliver unlevered returns of about 6% per annum on a five-year horizon. Obviously with a lot of volatility around that target period to period. That sounds attractive but it’s nominally less than our underwriting would suggest is required.

For preferred and debt, debt spreads have fully acclimated to the reality of the new .7 treasury, so we really don’t see much opportunity there. Preferreds on the other hand has been highly attractive as they continue to rebound from significant dislocation that was experienced early in the year.

We see the opportunity in preferreds transitioning from mispricing of existing issues to widespread on a new wave of issuance that we’re beginning to see the signs but really hasn’t yet fully occurred in mass among the bucket three companies.

(Katherine Pasqualone): So (Kevin), one of the things that you teased earlier was a point on malls, and I know you mentioned that there’s a lot of differentiation between the high quality and some of the lower quality areas. So if you could, just spend a moment expanding on your view in the retail space first then then a maybe a point on office as well.

(Kevin Bedell): You know, I sometimes kind of use it’s unfortunate that we only have one word to describe these formats it’s mall and it gets applied to everything and yet it’s increasingly not very descriptive.

I think what emerged out of the (unintelligible) several years back, it was probably five or six years ago with (unintelligible) sell of their portfolio to Starwood was a recognition that there was a massive bifurcation occurring. And as long as I’ve been in the business, people said, “Oh, the mall business is bifurcated.” But this was very different.

And the first thing that comes to mind is when Restoration Hardware decided to say we’re Omni channel. We’re going to have one store at the best mall or the best location and then we’ll serve the market online with the catalogs. 

And that began a process within the mall business of there being only one mall that could really survive in a traditional format in a trade area. And a trade area is pretty big. Call it, you know, 10 mile radius. And that everyone else was going to have to find another way to survive.

So a lot of what we’re observing in the mall business is that activity playing out. You know, if you look at Suburban Philly, King of Prussia is going to be fine. They’ve got Anchors, the (unintelligible), they’ll have to repurpose them, they’ll put in different uses and so forth. But, at the end that will be a dominant location.

(Plymouth Kneading) on the other hand, a smaller mall with great demographics but in the shadow of King of Prussia isn’t going to be the best mall. And therefore, they’ll lose their anchors, they’ll spend all their time repositioning, they put in a grocery store or Kids Lego Land. 

And so much of what we see playing out has multiple dimensions. And certainly there’s the apparel focus that’s troubling. There’s the COVID related changes to the replacement anchors. You know, health clubs, movie theaters, entertainment. But, you know, if we can make it through this fog, I think the dominant format, these venues that are North Park and Dallas always comes to mind. I’ve got family down there and there’s just no issue there whatsoever.

But, you know, the Galleria a few miles away, different story. Valley View is gone, bulldozed. So, I think the mall business, and people would chuckle but, Ricky Bobby’s father in the great movie, (unintelligible), he said, “Ricky if you’re not first, you’re last.” And I think that’s true in the mall business today as well.

The only thing I’d say apart from that is one of the big issues with the mall business is the owner of the real estate doesn’t own the real estate. The business model grew up where it was the partnership between the owner of inline space and essentially owners are long term controllers of department stores.

Now the department stores, who knows how many will survive, but one of the huge challenges that a lot of malls face is regaining control of their real estate, and that takes money and creativity. And the recent activity of Simon and Brookfield to take control of JC Penny. I don’t think it was in the interest of repurposing that business and so forth as much as it was to make sure that an interloper didn’t come in and take control of that real estate and then shake them down for it moving forward.

(Katherine Pasqualone): That’s helpful. On behalf of (Kevin), (Bob) and the broader JPMorgan Team, I hope you all enjoyed today’s call and we want to thank you for your partnership.

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