American Assets Capital Advisers' Burland East Discusses RAAIX
Burland East, CEO of American Assets Capital Advisers and sub-adviser to the Altegris/AACA Real Estate Long Short Fund (RAAIX)
Interviewer: Hi, everyone. We're on today with Burland East, CEO of American Assets Capital Advisers and sub-adviser to the Altegris/AACA Real Estate Long Short Fund (RAAIX). I was reading through your materials. You have a very different approach to investing in rets. Can you tell us about that?
Burland East: We've been at this for about 5 years in this format. And then, prior to this, I spent close to 30 years on Wall Street. So I've been through three cycles. My observance over these cycles is that what tends to win over time in the long run is real estate that is in some way unique, and unique in a way that the tenants either can't or won't leave. I can give you a couple of examples. Within real estate, which is a large space – well north of a trillion dollars in equity market cap, and multiple hundreds of companies, they tend to be in what I call silos. For instance, manufactured housing, which would be mobile home markets, would be a silo, and lab space would be a silo, and suburban office space would be a silo, and strip centers would be a silo, and malls, and so forth – there are about 30 of these different silos.
What we look to do is underwrite a silo of companies, looking to find a situation where the real estate is either physically unique or locationally unique, or both; which creates a situation where the tenant either can't leave or is highly reluctant to leave. And as a result of that, the landlord can maintain high occupancy and have pricing power, i.e. leverage, over the tenants, so they can raise rent at a very healthy clip over a long period of time. That's our strategy.
Interviewer: Can you give us some examples of the thing you called in your literature, you called the tenant denied a choice, whereas you said they either can't or just won't - it's just not economically advantageous to them to leave. Can you give me some examples of some of those?
BE: Yes. Let's imagine for a minute that you inhabit an apartment. You're in your late twenties and you live in the suburbs of Atlanta, and you're well employed. But in Atlanta, there are no barriers to entry: apartments are functionally the same. They provide the same functional utility to the user. Within your little ring of where I want to live relative to my job, there may be 5 or 10 apartment complexes. What you are looking to do is optimize utilization, your functional utility per unit of money. Somebody builds a new apartment across the street, and offers you 6 months' free rent and better Wi-Fi, you will move. The point is, you can move, it's easy to move, and the set is functionally the same, so we don't have any embedded interest in remaining. And as long as the place across the street is practically priced, you might move. So, that's an example where the tenant has lots of choices. But instead, let's imagine that you are a large corporation, and you occupy 300,000 feet of highly developed and highly built out wet lab space. Wet lab is what you see in the science fiction movies, the gene sequencers and fume hoods and deionized water, and all kinds of highly technical stuff. And this company has PhD's in there running around that are in year three, of a seven-year efficacy study of some drug. And you, the corporation, have invested $75 million in the space yourself to bring this heavy duty equipment in and bolted to the floor and the ceiling and calibrate it.
So, if you are in this situation, you're the corporation, as opposed to the guy living in the apartment, it just seems to us that you're a lot less likely to move. Mechanically, the act of moving would disrupt the research and force you to disassemble all of this highly technical equipment. And some of this, by the way, you've built it in a way that you can't take it with you. So, if we look at those two situations, it tells us we would rather own lab space leased to life science companies than we would own an apartment leased to some yuppie living in Atlanta. So, that's the very simple analysis breakdown. And we take this concept and apply it across this broad spectrum of real estate companies looking for this relationship with the tenant is denied choice.
Interviewer: That actually makes a lot of sense to me. I don't think I've ever heard anyone else talk about using this approach.
BE: Most people don't do this. I just used lab space and multifamily as an example, but there are other silos like manufactured housing which we like, or student housing, or cell phone towers, or data centers, or super regional malls, whatever it is. So, we're looking across all these different platforms, these silos, and then we're looking at it regionally. We want to be in markets that have a couple of characteristics, physical markets. The markets we want to be in have what I would describe as net domestic in migration. What that means is people are moving there. For instance, people are moving to Dallas. People aren't moving to Chicago. Simple analysis. You go back to the days of Kennedy, and Chicago had about six million people in it and Dallas had about a million. Flash forward to today - Chicago still has six million people, but Dallas has six million people.
So where would you rather invest? You'd rather invest in a market where people are naturally moving in. That tends to be the Sun Belt. It tends to be coastal. It tends to be communities that have a lot of amenities, particularly recreational amenities and educational amenities. So, those are first cut. And the second cut were looking for is we want those markets to also have high barriers to entry. So, whereas I just used that as an example, Dallas has no barriers to entry. It's easy for a developer to build new products. So, if I'm trying to deny the tenant choice, the ability for an additional developer or real estate owner to come into that market and give my tenant choice is what I don't want. I want the tenant to be denied choice.
So, I would rather own, for instance, in Boston or New York or Miami or Seattle, where there is extensive, complex, regulatory, environmental and zoning structure in place. So, it's very very hard - or certainly harder, and more expensive - to add a product. So, let's say we were going to buy apartments. We would prefer not to buy them in Dallas, because they're easy to replicate in Dallas. We'd rather buy them in Seattle. It's just harder to replicate. It's harder to provide that tenants with that choice of opportunities. What most investors in real estate do is they come to the decision matrix, bringing with them baggage.
The baggage comes in two forms: First, where they live. Second, what they do. For Instance, if you happen to be in a conference, you'll eventually run into someone from Cleveland that owns suburban office space in Cleveland. But what do you have to realize is, he comes from that experience. He doesn't know anything about lab buildings or data centers or cell phone towers or super regional malls. There's no domestic in-migration in Cleveland, people are leaving. And suburban offices are a very generic product, and the user considers it just to be functional. They are not married to the space in any way, shape, or form. So, for him, what he's looking at is, this is all he knows. The other false decision matrix is what I would describe as chasing cheap. There is an inherently attractive story in the idea that a thing, some asset, is cheaper other than other assets at the time in the same market, or cheaper than it was. The idea that I'm going to buy a dollar's worth of something for $0.50 is very appealing. So, what many real estate deals, are built around this fundamental investment concept. We don't typically pursue cheap for the sake of cheap alone. Once we decide what we like, I'll try to buy those stocks inexpensively.
But what I won't to do is go to Cleveland and buy suburban office space just because it's cheap. But many investors will. Investors are driven by the pursuit of cheapness. We find, historically, and again, we've been doing this for a long time, starting in the mid-eighties, that things are usually cheap for a reason. The market is more efficient than you think. And the other thing about real estate is, real estate doesn't know who owns it. But it knows where it lives. Unless you can move a suburban office from Cleveland to say San Francisco, one can't fundamentally change its value. It's captive to location.
Interviewer: That brings me to an interesting question, because I talk to a lot of people, real estate is one of my two or three major focus areas both in writing and investing. So, when you talk to a guy in suburban Cleveland, he thinks that commercial real estate today is probably about not much going on. But if I talk to developers down here in Orlando, they can't build or buy the stuff fast enough, and they think we are in the early stages of another long bull market. Coming back up to 30,000 feet, where are we today in the real estate markets?
BE: You've highlighted a really interesting point just right there in your commentary, because you're absolutely correct. If you took the country and laid it out on a map, and you looked at - let's call it the smile states. You start at let's say Charlotte, and you run a big smile that extends up all the way to the other side all the way to Seattle. Most of those markets are growing jobs and gaining population. So, Orlando, where you live, Orlando has terrific job growth. I think Orlando's job growth - in fact, I have it right in front of me - is probably 3.5%. The country as a whole is 2.5%. So, Orlando's growing roughly 1/3 faster than the rest of the country. So, the question is, why is that? And the answer is, because you have a Republican government, no taxes, and you have available land to build.
Interviewer: I call it the sunshine tax factor.
BE: And also it's warm. Orlando's a nice place to live, it's a beautiful city. So, you've got 3.7% job growth. The rest of the country is 2 and change. Cleveland is probably close to zero, or one or two. So, that's the first thing. So, you have net domestic in migration. So a developer can convince the bank to give them a loan, because the banker gets the same economic reports as the developer and says, "You know what, in the next 5 to 10 years, 250,000 people are moving into Orlando," for example. I think the answer is, we're halfway through the cycle. The cycle started in 2011-ish, as the great recession faded, and the normal liquidity mechanisms returned to the market. So, 11, 12, 13 accelerated. We're now in 15, so we're in, call it halfway through.
Real estate development is exactly like the prisoners dilemma. You have a dozen or two dozen developers in a place like Orlando and all of them have the same imperfect information: they know the market is growing, but they don't know exactly how much, they don't know exactly how tenants are going to expand and they can't predict the actions of their competitors. They have imperfect information. They have guesses and estimates. And most importantly, they feel like if they don't develop, someone else will. So they all read the same report that 1M new feet of office is needed and they all rush to build it – and 3M feet gets built. This is how markets get overbuilt.
Interviewer: That makes sense. So, we are about midway through. We like the smile region of the country pretty much. Now, what factors are going to give us that bulletproof tenants have no real choices markets?
BE: That's probably the single most important question. We've described real estate the way you would describe it to a general investor who might not be familiar with any of these interesting or more niche property types, but works in an office building and lives in an apartment and is familiar with those kind of concepts. So, for the most part, if it's generic, we don't want to own it. What we want to own is where the industry substructure - the silo - is either a monopoly, an oligopoly, or a duopoly, with a couple to a handful of competitors. We don't want hundreds of providers of the type of property. Let's say we're in apartments. There are probably thousands of owners, developers, managers of apartments. It is a widely supplied business.
Instead, if you look at lab space, most of the lab space in the US is owned by three companies. So, we have a loose oligopoly. If you start out with an oligopoly, the oligopolistic competitors are less likely to compete on price. That's just the way things are - behavioral economics. The corollary to that is an oligopoly is an oligopoly because the business itself, the silo, has barriers to entry. It's hard to get into the lab space business. Now, you and I could go into the apartment business, though, it's a lot easier. So, we first search for this structure, where there is a limited number of competitors. The second thing we do is, we say, okay, we want a business in which there are enormously high barriers to entry. So, we want businesses where it's very difficult to add products, in a physical sense. And that can be entitlement, zoning, land use issues, a bunch of other stuff. So, apartments wouldn't fit, because they're easy to build. Lab space would because it's hard to build. Next thing we're looking for is this thing we call barrier to exit. What we mean by that is, could the tenant leave even if you gave them a choice? The example we usually use, we've already used one with the apartments, it's easy to leave an apartment and hard to leave a lab space.
Then the last thing we're looking for is, is the tenants business healthy and growing? We want our tenants to be coming to us most of the time saying, "I'm growing and I need more space," not, "I'm thinking of reducing my footprint." So, when we sift through all of this, we end up with things like data centers and a cell phone towers and manufactured housing and student housing and self-storage, these silos that are niches, i.e. there are two or three players.
Interviewer: That's a totally different way of looking at real estate markets than, I'd say, 90% of the people I've talked to over the years. Now, on your website - you've been very generous with your time, & I want to sneak one more question in here - on your website, there was an article with you talking about what's going on with California and the drought situation, and some interesting ideas of real estate companies involved in that situation.
BE: The drought down here has been ongoing for years and years. We are now at the point where over 80% of the state is categorized as being in either extreme drought or exceptional drought. Additionally, the region is a desert. There is a relatively modest amount of natural rainfall in Southern California, San Diego, for instance, gets about 7 inches of rain a year, which isn't very much. And the way the place is paved and with the basic terrain, much of that simply flows into the ocean.
So, we don't have much in the way of ground water retention the way you'd have in maybe New York or Illinois, where you'd go and sink a well. Our water is mostly stored in the form of snow pack in the Sierra Nevada Mountains. It snows over the winter, it's frozen, and in the spring it runs off. And when it runs off, it runs down rivers, and we've dammed a lot of those rivers and creates reservoirs, and that's where the water lives. The system reservoir capacity is currently 42% full. The population of southern California has increased tremendously in the last 25 years. Meanwhile, water conveyance, water storage, water purification, all of the systems put in place to provide a safe and reliable water system for the SoCal region has not kept up with that. So, we find ourselves now with 25% mandatory water reduction in Southern California.
Interviewer: Do you have any final thoughts for us?
BE: Real estate has been a leading asset class now for 30 or 40 years. We think most investors should allocate 10 to 15% of their diversified portfolio income to commercial real estate.
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