Ladies and gentlemen, welcome to the Business Brew.
I'm your host, Bill Brewster. This episode features Ryan
Dobrats of 3rd Ave. Funds.
He stops by to talk about 3rd Ave's real estate strategy.
It's an interesting conversation.
It probably should have occurred in the middle of the Reed
episodes. Think Ryan has some good
counterpoints to some of the REIT structure and I kind of
wish that I had dropped it then, but alas, things are not perfect
and here you are. I think this is a very
interesting conversation. I enjoyed speaking with him and
I hope that you will enjoy listening.
As always, none of this is financial advice.
Everything contained in this program is for entertainment
purposes only. Please consult your financial
advisor before making investment decisions.
Do your own due diligence and the information in this
interview represents the opinions of Ryan Dobrats and is
not intended to be a forecast of future events, a guarantee of
future results or investment advice.
Views expressed are those of individual and may differ from
those of other portfolio managers or of 3rd Ave. as a
firm as a whole. Investors should consider the
investment objectives, risks, charges, and expenses carefully
before investing. The 3rd Ave. funds are offered
by prospectus only. The prospectuses and summary
prospectuses are available on 3rd Ave's website or by calling
1-800-443-1021. Read the prospectus or summary
prospectuses carefully before investing.
Read the docs folks, you know the drill.
Read the docs. Anyway, hope you enjoy the
episode. OK, bye.
So, ladies and gentlemen, thrilled to be joined by Ryan
Dobratz of 3rd Ave. How's it going, Ryan?
That's going Bill, great to be with you today.
Nice to have you. I tell you, one of the things
when I was reading your letters that I was super jealous of is
your signature. I'd like to just be Bill and
have that kind of like your penmanship is good and it's
crisp and it's just Ryan. I was like, that's dope.
I like that. Like.
I appreciate that I I see that in your future.
It may be, I don't know. My my signature looks like
chicken scratch. When did you just go with Ryan?
When I stopped writing checks. There you go.
Yeah. I used to go by Billy and then I
went to, I went to work at like a Bank of Montreal.
It was B MO Harris. But anyway, they were like, you
can't be Billy until you've done something.
So then I became Bill and then I never went back.
But I I kind of miss like Billy Brewster had a good ring to it.
Oh, well, maybe maybe if I make it again, I'll go back to Billy.
We'll see. So anyway, you want to describe
what you do? Yes, sure.
You know, I've been at 3rd Ave. management now for for about 18
years now, a portfolio manager focus on the real estate value
fund. The the real estate value fund
was launched in 1998. Today I manage it with Jason
Wolf, but kind of took an interesting route to to get
here. I started off at the University
of Missouri was there in the late 90s and early few.
Yeah, I like Mizzou. Mizzou has called has had a a
resurgence of sorts. And when I was in Business
School there my last semester, I was so lucky.
I took this class, semester long course focused on Warren
Buffett. And it was funded by a great
guy, Harvey Eisen that wrote Bedrock Capital out outside of
New York. But he paid for it out of his
own pocket for, for US students at Missouri to take it.
And it really just opened my eyes to to so much.
I mean, amazing to read the Warren Buffett way and the
Warren Buffett shareholder letters as textbooks.
And as part of that class bill, there was a speaker that came to
us to present at the end of the semester.
His name was Scott Moore and he was at that point running the
value funded American Century, which is based out of Kansas
City. And I really enjoyed his
presentation. I, I went up and, and spoke to
him afterwards and I said, if I wanted to get into your seat
down the road, what would you kind of recommend?
And he said, it's probably pretty challenging.
There's not a lot going on in investment management business
in this area. But if you, if you really want
to get into the business, I would tell you to choose one.
Go learn an industry and had learned it very, very well
because you'll become an expert for that and a resource to
others. And it will also be easier for
you to pick up other industries as you go down the road.
And he said to go get your CFA. And both of those pieces of
advice were, were terrific in retrospect.
And so after that I, I started to look into the CFA.
I, I graduated from a zoo. I joined up with Ernst and
Young. I was originally part of their
cash management practice, which was a, a great business.
They were kind of the go to advisor for financial
institutions, insurance, banks, etcetera to to maximize their
interest income. That was kind of the projects
they were signed up for. However, when I joined them, it
was right after 911 and in Greenspan had had cut rates and
so there wasn't a lot to do. And I got reassigned to a
Sarbanes-Oxley project and I got sent to Milwaukee in the middle
of winter. And I was working on an
insurance company and going through their controls.
And while it was sort of interesting, it wasn't really
what I what I signed up to do. And at about that same time, I
reconnected with someone that I knew from Kansas City who worked
at Morningstar. His name is Mike Trigg.
Mike. Yeah.
Do incredible things that WCM with some other Morning Star
people that followed him out there.
But I I connected with Mike and he told me that Morningstar was
what was in the process of hiring and he kind of knew I was
interested in value investing. And so I sit in my info had an
opportunity to to interview a few different times when was
taking the train from Milwaukee to to Chicago in in between my
my role and Ernst Young to talk to them.
But ultimately took that, that job and so I moved to Chicago
and I got a side to their, their real estate group.
And I didn't have real estate experience at the time per SE,
but I grew up around real estate.
My, my grandpa worked in construction, my dad did a lot
of real estate tax and and and finance.
So it, I, I picked it up pretty quickly and I ultimately was
covering kind of 3035 different companies.
And after about a year in, I realized they're really only
four or five of these companies that are, are, are really
interesting. I mean, that own, you know,
really high quality assets that have thoughtful management teams
that are, you know, redeploying capital, creating value.
And one of the other things that those companies had in common is
was Third Ave. was one of, if not the largest shareholder of,
of each of those businesses. So that's how, how 3rd Ave. kind
of got on my radar. And so this was called, call it
2000 and, and five. And so I, I got onto 3rd Ave's
website and came across their shareholder letters.
It's something that, that the firm has historically, you know,
put a lot of time and effort into.
And I, I read those shareholder letters and I learned more about
real estate and value investing in, in, in parsing through those
letters than than really anything else.
And at, at one point I, I got on there and realized that Marty
Whitman had written a number of value investing books.
And so I went out and got those books.
I, I really identified with his kind of safe and cheap or modern
value approach to, to investing. And ultimately I, I got onto the
website one day to, to download the, the updated letters and
there was a, a job posting for a, for a real estate analyst
opportunity. And so I basically fell out of
my chair when I, when I saw that I didn't have a resume put
together at at that point, had no plans of leave, you know,
leaving morning. Sorry.
It was a it was a great role, great, great group, but that was
a, a fat pitch opportunity in my mind.
So I went home, put together a resume, sent it in, connected
with Jason Wolf, had a great conversation with him.
And then he ultimately had me up to New York, met the rest of the
group there. And probably within a month I
was moving from Chicago to New York to, to work for 3rd Ave.
And that was 2006. And so it's a.
Shame that you downgraded cities, but I forgive you.
Well, you know, interestingly, I, you know, I, if, if you were
to look at the backdrop behind me, you may pick up on the fact
that it's, it's not New York, it's it's actually Austin, TX.
And we could definitely get into that.
But about seven years ago I moved down here to open an
office for us. It's been very strategic for us
on the residential real estate from well, I mean, we're
basically within two hours of four out of the top 6 building
markets in the country. Yeah.
And it just gives us some boots on the ground at a different
perspective. Paid off particularly well.
I think coming out of the the pandemic, it's very helpful to
get out and go visit some of the sites.
I mean, I can go see what's going on at some of the Dr.
Horton and Lennar communities. I can see what kind of HVAC's
they're installing. I could talk to the sales
people. It's, it's been really
beneficial. It's also actually been helpful
to avoid certain things. There's I I think been a
narrative that Sunbelt office is, is OK.
People are back in, in, in the office and certainly utilization
rates are up, but they're nowhere near where they were pre
pandemic. And I mean, if you can see some
of these office buildings behind me, they're either half leased
or fully leased but not being utilized.
There's just a ton of access space.
So I think it's been helpful many unexpected ways.
But yeah, I've been down here for for seven years, but been at
3rd Ave. for for 18 now. Yeah.
So with Office, right, I mean, I am pretty certain that I'm going
to characterize Marty correctly. So, but if I don't, please
correct me because you know better than I do.
But a lot of what I perceived him to do was look at asset
values and think about, OK, well what's the future earnings power
that this asset base might be able to create.
And you look at the amount of capital that's in office and I
think it's kind of easy to say, OK, well maybe this look at the
assets, what should they earn. But to your point, like the
current outlook is not good. How do you think about what is
too hard to forecast in office versus when it might get sort of
exciting? Because I, I do think like
office fundamentally has some purpose and the probability of
just from like a capital cycle theory, there's not a whole lot
of capital flowing into it. But the economics also seem too
hard. I don't quite know the right way
to frame this, but there's a lot of sunk capital in office and a
lot of it is underutilized, right.
And on, on one hand, I look at the asset base and think, well,
for good properties there should be a future here.
And I sort of like the idea of the capital cycle working in
your favor because a lot of incremental capital is not going
into office, it doesn't seem. On the other, the current
economics are so uncertain. So I'm kind of curious how you
think about putting things in a too hard pile versus when you
see an asset base that you say, OK, I, I can kind of see how the
earnings power can grow from here just like philosophically.
You know what, absolutely. I mean we operate with a
contrary mindset and and so we're naturally interested in
situations such as what offices is going through today.
And I, I think we certainly believe in the, the narrative
that is out there that suggests that the high quality, well
located modern buildings will ultimately take market share as
tenants move to those more desirable properties, sort of
leaving the B&C property types underutilized and, and, and
probably more fit to, to be, you know, repurposed or put to a
higher and, and, and, and better use.
And so as a result, you could theoretically do well by
focusing it on those Class A locations and we'll continue to
to monitor those opportunities. But you know, one of the the
issues with office is that it's incredibly capital intensive,
right, because you're paying very significant CapEx dollars
for tenant improvements for for leasing commissions.
And as a result of that you're sort of after CapEx return can
often be be diminished. The one other thing that we're
probably more cautious on relative to others that have
sort of bought back into the office space, it is, is that we
think that property taxes for these Class A locations,
particularly in the gateway cities is going to go up pretty
tremendously. And while you ultimately do pass
that through to the tenants, I think that that will sort of put
a governor on how high rents can go.
But historically, financial service firms, they may pay 6 to
7% of their their revenues and rents and we don't see that
going to 10:50 percent. So if, if taxes are, are, are
going up as these cities, you know, need to fill their budget
deficits, that could impact the economics of, of owning office.
And So what we've done is we've taken a little bit of a
different approach and we've really focused in on the real
estate services companies. These are the CBRES, these are
the, the Jones flank, Lasalle's, the Savils of the world who
historically have really made most of their money from
transacting to real estate, right?
They get paid to lease, they get paid to oversee financings, they
get paid for capital markets transactions.
But over the past kind of 10 to 12 years, they've also built up
pretty substantial recurrent cash flow streams doing property
facilities management, investment management, etcetera.
So they're more diversified today, but their earnings are
are depressed because of the volatility that we've seen that
in the real estate capital markets because the lack of
leasing transactions with all the uncertainty out there.
But as the demand starts to to come back to market, we think
that those companies are are poised to be ones that that
really put up the earnings growth, the cash flow growth and
ultimately increase the the underlying value as as things
unfold. That makes sense to me.
One of the sort of questions that I that I come to is that
there's the value sort of investor studies that say like
the lowest decile companies are the ones that do the best as a
valuation wise, right? Lowest decile does the best
because of I guess the improvements make the stocks go
higher. When you think about like CBRE
is a high return on capital, higher multiple business versus
office theoretically is at well, not theoretically it is a lower
return on capital business and trades at a lower multiple.
So how do you think about sort of like trading up in quality
and paying more to do so? I mean, I, I, I fundamentally
think it makes sense. I'm just kind of curious to hear
how you think about it if. If you look back at you know,
the 26 years of our our strategy, I think you will have
seen us migrate from some of the more statistically cheap real
estate companies over to some of the the real estate companies
that are compounding the underlying that asset value of
the business underlying intrinsic value, however you
want to refer to it. And we can go into this little
bit more. But I I think Marty actually
made that same transition over the the course of his career
where, you know, a third Ave. we've always focused on well
financed, well managed companies that treat at discounts to
conservative estimates of that asset value.
What people I don't think appreciate is that in the last
kind of 10 to 12 years of Marty's career, he really
emphasized the 4th pillar and that is companies that are also
compounding NAV by 1010% or more per year when including
dividends. And, and so that way if the, you
know, discount remains, you're still making 10% a year as the
underlying value compounds. And we've made that, that, that
sort of same migration because when you look at some of these
real estate companies, particularly if they're in
commodity property types and you factor in that the CapEx and the
T is that we talked about earlier, the returns aren't as
compelling as, as they may seem. The the one other thing here
and, and, and this applies to a lot of the office companies, the
office REITs is that they're also, you know, already fairly
leveraged with debt that's at, at pretty low cost.
However, it's rolling over the next four to five years.
And and so to the extent that they can't drive the top line
higher, you're going to see that interest expense reset and
really chew up some of those, those cash flows.
So that's another thing that makes us a little bit more
cautious on, on some of these office companies.
And we'd much rather be in a, a company like CBRE that you know,
is trading at in maybe 14 to to 15 times earnings based upon a
rebound of their transaction activity.
And a, a lot of that cash flow, 6065% of that cash flow is now
recurring in nature because they are on the long term contracts
and property management, facilities management, not much
CapEx, their capital light like you said, in fact the cash flow
stream may be more desirable than an 8 to 10 year office
lease. So those are things that we
waive it at the end of the day, what we're doing and when we
underwrite these companies, we're looking at sort of low,
mid and high case net asset value estimates for for every
one of the businesses. Generally we're trying to buy in
plus to our low case and and trim it back and exit closer to
our our high case. But in addition to looking at
the Nabs, we try to come up with sort of a, an IRR and looking at
what that NAB will do over the expected holding period.
You know that may be four or five years and then make a risk
adjustment to that to come up with our expected risk adjusted
return for, for a business. And then within the fun try to
concentrate our capital prudently concentrated around
some of those highest risk adjusted return opportunities.
And in our view, CBRE is certainly one of them.
Now when you say NAV is that, I mean do you use that in that way
that some people might call private market value or
something like that? Yeah, that's certainly one of
the components. So when we talk about the range
of Nabs, the kind of low, the mid and the high case or high
case NAV will typically be the private market transactions,
what a controlled buyer is willing to to pay for the
business. On the flip side, if we're
talking about a commercial real estate company, our low case may
be replacement cost that's generally a, a decent proxy, a
good safety net. And then our our mid case, it is
usually sort of a mid cycle cap rate or, or or cash flow
multiple. And so we used sort of different
benchmarks for different types of businesses.
But for commercial real estate business, that's kind of how we
think about the low, the mid and the high replacement cost, mid
cycle cap rate and then what a control buyer would pay for the
business. I think where some of those
asset light businesses, you know, when, when you think about
the statement of conservative appraisal of value, the asset
light gives you potentially a more bankable to the extent
anything in the world is bankable, but earning stream to
actually base the valuation off of, right.
Whereas some of the more capital intensive to your point, if if
you have to come out of pocket for tenant improvements, what
you may think cash flow is, you may wake up and be like, oh, I
was way off of what my estimated cash flows were in more in some
of the more asset heavy businesses I feel like.
Yeah, that's, that's fair. And then you know the other
component to some of these asset light businesses such as CBRE is
if they are really well capitalized.
And they're very well managed. They tend to take market share
when industry conditions are are are challenged.
And one of the other things that gets us excited about where CBRE
and JLL sit is that one of the largest players out there, I
won't name the name, but the third largest player in kind of
the real estate services brokerage space is not that well
capitalized. And with the reduction in
transaction activities, their businesses under a little bit of
pressure and we've seen them, you know, lose some key
producers and lose some key mandates.
And those people are migrating over to the the best in class
companies of CBRE and Jol, you know, are, are taking more
share. And, and so not only are they
likely to get back to, you know, peak earnings when transaction
activity does rebound, but that they should actually likely
surpass that. And, and that's one of the
things that we've really seen out.
If you go back to sort of the GFC, we got involved with the
title insurance space and there historically were three big
players in that going into the GFC.
It was Fidelity National, First American and then Land America.
LFG was the the, the ticker and they didn't make it through the
GFC. And the bulk of that market
share migrated to the F&F and Faf.
And then some other players like like Stewart, Old Old Republic
picked up share. But those that are well
capitalized and well managed will will probably survive those
challenging moments and ultimately emerge more valuable
and more profitable. Yeah, that makes sense.
And then I guess the other side of it is when things are good,
sometimes some producers leave, but they're not exactly.
I don't, I don't know that that takes the the enterprise value
down too much, right? That's true.
And, and, and for some of these businesses that are much more
dependent on, on the transaction activity, that would certainly
be the case. But as I mentioned with CBRE and
it's the same as the case for JLL and Savils, they've really
diversified their businesses coming out of the financial
crisis. They wanted some more recurring
revenue streams. And so they have focused on
these property management, these facility management mandates,
investment management, etcetera. And also, I, I mean, when
you're, when you're working with these Fortune 100 or Fortune 500
companies, brokers may leave, but ultimately that they,
they're giving the mandate to the franchise, They're giving
the mandate to CBRE because they have relationships with them in
a certain market, but also in throughout their global
footprints. And that's really changed it.
What's really interesting to see how significant the market share
is growing. CBRE accounts for almost 25% of
global real estate transactions. How, how promotional.
Yeah, yeah. And it's actually slightly
greater internationally than here in the US Have talked to
some smart people in the past and they actually compare what's
going on in the real estate brokerage and services
businesses to what happened with insurance brokerage resolve
significant consolidation. And I, I believe in that case
they, they ultimately consolidated up to about 7075%.
And and so there does seem like there's still room for growth,
particularly if the third largest player ultimately gives
up a lot of market share here. But yeah, very interesting
devolution and in that part of the real estate sort of value
chain and they've always been a sort of tollbooth on real estate
transaction activities when these businesses have been
around for more than 100 years in most cases.
And a lot of other real estate investors don't own them.
And and that's because they're C corps, they're not Reit's,
they're not held in a lot of the the real estate benchmarks or or
indices. And so I think we're one of the
few kind of real estate dedicated investors out there
that have a significant amount of capital invested in them.
It's probably about 15 to 60% of our portfolio today, but we
think that they are superior businesses that own over, you
know the long term which is our focus kind of five to 10 years.
It does seem like at least from the letters that I've seen,
there is not much of A focus on Reit's or or I shouldn't say not
a focus because but you choose or have chosen recently not to
own many Reit's. Is there a reason that you
prefer the C Corp like operating company type as opposed to the
Reit's? Yeah.
So if you go back in time, 3rd Ave. has always favored the C
Corp model over the the the REIT model because 1, 3rd Ave.
focuses on long term capital appreciation as opposed to
current income. While we like current income, we
would much rather have the companies retain that capital,
reinvest in their business, compound the underlying NAB over
over time. It's just more a more tax
effective way to compound capital in our view.
But in addition to that, it's a much more reliable and, and
safer business model and in, in our view, right, because the
real estate operating companies that are retaining capital,
they're self financing their expansion where a REIT is
required by law to distribute about 90 to 100% of their net
income, depending on the, the jurisdiction.
So to the extent that they want to go make a, a large scale
acquisition or they want to, you know, fund, you know, a, a
pretty decent size refurbishment project, they typically have to
go out to the capital markets. And while the capital markets
might be cooperative most of the time, they're certainly not
cooperative all the time. And there are moments when the,
the, the real estate capital markets are locked up and those
reefs can't raise capital, but it puts them in a tough spot.
And if you were to go back and actually look, you know, reefs
have been around since the Eisenhower era.
He was the one that sort of passed legislation.
But they, they started to, to grow a lot in the 70s and the
70s was a more challenging period for real estate in the
first part of the decade because it was more stagflationary,
right? And when you saw rates reset
higher and a lot of those Reit's that were out there couldn't
raise new capital, they filed for bankruptcy.
And, and that was something that Marty always kind of reminded us
of. And as a result of that, he
would never really, he loved real estate, but he wouldn't own
Reit's just because of his experience with REIT in the, in
the in the 70s. So when we launched our real
estate fund in 98, we also emphasize the real estate
operating companies over reeds and that's remain the case.
Historically, we've had probably 2/3 in Riox, 1 thirds at 1/3 of
the capital in, in reeds. Today it's even more
significant. We have about 80% in, in, in
real estate operating companies versus 20% of reeds.
And that's just because of some of those core principles that I,
I outlined. But in addition to that, when
you look at the, the next kind of four to five years for
certain pockets of REITs and it's going to be challenging
because going back to office, it's hard to see a lot of top
line growth. At the same time, these interest
rates that they had locked in previously are resetting at, at
higher rates and it's just chewing up cash flow.
It's going to be tough to create value.
It wouldn't surprise us to see a lot of consolidation actually in
the in the REIT space because that's going to be one of the
few ways that that some of these REITs can can create value and
increase cash flow per share is just to to merge, strip out the
GNA and move forward as a larger enterprise.
I like it. I guess it that's likely why you
see, like a lot of public REITs, the argument is that their
balance sheet, at least when it comes to residential
multifamily, the argument is that their balance sheets are a
little too lazy. But that's probably a reflection
of the fact that if you have to always issue equity, you may
want a lazy balance sheet. Yeah, that, that, that's fair.
I mean, if you look at the company's balance sheets today,
the Reed's balance sheets today relative to where they were
going into the the GFC, they're much better.
I think the average loan to value ratio or net debt to asset
ratio is in the low 30s where it was at the the mid 40s sort of
pre GFC. The debt to EBITDA ratios have
been reduced from you know, nearly seven times back then.
So it's sort of kind of five, 5 1/2 Times Now.
So the, the, the balance sheets are in much better shape.
It's, it's just the set up for cash flows and dividends to
continue to increases is difficult for certain property
types. And it goes back to the top line
kind of maybe being a little bit more stagnant and also your
interest expense just resetting and increasing and that sort of
challenging that the ultimate free cash flow in the business.
Yeah. Do I recall correctly that you
own Prologis or is that not correct?
No, we do. In fact it is one of our larger
RE holdings. And I mean you probably know pro
lodges pretty well. It's the largest owner of
industrial and and modern logistics assets.
You know globally they have a just incredible portfolio, I
think 1.4 billion square feet on a on a pro rata basis globally
about 80% of it is in the US In addition to that, they have a
very sizable asset management business and they have a an
emerging sort of data data center opportunity which we can
we can talk more about. But PLD is in our view set up
much differently than than some of the other Reese in the sense
that we see significant top line growth and they also have their
debt locked in at low cost for long term.
And so we expect them to continue to to drive the bottom
line so to so to speak. And in fact, if you look at PLD
today, their in place rents are about 40% below market rents.
And that's because unlike multifamily, which typically
rolls their leases every 1 1/2 years, industrial real estate
companies are are typically rolling their leases, you know,
every four to five years. And given the significant
increase and demand that we've seen for industrial space sort
of post pandemic, PLD has yet to capture all the embedded
reversion in their in their portfolio.
And so as they capture that, they're increasing their overall
cash flows by about 8:00 to 9:00 percent a year.
And then their debt is also locked in for about 3% on an
average term of about nine years.
And so their interest expenses is, is pretty steady.
So that top line growth is turning into cash flow growth.
And the other thing that's really interesting with PLD is
they have this opportunity to continue to add solar to their
rooftops. They're the the second largest
owner now of on sites rooftop solar, which has become a decent
sized business for them. But they're also evaluating data
center opportunities throughout their portfolio and they're
dropping little heads here and there about it.
When their most recent conference call, they basically
outlined that they have up to four gigawatts of development
opportunities in the portfolio, and that is a a pipeline that is
nearly the size of both Digital Realty and Equinix combined.
It's quite sizable. Now, 2 1/2 gigawatts of that is
actually sort of locked up. The power of the other 1 1/2,
they're going through the planning and application
process, which is difficult, but PLD is also assembling a pretty
talented team of data center professionals.
And to the extent that they can unlock value in there, that
would be a, a, a big game changer.
So we are involved with PLD. We, we, we see opportunity in
that mark to market opportunity on the leases.
We think there's value in their low cost debt, but they're also
some ancillary opportunities that the data center one being
the most interesting in our view on what could drive value kind
of over the next four to five years.
How do you think about the risk of capital chasing sort of both
those end markets and what that could do to economics?
Yeah, no, absolutely. I mean on the industrial real
estate side outside of self storage it it's probably the
easiest property type to build and you know lead times are are
usually only a year and a half to 2 1/2 years out.
And so you can see new supply come online and it changed the
economics in the market and that's what we have been
experiencing, You know, more recently in the industrial real
estate space, overall supply increase to about six, 6 1/2
percent of the national market. And, and, and so that that is
ultimately translated into higher vacancy rates for
industrial real estate relative to what we've seen kind of over
the past 10 years with the, you know, big demand driver of
e-commerce having a big impact on the market.
But when you look at the supply pipelines, they're moderating
very significantly going into 2025.
And there are other demand drivers on the industrial real
estate side. I mean, not only does e-commerce
continue to increase, but near shoring is driving demand.
And I know that is a blanket statement and a lot of that
demand hasn't materialized. But in terms of autos and and
pharmaceuticals and it is having an impact in semiconductor as
well in certain markets like Phoenix.
And also with probably of all the uncertainty that we're going
to going to face with the the new administration and what the
impact of tariffs are. We believe that the corporates
will continue to run their supply chains with a focus on
resiliency as opposed to strictly efficiency, which
should lead to to higher levels of, of inventory.
So those are all positive drivers for demand that should
continue to allow, I think industrial real estate owners to
be in a, a favorable backdrop. And while people are have been
up in arms about the, the supply levels, yeah, vacancy rates are
are still kind of only 6 1/2% nationally.
And historically that's a strong market and it remains a pretty
strong market. They're just areas that are a
little bit more more challenged. So that's something that we have
to watch on the industrial side as well as the the self storage
side. And you were asking about it as
in regards to to data centers as well, right?
Yeah, yeah. And I was just thinking like if
you own, by the time that you see the vacancy numbers tick up,
seems like the stocks will sell off a little bit.
But I guess if you own it for the long term and you think that
that you're owning it at a conservative appraisal of NAV,
that's just kind of part of owning real estate.
Yeah, that's very well said that.
And you're right, listed real estate tends to lead direct real
estate. And in terms of valuations
resetting both on the downside is as well on the on the upside
usually listed real estate as a head of appraisals by call it 9
to 12 months. And and so to the extent that
fundamentals are slowing, if there is excess supply or more
limited demand, yeah, you'll see the list of real estate stocks
correct pretty quickly, but they often times overcorrect sort of
both ways. And PLDS stock price went
through a difficult period earlier this year on, on some of
those concerns, we actually took advantage of it and added to our
position. I mean we are buying into PLD
earlier this year at at sort of a look through cap rate of about
a 7 1/2% if you were to mark their, their leases to market
and also an applied price per square foot value of about
$150.00 a square foot, which is below replacement costs in our
view. If you look at some of the the
high barrier to entry markets which they're focused on, the
cost to build new product is probably 180 to $200 a foot.
So when you can buy really well located real estate at at high
yields and discounts for replacement cost, things tend to
work out over time, provided there aren't secular changes
such as what you know we're seeing in office and what we've
seen in in retail. But we, we, we think much like
single family residential industrial is secularly favored
looking out over the next 5 to 10 years.
Just from a business standpoint, how do you compete with a
private firm? I mean, I saw, I saw what B Reed
had something like a 3% drawdown in 2022 and the publicly traded
ones had like 35. And I always found that to be
kind of interesting. I don't think that those numbers
are exactly correct, but directionally they convey the,
you know, do those people that you talk to understand the
private equity is like volatility smoothing for lack of
a better term. I said it's not you.
Yeah, there's been a lot written about this a lot, a lot of focus
on the space that the private read format.
In our view, there are advantages to focusing in on
unlisted real estate where we we spend our time and they're also
disadvantages to focusing on unlisted real estate.
I mean we think some of the primary advantages to to being a
real estate securities listed real estate is that you can buy
into some of the highest quality real estate assets and
portfolios across the world. You can also align yourself with
some of the most talented management teams globally that
are often well incentivized to create value for the entity.
In addition to that, publicly traded real estate companies
have competitive advantages in the sense that they have
multiple channels of capital to access.
They can issue new equity, they can issue JV equity.
Publicly traded companies can typically tap the unsecured bond
markets which private reap's usually can't.
They can access mortgage debt. There are certainly a lot of
advantages to to be public that the primary drawback is that you
have to deal with some of this volatility in the stock prices
that that you alluded to. But in our view that's actually
an advantage in the sense that you get these market
dislocations and you can buy into these irreplaceable
portfolios at huge discounts. Relative to what any private
buyer could ever buy that portfolio or that could that
company at and if you truly are long term and the company is
well capitalized, that security price is likely to rebound over
time. So if you're in it for five
years plus you're likely to do do pretty well.
So that that's why we like the listed space.
And if you look at listed real estate relative to direct real
estate, most studies will suggest that listed real estate
has historically outperformed. Another drawback though, to
listed real estate, and then it's something that you're, you
know, better off on the director private side is that you don't
have to deal with the ups and downs, but you also have
control, right? You can make the decision on
whether you want to finance the asset, whether you will lease
the asset, whether you want to sell the asset.
Depending on who you are right, If you have the LP you don't
exactly make those decisions through the GPS.
No, you're right. If you're an investor in a
private REIT, that's not the case.
But if you're an owner of direct real estate, you have that that
element of control. And actually going back, Marty
and Sam Zell were were good buddies because they work on
some things together. They used to have this debate at
some of our conferences. Sam Zell was of the view that
publicly traded real estate should trade at a a premium to
the real estate value because of the liquidity right there there.
There's a value in being, being liquid.
And if you look at a lot of markets historically, they
probably have traded at NAV if not a slight premium.
And Marty was always of the view that no, in fact, it, it should
trade at a slight discount, if not more of a more than a slight
discount to NAV because you don't have control and also you
don't get some of the tax benefits that the direct real
estate owners get, right. I mean, if you're directly in
real estate, you're probably taking advantage of accelerated
depreciation as other items to boost your after tax cash flows.
And often times when those are owned and reads for C corps, you
might not get some of those benefits.
You certainly aren't going to get those benefits as an outside
investor in in in the stock. So maybe the market sort of
agreed to meet the two guys in the middle and then trade around
NAV. But yeah, they used to have that
debate on terms of whether listed should trade at a premium
or a discount. Yeah.
I guess the thing that's been popular over the last I guess
since 2020 is the idea of almost like an illiquidity premium as
opposed to liquidity premium. And I guess so I've kind of
settled on this is it makes sense if you think about people
protecting their career just from like an incentive
standpoint. It's nice if you are allocated
to private and have to answer some questions.
It's nice to be able to have a mark that you can say, well,
somebody else did this, like it's not my mark, it's their
mark and my volatility isn't bad and.
We're all doing it behaviorally. It makes a lot of sense to me.
It makes a lot of sense too, from like a hurting perspective,
which I guess it's just another way to say behaviorally, but
theoretically it doesn't make any sense to me.
But it's the way the world works.
You know, clip that ask misses, and certainly, you know, written
about this to a great extent. And there's also a similar
mindset when it comes to investing in active versus
passive in the listed space. Morningstar wrote a study that
was published I believe earlier this year.
And they looked at all of the, the different sectors and how
those actively managed funds within the sector performed
relative to the the broader indices.
And real estate was the only sector and actually category
which had the active managers outperform the the passive funds
over 35 and in in 10 years. And so there's statistical
evidence to support that you wouldn't want to be active in
the, in the real estate space, but that's hasn't shown through
in the fund flows. The fund flows continue to go to
go to passive. And I, I think actually late
last year, earlier this year was the first time that in the real
estate space there was actually more capital and passive
relative to active, which isn't, you know, not dissimilar to what
we're seeing just in the, in the broader equity space.
But when we, when we stack up our portfolio relative to a, a
passive funnel, I'll just mention the V&Q that the
Vanguard real estate index, because they're the largest one.
We think it is a superior alternative and proposition,
especially if you believe that real rates are going to going to
stay positive. And some of those were
traditional REITs are going to be pressured as interest costs
reset. But I mean when when you look at
our portfolio relative the the VNX, our portfolio on average
has a, a loan to value ratio or a net debt to asset ratio of
about 15%. The B&Q is about twice that at
about 3233%. The B&Q trades at more than two
times book, we're at about 1.2 times book.
However, you know a lot of those books are, are depreciated costs
or to the except they're a service business, they're not
reflective of the underlying value.
You know, our portfolio trades at a 15% discount to our
estimates, probably more like a a low mid 20 discount to our
high case estimates of of NAB. Whereas if you were to look at
some of the sell side firms out there, they would tell you that
they're real, they're re universes trade at kind of
parity to NAB today. So we think the 3rd Ave. real
estate value fund is a better proposition.
And historically we've been able to outperform our index over the
long term, which is our our main focus.
But a lot of investors just want to go passive.
They're more focused on fees rather than net returns.
And we've seen that shift impact the the real estate markets
pretty significantly over the past four to five years.
How institutionalized? Is Third Ave. like if I were to
buy your fund, how much am I betting on Ryan versus sort of
the firm. Well, we have a very.
Robust process that that the real estate team has has put in
place in in in practice over the years.
I mentioned that I, you know, been at, at at 3rd Ave. since
2000 and, and six and coming out of the first three to four years
really coming out of the GFC, we did pretty well during that that
time period. But we we realized that we could
have done even better. And I worked closely with my
long time business partner and the Co manager on the front,
Jason Wolff to, to put this more robust and more repeatable
process around what was already a very unique real estate estate
strategy. And as we have implemented that
and fine tune that, we, we think that we've made this, this
strategy even more compelling and, and, and made the return
profile, especially relative to some of our peers and some of
the index funds more compelling. And, and, and that shows up in
the numbers. If you were to look at our
funds, depending on the share class, we're going to be a four
or five star fund. Over the last 10 years, I
believe that Lipper has recognized either the mutual
fund or the use its fund as, as one of the best global real
estate funds in, in various categories.
And these are things that we weren't recognized for earlier
on. So we think by, you know, taking
this unique strategy and putting the robust and repeatable
process around it, we've made it a more durable strategy and one
that can add even more value over the long term.
But no, we have, we have 4 dedicated real estate
professionals at the strategy and we also have, you know, 10
investment professionals at, at 3rd Ave.
We're very collaborative. We meet as an investment team
every Tuesday and, and Thursday morning.
That's something that we've done at 3rd Ave. for, you know, 2
plus decades as a tradition that, that Marty kind of started
and we, we've carried that on. But in addition to that, we meet
separately as a real estate group.
So Jason and I are, are certainly key components of that
the strategy. But we think that we built
something that is is sustainable and and durable going forward
because of the the the process that we put in place.
That makes sense. I ask because the.
Extent that you traded a discount, maybe that would be a
reason, right, If there's like key man risk or something, but
apparently not, not to not. To talk down about.
Yourself, by the way, I mean, well, a, a, a.
A key point there in terms of the the discount in NAV that's
sort of the the look through discount on where our holdings
trade relative to what we think it's worth, not necessarily
where the fund trades. If this were a closed end fund,
you could often see that that discount, right.
But as an open end fund, it it trades in line with the the
daily in AV of the underlying holding.
But just in terms of the price to value proposition, what we
all we think that there's there's that disconnect there.
Yeah, yeah, I, I. Followed what you were saying,
but it's good to clarify that. Well, yeah, certainly I I.
Mentioned, we not only manage a a mutual fund, but we also have
a a usage fund, which is a mirror image of our mutual fund.
It's just available for offshore investors and you know, a lot of
time when we're talking to investors and and other
geographies that that comes up and and they associate the
discount to NAB with the the the discount to the underlying
holdings such as what you would see on a closed end fund.
So yeah, always good to clarify. Yeah, indeed.
Do you want to talk a little bit about residential real estate?
What are the big advantages that we've?
Had at 3rd Ave. particularly on the real estate side is that we
have this flexible mandate that allows us to not only invest in
some of the real estate services companies in the commercial real
estate companies that we talked about, but also the vast amount
of opportunities on the on the residential side.
And we've always had a little bit of exposure on the
residential side, but we really started to increase that coming
out of the more challenging period, putting it gently, that
the residential markets went through in 2007, eight and nine.
And for the better part of the last call it 7-8 years, we
probably had in between 30 to to 40% of our capital invested in
the residential space. And really throughout the value
chain, timber home builders, home improvement, title
insurance, really a, a diversified set of the
companies. I mean, they're targeted
investments. They're all really well
capitalized, really well managed, but largely positioned
to capitalize on the continued recovery in the residential
markets. And when you look at global real
estate, there are very few places that have the supply
demand dynamics that the US residential markets have in
terms of us being basically at record low levels of supply was
often quoted or cited as a as a, a number of months of supply,
but that's based upon transaction activities.
So when transaction activity is very low, the supply looks
higher. When transaction activity is
high that the supply might seem low, but it where it's really
not. We look at just overall
inventory levels. And if you look at national
vacancy rates, we're, we're basically at a a 4550 year low,
So very low levels of supply. At the same time, you have
record high levels of of demand. And that's a result of basically
millennials moving into their prime home buying years that 35
to kind of 49 year old age bracket.
The average homebuyer today is 38 years now.
So as you continue to see growth and in that age bracket as the
millennials move through there, you're, you're, you're going to
see more demand and that and that's really driving activity
in the single family space where we have a, a lot of our
residential investments focused. And actually, if you look at at
what's going on more recently, a lot of homeowners are are
essentially locked into their existing homes because of of
mortgage rates, right? Yeah, well, choosing to stay
would be. How I would say it, but yes,
yeah, yeah, no, that's that that is.
A better way to put it, but approximately you know, 75% of
homeowners that that have a mortgage have a have a rate of 4
1/2 percent or or below and prevailing mortgage rates are in
the 6 1/2 to 7% range. So if one wants to move the
monthly cost, it, it is likely to change pretty significantly
if they want to maintain the same level of accommodation.
So what we're seeing is existing homeowners staying in place, but
at the same time, the millennials continue to to enter
the market and, and, and what single family homes.
And so the new home market is, is experiencing much different
fundamentals than the existing home market.
And what's going on in the, the new home market is that the, the
large builders are are taking significant share.
They're using their balance sheets in their, in their scale
and their efficiencies to give up some margin to, to buy down
mortgages so that they can make it affordable for a, a, a new
home buyer. So if someone were to go look at
ADR Horton or Lennar home today, they may have an opportunity to
buy a home with a 5% mortgage rate instead of 6 1/2%.
And it costs the home builder probably 250 to to 400 basis
points of margin and apply that down usually for the the life of
the loan. And as a result of that, you've
seen the large builders take significant share, something
that the smaller and regional builders really can't offer it.
It's pretty amazing pre GFC that the large builders accounted for
about 25% of new home sales and they're basically on on pace to
be 50 to 55% at the end of the year.
So that the large public builders have taken, you know,
significant share or so. And and because of those
incentives, they've they've continue to deliver new homes.
And Lennar, it is really you know with Dr. Horton the the
leading player in the in the whole building space today.
Those two alone account for about 25% national market share.
I mean pretty amazing to think those two companies account for
basically one out of every four new home sales.
Yeah, it is wild in in the country, but they have certainly
taken advantage of their scale to lock up land, to lock in
labor, to get efficiencies on materials and as a result
they're able to deliver affordable homes.
And and we're actually, we, we've really been focused in on
the Lennar B shares relative to the A shares, which we think are
a, A, a pretty interesting security.
The B shares have historically traded at a discount to the A
shares. And historically that was the
case because the, the liquidity wasn't there.
But Lennar bought Cal Atlantic back in 2017.
I think the deal closed in 18 and they issued new shares,
including B shares as a part of that.
And the trading activity really, really picked up.
And the B shares, which once traded at a maybe a 1516%
discount to the A shares, now trades that had maybe a six to
7% discount. But what, what's really
interesting about Lennar is that it's, it's more than just a best
in class home builder. They're scheduled or they're,
they're expected to spin out a, a, a land development business
soon. They've kind of guided that that
would be in the range of 6 to $8 billion of, of book value.
And they also have some other investments in a single family
rental platform. They still have some multi
family investments left, some prop tech investments.
If you add them all up, it's about $40 a share.
I think the Lenore B shares trade about maybe 16165 today.
So you strip that out, that's kind of implying 120 to $125.00
a share for the the whole building business and they do
about $15 a share in, in, in earnings.
So you're kind of backing into this best in class builder at
around kind of eight times earnings.
But what what they've done over the last six to seven years is
transition the home building business to one that that really
looks more like NVRNVR has historically been the one
builder that hasn't owned a lot of land.
They've always used options it it limits the amount of capital
that they have invested in the business.
They also have significant scale in the markets where they focus.
NV Rs historically dominated the Mid-Atlantic and now through
some of these acquisitions that Lennar's made, they have similar
scale in in other markets. And NV Rs also been historically
a net cash home builder. And and that's one thing that's
really changed with the home builders over the last five to
six years is most of them have paid down debt, Lennar's
actually net cash. And so once they effectuate the
spin, you're going to have a net cash filter.
They're going to be land light real market leader.
We we think that they could trade more like NVRNVR is
historically traded around 15 times earnings.
And so if Lenore re rates as that's been happens in our view,
there's significant value to be be recognized, right A 15
multiple on 15 times. SO15A share is few 25 + 40
dollars a share for some of those other things you're at
265. And the last thing I would say
on the Leonard B shares and this isn't something that we we
underwrite to, but it's certainly free option value for
for B shareholders. And historically what we've
witnessed is when B shares convert into A shares and they
have super majority voting rights which these Leonard B
shares do they, they tend to get a about a, a 30% premium,
meaning that they'll exchange at at at into 1.3 A shares.
We've seen it at for a city, we've seen it at Magna more
recently with tech resources, Constellation brands, etcetera.
So with Lennar B shares trading here at 160 take a reasonable
value kind of in the in the mid 2 hundreds and then potentially
ending up with 1.3 air shares down the road.
It's a pretty interesting security.
It's been one of our our top holdings for a a number of years
and it remains that the case today.
But that's one of the the larger positions that we have in the
residential space right now. That is interesting, the home
builders. Are something I completely
missed, which was real fun, but I I I knew for sure no I well
that I know, but I I knew I well knew I suspected highly that
people weren't going to be moving.
I didn't know the rest of the I failed to see how the big home
builders would be buying down mortgage rates.
But I think if if rates aren't going down, continues to be a
tailwind, right? Yeah, if you go.
Way back, it was actually an incentive that was used in the
late 70s and early 80s when mortgage rates were an issue on
some of these builders. Back then US Home, what was was
the dominant player. US Home was actually acquired by
Lennar in the in the late 90s. But some of these tools have
been used before, but with the regional banks sort of being
under pressure in terms of lending, especially the land
acquisition and, and development, that's created an
opportunity for private equity capital to, to step in and
basically the big builders to team up with them.
And then so the industry dynamics have have changed.
But I know that you've talked about multi family with some of
your, your previous guests at great length.
And one of the things that that we've been focused on, we like
multi family. I mean, it's a terrific asset
class, right? And you typically rents track
wages and you can get positive leverage.
They have a, you know, borrowing advantage through the GS ES and
you know, it's been under a little bit of pressure more
recently with supply, but still a great place to be in in real
estate. The the, the only item we would
add is that if you look at demographics for the rest of the
decade, that that sort of 20 to 34 year old cohort, it's
actually going to start to decline next year and, and do so
for the rest of the decade. And I know that that's not the
only people that they utilize multi family, but you know, the
millennial cohort as they went through that, that age bracket
20 to 34, it provided tremendous demand tailwinds on the
multifamily side. And that's what we experienced
from kind of 2011 basically through the pandemic.
But now that larger cohort is in our view favoring you know the
single family format moving to the suburbs and and that will
continue to be tailwinds for the single family residential
markets where senior living. Well, senior living there,
there's. Certainly a lot of tailwinds
there in terms of growth just in that that cohort.
But you know, one of the items that that is increasingly
evident is that people are just staying in their homes longer
than they used to. And there are a lot more, I
guess, reliable home care options and because of mortgage
rates also some people just don't want to leave their homes.
So that's another part of the equation in terms of the
depressed levels of existing homes.
It's that a lot of people are just staying a place longer, not
to mention what's going on in the in the brokerage market,
right? I mean that that business has
been turned upside down just in terms of how commissions were
and uncertainty on where you can advertise buyers commissions
where you can't do it. There's certainly probably some
opportunities that come out of that.
The US historically the models then basically 6% of total sales
price get split up 5050 between the brokers.
And when you look at what 6% as a percentage of a lot of
people's equity, if they have a a mortgage on on it, that's a
disproportionate share of their investment.
I mean most markets internationally are kind of in
the one 1 1/2 percent range. So we would expect to see some
more pressure, which should you know generally be be good
because the 6% Commission is AI mean.
It's ridiculous, is what it is. Yeah.
Thank you for saying that. Yeah, that's insane, especially.
Given the skill set of most people that take it.
But anyway that's again me saying it, not you.
Another thing that that's changing.
And something that we're watching and we're also very,
very heavily involved with as it relates to the residential
markets is what is going on with the GS ES, right?
What what's going on with Fannie Mae and Freddie Mac.
And I know that you've talked about it with guests and in the
past and I have I'm sure most of her.
I think just Bruce, I don't think we've.
Talked much Freddie and Fannie I, I was curious because you've
had a a holding in it for a while and I wanted to ask you
from a portfolio standpoint, how did you think about holding I I
don't want to deem. It speculative.
Because the price you paid would probably argue that it was not
speculative, but the timing in which you would realize the
ultimate outcome I think is like almost certainly speculative.
So how did you think about sizing that and running a
portfolio with such an uncertain out timing outcome before I get
into? That that portion of it.
Let me just give a, a quick update on, on where they are
because a lot of these facts and in our opinion get overlooked
and, and are certainly not reported in, in major financial
publications. As you and I, I, I would imagine
most of your viewers know Fannie and, and and Freddie are mission
critical entities when it, when it comes to the residential
mortgage markets. They were pushed into
conservatorship and in late 2008.
Ultimately, they were forced to take accounting losses based
upon anticipated provisions or or anticipated losses that they
would take on the mortgage book. Because of that, they had to
draw down on the the senior basically preferred credit
facility that was provided by the Treasury.
However, as conditions involved in the residential markets began
to stabilize and then ultimately rebound, those losses were were
reversed. However, the capital was never
really returned to to Fannie and and and Freddie because of a a
controversial change that took place in 2012.
What is now deemed the 3rd Amendment or that the net worth
sweep. And basically there was a change
made prior to those accounting changes being reversed where the
Treasury, which had previously charged about 10% annually for
that the credit facilities provided, would now receive all
of the, the, the GS ES future, future profits.
And lo and behold, right after that change was made, the
accounting changes were reversed.
And they've gone on to generate significant profits.
And there were multiple lawsuits related to that.
They were tied up in, in various lawsuits and in, in courts for
many years. But a lot of this actually
started to to settle in kind of in the the 2019-2020 time frame.
And one of the major changes that that took place was under
the Trump administration when Mnuchin came in as as Treasury
Secretary. And ultimately when they were
able to appoint their head to the FHFA, Mark Calabria.
And they they reversed that that net or sweep and began to allow
Fannie and Freddie to retain a certain amount of capital,
ultimately retain all of their capital.
And because of the reforms that Fannie and Freddie have taken
since they were placed in the conservatorship and some of the
other changes that have taken place with their business model
over the past 1415 years, people in, in our view don't appreciate
how much that business is involved and how profitable they
they've become. I mean, just to put it in
perspective, they've reduced their mortgage portfolios by
more than 90% since they were placed into conservatorship.
And they've also increased their profitability to a point where
Fannie and Freddie are now making about $36 billion
annually on a pre tax basis. I mean, these are some of the
most profitable companies out there, especially in the in the
real estate space. And even since they were just
allowed to start retaining capital kind of in that
2019-2020 time frame, they've already retained about $150
billion of capital, which is more than they've ever had.
So these these businesses have really been been transformed and
there were, you know, serious efforts to get them out of
conservatorship under the Trump administration.
Those were probably the most well documented through Mark
Calabria's book Shelter in the Storm.
If you haven't read that, it provides some good background
on, on where things back went. But it it seems like the process
was sort of set aside during the, the, the Biden
administration. But coming back to your
question, how do we think about, you know, sizing it and thinking
about how this could evolve? Our view was we weren't involved
with it prior to the point where the companies can retain
capital. Again, we were very actually
close to investing in the entities prior to that network
suite because we were tracking them.
We, we, we could see the profitability coming, but then
the network sweep happened. And so we also kind of put it
aside. But when they were allowed to
retain capital, we, we thought that it was tracking to the
point where it would exit conservatorship.
And we still believe that to, to be the case of the the warrants
that the Treasury received as a part of the financing package
that the company put in place when they wanted a
conservatorship, not only included that that senior
preferred facility, but also warrants to purchase, you know,
80% of the common stock of the two entities.
And, and those warrants actually expired in 2000 and, and 28.
And so we always thought that that was sort of a, a reasonable
expectation on when they could ultimately exit.
And we were buying the preferred securities at sort of 10 to
$0.15 on the dollar. So in our view, even if it took
six, 7-8 years to get out, we, we didn't really envision a
scenario where the preferreds would be sort of wiped out, so
to speak, given how profitable they were and how quickly the
companies were, were, were, were, were building capital.
And our estimate would actually only be enhanced to the extent
that there were once again plans to sort of raise additional
capital and get them out of conservatorship via recap and
and release, which under a new Trump administration is more
likely to come about rather than less likely given that they were
already working on it back in 20, but kind of got cut short.
Give it some of the delays with the pandemic and obviously with
him not getting an immediate second term, let's say if they
get. Released from conservatorship,
are they still going to be government, like basically
government sponsored or guaranteed or whatever?
Or do you think they'll be like fully private and not sort of
these quasi governmental entities in our view?
They will probably remain as as as government sponsored entities
with a charter to conduct business not totally dissimilar
from from from the banking business.
And that these entities will pay some sort of fee for a a credit
facility that will remain in place and provide capital to
these entities to the extent that they would need it.
So you know, maybe they wrong revolver fee or something.
That, absolutely. Right.
Just like banks will pay fees based upon their assets or their
their deposits, the GS, ES are likely to to pay something
similar kind of eight to 10 basis points relative to the
amount of capital that's provided to them.
And interestingly, if you were to look at their financials and
if you haven't recently, just take a look at one of their
quarterly reports. I mean it's, it's amazing how
profitable that they are. But I mentioned the $36 billion
of, of pre tax operating profits that they generate that already
included about $2 billion of charges related to what is
called a TCCA fee. And that's a fee that was put in
place on these companies related to basically the jobs and
continuation Act that was replaced in 2011.
And it it wouldn't be inconceivable to see that TCCA
fee basically be replaced with what is an FDIC like fee go
going forward. And and so even if they do pay a
fee for that backstop that would be put in place going forward.
And it shouldn't really impact that the profitability of these
businesses. And to the extent that you or
anyone else, you know, watching wants to do some, some more
work, there'll be, there's a lot of documents and a lot of legal
documents where you can find out, found out some, some great
details about the businesses in the process.
But there was a report put out I believe in August of 2020 by the
CBO and it covered the process and the timeline of
recapitalizing and releasing Fannie and Freddie from
conservatorship and putting them back into the public markets.
And they, they had sort of two different timelines in there.
The first timeline has already passed.
That was basically the one that Mnuchin and Calabria were
working on previously. And so that the second timeline
is a little bit more revelant. And I, I believe that they had a
capital raise taking place in 2000 and, and 25.
And in that timeline they had three different scenarios.
And, and those scenarios vary based upon what the capital
requirements for these companies were going to be.
And I want to say that the the three scenarios were I think it
was about 2 1/2 and in the low of 4% in the mid and something
like 5 1/2 to six in the high case.
And since that report was published, they've already sort
of locked in what the capital requirements are are going to
be. It's going to be closer to that
4% range that that mid case. It has the CBO outlines in that
in that case that the junior preferred securities which were
invested in or are are basically completely covered and in most
cases likely reinstated higher coupons, ones likely to be
refinanced down the road. The only scenario where the the
that there might be some impairment to the preferred
equities at least in this report is in that high case where they
have that 5 1/2 to 6% capital requirement.
But I, I think that most would would rule that out.
I mean, and, and, and instead point to the low case, the, the
2 1/2 percent requirement. That is actually pretty similar
to where Farmer Mack is. You, you may know Farmer Mack.
It's a GSE publicly traded. They're at about 2 1/2% of
assets because of what Fannie and Freddie went through.
We probably want to see them starting there.
But that that's a good report and and worth looking at if
you're interested to learn more about the the timeline and and
how things can play out and from an incentive.
Standpoint if they were released.
From conservatorship some. Of the argument is that they
would have an incentive to compress the spread on on
mortgage rates, right? Which presumably is in the
country's interest now. Absolutely.
Yeah, absolutely. So historically, the, the 30
year mortgage rate has traded at about 150 to 160 basis point
premium to the, the, the 10 year treasury.
It's not a perfect comparison. The average duration of
mortgages has, has historically been about 7-8 years, but it's
a, it's a good proxy. So historically 15160 spread.
However, when they were sort of out of the market because they
were placed in the conservatorship that the feds
stepped in and, and filled that gap.
However, ever since they sort of entered into QT starting in 2022
and they've been a net seller and a net buyer, we've seen this
historically wide gap. But between where the 30 year
mortgage rate is in the, in the 10 year.
And in fact, we've seen it kind of in the two 5260 range, right?
I mean, right now the 10 years at 4-5 and you know, depending
on what channel you're looking at, you know, mortgage rates
are, are closer to to seven. So if you were to, you know,
complete the recap of the release of Fannie and Freddie,
give them a little bit more capital, give them the ability
to go into the, the market and compress spread back to a more
normal level. That could provide a lot of
relief to borrowers and, and, and help out with the
affordability equation. I mean, we ran some numbers and
the difference to a borrower over the average life of a load
is something like 25 to $26,000 it in terms of interest and
principal payments. So we think it could make a, a,
a big difference. And in addition to that, to the
extent that this is effectuated and in 2025 or or 26, the the
Treasury will will recoup a significant amount of capital
either through their senior preferred, the facility that
remained outstanding or their warrants or a combination of the
two. And that could be helpful.
And in terms of reconciling that the budget or potentially
freeing up some capital to be invested in affordable housing
really throughout the the country, I mean to the extent
that you. Argue that mortgage duration is
pushed out because refinancing is down.
I'm in the 30 year treasury is what like 46457 today?
Yeah, it's. Still a big spread over the 30.
Year it it is and and you know. There are different components
that are built into that, right. I mean, you have, you know, the
option adjusted spread and you know, volatility has been higher
and that could lead to some of the additional spread.
But if you look at volatility as measured by like the move index,
it it's really come back in, but that that spread has remained.
Yeah, you know that that should certainly be a a focus.
But yeah, I think there are there are a lot of benefits of
of wrapping up this conservatorship process.
But compressing nest bread, which at the end of the day is,
is part of their mandate right to promote affordability and
foster liquidity and the residential markets.
And they're arguably not completing that, that mandate
right now in the in the current form.
And then to the extent that the and what is preventing them
from? Doing it in the current they
have caps They they they have. Caps in place in, in terms of
how much of their assets they can invest and, and MBS as well
as caps that they can provide to, to multi family.
And those could be adjusted upwards.
And, and, and given the profitability of, of the
companies, given the net worth that these companies have built,
they, you know, should have a mandate to be able to probably
increase some of their holdings going going forward.
Not that it's going to go back to where it was in 2006 or, or
or seven, but they certainly have the capacity to do a little
bit more interesting. It's a It's a thesis I've heard
for so long that it's fallen on deaf ears and probably shouldn't
have. Well, I mean, there have been
some probably unexpected and and unsettling rulings related to
some of those lawsuits of them and that were sweep there are
very frustrating and I think there were a lot of people
involved with this for for quite some time that were were very
disappointed with this. This SCOTUS ruling was
originally I, I guess Collins versus minutia when they ruled
on it was Collins versus Yellen where they, they basically
determined that this structure and, and their, that the agency
overseeing the conservatorship, the FHFA was unconstitutionally
structured. But they didn't provide any
relief to vanities. And Gorsuch didn't write the
opinion there. Alito did, but Gorsuch wrote
sort of an argument for providing relief.
And what he sort of called for was putting these companies back
in a position where they would have been had this net worth
sweep really never taken place. And to the extent that something
like that would be effectuated, you basically would have the
senior preferreds redeemed. You would have the amount of
excess payment that's gone to the treasury paid back to the
the the companies, probably by adjusting the strike price on
the warrants upwards. And and then the companies would
be sort of free to to exit conservatorship, which would
have been beneficial for not only that the preferred equity
junior preferred, but also for that the common stock.
However, because of that ruling, as well as probably the federal
claims court ruling, it, at least in our opinion, it seemed
less likely that there would ultimately be value for the
common stock. However, depending on on how the
process plays out that that may change.
But we've, we've taken the slightly more conservative
route. We think it, it focused in on
that the junior preferreds, which even though they, you
know, that moved up pretty considerably after the election,
they still trade at, you know, 40-45 cents of, of par value
when you factor in some of the damages that the entities
actually are likely to receive because of some rulings that
have gone in their favor in recent years.
So it's, it's still remains a a very interesting security in
our, in our view at less than 50% of par with a likely exit
over the next three to four years.
Are there reasons that? Other funds can't own them.
Like is there a structural reason why there wouldn't be a
bid on these or is it just kind of out, not something people are
really paying attention to? Yeah, I mean, I think there are.
Other funds that probably don't have the flexibility within
their their mandate to invest in preferreds as well as unsecured
convertible did. I remember when we were coming
out of the GFC, we invested about 15% of the the funds
capital and RE debt, whether it was bank debt or convertible
bonds or or unsecured debt. And they were very, very
profitable investments. And what we found is that a lot
of our peers actually couldn't do that because it wasn't in
their sort of portfolio guidelines at that at that
point. And a lot of them change that.
They have that flexibility now. But I would imagine there are a
lot of mutual funds out there that they can't invest in
preferred equity also. But it's not a, it's, it's not a
REIT per SE. I mean, this is a, a, a real
estate operating company, more of a real estate finance
business. And so for dedicated real estate
investors that don't do much in C corps, they're probably not
looking at at Fannie and Freddie.
And and also, I mean, because the company's in conservatorship
and it's been such a long drawn out process, there are, you
know, probably people that have just, you know, have fatigue and
then moved on from it. So yeah, I think there are
probably some structural barriers out there, but you
know, over time, hopefully those are addressed.
Yeah, interesting. I do want to close.
By asking you. Why there's no like tower Reit's
in your portfolio that I that I can think of.
They're very sexy. Why not as long term?
Value investors in the real estate space, we really focus in
on companies that are online, have durable businesses, durable
asset values and ones that we can get comfortable with over an
extended amount of time. And when we look at that the
tower business, it's just one where we've been a little bit
more hesitant to invest capital because historically, I mean
they've traded at you know, 35 to to 40 times free cash flow.
And if you dig through the the 10 KS on these companies, you'll
actually find that they don't truly own all of their assets.
And in fact, some of the big carriers have option contracts
to, to repurchase certain parts of their portfolio.
And also a significant portion of these companies towers have
ground leases on them. So it's not a, a freehold
situation. So for us to pay 35 to to 40
times free cash flow for a, a business where they don't
actually own all of the assets and own the, the ground
underneath them, that, that was something that we were hesitant
to do. But that was tough to live
through, especially when the tower companies were really
benefiting from the 5G craze and the 5G5G build out similar to
what what's going on in the the data center space today.
But that the multiples for the tower companies have actually
come back in and, and they're kind of trading now in that 20
to 25 times free cash flow range depending on which company you
look at, which is a little bit more more tolerable.
However, the issue is they're like most REITs now, they're not
getting much top line growth, particularly in the US, just
given the pressure some of the the large carriers, their large
tenants are under. And in addition to that, these
are some of the more lever real estate related companies out
there. I mean, if you look at the net
debt to EBITDA ratios for the tower companies, they're kind of
in the 8 1/2 to to 9 1/2 times range significantly higher than
the the broader real estate space.
And so they're rolling that debt at at higher rates.
And so it's chewing into the the free cash flows like some of
these other property types that we we talked about earlier.
And the one other item that's always kind of just been on the
radar as it relates to what the tower companies, no pun
intended, are, are the low orbit satellites that are increasingly
being launched, whether that's through Starlink, whether it's
through the affiliated entity. And and so it's not immediate,
but that could certainly create a substitute or a threat down
the road. So because of all those items,
we just haven't felt comfortable, you know, paying
those types of free cash flow multiples.
But there's some really compelling arguments to own
them. And it's really consolidated and
I I'd say more interesting internationally than than here
in the US at at this moment, which we've been a long time
investor in Brookfield and Brookfield has been very active
internationally consolidated. They've actually the largest
tower company in India now. So that's interesting.
Cash flow multiples are much more tolerant.
They just carved out a portfolio from American Tower, I think at
like 6 or seven times EBITDA, but much different than what we
see here. So yeah, we just haven't done
much with the the pureplay tower companies in our our fund today.
I used Starlink. During the hurricane in the
aftermath and I found it to be quite good actually had a little
bit of video buffering. But I said to myself self, this
gets a little bit more reliable and a little cheaper.
I could definitely see it as absolutely.
I think it's only going to. Be on more people's radar and
given the shift to we're expecting to continue from urban
to suburban, even suburban to rural, it really changes that
dynamic and a lot of those tertiary or markets that are
plugged into to fiber or don't have, you know terrific tower
service right now so yeah, that's something people should
definitely have on their radar as they're underwriting or
investing in the tower space in our opinion yeah well, it's.
It's like one of those things, the the, the multiples sort of
imply that the duration is there and it's what is it?
It's not what you know that gets you in trouble.
It's what you know that just ain't so.
That's a good point, yeah. So we'll see.
Yeah, almost ready. Well, cool, man.
I appreciate you. Stopping by.
Thanks for working through some of the technical difficulties
and appreciate it. Yeah.
I'm glad that we could do. This yeah great to great to
catch. Up with you.
And I've learned a lot from a number of your episodes, so
hopefully there's a nugget or two in there that's useful for
you and, and, and your followers.
Well, it's good that you had some.
Pushback on the REIT stuff. I I wish that I had dropped you
in between some of those episodes, but alas, at least
you're here to give the other perspective.
So thank you. Yeah, of course.
All right, have a good one and we'll.
Chat soon? Yeah.
Thanks so much.