The State of US Real Estate

This transcript has been generated by an AI tool. Please excuse any typos.

00:04 - 00:48

Hi everybody! And welcome to The Pulse, where we cover trends in the economy, the markets and asset allocation for long-term investors. I'm Matt Palazzolo, Senior Investment Strategist at Bernstein and the Head of our Investment Insights team. And I'm excited today to welcome two of our portfolio managers, Eric Franco and Ajit Ketkar, who run our global real estate securities portfolio strategy. And as I'm sure you're all aware, real estate has been top of mind for investors for quite some time, and particularly controversial through the pandemic, as we've had people calling for the end of the office as we know it and now as the economy recovers, housing emerging as a new driver of inflation. So there's certainly a lot to talk about with Eric and Ajit. So, guys, welcome to the show.

00:48 - 00:51

Thanks, Matt, for having us. We're delighted to be here.

00:51 - 00:52

Great to be here. Thanks, Matt.

00:53 - 01:18

Fantastic. So again, guys, there's a lot to talk about as it relates to real estate. We've gone through the pandemic. There's always a lot of interest in real estate and in particular residential real estate. And we'll touch on that. But just to level set everybody. Give us a sense for your outlook on the broad real estate sector now and in particular in light of where we are as it relates to the pandemic.

01:19 - 02:07

Sure. You know, I think it's actually useful to start at the onset of the pandemic in early 2020. As you know, I'm sure we all remember, the market quickly and somewhat crudely divided stocks into two groups, COVID winners and COVID losers. And, you know, real estate was put squarely into the camp of COVID losers. You touched on it, but the story went a little like this, right? No one's ever going to go work in an office again. No one will ever physically go to a shopping mall. It's all going to be done online. No one will ever travel and stay at a hotel. Working from home. We're all going to need a lot more space so people will be moving out of rental apartments and buying larger single family homes.

02:07 - 02:49

Fast forward to the end of 2021. And look, I definitely think it's fair to say that, you know, these controversies are resolving on balance much more favorably than originally expected. So just, you know, for example, the global benchmark that we managed to, you know, over the course of the pandemic, the two years, '20 and '21, the benchmark was up about 7% a year. And if you just dial that back even just one more year, back to the beginning of 2019, you know, the three-year annualized returns for the benchmark, just about 12% a year. So pretty good.

02:50 - 02:50

Yeah.

02:50 - 03:26

Eric, I think that you make some great points. You know, early on in the pandemic, people did have those concerns about how real estate was changed forever. And I know you guys are going to get into it. And real estate certainly has changed, but it hasn't changed to the extent that I think people worried that it would. Just to, anecdotally, I'm recording this podcast today from the office, right? And so that's just one of the points. The office is not dead. But you touched on how the real estate public equity market had traded, how it performed over the last couple of years. It's done well, better than many had expected. Why?

03:26 - 03:45

So, look, I think one thing that is really underappreciated is that publicly traded real estate is actually made up of a diverse group of property types, which themselves can be roughly split into COVID winners and COVID losers.

03:46 - 04:22

I want to get into that, Eric. But before we do, and I know this is a big part of your thesis now, is the winners versus the losers. But Ajit, let me bring you into the conversation. I want to talk about real estate as it relates to and with a framing of prior crises. Right. People often enough anchor to the last crisis that happened and real estate performed much better this time around related to how it performed during the global financial crisis. And you had noted it comes down to the quality of the balance sheets. And so can you just dig a little bit into that for the benefit of our listeners?

04:22 - 05:08

Yeah, absolutely, Matt. Look, it's night and day. Right? I mean, the global financial crisis now, gosh, it's more than almost ten years in the rearview mirror, but still it's fresh in the minds of all of us. Right. So the management of real estate companies that reach the trade in the public markets, have learned their lesson from the global financial crisis. And if I could say there was one lesson that was learned, that's quality of balance sheet is really what allows you to fight another day. Right. So on two metrics that we believe real estate companies have done really well. One is just getting the overall leverage down, net debt [...] or some such metric that you look at. It was north of seven or eight times in the global financial crisis and 4 to 5 times at this point in time.

05:08 - 05:14

So as it was, it was pared down expressly because of the global financial crisis, did they de-lever because of that?

05:14 - 05:54

Yeah, that was a big driver, actually. That was...nobody wanted to again stare down the abyss. Right. So I think job security, let me say that really, job security was the driver there. The second thing, which is equally important, the maturity schedule of the debt was also elongated quite a bit. So if you earlier had to refinance almost 25% of your debt every year, now you only have to do 10% to 15%. And that's a very different ballgame that we are talking about. So clearly that was a big driver. And look, proof is in terms of how many diluted equity raises that we saw in this crisis. Very little. And to us, that's just the proof that, look, all the great work that had been done just came to fruition.

05:54 - 06:11

So it's great to see that management teams in the crisis learned a lesson, pared down their debt to more comfortable levels and utilized, it sounds like, correct me if I'm wrong, guys, utilized the low levels of interest rates in order to extend out their maturities.

06:11 - 06:20

Absolutely. It was a great time to firstly take your debt down. Actually, debt leverage down with support of markets. Absolutely.

06:21 - 06:21

Yeah.

06:21 - 06:40

Okay, Eric, I want to come back to you. Let's go through your winners and losers. You had mentioned where we are now. It's obvious some of the subsectors of real estate ended up being winners and some the losers. Let's go to the winners first. It's always good to start on the positive. The industrial sector is one that you've highlighted previously. Talk to us about industrial. Why is that a winner?

06:40 - 07:29

Yeah. So, you know, look, industrial I think is the most obvious and intuitive example of a real estate winner. So the name of the sector is industrial, which, by the way, now accounts for about 15% of the publicly traded indexes. So it's a big chunk. And these companies, they own the warehouses and logistics facilities that are essential for e-commerce. So they're facilitating all of this online e-commerce that we're doing. And, you know, industrial properties near big city centers, the so called last mile facilities have just become really valuable. Right. We all get a little thrill when we buy something on Amazon and we find out it's coming tomorrow. Right. And it's these guys who facilitate that.

07:29 - 07:58

And look, this is common when a stock or a group of stocks starts doing well. You know, investors, you know, for a while consistently underappreciated how much this group would thrive. So the cumulative return for industrial stocks as a group over the, you know, two years that make up the pandemic, as a group, these stocks almost doubled, a 100%. So it's just a really good showing there.

07:58 - 08:22

I'm going to press you on one of your points for a second. You said that investors underappreciated how well industrial could do or would do. It was I mean, is that accurate or was it that given the pandemic, we've pulled forward so much tech adoption and e-commerce adoption, that now the trajectory for these businesses is a lot steeper than it was three years ago?

08:23 - 09:15

Quick point, then, Ajit, why don't you bump into. You know, I think the thing with the pandemic is that it has changed behavior, some of it temporary and some of it will be long lasting. Right. And I think that's a bit of the challenge, right, of active management, and where we can add value is parsing out those differences. Right. You know, I do think that for a lot of e-commerce, it represents a permanent shift. Like, I sort of walk around, oh, you know, I need this, I need this. I got to get to Duane Reade. I'm going to do it. And a week goes by and I don't do it. And then I hit myself on the head and I say Amazon. And then I go to Amazon and I buy it and then I never buy it at the store again. Right. So, like, these are habits that are just reinforced in a good way and a lot of these shifts in behavior are permanent.

09:15 - 09:45

Yeah. To just build on what Eric said. Right. I think this is overall maybe focus on how quickly, you know, I'm going to get my stuff I think is much more maybe pervasive now than maybe when it was before. So, for example, I think Amazon has gone publicly and said that, look, they want to do same day delivery across the US, right. Now, when someone like Amazon does that, guess what happens with the rest of the industry, right? You are Macy's of the world or what have you. They all kind of have to match that.

09:45 - 10:20

And I think the problem to deliver the same day versus the problem to deliver over two or three days is a very different proposition. Where you need the network, which is, again, people call it last mile, first mile, there are multiple terms are being thrown around. You need warehouses very close to where you have population density. And guess what happens, right? There's not that much land available there. There is not good structures there. So all of that actually is a demand buildup just when you don't have the supply. And that just further skews the dynamic in the favor of the landlords.

10:20 - 10:56

Well, sidebar, Eric mentioned Duane Reade. For those of you who don't know Duane Reade. Right, we're all here in New York. But Duane Reade being a drugstore, based, I think predominantly here in New York, and of which their line is the bane of my existence when I go in there. But hence the Amazon purchases on a regular basis. But Eric, let's keep going with your winners. So far, you've covered industrial. That's an obvious one. And we appreciate the additional color there. How about the digital economy? It's a tangential point, but to what extent does the digital economy then benefit other subsectors of real estate?

10:57 - 11:28

Sure. And you know, this is two sectors or subsectors that I think a lot of sort of non-real estate specialists don't even realize exist in the investable universe. So REITs own data centers, right. Which are the connectivity that large corporations, etc., use. And then also cell tower REITs, right? So we all like our mobile signal to be strong and it is REITs that own the properties that the telecom companies place their cell towers on.

11:29 - 11:35

Yeah, so two additional winners. I would assume those are much smaller than industrial in terms of percentage of total?

11:35 - 11:46

This might surprise you, but given how strong the secular trends have been in that subsector, they are actually collectively larger than the industrial sector. Oh, wow.

11:46 - 11:50

OK. All right. Gosh, so much transformation just in the last five, ten years.

11:50 - 11:51

Absolutely.

11:51 - 12:03

In availability of these publicly traded REITs. Let's keep going down your list of of winners. One additional one. I'm not sure if this is surprising to me or not, but self-storage, where does that fall?

12:04 - 12:37

Right. You know, if you wanted to think about a surprise, I think just how well the self-storage sector has done has been a bit of a surprise. Right. And just to, you know, take a step back. You know, you always ask yourself the question, you know, what drives demand for people needing storage space? And, you know, historically, it's been really anything that disrupted the status quo for an individual. Like big life events, like births, deaths, marriage, divorce have historically generated demand for space.

12:38 - 13:19

Then the pandemic, you know, as we're all painfully aware, has brought increased disruption, sometimes temporary, like young adults moving back in with their parents and sometimes more lasting, like increased job mobility and migration. And, you know, all of those kinds of life changes generate storage demand. So, you know, the rent increases that these companies are enjoying has really exceeded expectations. And like the industrial sector, these stocks as a group over the years '20 and '21 have roughly doubled up a 100%.

13:19 - 13:43

Yeah. So Eric, so far we've covered industrial, we've covered data center, cell tower, and now self-storage, you've covered where they stand today and over the last couple of years, given the pandemic and other influences. As we look forward over the next, let's say, five years, does this tailwind that they've had for the last couple, does that continue in your mind?

13:44 - 13:45

Ajit, why don't you?

13:45 - 14:20

Yeah. So look, from an overall demand perspective, we actually don't see much changing on definitely the warehouse or the industrial demand. And same with data center slash cell towers. I think self-storage is more transactional. Look, the surprise has been it's actually continued even so far this year. Right. So we will argue that if anything, maybe the demand picture on self-storage is a little less clear. But on the other three sectors, I think we believe the demand drivers are still very much there and the landlords should do really well.

14:20 - 14:42

Okay, guys, not to your surprise, but when we get asked about real estate, it's predominantly about residential real estate and everybody's always asking, you know, whether or not their house is going to appreciate over the next few years. We'll leave that off to the side for the moment. But residential is a, I would assume, meaningful part of the REIT market, the publicly traded REIT market. How's that doing? Is that a winner, is that a loser over the last couple of years?

14:42 - 15:09

I think residential was the most controversial in some ways when the pandemic started, but it's almost two years back. And the story was that, look, people have certainly gone to working from home and they now need a lot more space. So they are going to move from urban to something more suburban and they are not going to rent because rental apartments are typically smaller than wanting to get a home.

15:10 - 15:58

I think the picture has actually turned out to be very different. And for people on the call that are not really familiar with what we mean by residential from a REIT context,. right It's, of course, apartments that I think most people are familiar with. But there is also single family rentals, manufactured housing and student housing that come in, right. And broadly, the theme has been exactly similar. So what has actually happened, if you will, is overall over the last ten years, the housing supply overall, again, this is both single family and rental, has just not kept up with what the real demand has been. So the picture has been that people who want to live in a certain area, either rent or own, they just haven't had the supply that's required because we just haven't built.

15:58 - 16:01

Why is that? Why has there not been sufficient supply?

16:01 - 16:08

Yeah. So look, I'll give you some numbers, right? So the highest that we built ever was about 2 million units.

16:08 - 16:10

That was a... a Two million homes

16:10 - 16:51

Yes, exactly, right. That was way back in 2005. Okay. Since then, actually, we have averaged half of that, 1 million per year. Right. And that's really driven by a few things. One is the cost itself, right? I mean, I know we are talking about supply chain and so on now, but the cost of a home has continued to go up, especially if you think about the land and so on. The other side of it is that also where people want to live has changed, maybe more Sunbelt cities where it's more affordable. Again, affordable home to build is actually not that attractive a proposition because again, all the cost pressures that I talked about, right.

16:51 - 17:25

So if you're going to combine both of those, we have a lot of undersupplied housing in the US that of course holds the pricing power. I mean, people are complaining about, hey, it's been so expensive to buy a home, it's a direct result of that. But the good from a residential REIT perspective is that the same narrative helps, right? Because housing, whether you want to own or rent, is essentially a substitute and the landlords have had pricing power then on the rental apartment side or manufactured housing side or student housing side and so

17:25 - 17:53

And I think that's been a benefit. So the whole narrative that, look, apartments are a loser and single family housing is the winner has just not turned out to be true. I will give you another anecdote. Right. The rental growth in places like Nashville, where our headquarters has moved, right, is like 20% year over year. So if somebody was paying a thousand bucks, they are now certainly paying 1200 bucks per month. And that's a big sticker shock.

17:54 - 18:11

Ajit, how about the other side of this equation? You talked about the supply of homes, but how about household formation? You know, I read or heard anecdotally about people staying in their homes longer, maybe living with their parents a couple of extra years. Is that actually the case or are there other trends going on?

18:11 - 19:10

So that was definitely the case. The millennial generation, especially, right, has most often lived with their parents and clearly delayed their marriage, right, which is typically the driver for the household to get kind of [...]. All of that has now finally coming to a head, right? So think about the supply picture that I said, which is more structural. At the same time, that supply picture is now meeting with the demand picture where millennials want to own homes. The other thing is also women are having babies a little later. And again, that time frame is also coming up now, if you think of the generational shifts, right. So when you combine all of that, the demand is extremely solid, robust, and that's meeting this undersupplied market, which, again, look, it's going to stay like this because I don't see a magic wand that can move us from this 1 million units that we are producing every year to maybe 3x that's required to eat up the undersupplied market at this point in time.

19:10 - 19:29

Yeah. Guys, I want to move on to losers. But before I do, Eric, you've made a point in the past in conversations that the publicly traded REIT market is only a fraction and you'll quantify specifically, but a fraction of the overall real estate market in the United States. What's the relevance of that point?

19:29 - 20:26

Sure. And I think this will be especially important as Ajit starts to talk about the, quote unquote, losers. So, you know, most people don't realize that about 80% of real estate is privately owned and only less than 20% really is owned by public companies. And the public companies, even though it's only 20%, the quality of that real estate is generally much higher than on the private side. So if you think about and again, you don't get to this, you know, an area that has two malls and, you know, because of all the trends that, we've talked about some, it really can only support one mall. Well, guess what? It's the REITs that own the really good malls, which is, A) where the retailers want to be and B) where the consumers want to go. And it's that other mall that's going to be turned into a, you know, a parking lot or drive-in movie theater.

20:27 - 21:09

Yeah, I think that's a fantastic point, particularly for, I don't know, investors or clients that don't do this every day because often enough, and it's understandable, we look around our local town or our community and we say, oh, that building on the corner is underleased or that retail shop is closed and we project out to the entire real estate market. And that's to your point, not exactly true or applicable because the highest quality real estate, the ones that retailers or offices or companies want to be in, is the publicly traded market and the rest is privately owned. And it doesn't discount that the challenges that they're facing, but we shouldn't project that out to the publicly traded REITs in the market. Let's get to these losers. This is the fun part.

21:09 - 21:21

So so, guys, what are some of the areas or subsectors of real estate that are facing some serious challenges either because of or alongside the pandemic?

21:21 - 21:54

So I'll jump in with maybe one in the healthcare sector, seniors housing. Again, just to be clear, seniors housing is one of the largest segments within the healthcare REITs. And clearly people, I'm sure, remember reports from early 2020 where seniors housing was the place where COVID really, especially in Seattle and so on, COVID really came to the public, into the public psyche. So clearly it was combined. It was put in the group of COVID losers at the beginning. And indeed we saw the occupancy in seniors housing go down.

21:54 - 21:59

I'm sorry, not to be crude here, but explicitly because of deaths in seniors.

21:59 - 22:04

Unfortunately, yes. Unfortunately, the average stay in seniors housing is less than three years.

22:04 - 22:08

Now and post-pandemic. And it was it was meaningfully longer?

22:08 - 23:08

It has always has been that. It has always been that. It's that just what happened was the funnels to come in essentially got cut off because people did not want to move in, given all the negative headlines and so on. Right. Reality could be very different, but the negative headlines... and you continue to have unfortunately above average deaths. Right, because of the pandemic. So clearly, cyclically, that sector has been a loser. But again, cyclicly is the keyword because we actually believe that given that it's a necessity driven product, and especially as the adult children who are the decision makers for that decision to put their frail and aging parent into seniors housing as they go back to work now, will come to office in a minute, as they go back to work. Some of these things are unavoidable. And I think seniors housing landlords have done a very good job of vaccinations and really getting protocols in place where I would argue that actually that environment is safer potentially for seniors than any other environment. Definitely not their own home.

23:08 - 23:17

And Ajit, where are we, and sorry to interrupt you, but where are we in terms of percentage of the population that is of the age that would go into senior housing?

23:17 - 23:49

Yeah, we are actually exactly at the precipice, actually. You essentially gave the bull case for landlords. I'll give you one metric just to answer that. Right. Let's say about a 1% growth that we have seen in that population in the decade 2010 to 2020. It's going to be 3% growth rate. And that's a significant change as we think about the demand profile. Right. So we believe it's a cyclical loser. I think it's going to be actually a winner as things normalize. We are already seeing those green shoots over the second half of 2021.

23:49 - 24:00

Interesting. Okay. So that's healthcare. That's senior housing. Anything else in healthcare, whether it be, I don't know, medical office building or hospitals, that's notable?

24:00 - 24:33

So medical office buildings have been really a very defensive asset. And yeah, you could have, I mean, we have had handicaps with Omicron and earlier with Delta and so on, but no, long term fundamentals are unchanged. If anything, on hospitals, I would argue that the long term fundamentals are a little better as people have realized that when nothing else works, it's the hospitals that come to you, the ICU and all of that capacity, right? So we would argue, no, I don't think there are other large enough subsectors within healthcare that are worth talking about.

24:33 - 24:47

Okay. So let's get to, I don't know, the big three in terms of controversy. We've got retail been controversial for some time, even pre-pandemic, lodging, and office. Take them in turn, your choice on what goes first.

24:48 - 25:39

So I'll start and Eric, feel free to jump in. Right. So I think retail, right. I mean, we have all heard this malls are dead story for the last five or six years. I think we would put malls post-pandemic very much in that same category. We have been extremely negative on their prospects pre-pandemic. If anything, pandemic has further maybe strengthened our resolve that yeah, they don't really have a mode anymore going forward. And very simplistically, it's an enclosed setting. Correct. So if anything, with COVID, given people's behavior changes, typically inside is not as preferred as being outside, given again, how COVID transmits and so on. And if anything, malls are exactly that, which is it's all enclosed setting for shopping. And that has been a problem.

25:39 - 26:12

However, the fundamental issue continues to be the department stores, which were their traffic drivers. The reason to go to a mall was because you like a MACY's at certain mall or what have you, and then you went to other online shops and so on. I think department stores have continued to tread water and actually become weaker and weaker over time. So we would very much put that front and center into the COVID loser bucket. I think the second part of retail, which is maybe somewhat more controversial and actually we are now more positive, is something called an open air shopping center.

26:12 - 26:45

Right. So unlike an enclosed mall, which is of course a large behemoth, right, shopping centers are much smaller footprint and typically these you will find inside of the community. So their driver is convenience. You can go to your grocery very quickly and do that and park the car in the middle where there is all the parking. Just walk in to the grocery store that you want to go to, maybe Kroger's or what have you, and walk out. So not only is that easy to get to, but it's also easy once you are there to get into the shop that you want to and just get

26:45 - 27:37

Right. And of course, we saw that as a necessity in retail. Groceries were very much a winner. I mean, we have all seen those pictures of stacks of toilet paper or what have you. Right. And they were allowed to be open right through. And given that their driver for existence is convenience, we believe if anything, in this work from home era where more and more professionals potentially are going to work at least part of the time from home, there are more opportunities for people to go and shop. And in fact, I think that the angle that really excites us, is the whole buy online, pick up in store, right. So if you think about that as the ideal for a large chunk of population, physical open air center is actually...which is conveniently located, is actually a very good proposition. So we believe the prospects there if anything, are actually better after the pandemic.

27:38 - 27:54

So Ajit, I'm a lifelong New Yorker. I've barely left the city for 47 years. So I have no idea what you're talking about. Open air malls. Is this a new concept, like, new within the last ten years, or did this exist 20 years ago?

27:54 - 28:30

Maybe I should clarify. Right. So open air. Why do I call open air? It's really because there's a parking lot in the middle and in a C shape or an L-shaped. You have different stores and typically it is anchored by grocery or it's the other category killers like TJ Maxx or Home Depot, Lowes and what have you, right. So it's either a grocery anchored open air shopping center or it's something called a power center, which is anchored typically by a Home Depot or TJ Maxx or what have you. Again, if you think about the last 15 years, those have been the retailers which have gained share away typically from department

28:30 - 29:06

Yeah, I mean, think of a big typical high quality suburban strip mall as Ajit says, you know, anchored on one side by a big grocery store, on the other side, maybe by a big gym, or something like that. And in the middle, right, you've got the pizzeria, you've got the pet shop, you got nail salon. And, you know, a lot of these are service-based and meet convenience needs. And they're, like Ajit, said you know, we think the outlook is extremely healthy and the stocks are still attractively valued. So it is an area that's interesting to us.

29:06 - 29:07

Okay, great.

29:07 - 29:23

Okay, let's get to lodging, guys. Lodging I know has been challenged because travel is down significantly. It seems like, at least to me, personal travel has rebounded somewhat while business travel remains on its back. Where does lodging stand?

29:23 - 29:47

Well, I can start on that one. So there's really three big categories when it comes to lodging demand. One, as you say, is sort of leisure travel. Right. The second is transient business demand. If you go to a city or a couple of cities and you're in the city for a night or two to see some clients, and then by the end of the week, you're back home. And then the third, which is actually a big category, is group business like big conventions.

29:47 - 30:39

Right. Okay. And as you said, leisure travel is essentially all the way back. And hotels that cater to the leisure customers are enjoying revenues and profits that exceed pre-pandemic levels. So really healthy there. Not surprisingly, business travel and group travel are lagging. And so, look, I think we just have to admit we don't know what the longer term is going to look like. Are people going to do conventions or gosh, there's just too many people, I'm not doing it? Or do they say, look, I used to see the client four times a year, now I see them two times a year. Will do the other two on Zoom. And if I want to see a bunch of companies, you know what? I don't need to travel to Chicago one day and Boston to the next. I'm going to go to the big convention.

30:39 - 31:36

Right. And so I do think that there's a range of outcomes which, by the way, is reflected in the valuation. Right. That's the range of outcomes is [...]. So there's a risk premium added. You know, that said, I do think the outlook for the next, I don't know, 12 to 18 months is probably pretty good because just like we had this pent-up leisure demand, everybody was dying to get out and go on vacation. Right. And the hotels are enjoying that. I do think that there's going to be a decent amount of pent-up business demand, at least for the next 12 or 18 months. And, you know, the companies are saying, I'll just make this the last point, in terms of the group business that had been maybe scheduled, the convention business that had been scheduled, say, for January, February, that was canceled because of Omicron the, what hotels are finding is that that business, though, is being rebooked for later in the year, often at higher rates than were originally in place.

31:37 - 31:51

Okay. Well, we'll see. I'll be interested to see how that plays out, whether or not those big conventions, you know, Vegas or wherever it might be, ends up coming back and be any picture like it was back before the crisis.

31:51 - 31:56

Okay, guys, last subsector, the big one. I'm sitting in an office. What's the office sector like?

31:57 - 32:47

Look, if you ask us where maybe there is the widest variability in outcomes, I think it's on office, and for one stable business. I mean, look, the office used to be the asset class we would go to typically, if we found that... high quality office was the asset class we would go to if we found that the economy was starting to be weaker, right, or volatile. So a work from home revolution has definitely rattled, you know, this one stable business, I think. I can't help but note that people do, at this point, leisure demand is back, right? People are willing to get onto an airplane to travel to their leisure destination. But they are not really willing to come back to office. And really what that means is it's less about any, as much about a concern for their health. I think it's might be just a preference or a structural shift.

32:47 - 33:09

Right. And that is something that we don't know how that's going to play out because the tenants, the large corporations especially, like ourselves. Right. We are very clear. We want people to come back into the office because of culture and our business is apprenticeship. So again, how we maybe onboard the young talent and groom them and all of that very much requires office, right?

33:09 - 33:48

So there is this tug of war between maybe what maybe the employers want and maybe what the employees want. And we are not 100% sure how that ultimately pans out. I mean, what is very clear is that there is something that has to give. And could it be that the high cost coastal cities like New York will see office landlords lose out because the talent there A) wants to go to more affordable cities, but B, don't want to commute for an hour plus that many of us do to get into an office, and maybe the Sunbelt shiny brand new towers in, Atlanta, Buckhead or Austin Domain, or what have you,

33:48 - 34:11

really thrive because people are willing to drive in, park their car and then go up to their own cubicles, if you will. So I think that's really where there is a lot of variability. The earnings impact so far has been minimal because these are very long-term contracts, but clearly multiples on the stocks have really cratered. Is it a falling knife or is it a value trade? I think the jury's still out.

34:12 - 34:35

Yeah. And look, this is a spot where the quality really matters too, public versus private. Right. So to the extent that there is demand, which there is, of course, today, it's really gravitating to the new high quality buildings that have the amenities and the open spaces, whereas, you know, the smaller commodity type office is really, really struggling.

34:36 - 35:30

Yeah. I love your guys' take on this. I heard this, you know, six months ago when everybody was talking about companies reducing the amount of days that their employees had to come into the office. Like, for example, for us, we have three days mandatory in the office and then two that are flexible. So let's assume that, broadly speaking, companies across the country go to a three days in, two days out. The popular refrain is that, well, then you just need less office space. As I think about that, maybe that's not actually true because a certain percentage of your floor is conference space. It's the pantry. And I still need my office, even though I'm only here three days a week and I'm home for two. I still need my office. I don't lose whatever that is, 3/5, 60% of my office. How does that all work? Do you actually need less space if you go to a flexible timeframe?

35:30 - 36:01

Look, I actually chuckled when you were asking that question because I actually think that that's not really a choice. Right. So not only are employees preferences shifted from open floor plan to wanting their own personal space thanks to COVID. But really, as you think about it, right, the whole reason for employees to come back to office is collaboration, right? So many times what we are finding is that even though it's three days, any of the three days of the week, typically, we are finding Tuesday, Wednesday, Thursday as the highest utilization days.

36:01 - 36:01

That would be nice.

36:02 - 36:30

If everybody is in on Tuesday, Wednesday and Thursday. And employers should want that. Right, because that's when the collaboration happens. You cannot really have what, 40% less space on those days. I know you just don't have enough. So I almost think from an employer perspective, it's really a choice between getting all of the space and living with that extra expense or allowing fully flexible work from home policy. So I don't think there's a halfway house works.

36:31 - 36:33

There's no... it's all or none. It's all or none.

36:33 - 36:54

Guys, we're getting close to our time, but I still have a couple of, I think, important questions for us to touch on. Inflation is all the rage, conversations about inflation. Certainly for our clients. We've seen a number of the CPI and PCE prints of late be at record highs or multi-decade highs. How does real estate, if at all, hedge against inflation? How do you guys think through that?

36:54 - 37:39

So real estate historically has been a good inflation hedge, and if we have another period of extended high inflation, we expect that real estate will once again be an effective inflation hedge. So I think that's it; that it will do what you want it to do. We think so. And part of it is just the structure of the industry, the assets. Right. Which is, you know, the way it ends up affecting supply and demand. As inflation hits input costs, it slows development of new buildings. And then that, in fact, constrained supply over just a few years leads to better supply and demand dynamics.

37:39 - 38:13

Right. And so the landlords enjoy the profitability increases from that. And Ajit, I'll let you jump in, but the profit growth is generally better for real estate because you don't really have rising input costs in the same way that you would if you were selling widgets. Right. I could sell the widget for more, but all the stuff I need to make the widget also costs more. Here, the building and the land already exist, right? And you don't have to pay more for them. So you get the higher revenue with a cost base that's largely intact.

38:14 - 38:30

That is one of the best explanations for why real estate works well in an inflationary environment that I've heard. That comes down to the supply and demand, the cost pressures and all of that and rental increases. So I appreciate that color, Eric. Ajit, your thoughts?

38:30 - 39:13

, I mean, I would just build on what Eric said, right? The gross margins in the business are very high. I mean, 75% plus and they are quite defensive in the inflationary environment. And if anything, they could actually grow because we don't really need a whole lot of labor to manage an asset portfolio worth billions of dollars. So yeah, there might be a 3 to 5% increase in the the headquarters staff, which itself would be just 100 people to manage $10 billion in assets. But those assets are inflating annual rents that you can charge because of the dynamic that Eric talked about. Demand and supply are actually rising way faster than that 3 to 5% in most cases. So the margins actually could expand. So this is actually one of the better asset classes to own for inflation.

39:13 - 39:39

Because my final question and then we touched on this a little bit earlier in the show, but historically or traditionally, real estate has necessitated a lot of debt because you have to buy the asset and manage it and roll that debt over time. We are now, I would think it's safe to say, entering into an environment of higher interest rates. What effect does that have on the debt levels and the carrying costs for real estate owners?

39:39 - 40:35

So, I mean, I'll jump in and I'll continue with maybe the thoughts that I provided to you earlier, right. I think REITs are in a very good place to handle any interest rate increases that one can see. Not only are the debt levels lower than otherwise, and secondly, the staggered maturities means that any risk with the refinancing that comes, any increase in interest rate that one could see is going to be lower than what they would have seen before. I think the last point I'll make is, look, why the interest rates go up matters a lot to REITs, right? If it's because the economy is overheating and that's why things are, the interest rates are going up? That's actually not such a bad thing because again, going back to rental pricing power, rental, your rental pricing power is very high. So you could very well eat up a little bit higher interest rate because your net operating income from your property is just so much higher.

40:35 - 40:57

Sure, higher interest costs raise costs, but the important point is the increase in interest expense is going to be very gradual because, A) you're starting with less debt than you had before and the maturity schedule is lengthy. So the increase in interest costs from one year to the next is going to be extremely gradual.

40:57 - 41:07

And are they financing themselves? Important point here, guys. Are they financing themselves with floating rate debt or fixed rate debt? Have they locked it in, I know they've extended their maturities, but have they locked in the rates?

41:08 - 41:20

So it's typically unsecured. So they are actually not using their assets to get debt. That's one. And it's typically a fixed, fixed rate for a certain maturity

41:20 - 41:29

Period of time. Sure. Okay, great. Because we've covered a lot of ground. We really appreciate your perspective and color here. I think this was a fantastic show. Eric, Ajit, thanks for joining us.

41:29 - 41:31

Thanks, you guys. Appreciate it.

41:31 - 41:32

Thanks for having us.

41:32 - 41:50

And thanks to all of our listeners for joining us today on this episode of The Pulse. If you enjoyed this podcast, please subscribe and rate us. And e-mail us any of your thoughts or feedback or any questions that you might have to Insights@Bernstein.com and be sure to find us on Instagram and on Twitter at BernsteinPWM. Thanks and be well.