Finding Value in Commercial Real Estate

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0:53Hi, everyone. Welcome. We are going to take a look at the commercial real estate investing landscape over the course of the next 30 minutes or so. And to do so, I'm very pleased to welcome Zach Goodman, director of the commercial real estate firm TSP. Hi, Zach. How are you? I'm very good, Maggie. Nice to see you. Yeah, welcome to Real Vision. So Zach and I were at a conference together in person in Lisbon just a couple of weeks ago that Real Vision held for our Club B group of family offices. But it's your first time on the platform because I asked you to come on when we were there together. So we're thrilled about that.

1:27So to start off, why don't you give us a little bit of background on yourself and what TSP does? Well, firstly, thank you very much for having me. delighted to be here. TSP is a real estate investor and manager. We control, invest, and manage in about 1.2 billion pounds worth of real estate in the United Kingdom. About 90 % of that is in and around London, primarily in commercial real estate. And we're active and growing. We're 15 years old. It's led by me and a very experienced management team. And And we're quite eager to carry on growing the platform. And it was fantastic to be in Lisbon with you and sort of speaking to some of the more global investors who look and see how they're looking at the world and what their next move is.

2:21Yeah. And I think that London especially is a real proxy for some of, I think, the concerns and maybe the opportunities in real estate. So I would love to hear your thoughts. And let's start big picture, because when we talk about commercial real estate, the commercial real estate sector right now, I think it's fair to say most of the tone is pretty bearish. In fact, there's a headline I just saw in Fortune over the past week that read, economist Gary Schilling warns the commercial real estate bubble is about to burst. I mean, I think there's this pretty steady drumbeat of that kind of sentiment.

2:56What are you, what's your sense of what's happening? What do you see in the markets where you operate? I think for me, I think there's cause for concern within commercial real estate without a single shadow of a doubt. The simple way of looking at it is the world needs a refinance right now. We've moved from, you know, a 10, 15 year regime of incredibly low cost of capital. And real estate investors and entrepreneurs have taken advantage of that. They've bought a lot of assets across the world. and those assets have been bought at incredibly cheap rates. We've now come into a post-pandemic world where inflation has caught up with us.

3:36In order to fight that inflation, central banks across the world have had to raise rates. And this is having an impact directly on real estate. You know, the correlation of rates to real estate is similar, but much more direct than the correlation of rates to corporate America. We don't work off an EBITDA multiple or price earnings multiple. We are directly correlated to interest rates and typically should be trading around 100 to 200 basis points above those rates. So those saying that they're concerned with where we're at in the cycle with real estate and where that stands within rates, they're not wrong.

4:18I think where I'd probably step in and correct that is I'm not sure if I'd call it a bubble. I think a bubble sort of envisages that prior to these rates climbing up, that there was irresponsible lending in the market, that people were grossly over-leveraging assets, that we were leveraging 100 % LTVs, that we were underwriting impossible numbers, the kind of antics that we did see before the Great Recession. So I'm unsure that it's a bubble. I think the market has been correcting, is correcting still. And I think into next year, we'll see more corrections. But I think it's a much more nuanced picture than a lot of people give it credit for.

5:02Yeah, I think that's fair. And I think that anyone looking at it does feel that. One of the things I think that has people concerned, and we'll talk a little bit more about that sort of impact from rates, is that there's a double whammy, isn't there? Because you have the higher rates. But then you also have this dynamic of vacancies and the whole shift to hybrid work, which people are still trying to figure out, frankly, how much of it's permanent, how much of it's temporary. It's a big debate here in the U.S. I sit, you know, not far from New York City. Much of the many of the people I know, including myself for years, commuted in five days.

5:37It wasn't even a question. I mean, it was just what you did. And now that's radically changed. And there are still really tense conversations from companies that may want their workers back in and then others that just realize and recognize it's never going to go back to five days. Is that hybrid work issue as much of a problem in Europe and in the UK? So I'm going to step in there and say I don't think it's a double run. I think it's actually a triple run. But I think you're 100 % right. I think flex, work from home is a prong that's hurting us. I think interest rates, as we spoke about before, is hurting us.

6:14And something that we can roll onto a bit later is also ESG, which is starting to cause obsolescence in the market as well. Moving back to flex or work from home or hybrid or, I mean, pre-pandemic, I'm pretty sure we all called it agile working as well. There's a million names for it. No, in short, I'm not that worried about it. I think we, I would argue that we were seeing a move to more flexible working for the last 10, 15 years. The rise of the likes of WeWorks and other service providers were responding to a nascent demand in the market anyway. I think the way that that's impacted some landlords is probably affecting certain landlords much more negatively who hadn't geared their buildings up for being able to serve this demand.

7:05Actually, we're seeing the more flexible landlords in the market, certainly in the UK, are doing very, very well at the moment in terms of occupancy because they're offering people what they want, which is a more frictionless tenancy. They're offering them shorter lease terms so that the occupants feel like they have more choice and that they can be more malleable to how their business waxes and wanes over time. But no, if we're looking at the idea that everybody will be working from home within the next few years, personally, for me, it's a nonsense. I actually think that occupancy is doing okay.

7:41We are at the higher end of the 10-year averages. I think there's a big changeover going on. I think a lot of businesses have taken the last couple of years to say, do we need this much space? Do we need to be in this location? How are we working going forward? But certainly in places like London, what we're also seeing at the same time is a lot of supply being taken out of the market. It's been taken out of the market because of obsolescence. All the while, we've got a growing population here. There's net migration into London. We've got a very, very slow pipeline in new stocks. So actually, a lot of the big real estate houses in London are now calling out and saying, we have a shortage in 2026.

8:19forward. So it's a mixed picture. I think in the high end of the market, it's all full up. And I think in the commodity end of the market, this kind of low quality end of the market, the tier three, the tier four, again, however you want to classify that, you can't give away that stuff. And so what we're seeing is a market that is bifurcating. And we've seen this before. We've seen this in retail. We've seen this in hotel markets. And I I think it's going to be down to the savvy investor moving forward, being able to differentiate between what is good and what is not, and not conflating the whole mess and saying, it's all bad.

8:55It's all negative. That's an overreaction. And that is personally what I think we have in the market right now. So I'm less pessimistic than most, I would say. That's so interesting. So when you, and I love bringing up the third issue, talk to me a little bit about what you mean by ESG. How is that impacting it? Because that doesn't come up a lot. And I think it maybe speaks to the nuance that you're just referring to. What do you mean, ESG? How is that a potential problem? And I'm assuming if there's a flip side, an opportunity as well. There's a huge opportunity, as there is with FLEPS, by the way, because these are levers that landlords actually have the ability to pull and add value with.

9:33Unlike interest rates, where there's really very little they can do about that. So ESG, as far as I'm concerned, is going to be more of a regulatory issue than anything else. But it does affect consumer buying trends and everything else. So certainly in the case of the United Kingdom, we've signed up to be carbon net zero by 2050. The way in which the United Kingdom will look to get us there is within different sectors setting milestones for how we're performing on a sustainable basis. So in real estate in the UK, we have a system called the EPC, Energy Performance Certificates, and that's rated A, B, C, D, E, and F, and G.

10:08And what they've basically been doing is putting cliff edges every couple of years into the future, saying, OK, from 2025, you must be EPC-C or better in order to legally be able to lease your property. By 2030, you must be EPC-B or better, and so on and so forth. The problem being 85 % of commercial property in the UK today is EPC-C or worse. And so if you think about that, in six, seven years, we're expected to get 85 % of all commercial property in the UK up to this level. It's not possible to do that. We don't have the supply chain to do that. The demand surge will in itself cause a whole mess, including inflation and what have you.

10:51And so really what we're seeing with ESG and with the government's commitment to carbon net zero is that it is going to force certain assets in different classes to become obsolete. And that's a big, big problem. I think, interestingly, I'm no expert on the US market, but looking at some of the places where there's the most distress in the office market, we're looking at 1970s, 1980s purpose-built office blocks that are structurally very, very difficult to adapt to anything else. And those are typically the buildings that are the worst energy performing buildings as well. So these things are linked.

11:30This isn't just down to the behavioral practices of businesses not necessarily wanting to use certain offices anymore. So that's just the beginning, I think, of where ESG, where the sort of the tire hits the tarmac with ESG. It's also driving a huge amount of cost inflation into new developments. It's causing speed bumps in the planning process where you've got government authorities demanding much more costly approaches to design and build. We've very famously at the moment in London got a situation where there's a very, very large and prominent building on Oxford Street, one of the most well-known streets in Europe.

12:05They've denied now twice for a building to be knocked down and redeveloped. The reason why they've denied the building being knocked down is because they say that there is already too much embedded carbon within the structure. And so you have the developers basically arguing it's not commercially viable for us to retrofit this particular building. It needs to be knocked down and started again. And you've got the government pushing back and saying, no, you've got to do something with this. And we're getting gridlock. We're getting friction. So ESG is kind of quietly and pervasively making its mark in our market right now.

12:38And I can only see that getting more intense over the coming years and decades as we creep towards this net zero goal. Hey, everyone, we're going to take a quick break right now to hear a word from our partners. We'll be right back with more of the day's top analysis on the Real Vision Daily Briefing.

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13:58so is it fair to say that there's there it sounds like there's a problem overall with all of the well certainly at least with the vacancy and the um and the esg part of it that the buildings that are older face challenges if you are an owner or an operator of one of those buildings it's difficult, it sounds like it's difficult to revamp them or renovate them or to in order for them to thrive in the environment or meet the demand that's out there. So is that is that true? Can they be repurposed? Or are they just essentially stranded assets at this point? I think I think many of them can be repurposed.

14:43I mean, everything's a question of money and skill at the end of the day. And interestingly, if we think about what real estate has been for many investors over the past millennia, nevermind 20 or 30 years, it's been the business of let and forget. We buy the land, we have the asset, we put it on a nice long lease to a tenant, we forget about it. We didn't have landlords coming back in three, four years later and fitting new windows and doing new office layouts and picking paint swatches and what have you. So this is a new skill set that landlords are suddenly en masse having to adopt at a time where money is in short supply and what there is of it is coming at a premium.

15:22And at the same time, build costs have inflated significantly. And so we have a lack of that skill set in the market. We've got a lack of our supply chain is probably not big enough to handle the demand that is going to be coming at this segment. And then there's some other contextual matters, demographics, geography, how old is the building? In the UK, for example, interestingly, we find it quite easy to retrofit Victorian buildings. They were built to be very high occupancy. They were built to have machinery from the Industrial Revolution working in them. They're naturally ventilated. They were built without the idea of air conditioning or electronics in mind.

16:03And so they're quite easy to pick apart. But then you get to the sort of mid 50s, early 60s, when people started playing with, you know, concrete prefab. And you can just imagine it when you're looking at a concrete slab to slab building, and you're thinking, how on earth am I going to run new pipes through there and drill holes here and pop a staircase there? They're just much harder to deal with. And so it's a mixed picture. I think the market's starting to get this, it's starting to adapt to it. There's lots more operators, whether they be development managers and asset managers coming to solve this problem.

16:37I think a lot of landlords are kind of sat there in a very difficult position where if they've got a building that's facing obsolescence, they're sort of, do I just try and sell this building and get out of it into the market right now? Do I partner with someone to try and develop and refurb this? Can I do either? Am I willing to accept the value of of what this building has become. So the sorting hat is very much working away at the moment. And in property, it is an illiquid asset class. And so that filtration system is pretty sludgy. Yeah, I love that let and forget model being sort of something of the past.

17:16We hear a lot extend and pretend too, right? So everyone knows these are difficult problems. What do you do? Hope that something changes, maybe. We have seen rates come down a little bit here in the US. They might come down more. But is it going to be fast enough to resolve this? I mean, can this sort of trio of issues resolve themselves enough that they just don't have to pretend that you can get some forward motion? Or is it inevitable that we're going to see defaults and bankruptcies? Again, a little bit of both. I'm a big believer in the market solving the problems for us. So will the rates come down fast enough?

17:57I can't tell you that. But as long as the rates stay higher, it's prohibiting more development happening and more refurbishment happening, which is therefore making higher quality product more scarce and therefore more valuable because demand is increasing for it. And so at some point, you get this equilibrium where rents come up high enough to kind of make cash flows look sensible at our current financing rates. And we've seen softening in commercial prices in London, I would say, since very early 2022. So I would say even on high quality product, we've seen prices soften 25%, 30%. And in some cases, we've seen softening that goes way beyond that.

18:42I think where we see distress next year, where we see bankruptcies and what have you is going to be in scenarios where I think landlords have let a bad position fester for too long. And the banks got fed up and decided it's time to cut our losses. I think banks are being quite sophisticated about what they go after and what they don't go after as well because they don't want to be left holding the baby. and unlike post credit crunch, rates hit the deck, stimulus started coming through. And so actually that was a market where you were able to clear stock and you were able to clear stock at quite good speed if the banks were willing to let it out.

19:26I actually think we have the opposite now. We have rates that have gone up. The market's gone incredibly illiquid. There's virtually no stimulus around. We're still in a QT phase here. And so I think that's why banks are extending and pretending because they know really they've got no clearance market. So if they start stepping in and taking the keys off people, then in effect, they're no longer being financiers. They're going to be property managers and they're probably going to be property managers for the next couple of years. So it's an interesting one to see if we do hit some kind of equilibrium.

19:59There's always going to be bankruptcies and distress and financings that just cannot simply work anymore. Whether it's as cataclysmic, I think, as some people have forecasted, and what we saw 14 years ago. Again, I'm probably a little bit more on the optimistic side. I think the market's going to do a lot of the sorting for us. I think it has been doing for a while now. Yeah. And I think that I think the the lessons from the great financial crisis for banks was that they don't want to be property owners. They didn't want to be property owners when it was a residential building that they could understand a lot more.

20:33A commercial building with some of the challenges, the sort of larger challenges that you're talking about in this changing ESG world sounds like something that they would not want to do at all. So there's an incentive, I think, for them to try to at least, you know, work with their their current lenders. Quinton said, opportunity lurks. Looking forward to this, opportunity lurks in the most hated sectors. So how are you thinking about the opportunity? Since you are a little bit more optimistic, how are you investing in this kind of environment? And are you kind of focused more on new buildings and the buildings that are that sort of high end where you see this potential shortage coming?

21:14So I think it's a great question, Quinton. I am a humongous fan of the late great Sam Zell, one of your countrymen who passed away earlier this year. I think his expression was, when everyone's looking left, I'm looking right. And so at a time when I think the market's mispricing office assets. And rather than going into the market, the top of the market and buying the high quality assets, I think it's interesting to look at those assets that sit just below that have a journey to go on in terms of refurbishment, repositioning, and what have you to make them high quality. But I think what the market is going to be asking us for over the next two, three, four years is for more high quality assets, and they're in short supply.

21:57I think to build them out of the ground, certainly in my market in Europe, where land and planning is very, very constrained, the way you want to go about and do it is look for those slightly, those assets that might be a little bit at risk of going into obsolescence, but bringing them back from the dead and actually taking them, taking them up to high quality. And, and, you know, we we've been focused on doing that for quite a long time in London anyway, sort of buying the crumbs off the end, end of the bigger players table, um, and, and giving them a bit of a glow up. Uh, this might be related, but Matt asking if we're, if we are going to be in an inflation, higher inflationary environment moving forward, how, if at all, do you think that will affect real estate strategy?

22:43It's very interesting. I mean, real estate strategy over the last certainly 15, 20 years has favored the longer lease. Capture the longer lease with a great covenant, have security of income, build in rent reviews and what have you. But rent reviews never really efficiently pass through inflation. So if you take again offices as an example, as we move into the flex market, we're seeing much more price action at the one year, two year, three year term certain. And so if you like, that's if you imagine it just as a strip of cash flow, this is giving us far greater reset points and allowing us to kind of pass inflation through.

23:18So, you know, as an example, our portfolio, we've seen our rents increase about 30%, 40 % post-pandemic. I wish we'd seen our capital values increase 30%, 40 % post-pandemic, but we've seen the rents go up. And what's interesting is it's stock we've invested in, it's stock we've spent money in, and we're able to pass through that capex through into the final product. And we've been able to monetize inflation coming back through the rent. So, I mean, traditionally and historically, if you look, inflation has actually been very good for real estate. It often comes through inefficiently and lags behind everything that's going on.

23:59But, I mean, I'm a great believer in the school of Mark Twain. Byland ain't making any more of it. And I think if you really do want to zoom out and have a bird's eye view over the last 20, 40, 60, 80 years, you've never seen real estate go down. We're going to take another quick break to hear a word from our partners. We'll be right back with more of the day's top analysis on the Real Vision Daily Briefing. Join over 5 ,000 attendees for the largest AI event in Asia, Super AI in Singapore, June 5th and 6th, 2024. Edward Snowden, Benedict Evans, Balaji Srinivasan, and over 150 others will hit the stage, joining the industry's most influential to explore and unveil the next wave of transformative AI technologies.

24:49Singapore will become a vibrant AI hub for a full week from June 3rd to the 9th, with over 150 side events that will make for unparalleled networking opportunities. Visit superai.com for 20 % off tickets with the code REALVISION. Look for the link in the description. I want to ask you about ESG. It's just interesting. The minute you say that, you know, people feel very tribal about it and you're going to have people immediately hating everything. And we know that there are some difficulties and I think a little bit different here versus where you're sitting because some of it's already been regulated in Europe.

25:26So you're having to already sort of be dealing with some of the regulations. We don't have as much of it here or if we do, it really varies on a state by state level. and so there's a lot, but still broadly, we can see where the trajectory is. Is this just a negative and a cost that has to be overcome that you've got to factor into when you're looking at investments? Or is there upside or a flip side once you make that initial investment? How are you thinking about the math around ESG? I look at ESG as ultimately demand driven, whether it's demanded by consumers, whether it's demanded by the government, it's something that's demand driven.