UK Commercial Real Estate Is Undervalued w/ Tom Caddick

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1:24And now to the top analysis of today's markets. every investor in the world wants to catch the wave of the next big trade there's no time machine to go back and buy amazon in 2013 or apple in 2009 but what we can do is talk to the world's best traders about their next big buy join me harry malandry of mi2 partners as we do exactly that on The Next Big Trade.

1:54Welcome to The Next Big Trade and thanks for joining us. This week I'm intrigued to be chatting to Tom Kadic, Managing Director at Ned Group Investments. Tom has over 20 years investment experience including several years as Head of Multi-Manager and Fund Selection at LV Asset Management and he was the CIO at Santander Asset Management in London. Tom, how's it going hey arry good to see you good to see you i understand you've just launched ned group's first in-house investment boutique that'll keep you busy it's been yeah and it's been a big news week for us um just this this week and last um it's been quite an exciting time so we've launched our first in-house boutique uh to complement our existing uh external partner investment firms that we've worked with for some time, really just expanding out our product offering.

2:48Cool. It sounds like you've been busy recent, but I also understand that you're an avid runner. And I think you can tell by looking at me that I am not an avid runner. How avid are we talking? Well, I think you can tell by looking at me that I'm not a truly avid runner. Just a A keen one with the needs of a 90-year-old, I think, these days. You don't have that gaunt, like starving look. I've eaten. It's OK. Right, exactly. So forgive me, but I'm very excited to be discussing your trade, because in my humble, I think this is the big question that everyone's wrestling with in markets at the moment.

3:32So talk me through the investment thesis you wanted to discuss. I think it's an interesting one, commercial property. You know, typically speaking, as you go into a potential cyclical downturn or certainly cyclical weakness or indeed a recessionary environment, you don't want cyclical stocks. And commercial property, property generally is sort of tends to be a cyclical by nature and an area that you typically want to avoid. However, so much out there now has already, depending on how you access that market, and I'm not talking about accessing it direct investment, I mean going in via a vehicle, be it through an investment trust, which is really popular here in the UK, which has similarities to, say, a REIT, it's directly invested in properties, but is then at the mercy of the secondary market, where a lot of the bad news is arguably now priced in.

4:37Likewise, an area such as global REITs, which I think look really interesting, where again, you've seen sort of relative underperformance in this area in double digit, in some cases sort of 50 plus percent, where you've now built in a degree of cushioned comfort if you can identify prime, good quality assets I think it could be a really interesting time of not to be too sort of flippant about it by buying on the bad news rather than the good. Oh, that's not flippant at all. I'll show you flippant. So how bad is bad in this case? I mean, what kind of discounts are we talking about NAV? What kind of price reductions have we seen in the underlying asset?

5:28So if we think about an area such as one of our investments, for example, BCPT, which is the Balanced Commercial Property Trust, which is an investment trust listed on the LSE, you're talking a discount to net asset value of about 35%, 30-35%, something on a position that's got leverage, sort of loan to value of about 20-25%. It suffered significantly during the COVID period, as you would expect. A lot of these assets sold off heavily, moved to a very wide discount. So some recovery, but has seen some subsequent weakness and some billowing out again of that discount. So you're talking around 35 % discount loan to value and a loan to value of about 25%.

6:21So, for me, this is a fascinating observation you make because there's a price discovery problem generally in real estate and particularly in CRE, commercial real estate. And when I see 30 % to 50 % discounts on investment trusts, some people might think investment trusts are retail instruments. I don't really think they are. Or if they're retail, they're informed retail. Quite often, your retired stockbroker likes to dabble in investment trusts. So that kind of discount tells me that people want to be out, that they are happy to cross big spreads and big net asset value discounts to get the flip out of that risk.

7:14and that makes me think i wonder if the underlying deterioration is is consistent with that market are they wrong to sell out so aggressively or are we looking at a wider decline in the prop in the commercial markets of that order of magnitude 35 percent 40 because of course if we are there's going to be collateral damage from that there's going to be uh problems in other markets banking problems. And not all securities will be money good. Am I wrong to think of the glass being half empty like that? I mean, clearly, I'm coming to you with a glass half full, Harry. But I think, I mean, I'd probably challenge your point on not retail investments.

8:04Investment trusts are sort of almost the epitome, to my mind, of retail investment, given the, you know, the periods that some of these investment trusts, these investment vehicles go back, you would argue, you know, I think one of the challenges that the investment trust market has had, we're looking purely investment trust, has been liquidity. So they've been comfortably liquid for a small investor, challenging for a larger investor. And as the market has developed and changed over time, where you've had private clients of retail-like investment going in en masse for private client and retail type investors, that can create something of a liquidity squeeze at times.

8:50I think that there's a general malaise, an understandable one. I mean, let's face it, it is understandable why there is a malaise over the commercial property market. It was just starting to recover post-COVID, it varies profoundly depending on where you are looking geographically and by sector and by quality. Of course it does. But that broader malaise has sat over the market for some time and caused some of these blowouts in discount. But because of the liquidity on some of these instruments for a larger investor, that can create something more of an extreme in terms of discount to premium periods.

9:31I think if you look at something like the REIT market, so the global REIT market, that is an interesting area. They tend to be more liquid. And if you can invest in a way that is far more selective geographically as well as by sector, REITs tend to be more focused, single REITs tend to be more focused on a particular geography or typically a particular sector. If you can be very selective, you can pick up some really, really interesting opportunities. 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.

10:17So I totally take your point with regard to the illiquidity of closed-end funds, there is no other exit of a closed-end fund. You're going to get paid out by the board or you're not getting out. So you've only got selling. And if the world doesn't want to buy, that can create very big discounts.

10:40What's the price discrepancy between rates and global rates and the closed-end funds? The closed-end funds might be down 35, 40%, 50 % even. How much are the rates down in comparison? It will absolutely vary. It'll vary by sector, by geography, by quality. But you've seen, I mean, if you think like US office has had, again, understandable given the backdrop, has had a really savage time and continues to look challenging, Clearly, the broader office market globally has its challenges, but there are opportunities out there. But if you're comparing that against broader equity markets, then there's been a significant downturn that is now already priced in to reach broadly.

11:37so one when i was thinking about this like writing some notes up before this it occurred to me that a large part of the problem is simply the policies very hostile to long duration assets um i was reading a piece this morning that pointed out how for the most part cash flows of us cre and i gotta say for you know warning number one for anyone listening in nothing we talk about as an investment recommendation so bear that in mind warning number two i know an awful lot more about us cre than i do about what's happening in the uk market so i really don't have a good grasp of of how where the problems are in the u in the uk but in the us i have been studying and the the general sense i get in the us is that for the most part especially if you ignore office cash flows are generally robust um the problem is that rates are so much higher so that as refinancings happen people question whether the refinancing can go through uh because you're upside down on your financing relative to your cap rate um now in that sense cre is basically the same as long bonds so if you're if you like long duration rates if you like bonds then you'll love cre and when rates come down cre will perform so it's basically a you know no bad assets just bad prices argument um and that prompts two observations one of which is some of this stuff has been financed so where you're financed uh you could be substantially diluted in the refinancing uh because you know if you're financed via cmbsc Who knows if you can even arrange every financing?

13:25And if you're financed by a bank, the bank can require you to put more money up. And that's difficult when you're a trust, whether you're a CMBS. It's even difficult for REITs. So that financing thing is one of the things that's terrifying the market.

13:45I should stop talking at this point. What do you think about that financing question? how are we going to refi all the real estate that needs to get refied in the next year? But I mean, for sure, that is a challenge. I think you'll find that the percentage of refinancing within, say, 2023 is actually really relatively low. In the US market, I think I did have a look at some of the numbers on that. I think the average debt maturity is about six and a half years within CRA, which does give you to a certain extent that longer dated I mean it is absolutely as a longer duration asset anyway by its nature but in terms of the refinancing I would argue that that is less of a problem I think it does present challenges for new stock coming to market or new players coming to the market which arguably is is a positive argument for existing quality assets but you've got a shrinking competitive landscape.

14:50Yeah, we're the assets of quality. So I may well have screwed up my research here. It would certainly not be the first time, right? But the impression I got on the refi situation was that maybe we have$4 trillion to$5 trillion of outstanding US CRE in total that's been financed and that we have over the next 12 to 18 months, something like$1 trillion that will roll. Now, not all of that, you know, in different forms because the financing there, maybe 30 % is bank financing, maybe a whole block is CMBS. A fair amount is going to be insurance company financing. Insurance companies have been incredibly aggressive in originating new assets in the space.

15:40So, yeah, and your numbers there, I mean, The numbers I'm referencing there is looking at bank financing. Right. So you're absolutely right, which makes up, I don't know what percentage that makes up in terms of the total financing for the CRA market, either in the US or globally. But certainly in the US where you've got the major banks, the top 25, who have shrunk their books significantly since the GFC. Absolutely. So it's become probably a bit more of a prevalent issue for what are defined as smaller or regional banks. But then you have your other sources of finance, so the private financing, mezzanine finance, et cetera, of which there might be a shorter duration.

16:27So my suspicion is that if you leave – it's basically my suspicion nonsense. Let me be straight here. I'm stealing this from Jeremy Stein. Jeremy Stein in 2013 gave a speech at the Fed. And he was a Fed government at the time. And he said monetary policy has serious problems, but it has one big advantage, which is that it gets in all the cracks. And I think the point he was trying to get at when he said that was that if you leave rates low for long enough, people will get acclimated to them. and their business models will adjust to low rates and they will do things which only make sense if the future is a low rate future too.

17:14And I have a sneaking suspicion that that's the ultimate cause of the issues we have at the moment. If rates stay where they are, this financing problem doesn't go away because a whole bunch of real estate was originated. The debt assets on it was originated partly to strip out the equity, by the way, but also partly because, you know, it's originated with rates that are relatively low. And so the finance, you know, if rates come back down, the problem's gone. If rates stay up here, the longer they stay up here, the bigger the problem gets in terms of how much is totally and how upside down people are.

17:54I saw an excellent example, and of course any example can be misleading for all sorts of reasons, But it was a 95-unit building in New York City, residential, traded for$69 million in 2014, was valued at$125 million in 2016. They did a refi at that point. Clever guys. And that meant they got$80-something million out. But that loan failed at the new high valuation. And when they auctioned the building, they only got 13 million for it, an apartment building in New York. And I think that tells me something quite interesting, that it's hard to find hard money right now. Because rates are high, there's a shortage of hard cash out there.

18:48So a lot of this is people being forced to disgorge assets. but they just can't get financing um why am i wrong to think that financing is going to be a problem for the real estate market over the next 12 to 18 months i i don't i don't think the answer to that is that you are fundamentally wrong clearly financing is a challenge i don't but i would argue rather than argue i think i would point towards the differences now to the period going into the financial crisis where you saw excesses, clear excesses, certainly with hindsight in the real estate market, in the residential in particular. Clearly that was the big problem with the subprime crisis that we saw coming out of the US, but we did see it globally.

19:41We're now seeing debt levels, I think the global REIT market is a loan to value of around 30%, which tells you something about the level of debt and whether that is likely to be an issue. Of course, there will be challenges, localized challenges. I would argue that what you've described there, absolutely, there will be some major challenges, but that also says that there's some real opportunities, doesn't it? Sure. Real opportunities for a strong balance sheet to be able to come in and pick up opportunistically, globally. Clearly, what you've described there is residential and it is US. Most of our exposures tend to be through our own investment, which is the Global Property Fund, or indeed the investment trust I described to you before.

20:34We tend to focus more on one, which is on prime market, typically, and diversified with a significant UK bias. And then our global property fund, which is looking at opportunistically at global REITs and being able to pick out opportunities as they come, effectively become that sort of distressed buyer rather than picking up off the distressed seller. So I don't want to give the impression that I violently disagree with you. I think if you've got where the asset reflects the current sentiment surrounding commercial real estate assets, there's probably too much. You know, it's probably overly discounted.

21:21It's just I suspect a lot of assets are not fully respecting, fully reflecting the overall sentiment. So you discussed some assets you like, but there's a world of real estate-related fixed income assets. A huge pool has built up over the last 20 years. In the US, we have CMBS, lots and lots of CMBS. And I obviously thank you, Real Estate Twitter, for all of the careful briefing on this subject. Let's hope it's unbiased. But Mr. Slow-Mo Chop suggests that actually CMBS problems are surprisingly big and will be surprisingly intractable. And his suggestion is CMBS works, CMBS debt works in two instances, when you cash out and when everything goes according to plan.

22:19I think it's a beautiful tweet. If I had a hat on, I'd take it off to Mr. Chubb. But I think he's got this one absolutely nailed on right. It's a very ungainly structure. And this is going to be messy and there's an awful lot of debt. My suspicion, this debt sits, I think, for the most part with ultimately with pension funds and endowments. So supposing you say we've got a 35 % drawdown in the investment trust. That's where the investment trusts are trading as a discount to net asset value. So that means that net asset value might be down 10 % as well. So maybe a 45 % drawdown in total from highs.

23:00That number might well be about right. In which case, there's going to be enormous holes in some pension fund balance sheets. and their asset portfolios and endowment balance sheets. Why wouldn't this turn into one of those nasty, vicious circles where bad debts cause write-downs, reduce demand for the asset, which causes further write-downs, and we just have a vicious circle that takes a while to kind of settle 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.

23:44To be fair, I think there's some truth in validity and exactly what you're saying there. And that could exactly be the case. If you've got assets on your books which have been priced at valuation, you've got no downside already priced in, then, yeah, this isn't a great time to be holding commercial property, regardless of how high a quality it is, it's not a great time. Throw into the fact that you might actually have exposure to direct office that's looking particularly challenged or whether it was sort of very specific office in sort of parts of the US, which do look challenging, then yeah, I agree.

24:28I think you could end up with a hole in your balance sheet. So which parts of the US do you think look a little ugly, a little challenged at this point? Office, clearly. I mean, I don't think I'm saying anything. I don't think I'm saying anything new there. I think we're seeing less of an issue in Europe and the UK specifically, albeit that office is probably an area that you'd want to have less exposure to, given the structural headwinds you've got in a post-COVID environment, which have been spoken about a lot, so there's no point in sort of rehashing that. We are starting to see sort of pre-COVID football coming back to central city, but realistically, you know, your total capacity in offices has dropped significantly, or certainly usage in a post-COVID environment.

25:28So that does throw out all sorts of structural issues. I think we've started to see evidence of something of a paralysis within the residential markets where with higher rates, turnover has dropped. So rental market has significantly picked up from what I can see. And that's both in Europe and in the US. But you've got to look at it from a country by country perspective, because in some markets, they tend to be more landlord sort of rental market driven, as opposed to markets such as the US, maybe certainly the UK, which tend to be homeowner driven, where you are starting to see a squeeze on that sort of first time buyer, or certainly on turnover on properties.

26:15Yeah. so definitely challenging where it starts to look sort of slightly more interesting um sort of core industrials prime retail but apart from that probably retail is another area to be staying away from um storage healthcare looks okay student property can be quite an interesting very small segment of the market but looks relatively healthy um so first of all Well, I've just been reminded that if viewers have questions, you should feel free to drop them into the chat and then somebody will try and attract my attention waving at me or mild electric shocks to my chair or something to get me to ask those questions.

27:03secondly so implicitly there has to be some sort of view your view has to be built on some kind of broader macro view about the likely recession risks we're facing and the intensity and duration of any of any of the coming recession or if there is even a recession because obviously if the fed rate raises rates some more you might not necessarily be so bullish of real estate and also if recession is sufficiently intense that could also put you off real estate as well so what sort of recession risks have you built into that view um so our base case our base case is that we will start we've already seen peaking inflation certainly in the us we're starting to see peak inflation in in uk and europe um and that we We will continue to see a slowing but continued upward cycle in terms of base rates.

28:00But that is slowing and we will start to see that moderate and move to a more dovish or more accommodative environment from central banks. So looking towards the end of this year to start to see evidence of that. So clearly some continued headwinds. But a lot of that is already priced in. Sure. You know, you just need to look at the yield curve to see that. Absolutely. Yield curve inversion is telling you that they don't think the Fed will keep this up.

28:35So, you know, as I was thinking about this this morning, I started thinking of the old economic rents, the economist definition of a rent. It's definitely not exactly a real estate definition of a rent. But there's a connection, isn't there? There's a sense in which economic rents are about what a market can bear. And a central London restaurant can support higher rent per square foot than a suburban mall shopping outlet. The supply side of it almost never matters until you get to very low rents because generally speaking, constructing new supply doesn't set, the flow of new supply doesn't set new prices.

29:29Central London is a restricted supply of it. And I was thinking that actually the ability to extract rents from the economy may have declined in a secular way because of big geopolitical shifts. Now, I know this, bear with me, this sounds absolutely nuts, but I was watching a Jake Sullivan speech to the Brookings, or I was reading a Jake Sullivan speech to the Brookings in remarks, and he was talking about the reintroduction of industrial policy because of the need to onshore things in the US. So you probably need a lot more industrial space in the US if you're going to switch to an on-shoring market.

30:14He was also talking about more inclusive growth. I put this together with another video I watched where some Princeton economists were talking about what happened in Weimar, Germany. During the Weimar, it turns out that real estate was not a good play, better than bonds for sure. But one of the problems of high inflation in Vibergemini is it created a political pressure for rent control. So you had rent control happening, which just made it impossible to maintain the real estate stock or to make it profitable. Is it possible that the world is shifting in terms of the rents that our economies can support, given we have these geopolitical objectives?

31:01objectives could that yeah i know it sounds weird when i say it out loud but you know it does occur to me that something along those lines is going on right now i mean are we going to see a return to weimar germany i think unlikely um or you would certainly hope not and you'd hope that our central banks and treasuries do not just start printing cash there's a very quick wave of trying to solve a very short-term problem and then making it 10 times worse. I mean, clearly there are some macro trends, themes that play out over a long period of time. And actually over a relatively short time, you've got things like the retail property sector.

31:59which has come under intense pressure. And I think you're absolutely right. Central is one thing. Central City prime, you've got a limited stock availability, tight space, you can price accordingly and actually looks relatively healthy. But those broader, bigger macro shifts of, let's say a shift to online life, for example. It's not just about Amazon, it's about the broader shift has seen this sort of broad malaise fall onto sort of the suburban high street shopping centres and shops that does not look reversible. It looks like those areas need to be repurposed and repurposed quickly otherwise you've got the death of of of sort of central towns in the outskirts of of cities and that's not a UK thing it's a global thing um so for sure you've got some of those impacts um just like you've had you know for example sort of storage units for sort of energy, batteries, et cetera.