Lauren Hochfelder: Predict How People Will Live Tomorrow

0:01Mandell Crawley:For Morgan Stanley, this is Hard Lessons, where iconic investors reveal the critical moments that have shaped who they are today. You'll hear about two out-of-consensus calls, one that was on the money and one that wasn't.

0:15Lauren Hochfelder:I'm grateful that we had that experience where we stubbed our toe, because that caused us to really, you know, dig deep to understand, how did this, how did we get this wrong? and in turn pivot our whole portfolio.

0:30Mandell Crawley:Today on the show, Lauren Hochfelder, Global Head of Real Assets at Morgan Stanley Investment Management. Lauren oversees a global team with over$78 billion in assets under management focused on real estate, infrastructure, and credit assets.

0:44Lauren Hochfelder:What drives real estate is all about seeing where things are going. It is where we live, where we work, how we shop. It's the infrastructure that underlies human lives. So investing in real estate is investing in the way people live.

1:02Mandell Crawley:Lauren reveals the thinking behind two of her out-of-consensus calls with Mandel Crowley, Morgan Stanley's executive vice president, and chief client officer. They met at the Campbell, inside Grand Central Terminal. Listen in to find out how Lauren spotted a critical cultural shift early, how she turned a loss into a win, and why in real estate, it's not always location, location, location.

1:28Mandell Crawley:So, we're here to talk about two out-of-consensus calls that you've made. One worked really well. You knocked it out of the park. And the other, that didn't go so well. I don't know if that makes you nervous or not.

1:48Lauren Hochfelder:Who doesn't like talking about their mistakes? I think I can do it.

1:52Mandell Crawley:So set the scene for us. Let's talk about one of your biggest wins.

1:57Lauren Hochfelder:Look, what we do as investors is generally try to find pockets of mispricing. So almost by definition, if we're doing our jobs well, things are at least partially out of consensus. One of my favorites is you go back to the early 2010s. And we developed really strong conviction that e-commerce was going to grow rapidly and in turn be a really powerful tailwind to industrial real estate, so to warehouses, and in turn be a really negative headwind to retail real estate. And, you know, sitting here today, it's probably pretty obvious to us that, in fact, e-commerce has taken hold and it's been massive.

2:46Lauren Hochfelder:And it's probably pretty obvious to even non-real estate investors that you've seen the death of the Class B Mall, certainly in the U.S. So all feels pretty obvious today, but let me tell you, it didn't back then. We're talking when e-commerce penetration rates were circa 4%. and investing in real estate, more than half of it was owning malls and office buildings. Warehouses were boring beta bets. And perhaps for good reason if you looked historically, right? So they were flat income streams, no real rental growth. I mean, I think if you look sort of in 2015, rental rates on an inflation-adjusted basis were below 2 ,000.

3:32Lauren Hochfelder:So no growth, no real institutional adoption, probably, you know, 12 % of portfolio. So this was at a point where industrial was sort of a, you know, a sideshow, if you will. But we saw things differently. And we looked at early shifts in how our tenants were using space. and probably most fun, we looked at shifts in our own behavior as consumers. I literally remember waking up one day and saying, there's nothing in my apartment that didn't come out of a brown cardboard box. I mean, this is like, this is real. This is how we live our lives. And I mean, I remember sitting around tables, you know, maybe a little bit bigger than this and debating how far can this go?

4:21Lauren Hochfelder:And by the way, we had different perspectives. I can tell you that even And even as the U.S. team maybe developed conviction, we were talking to our European colleagues, and they're saying, you guys are crazy. Like, this will never, you know, in Europe, people like to go, you know, try on their clothing, and they want to, you know, feel the peach. And then our colleagues in Shanghai were like, you're all crazy. Like, why would you ever go to a store for anything, right? Because e-commerce in Shanghai had just, you know, they almost skipped the mall phase. And so we started really buying and building the warehouses that help get those goods to our front doors every day.

5:04Lauren Hochfelder:And, you know, we invested well ahead of what ended up being, you know, a doubling, a tripling of values on an unlevered basis. And this was a call that went, you know, really well.

5:17Mandell Crawley:So when did you know that you were on the right path, that you had the gut call, but you were starting to see enough evidence to confirm that you were going to be on the right side of this thing? When did you know that?

5:33Lauren Hochfelder:There were a few steps along the way. On the data side, we saw essentially evidence that the human behavior was shifting faster than the supply chains could keep up. So what do I mean by that? You saw e-commerce as a percentage of industrial leasing go from 5 % to 20 % over not that long of a period of time. But interestingly, you could see why maybe some others missed it. Because I recall at the time, retail sales were growing at circa 4 % a year. And in-store sales were growing at 3 % to 4 % a year. So there were folks who were saying, you know, they're growing in tandem. This e-commerce thing, it's not eroding market share, right?

6:24Lauren Hochfelder:The in-store sales are still holding up, you know, almost in lockstep. But e-commerce sales are growing at 20%. And so, yeah, it's off a small base, but you really saw it start to take hold. And in turn, you started to see the leasing flow from it. But I'll tell you, there were moments along the way where you saw the rest of the industry not necessarily agree with us. I mean, I, you know, real estate can be a pretty social industry and, you know, we all like to get together and exchange notes. And I mean, I remember being at this dinner with some of my, you know, greatest industry colleagues, sort of competitors and, you know, peers.

7:06Lauren Hochfelder:And, you know, we're all sitting around a table at an Italian restaurant and talking about what we're doing. And this was the age of the creative office. So this was sort of these big office buildings and every real estate guy thought he was like Basquiat, like with these fabulous buildings. And, you know, they're talking about transforming these buildings. And, you know, this one's talking about buying, you know, resort properties. And I'm talking about, you know, I'm a frontline real estate investor going and buying industrial warehouses in New Jersey. And let me tell you, that was like a, right?

7:39Lauren Hochfelder:It was like Debbie Downer. Or I was, you know, they kind of accused me of being a bit too risk averse. And, you know, I remember laying out why we believed this was a real thing. And I had incredible conviction around this. And one of the folks at the table, you know, from a really, really strong competitor of ours, says to me, you know, I'm buying Class B malls at a 15 % cash on cash yield. Like, you've got to grow income to make money. I just have the cash flow. And, you know, I remember sort of saying to him, like, I'd love to have a 15 % cash on cash yield. But if it's a melting ice cube, right, if that cash flow is coming down over time, that doesn't bode well.

8:25Lauren Hochfelder:That's not how we all make money. So I'm not sure I convinced anyone at dinner that night. But there were these moments of—

8:34Mandell Crawley:You knew.

8:35Lauren Hochfelder:Right? Yeah.

8:36Mandell Crawley:You knew. So I have to imagine with a win like that, you know, again, making such an out of consensus call, the learnings from that, you were able to apply at other moments, other points in your career, in your life. Can you maybe talk to us a little bit about how that lesson was applied to other positive outcomes in your investing career?

9:01Lauren Hochfelder:When you start as a real estate investor, you know, what is definitively pounded into, of course, is location, location, location. And I think what this experience taught me was that it's actually dislocation, dislocation, dislocation. So location matters. But what's more important is to find what's changing, find what's being dislocated and invest accordingly. Because when you see these profound shifts in human behavior and human needs, you want to go own that infrastructure that supports how people are going to live their lives tomorrow versus yesterday. And, you know, it's interesting. E-commerce changed the way we shop.

9:57Lauren Hochfelder:There are other things that change the way we live. And one thing we've been so focused on is just demographics and aging demographics. You know, as people age, their needs change. And, you know, we've been seeing for 15 years this silver tsunami coming, right? This graying of America. So, you know, coming out of the GFC, you know, for 15 years, we were really focused on getting into senior housing. And we did not deploy one dollar of capital. Talk about a frustrated acquisitions team, right? But when everyone agrees and there's so much capital chasing it, guess what? It is too expensive. It is too oversupplied.

10:40Lauren Hochfelder:And in this case, it was also too early. People don't move into senior housing facilities at 70. They move in at, you know, 82 on average. And so we thought we were right about this structural change, but the pricing wasn't there. But then comes COVID. And it was sort of the perfect storm. We had, you know, occupancy plummet, labor expenses spike, then shortly after interest expense spike. And you just, you know, saw this complete meltdown in senior housing. And that's when we stepped in. It was no longer too expensive. It was no longer too oversupplied. People stopped building. And it was no longer too early.

11:21Lauren Hochfelder:And so senior housing has been an example of another high conviction strategy.

11:26Mandell Crawley:Great example. Two very different scenarios, but the same rigor, I guess, in terms of, you know, how you approached it. You know, the conditions, the backdrop was different. I love to switch gears. And same frame, same question. But in this context, let's talk about the out of consensus call that didn't work out. Sure.

11:53Lauren Hochfelder:So coming out of the GFC, we made some investments in Class B and suburban office. We bought some assets in Phoenix and in Southern California specifically. And as we all know, in the GFC office assets, you know, saw a lot of value destruction. And coming out, we saw A, properties pop back relatively quickly. Maybe not pop back, but appreciate. And B, properties were lagging. and in every past cycle we had seen you know a's recovered first b's followed and to overly simplify you know we we expected that this cycle would behave similarly to past cycles and it didn't uh leasing these assets was a slog you know we acquired them at what felt like really cheap levels.

12:57Lauren Hochfelder:I mean, they were at fractions of the cost to build. They were at, you know, material discounts to what they had traded at historically, blah, blah, blah. It didn't matter. And as you're sitting there, like, you know, really like trying to lease these assets, you start to observe some things. And one of the things we saw was how capital intensive it was to lease them. To get an office tenant into a building, you lease them space, they pay you rent, they get the space.

13:30Mandell Crawley:Seems simple.

13:31Lauren Hochfelder:Seems simple. But actually you're paying a big amount of money up front in tenant improvement dollars to make that space look good and paying big leasing commissions. And one of the benefits of investing in and owning real estate is you can get a really durable yield. You're collecting cash flow. Well, it turns out in office, a lot of times every dollar you collect, you're putting back in. It's like, what was it, like the myth of Sisyphus, where it's like you're rolling that boulder up and it's coming back down. And just to maybe demonstrate, one of the dynamics that emerged was, take New York, where we're sitting, obviously.

14:15Lauren Hochfelder:To get a tenant into an office building, a landlord, you know, is writing a$300 a foot check. So that's a tenant improvement dollar to build out the space. That's leasing commissions. It's maybe some base building work, but it's a$300 a foot outlay. And in exchange for that, you're maybe buying up your income by, you know, 30 bucks more, 40 bucks more. But think about what that means. That means you're writing a check for$300. And then over the next 10 years, someone's giving you, you know, 30 to 40 bucks more in income a year. Well, we shouldn't be in the business of writing someone a check for them to just give us back the money over time.

15:02Lauren Hochfelder:That's what we call a 0 % interest loan. And recognizing that the sort of net present value, you, it doesn't work unless someone's going to pay you too much for that income. And in fact, that's what we saw was happening. And so we came to the very uncomfortable conclusion that these cap rates didn't make sense because they were applied to the wrong income stream. They were looking at an income stream that ignored capital and ignored recurring capital. You used to run all of human resources for Morgan Stanley. It's one thing if you give someone a one-time signing bonus. But if you're giving them that every year, that's just part of the recurring compensation package.

15:50Lauren Hochfelder:And when we saw this in this, fortunately, very small portfolio of assets that was underperforming, we eventually got through that and we made a small profit and moved on. but we zoomed out across our whole global office portfolio because we really wanted to understand how did we get this wrong? Why are these not performing the way we expected? So as we zoomed out across our global portfolio, we saw some trends or patterns emerge. We saw that the U.S. and Australia were terrible offenders in terms of capital intensivity for office. We saw by contrast, a market like Japan, there was no capital intensivity.

16:34Lauren Hochfelder:Like the tenants actually paid to build out their own space. So we saw these divergences. And, you know, bluntly, what we concluded is offices mispriced. And ultimately, we basically we kept investing in Japanese office, but we dramatically took down dramatically our US office exposure and our office exposure in markets that had these dynamics. And I would tell you that throughout, you know, office has been, it's sort of like the trophy, big chunky, you know, asset class in real estate. People kept investing in the space. And so, you know, from 2012 on forward for a while, we saw our competitors continue to invest and we really, we held back, but then fast forward and you get to COVID and office market falls apart, right?

17:28I mean, you know, you've seen the CMBS

17:31Lauren Hochfelder:delinquency numbers. I mean, office just falls apart. And I think the markets out there saying it's because of work from home and certainly that reduced demand. But at the end of the day, I think it was really more of a long overdue recognition about how capital-intensive office is. And I'll tell you, I had an investor, really phenomenal guy, long-time investor of ours, say, Lauren, we're so appreciative that you all reduced your office exposure before COVID. And it must be because you have such a global platform that you were able to sense, like work from home trends and, you know, hybrid work and, you know, probably being a part of Morgan Stanley really helped you appreciate these nuances.

18:24Lauren Hochfelder:And, you know, I looked at him and was like, you know, you're giving me way too much credit. Like I did not have the creativity to think that Americans preferred working in flannel pajamas. Like I did not see that coming, right? But what we did see is the asset class was mispriced. And, you know, you look at New York today, for example, everyone, again, everyone wants to say values down because of work from home. Well, New York is back to 97 % office utilization, right? We're practically back to pre-COVID levels. Values are still down 45 plus percent. So you tell me if it's all, you know, work from home.

19:03Lauren Hochfelder:So it really hurt to underperform on those Phoenix and California office assets. That was painful because we have a job to do. And, you know, our investors who are public pension plans, I mean, we need to deliver performance for them so that in turn people can live a good life. And so when you underperform, it's painful. But I am so grateful that we have that experience where we stubbed our toe because that caused us to really dig deep on the sector and on ourselves to understand how did this, how did we get this wrong? And in turn, pivot our whole portfolio. I mean, we took our office exposure down by two thirds.

19:55And that then led to enormous outperformance when we saw what was really going on with office.