John Khoury – Asymmetry and Opportunity in Public Real Estate at Long Pond (EP.474)

26:38Defensive, certainly. What does shorting look like in this sector? It's funny. People often say it's hard to short REITs because they pay dividends. If you go back to who the market participants are today, if you've got a significant amount of passive capital, which the REIT market now does, and a passive capital doesn't really care about anything, oftentimes securities can trade at levels that are higher than they otherwise would be because they're paying dividends that they can't afford or have low integrity or have risk of being cut. The short book breaks into two categories. There are the alpha-driven shorts.

27:15These are shorts that on their own, we're expecting to make a lot of money when the world sees what we see over some reasonable period of time. We're much more catalyst-focused on the short side than we are necessarily on the long side. Another portion of the short book are means to be longer something on the long book. In the depths of Liberation Day, we bought a lot of Hyatt. Hyatt's an amazing company. It's a company I know very well that got massively repriced to a level that we felt even if we went through a recession, you were going to make a lot of money. We didn't know for sure you weren't going to go through a recession.

27:52There's a lot of unknowns happening around Liberation Day. It's not uncommon for us to say, okay, what are the lowest quality hotel REITs that are not going to grow the same way Hyatt is going to grow, where the delta in performance between those two companies will be large enough to warrant the gross exposure, but where the risk can be mitigated by having this low basis underperforming short on the other side of something we love. When you put your portfolio together, roughly speaking, what does the composition look like? 30 longs by 30 shorts with the longs almost always being larger. How do you think about position size in this sector?

28:31I like to run concentrated. One of the nice things about real estate is you can oftentimes know very well the risk you're taking. If you're looking at an apartment REIT and you can see every single asset they own, you can see every single secured and unsecured obligation that they have, you can see the incentives of the management team. You can understand the private market value. You might lose money in that stock, but you can quantify the risk. You can really understand through hard work and disclosure, the risk that you're taking. There are times when high quality real estate with solid balance sheets and great management teams for short-term reasons get absolutely dislocated.

29:17And my view is that's not supposed to be a 5 % position. We run with 12 % positions. We don't do it all the time. It's reserved for special situations. If we really love something and we think it's incredibly downside protected and the passage of time works in our favor and we're comfortable in the case of an apartment read that there isn't this secular boogeyman living around the corner, we're still of the belief that buying a lot of something you love is a good way to allocate capital. How do you think about position sizing and duration on the short side? Much smaller. We all know that when a short goes against you, it gets bigger, not smaller.

29:52In today's world, we're learning. Shorts can do things from a volatility perspective that was less common or completely uncommon pre-GameStop. We have the benefit of dealing in REITs. We're not dealing with companies that are generally doing those kinds of things. For us, a short being a 3 % position is a big position for us. You described how some of the pot activity at times can create opportunities on the long side. How does that play out on the short side? Not dissimilar. The volatility is both ways. The volatility is to the up and to the down. That can create opportunities for us on both sides of the book.

30:29Broadly for both sides of the book, REITs disconnect from intrinsic value in a wider way than they used to. If a REIT traded 125 % of NAV, that was Wall Street Journal News. Today, it's the norm. While value matters to us, we need to be respectful of the disconnects that can exist longer or wider than they have historically. How do you organize your team to cover the more subsectors in the space? It used to be that one analyst or two analysts could cover REITs. The four major food groups covered two-thirds of the space, and they were correlated, and there was no secular. Today, that's not the case.

31:09Whatever you know about office is completely irrelevant when it comes to what's happening in the industrial space or the retail space. We have a coverage model. Each analyst is responsible for 40 to 50 securities. Those all flow up to that asymmetry ranker. The ability to cover more than that amount of stocks is a thing of the past. I'd love to dive into your perceptions of the different subsectors. Probably the hottest people are talking about that touches your space is data centers. I would love to get your sense of what you see in the public markets in that space. Data centers, they're one place in real estate where the better opportunities are in the private.

31:49There are two large data center companies. Both of them have large existing footprints. The most exciting thing about data centers today is the development economics. You don't really get that as a percentage of enterprise value that you're buying very meaningfully in the public. That's something that we're doing very little of. The jury is out on what terminal value of these assets will be. I understand why there's a lot of capital going to them. And the math is very powerful. There will be a lot of these built. There will be people who want to sell them. What cap rate or what multiple a 10-year-old data center with a five-year remaining lease term will be, will be an interesting outcome.

32:30Not something we think a lot about because we don't have a lot of that exposure. In the public, the most interesting thing is the value available today to the highest quality, secularly winning real estate subsectors, apartments, industrial, and self-storage. they all suffer from a similar problem. It all rests in pre-22. Real estate went one way for a very long period of time coming out of the GFC. Rates went lower, cap rates went lower with it. We came through COVID. A lot of these asset classes really over-earned during that time period while interest rates basically went to zero. You had this confluence of macro factors that led high quality public and private real estate to trade at cap rates that would have been real head scratchers 10 years ago.

33:28They were there for logical reasons. Money was free, they traded at spreads and they had some growth. Then in 22, we know what happened. Rates went from zero to five, multiples expanded, and it was pretty painful in real estate. If you entered a change in cap rate environment at a four cap and you went to a six cap and you had no leverage at all, your value went down by 33%. That was a multiple repricing for the industry began in 22. Now, interestingly, what the best industries had was a second problem that was relatively unique to the highest quality secularly winning asset classes was they now had a supply problem that we had to digest for the next three years.

34:12We had a supply problem because everybody wants to build the best type of real estate. When money's free and cap rates are going lower and incomes are always going higher, it's very easy to pencil development. The problem in overall real estate is while we had a multiple repricing that was very logical and would have happened anyway, we now had to deal with the fact that we were getting the deliveries of all of these assets that were started in 20, in 21, and in 22 when money was free. Real estate deliveries are never reflective of current capital markets. They're reflective of capital markets from three years ago.

34:49In industrial, in apartments, especially the Sunbelt, and in self-storage, while you were losing multiple, you couldn't grow earnings. There was always someone putting a new one up across the street. Now, you combine that with our view that the public markets has become much more short-term oriented. If every participant is looking at one quarter, and this quarter is going to be bad, then it creates an interesting dynamic. And the Sunbelt apartment REITs, which in aggregate are the largest exposure of the fund today, we're buying these companies at 6.5 % to 7 % implied cap rates, while the private market is close to five, five and a quarter in 25, 30 % discounts on that asset value.

35:34Companies like this with modestly levered balance sheets, they don't trade at those levels in a sustained period outside of the GFC. This is unique pricing stuff. What's interesting to us is when you rewind 26 minus three is 23. And in 23, we stopped building stuff. So the output of that is in the secularly winning real estate asset classes, sunbelt departments, industrial and self-storage, that supply starts or down, depending on market subsectors, 60%, 70%. We think you're not only buying incredibly cheap securities here, or they're very cheap in the public markets, but you're at a point where the inflection's on the horizon.

36:16The issue for many market participants is we don't know if the inflection is starting next Friday or a year from now or two quarters from now, which makes it, if you're short-term focused, very difficult to time that. But if you have a reasonable holding period, the IRRs available in the public market for this high-quality, secularly winning real estate asset classes is exceptional. I'd love to ask you about the office space. Felt like there could be secular headwinds coming out of COVID. How has that all settled out? That's been a fun one to watch. Yes, in the depths of COVID, we were never going to use offices.

36:53Again, everyone was going to work from home. That has certainly reversed itself pretty meaningfully, not 100%. But that has led to a lot of these markets that were left for dead coming back viciously. The supply and demand for space in New York City is excellent. San Francisco is bouncing back in a way very few thought it would as recently as 12 months ago. This all offices left for dead today seems highly unlikely. And the private markets and the public markets quickly got back to a point where they are willing to ascribe capital at lower cap rates than people have expected a couple of years ago.

37:34The supply and demand for space is much better, which led to supply and demand for capital to be much more fluid. One still has to differentiate between A and not A office buildings. The best stuff is where you're really seeing capital go and values go. What you're seeing is the best, most profitable companies. The expense of office is de minimis and people want their employees back and they want them to have a great experience. They're willing to pay a lot of money for the best. You're seeing that play itself out. The less than the best stuff remains dicey. It depends on location, depends on market.

38:11The office business, it's never been a great business. It's a hugely capital intensive business. 25, 30 % of the income from an office building is going into repairs, maintenance, capital expenditures on a recurring basis. And when you think of a self-storage facility, that number is the minimus. You have one person working there and you paint the little walls every now and then. It's not a great generator of free cash flow over cycle relative to other asset classes. That's where the state of the world is today, much better than it was. You have to really think about what the impact of AI is going to be on office.

38:45Highly unlikely to be super good. I can understand why in some markets it's good now with AI tenants taking space. That space that AI tenants are taking will be dwarfed by the magnitude of vacancy that they create over time. We'll see. We don't really have exposure today in the long side In terms of garden variety offices, we believe it's a dicey space. Been a lot of change in housing. Now housing's delivered, single-family rentals, mentioned change in the business model, home builders. Where do you see the landscape for the various subsections of housing today? As dicey as ever, we have a housing problem that I think is leading to political outcomes that are going to lead to hopefully somebody finding a way to deal with this housing problem.

39:33But single family homes in America are too expensive for Americans, full stop. The home builders have done better than many expected them, including us in some instances, to do in this environment because they've leaned heavily on these rate buy downs. they've gone to consumers and said, if you want to buy an existing home, which by the way, nobody wants to sell because they have 3 % mortgages and the mortgage rates are at seven. So you have this frozen existing home market. But if you could find someone to sell, you've got to get a 7%, 7.5 % mortgage, depending on what timeframe we're talking about.

40:07The home builders will say, I'll buy down your mortgage to a 5 % mortgage. It might impact my margin by four or 500 basis points. If I'm an ROE machine, I'm still paid to run my machine, generate cash flow, shrink my float, and maybe I'm generating less cash flow, but cash flow is better than none. We'll see how long they can do that. As rates have come down recently, there's been very little elasticity of demand. The consumer is stretched. The low-end consumer, low-end homes are not in a place where they're transacting in a way where there's any element, we believe, of health. Certainly, there's some markets, but it's difficult.

40:46I don't believe that means every home builder is uninvestable. Valuation matters. Business model matters. Balance sheet matters. For apartments, that problem in housing is a good thing for you. If it's really expensive to leave an apartment building, then your people are going to leave an apartment building. If there's been rent growth back to that whole supply thing, rents have been flat or down in many of these markets for these Sunbelt apartment REITs, but incomes are growing. Quietly, which is a really important metric that people don't talk a whole lot about, rent to income in the Sunbelt has been going lower and lower and lower every year.

41:23So once you get back to equilibrium, we're of the view that it's not going to be, oh, we're back at equilibrium, we're going to grow a little bit. You're back with equilibrium in the case of many of these markets, a healthy rent to income is about 22%. In these publics, you're down to about 19%. Not only are you going to get the normal growth, but you're going to get this 19 to 22 catch up. You're going to put operating financial leverage on top of that. We think the dynamics of both what's happening in the oversupply of multi and the expensive nature of single family is going to potentially lead to some significant rental increases once supply and demand normalizes for apartments.

42:06The retail space, something you alluded to for a while has had at least certain areas, secular pressure from online businesses. That trade is over. There was a period of time pre-COVID where there was a belief that the physical retail experience was unnecessary. I'm exaggerating a little bit, but multiples compress massively from all companies. Today, Simon Property Group is one of the better performing REITs this year. They've called their portfolio. Retailers have figured out that they can't do everything online. They need an omni-channel experience. While we don't have a lot of exposure in retail today, simply because we think there are better alternatives elsewhere, the idea that we don't need physical retail in America or that multiples for these assets need to compress meaningfully.

42:53A lot have closed. Nothing was developed. The combination of those two has led to a normalization that is a much healthier market. How about hotels and other lodging assets? We like hotels. What we really like about hotels is we feel the opportunity created in many of these management and franchise companies. If you look at the difference between expressing a view on hotels between a management and franchise business and a REIT, Blackstone orchestrated the separation of Hilton and Park Hotels. Park Hotels became the REIT. They owned all the real estate. Hilton became a fully management franchise business in 2017.

43:35Interestingly, both of those companies did$2.19 in free cash flow in 2017. This year, Hilton is going to do over$9 in free cash flow. Park Hotels is going to do less than the 219 they did in 2017. Over that time period, Hilton has been a four-bagger. Park is down 30%. I can't go back in time and buy Hilton, but there's a lot of there there because what happened for that to happen is not going away. It's a separation of cash flows and a development of an amazing business by taking the assets out of an asset intensive business. One of the things that we frequently do is buying the companies that are in the process of going from asset heavy to asset light.

44:20Hyatt, when they came public, they owned 70 % real estate and generated 30 % of their income from management franchise. Today, it's 80 % management franchise and 20 % owned and leased. that evolution oftentimes leads to interesting opportunities to buy something that looks like an asset-laden business when you're looking out two to three years and seeing that 70 go to 80 go to 90 in M &F and the compound earnings in conjunction with the warranted multiple expansion that we think will come. We think it's a really interesting space as a specialist. It's one of the spaces that we like participating in.

45:00Like everything else, the underlying fundamentals in the hotel business today are noteworthy. The super high end, there's ostensibly no price that is too high of a price. In the low end, we're seeing negative rev par that you typically don't see outside of real recessions. It's creating opportunities in stocks. There's a real discrepancy right now in how hotels are performing based upon what chain scale or or RevPar level they're at. What are some of the other subsectors that you find interesting today? Manufactured housing. Sam Zell created a manufactured housing company called Equity Lifestyles.

45:40This is a phenomenal business. This is a business that's grown earnings in 99, 2000, 2001, 2007, 2008. You name the year, it's grown earnings. And their business is simple, but incredibly safe. They own the land underneath manufactured homes. They don't actually own the homes. It's an incredibly stable stream of cashflow. It's a cashflow that can grow. They have high quality, many times age-restricted communities where you're able to push those rents because they are such an affordable alternative. Those kinds of high quality companies have gotten interesting in the public markets. We're spending a lot of time on the cold storage space, which has been a really interesting space.

46:25There's a public company now called Lineage, which was a private darling that came public a little over a year ago at high 70s a share, quickly went to close to$90 a share. Today, it's at$35 a share. These are just numbers. It's nothing to do with valuation. There's a handful of things that have happened in that space. Like other real estate spaces that have great fundamentals, they got a lot of supply. They've been digesting that. Their customers who are the distributors of food throughout the country got a lot better at running their businesses through COVID. Occupancies ticked down a little bit.

47:08Sadly, people are realizing there's more economic sensitivity to food consumption than the general investment community appreciated. That trifecta has led to the reason why this company has gone from 90 to 35 is quarter after quarter misses, guide downs. Today, the company trades at, we believe, around 12 times free cash flow. Its competitor, AmeriCold, we believe, trades a couple turns lower than that. We think good longer-term businesses that are probably trading at 50 cents in the dollar to replacement cost today. That's one where we believe with duration, you're going to be paid to take some risk.

47:54That is an interesting place for those with duration. Underlying the assessment of almost any of these is free cash flow and supply and demand fundamentals. How have you thought about using AI as a mechanism to speed up the assessment of those two things? We use it in the table stakes form. There's a lot of information that we can slice and dice in a way that we were not doing two years ago. It can get to a lot of the data that you're referencing, what that data means, and a lot of ways that we hadn't looked at it before, it's necessary to remain competitive. For a long time, you've run just a hedge fund.

48:3510 % of the assets are in the public markets, 90 % in the private markets. Have you thought about whether to participate in where you originally thought you're going to take your career into the private real estate area? It's a much different skill set than it looks like. If you're from the outside, you say, well, if you can buy an apartment REIT, you should be able to buy an apartment asset and generate a great IRR. I don't think I can look investors in the eye and say, because we've run a hedge fund focused on real estate securities for 15 years, and I worked at DLJ for one year, that I'm going to go make great returns for you.

49:06There are talented people who do that. It's a different skill set. The opportunity cost is high. The return on invested time is low. I have a couple of things that are important to me in running this business, which is why we've never launched another product until recently, is if I'm not going to be the largest or amongst the largest investors in a product that we're doing, I don't want to do it. for the opportunities that I see in the public markets today. I don't want to put my money in the private market because I think the public is so much cheaper. So I'm not going to ask other people to do that.

49:37But we are doing something new, which we're really excited about. And we've launched an actively managed ETF. This is a space that is incredibly interesting. The structure is incredibly interesting. Our view is that institutional investors will adopt actively managed ETFs. We backed up a little while ago and we said, half of every potential investor meeting I've had in the last 15 years ends with, will you do a long only fund? And for all the reasons I stated, I didn't want to put a lot of my own money into it because I like what the hedge fund does for a living. We generally said, no. Publicly traded high quality real estate is so cheap today that calculus has started to change.

50:19and the understanding of the benefits of the ETF structure put us in a position to have a great product for those who want to be long real estate. If you've chosen that you want exposure to real estate, you've got a pie of capital. I sit across from you and I say, I have a product and this product can do the following things. It can give you daily liquidity at net asset value, not at a premium, not at a discount, and not liquidity only when you don't want it. If the public markets are open, you can come in and out at net asset value. Transparency. Every single dollar that you're invested in this actively managed long pond ETF, you can see where that dollar is.

51:05If we make a trade on a Monday, you see where that money went on a Monday. We're not marking that book. Bloomberg is marking that book, which is something that's valued amongst real estate private equity investors. The fees are very fair. It's a 1 % flat fee. There's a incredible benefit from a tax perspective. If run properly, the underlying investor is not taxed until they sell the ETF. For those who want long-term exposure to real estate, the power to compound that way is incredibly powerful. As a firm who has a 15-year track record of generating alpha in the space, we should do that on the long side just as well who've done it on the long short side.

51:43And these companies are generally under to unlevered companies. So the risk associated with them over a holding period we think is quite good. What we did was we said, look, we're going to create a product before seeing if it's a good business. I want to create what I would deem to be the most shareholder-friendly or investor-friendly way to gain access to long exposure. Let's do that and then let's figure out if there's a business. And we said, we think there's an interesting business here. What we've done is we've taken the data that we have over the last 15 years of analyzing these companies, and we've said, there are 80 high quality real estate companies.

52:26These are secular winners, compounders like Hilton. That will be the investable universe for the ETF. From an active perspective, we're going to own the 20 to 25 cheapest of those companies at any given point in time. The beauty of this for the firm, we do all of this all day, every day anyway. Unlike launching a private business, we have an amazing team. We have a great process. We have our asymmetry rancor already. We cut out the illiquid stuff for the stuff that needs hedges that exists in the hedge fund, and we keep it only to the high quality companies, we think there's a huge space in the market for this.

53:06It's a product that is for now without competition. You can go buy the VNQ, which is the passive index. They've got only 30 % of the companies in the VNQ that we deem to be high quality companies. There's another half of the companies in our ETF, Investable Universe, that aren't even in the VNQ. Hilton, for example, isn't in the VNQ, but you can get PARC. It's never going to grow earnings, but we'll take the one that's compounding 15 % a year in ours. It's a really interesting product. We're really excited about it. The return on invested time for the firm makes a lot of sense. For those who want long real estate exposure, it has all of the characteristics that I think the investment community will like.

53:51we are one of the first hedge funds to launch an actively manned ETF. It'll take some time. Those characteristics speak really well for themselves. And over time, I'm optimistic with what this can do. How different does the ETF look from your hedge fund long book? It's about a 50 % overlap at any given point in time. What was the process like for getting an ETF launched? Much easier than I thought it would be. Anthony Famiglietti, our CFO, took the lead on that. And there's some great advisors out there who can help you walk through it, making sure that the process for each product is set out in stone prior to trades being made.

54:32Outsourcing a lot of that so the trades on the ETF don't even happen on our desk. So there's a lot of things that we needed to put in place to make sure that it was run correctly. What excites you in addition to this ETF launch over the next couple of years? You're talking to somebody who's investing in the only GIC sector in the S &P that's still materially down since 22. The GIC and REITs is down almost 20 % while the S &P is up 40. We've now, since the beginning of 22, underperformed the S &P by 60%. I believe there's no other GIC that's even negative anymore. What do I look forward to in the next two years?

55:08Not swimming against a current. We've done well. We've generated more alpha in the last three years than we have in the history of the fund. So we're proud of what we've done in this difficult environment. Real estate is cheap and it's great risk, but it's not loved. We're not as popular as we once were. Coming through this, looking into the next couple of years, I'm excited about fundamentals inflecting for Sunbelt departments, fundamentals inflecting for industrial. The characteristics that exist right now in publicly traded real estate in real time are shifting for our business to be swimming against a current to with a current.

55:47The stocks are cheap. The credit markets are friendly to real estate. That 90 % of the capital that exists thinks real estate in the public market is cheap. The output of that is in the last short period of time, we've seen six public processes for sales of real estate companies to the private market, all of which seem to be happening at large premiums. If we're right, earnings are about to inflect. That's generally a pretty good cocktail. Al, I'm excited to stop talking about it and watching it happen. All right, John, I want to ask you a couple of closing questions before we finish. And before that, a quick advertisement.

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56:40Covid-19 Cheers. a great team building exercise. I grew up playing basketball. I love basketball. Your phone is put down for a period of time. What was your first paid job and what'd you learn from it? So my brothers had paper. We all worked when we were very young. That was just something that happened in my family. And my older brothers had paper routes and I was young and I wanted to be a part of it. My first job was delivering papers on their routes for them. What I learned from it was the power of operating leverage. When I went to get my own paper route, I realized that for every dollar I was making, my brothers were keeping a dollar, which I respected.

57:37I didn't resent, but it taught me the benefits of operating leverage. All right, John, last one. How has your life turned out differently from how you expected it to? I grew up in Fredericton, Canada. I now live in New York City. That wasn't on the bingo card. I thought I was going to do real estate private equity. I apparently run a hedge fund and an ETF now. The only thing that's gone as I expected is I married a Canadian, but I met her in New York and married her in New York. very little, I would say, went the way I expected when I was growing up. John, thanks for this exploration of real estate.

58:08Thank you. It was a lot of fun. I appreciate it. Thanks for listening to the show. If you like what you heard, hop on our website at capitalallocators.com where you can access past shows, join our mailing list, and sign up for premium content. Have a good one and see you next time.

58:31allocators or their firms. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of capital allocators or podcast guests may maintain positions and securities discussed on this podcast.