With Michael Torres, CEO and Portfolio Manager at Adelante Capital, with a focus on Real Estate Investments
Steve speaks with Michael Torres about the state of the real estate market and his thoughts about where it’s all going. Michael is Chief Executive Officer and Portfolio Manager of Adelante Capital Management, a global real estate investment management company. Before joining Adelante, Michael was the Director of Real Estate Research at Wilshire Asset Management where he created the Wilshire Real Estate Securities Index, widely recognized as the industry’s performance benchmark.
The Amazon Effect
Steve begins the conversation by asking Michael about the effect Amazon is having on malls and other retail outlets. Michael points to overbuilt retail commercial real estate in the U.S. and says it’s had a reckoning of sorts over the past 20 years with the adoption of the mobile phone, the smartphone maturing over the past 10 years, and changing customer behavior. As customers embrace the Internet and online commerce, Michael believes retailers really don’t have a strategy to embrace the customer. That said, despite record bankruptcies and store closings in 2017, there have been lots of store openings as well.
Ironically, a lot of new store openings are by online retailers trying to establish a brick-and-mortar presence; Amazon’s Whole Foods acquisition is a prime example of online merchants building up physical proximity to consumers in an evolving retail environment.
The Competitive Landscape For Malls
Steve wants to know if mall operators and bigger branded retailers are changing with the times or are stuck in the old paradigm, just as Kodak missed out on digital photography.
Michael believes customers still want to physically see and touch things, but retailers realize the need to step-up engagement. So, he sees traditional retailers increasingly investing in mobile storefronts, e-Commerce, and technology to get their fair share of customer eyeballs.
Do Malls Make Good Investments?
Moving to Michael’s core competency, Steve wants his take on whether malls make good investments. From Steve’s perch, while big stores are exiting malls, gyms and restaurants are moving in, and some malls are even switching to mixed-use plans with a combination of apartments and retail.
Michael agrees and says mall landlords are trying to meet local demand, and we could soon see micro-cities in mall locations. On investments, his firm focuses on identifying companies that own premium malls, often referred to as Class A or fortress malls.
Steve wonders if the heavy construction of high-rise rental units in Florida is another indication of over-building. Michael says the densification in a lot of municipalities is very real and keeps rental prices from going up, but is a result of prohibitions on land use. In addition, America has had a shortage of starter homes which created demand for rentals, but that too is changing as millennials are forming families and moving to homes.
The Future Of Single-Family Homes
On single-family homes, Michael believes rising land prices have started a push towards densification and smaller units in tighter proximity. In addition, there’s still a bit of a hangover from the financial crisis where loans are still hard to come by for large residential construction projects.
Real Estate Stocks
Switching gears, Steve wants to know if it’s too late to invest in real estate stocks because they’ve moved up quite a bit since the crisis in 2005-06. Michael sees real estate as akin to investing in bonds that grow because rent checks go up over time. In addition, in tight markets, real estate has benefited from an uplift in land values and cheap borrowing with low interest rates. So, in real estate, Michael suggests an investment horizon of at least five to seven years.
The Wilshire Real Estate Securities Index
In wrapping, Steve wants to learn more about the Wilshire Real Estate Securities index. Michael says the listed U.S. real estate market is now over a trillion dollars with 13 different property types, having grown from traditional commercial real estate (office, industrial, multi-family, retail) to now include a whole new growth segment of cell towers, data centers, healthcare, and storage. And this next-gen market has out-performed traditional real estate by about 10% over the past year because of strong demand.
Just as the Internet and smartphones have impacted traditional retailers, it has also bred a new generation of real estate that is stealing land away from traditional uses.
Disclosure: The opinions expressed are those of the interviewee and not necessarily United Capital. Interviewee is not a representative of United Capital. Investing involves risk and investors should carefully consider their own investment objectives and never rely on any single chart, graph or marketing piece to make decisions. Content provided is intended for informational purposes only, is not a recommendation to buy or sell any securities, and should not be considered tax, legal, investment advice. Please contact your tax, legal, financial professional with questions about your specific needs and circumstances. The information contained herein was obtained from sources believed to be reliable, however their accuracy and completeness cannot be guaranteed. All data are driven from publicly available information and has not been independently verified by United Capital.
Steve Pomeranz: Michael Torres is Chief Executive Officer and Portfolio Manager of Adelante Capital Management. Adelante is a global real estate investment management company. Mr. Torres also spent a lot of time, years ago, at Wilshire, where he created the Wilshire Real Estate Securities Index, which is widely recognized as the industry’s performance benchmark. I’ve invited him today to talk about the state of the real estate market and his thoughts about where it’s going. Michael Torres, welcome to the show.
Michael Torres: Great to be with you Steve, thank you.
Steve Pomeranz: Everybody can see around us the effects that Amazon is having on malls and other retail outlets. Let’s get your take on the Amazon effect.
Michael Torres: Yeah, one is we’ve actually overbuilt commercial real estate in retail in the country. From over the last 20 years with Amazon, the adoption of the mobile phone, the smartphone reaching 10-years old, what we now see is the behavior of the customer is changing. If anything, the customer today knows more, often, than the clerk. I mean, we went through a period of showrooming, and now we’re really seeing that the number of retailers really don’t have a strategy to embrace the customer. Despite this year being a year where we’ve had record bankruptcies and store closings, we’ve had lots of store openings as well.
Steve Pomeranz: Okay, like what? In what area have the store openings been?
Michael Torres: Well, you have some of the online stores, Warby Parker, etc, coming to the malls. Dominant retail locations are getting the online type of retailer that has to have a physical presence. This Amazon-Whole Foods transaction is really a validation of that. They weren’t buying the stores, they were buying the locations, the leaseholds, to get at the customers. Retail continues to be an evolutionary business.
Steve Pomeranz: Do you think that the retail industry, let’s say, the malls and the mall operators and these bigger branded retailers, do you think they’re changing with the wind? Or are they stuck, perhaps, just expecting these businesses to continue to throw off so much cash, kind of like the Kodak problem? When they had the film, they were just earning so much from selling film and their cameras that they kind of missed the whole digital thing. How is the competitive landscape with mall retailers and owners?
Michael Torres: Well, I think, again, the behaviors we have to … People still want to physically see and touch things. We’re getting much more comfortable with commoditizing parts of our lives. That’s where Amazon can make it fulfilled, but there’s still an experience. I think part of the issue is how does the retailer invite the customer back and have an engagement? That’s where mobile will actually be, I think, useful over time, where you can be more efficient in getting to where you want to be and see the goods you want to see. But again, we’re going through that ecosystem. I don’t think it’s the Kodak moment, per se. But people have taken part of those profits and devoted it to e-Commerce and technology at the expense of the store, the clerk, and the experience of the customer because we’ve all been fighting for eyeballs. That will change over time.
Steve Pomeranz: A lot of these big malls have huge anchors like Sears and others. I think it’s no secret that Sears is going through its own challenges and closing down stores around the country. I think the average person thinks, “Malls are really getting into trouble. Why would I invest in a company that runs a mall?” But I see in my area, I don’t think it’s that different from around the country, is the malls are changing. Maybe the big box is going out, but there are gyms and restaurants moving in. What’s going on there?
Michael Torres: I think the landlords are, again, trying to meet the market. They’re trying to identify the uses that, basically, the locality will want. Again, you mentioned a shopping mall, there’s some densification where you’re going to get housing on mall pads. You might remember, a long time ago, Montgomery Wards had a car service station there: tires, batteries, and auto. We’re going to bring other uses and densify. They’ll be little cities over time.
Steve Pomeranz: Okay, all right. You’re not writing them off as an investment. Are you light in that area? Are you heavy? What are you thinking?
Michael Torres: Well, we’re very selective. I think that there’s no question, in 2017, there’s much more stratification between, really, the density of the markets but also the quality of the assets within markets. I mean, in some secondary cities in the United States there’s two or three malls, where you really only want to be the number-one mall. In Los Angeles, very big metroplex, you can support three or four malls. We really try to focus on the companies that own those premium malls, often referred to as class A or fortress malls.
Steve Pomeranz: Okay. Yeah, that makes sense. My guest is Michael Torres. He’s the Chief Executive Officer and Portfolio Manager of Adelante Capital, which is a global real estate investment management company. We’re talking about all things real estate. Real quick, I really do want to get off of this. But in our area, we see strip malls, I mean, the explosive growth of strip malls. They hate to have 10-square feet of open land in my area. If you can’t build a house on it, you’re building a mall. You’re building a strip mall or something and putting a drug store in there. Is that when you say, “They’re overbuilt,” are you referring to that as well? Is that going to change, do you think?
Michael Torres: That’s really a lot of where the overbuilding has been is municipalities looking for tax revenue. But the entrepreneur in America still can have their own store. But we saw leading up to the financial crisis, where small business is exploding and people building their businesses using credit cards. We lost bad credit in the financial crisis; we were oversupplied. Some of those businesses never come back. It’s no different than what we’ve seen with auto dealerships. There’s some consolidation there. That land, ultimately, in markets that are tight and growing, will have a higher and better use. In a lot of markets, you’ve seen more multi-family being built.
Steve Pomeranz: Yeah, that’s what I want to get to next. When you say multi-family, I want to get into this rental apartment, because again—I’m sorry, listeners, but using my own area as an example—we are exploding here with high-rise rental units. I don’t know. It just seems to the point where it to me, that it’s kind of getting overbuilt again. What do you think about rentals?
Michael Torres: Sure, the densification in a lot of municipalities is very real. They want that to be able to support the growth. Supply actually keeps some of the rental pricing going up too fast. As in many markets, the land uses are prohibited, and that’s why you’re having continued land rental prices go up. What we’ve seen, part of the reason that you’re going to densification of apartments is because we’ve under-built starter homes, move-up homes, as ownership has gone down in America in the last 10 years. It’s only recently started to pick back up.
Steve Pomeranz: Yeah, I saw an article, I think it was in the New York Times, that millennials are starting to buy homes now as they’re forming their families, and they need more room. Here’s a quote, “It sent a chill through the rental markets.” Is that overstating it?
Michael Torres: I think it’s overstating it. I think the quiet little thing that’s been happening in many urban markets around the country is that we’ve had a reasonably good building boom. You see that in the densification. As those are delivered, there’s lots of options. All of a sudden, rents are kind of stable and not really going up. I don’t think it’s a complete chill, per se.
Steve Pomeranz: Okay. Single-family homes … We have a regular real estate segment with a local real estate agent. We’re always talking about single-family homes in our area. I think around the country there’s very little inventory for sale and that’s constricting the market. I asked the question, “Why aren’t the builders out there just cranking it out if the secondary homes are not available?” What’s going on there?
Michael Torres: Part of it’s land prices today. They just don’t pencil. The consumer has to get used to smaller units. Again, as we go to densification, we’re going to be having smaller units in tighter proximity. The kind of suburban, single-family home, big tracts, that is changing, and for the millennials, they’re going to have get accustomed to that. The other thing is lending to that, what is still a manufacturing and speculative business, is not completely opened up for the end buyer, whether or not you have the down payment or can qualify for the loan. I think that’s probably a little bit of a hangover from the financial crisis.
Steve Pomeranz: If I decided that I wanted to invest in real estate today, and I didn’t necessarily want to go out and buy a property, but I wanted to buy stocks of companies that were invested in the real estate business, is it too late in many of these markets? Because we had the crisis in ’05 and ’06, and we’ve come back in prices, as you just said, are higher, and maybe … I loved when you just said, “It doesn’t pencil.” I never heard that before, meaning the math doesn’t really add up. What are some of the short-term headwinds and maybe some of the longer-term headwinds or tailwinds that I should be looking for if I decide to make a decision in this area?
Michael Torres: Sure, I think the most important thing is the investment horizon that one looks at when they look at real estate. Then it’s an activity, where you’re housing the economy, you’re collecting rents, generally, on a monthly basis, as you look to have the benefits of those cash flows, which are different than bonds. Because every year you, potentially, have the ability to get step-ups in the income, offsetting some of the expense growth you might have. It’s really a bond that grows. In tight markets, you have the benefit of the lift of the equity, which is a residual value of the land. In the short run, it’s really financing costs. I think because we’re at the tail end of this building boom, and as I mentioned, things don’t pencil, in other words, the returns aren’t quite there yet, you’re going to see a deceleration of new supply, which benefits owners. You can see rents lift. Longer run, I think that markets are getting denser. It’s just not a lot of available land. In some markets, here in the bay area, there’s virtually no industrial land available. The rent difference-
Steve Pomeranz: Down here as well, it’s getting very limited, as well, down here. You’re saying future tight supply means rising prices. A lot of it has to do with the cost of borrowing the money, which has really stayed relatively flat for so many years. I guess, what could derail it is a significant rise in rates, borrowing costs.
Michael Torres: Well, yeah, that’ll affect the existing owners. But if you’re looking to deploy capital as rates are starting to rise, the companies you might invest in, through the stock market, are being repriced. You’re getting a chance, which is very different than buying an individual building or a home. You’re having the ability to kind of average in as, basically, the conditions change over time. I think that’s one of the true benefits [crosstalk 00:13:28] market.
Steve Pomeranz: What is a suitable time horizon for making a real estate investment?
Michael Torres: I think one has to look at this as really a kind of five-to-seven-year investment horizon. I think that’s, probably, one of the things we don’t talk too much about.
Steve Pomeranz: And the idea is that you may want to … if you do start, you may want to kind of average in over time if some of these headwinds that we speak about were to come about. The idea being what, that they can’t create any more land, I guess, unless you’re China and you’re building islands or something?
Michael Torres: Exactly, in many urban markets we are having a shortage of land, and so we’re going to have higher and better uses. With the companies, you actually have management teams that are incented and aligned with you to, actually, constantly look to improve their portfolios than being stuck on an individual building.
Steve Pomeranz: I want to get to something new here. You had a hand in creating a new index, a new real estate index. I’d like to hear a little bit about it. We just have a couple of minutes left.
Michael Torres: Yeah, sure, Steve. Look at the US listed market is now over a trillion dollars, and we have 13 different property types. What we were saying is that the core property, when people think of commercial real estate, it’s office, industrial, multi-family, retail. But there’s a whole new segment: cell towers, data centers, healthcare, storage. We’ve divided the universe to look at the performance of these two universes of property types. We’re seeing by looking at a trailing one year about a thousand-basis point difference between commercial real estate, traditionally, and the new next gen.
Steve Pomeranz: Yeah, so in other words, it’s not your father’s real estate market anymore. It’s not the sleepy commercial office building and single-family homes now you’re talking about with real estate. Why are cell towers real estate?
Michael Torres: A lot has to do with the land, and the placement of the cell towers, and the physics to move the signals.
Steve Pomeranz: Interesting.
Michael Torres: It’s really location, location, location.
Steve Pomeranz: I guess they have to have buildings to store all of these digital storage farms for the cloud and to create bitcoins and all that.
Michael Torres: Absolutely, the computer servers need the housing and, more importantly, they need power, and they need cooling.
Steve Pomeranz: Interesting. Well, we are out of time. This is a fascinating talk about the real estate market. I hope I’ve opened up some of my listener’s minds, broaden their thinking with regards to real estate. It’s like we said, it’s not your parent’s real estate market anymore. My guest is Michael Torres. He’s the Chief Executive Officer and Portfolio Manager of Adelante Capital Management, which is a global real estate investment management company. Don’t forget, if you want to hear this interview again, and you want to get our weekly update as to what topics that we’re discussing on our show, don’t forget to come to StevePomeranz.com. Thanks, Michael.
Michael Torres: Thanks, Steve. Thank you.