Stanley Iezman: Hello, my name is Stanley Iezman, and I’m the Chairman and CEO of American Realty Advisors. Joining me today is Sabrina Unger, our Managing Director of Research and Strategy, who is going to be talking to us about a very important topic, which is demystifying the entire space of alternative investments within the core universe, which has been a very big topic of conversation.

So, Sabrina, why don’t you talk to us and explain what those core properties are, what they represent, and how you would outline them for us.

Sabrina Unger: What we’re describing is niche or alternative or specialty sectors – this bucket of assets, it’s things like data centers, cold storage, student and senior housing, manufactured housing, industrial outdoor storage. It’s effectively any property that doesn’t fit into the classic definitions of the four main food groups you outlined. So it’s not an office building, it’s not an industrial building, it’s not a traditional apartment, and it’s not retail. I think what has historically prevented groups from thinking about those sectors as a core property type – there are a couple reasons. Number one is that they were relatively untested in terms of exit liquidity, so for core capital to make investments into those spaces, not understanding who the next buyer would be, that prevented some transaction activity. A lot of the ownership in these spaces was somewhat fragmented, and they tended to be smaller investments, so particularly for large institutions, it was very difficult to make the juice worth the squeeze of going out and acquiring these assets one by one to take any meaningful position. So there were some liquidity elements that kept people out of those spaces, there was fragmentation, and then there are some operating challenges. It is slightly more difficult to operate some of these properties relative to the four main food groups. There’s tenant credit quality, it could be riskier, so there were some of the reasons that they historically weren’t core in the past.

SI: So let’s think about this for a moment and talk a little bit deeper. The data that you’re thinking about when you start looking at these alternative spaces, what are you looking for? What are you looking at, and why do you think that investors really should be focused on this as a category?

SU: I think whenever we’re thinking about any property sector and whether that’s the traditional four main food groups or some of these alternatives, to me there are really three things that we think about as to whether or not they’re suitable and suitable for what type of capital, so if they’re suitable for core, for instance.

The first of course is just understanding the basics of the demand drivers. What are the fundamental things that are driving demand for space in that sector? Whether it’s demographics, technology, changes in the way we consume – for example, obviously the pandemic accelerated buying groceries online, so that might be supportive of cold storage. So, what are the demand drivers – having an understanding and an outlook on that will influence whether or not they belong in any portfolio, and then what types of capital they might be suitable for. So demand is one of them.

Pricing is another. We want to understand what’s happening in pricing. Is it being driven by speculative bets, or is it being underpinned by that demand picture? We want to understand pricing relative to demand.

And finally having an understanding of that exit liquidity because, especially for core capital, making an investment, the intention is to hold it long term, but in the event that there is a need for liquidity or the business plan has been completed, we want to have an understanding that if and when we determine to exit the investment, there is a next buyer available.

So we’re really looking at those key three elements whenever we’re thinking about making any sector allocation, including for the alternatives.

SI: So durability of demand is really important then?

SU: Absolutely.

SI: When you are thinking about this within the core space or even if you’re doing a sector-specific fund, whether it’s part of a core portfolio or not, when you start thinking about coming out of the ground with a new fund that is going to be sector specific, how do you deal with being a first mover and at the same time thinking about pricing that, and at the same time thinking about selling it to an investor?

SU: I think we have to define: what is the first-mover advantage? Effectively, you want to be rewarded for going into a space that is untested or relatively untested. And so when we think about core capital, that’s not historically what core investors are looking for, they’re not looking for you to take a position that’s necessarily risky. They’re looking for stability of income, durability of cash flow, and an expectation that returns are going to stay relatively stable and help diversify their broader portfolio. So I don’t think that there’s necessarily a first-mover advantage that investors are looking for when it comes to core capital.

Now, if you are doing something higher out on the risk spectrum, value-add, opportunistic, sector-specific, where your investors have an understanding that there’s a higher level of risk for a perceived expectation of higher returns, then the advantage of being an early mover is that you identify those demand drivers ahead of your competition, and then you’re able to exit into greater liquidity than when you entered the space.

SI: One of the things that I was thinking about as you were talking is that we typically leverage up our portfolios a little bit. When you’re dealing with alternatives, how do we think about whether banks are going to be capable or financial institutions to be able to underwrite these new strategies, so to speak?

SU: It comes down to education. The same way that we educate ourselves internally of understanding and getting comfortable with making investments into new sectors, the same way that we spend time with our investors, helping them to understand our rationale for entering the space, I think the same thing has to happen on the bank and lending side, and it comes back to the durability of demand: if we’re going to go add leverage to a portfolio of these specialty assets, we need to be able to demonstrate that there’s a resiliency of demand or resiliency of cash flow that would get the banks and other lending groups comfortable with the profile of the assets. I think back to 20 years ago when industrial was not as large a piece of core portfolios, banks had to get their arms around what e-commerce meant for industrial because it hadn’t been a driver previously.

Banks are incredibly smart, sophisticated organizations and ultimately them getting up to speed with the education that all of us collectively are trying to get our arms around for these new sectors, I think helps get there, but there’s probably less lenders that are willing to do that at any given point in the cycle than on traditional sectors.

SI: Let’s pivot to the whole issue of risk in these portfolios and these product types. The question really comes down to: is this real estate, or is this an operating business? Are we really looking at a hotel as a piece of real estate, or are we really looking at it as an operating business, or senior housing, or cold storage, or any of these other sort of quasi-operating businesses? How do you think about that?

SU: I think it’s a bit of a mixed bag. When we think about something like data centers – if we as the investment manager own the four walls and there’s a single tenant operating their business inside, that is inherently a real estate play. Whereas in the senior housing space, so much of the cash flow is coming from the operations within the building, and that has a heavy reliance on your group that’s including doctors and nurses and aides and all of the people inside that add value and create the cash flow that you then benefit from as the investor. So it’s a bit of a mixed bag when it comes to the alternatives, but I think more of them than less tend to fall into that operating business where there’s a heavy onus on being able to operate the facility and operate the business within versus office or industrial, for example, where we’re providing the real estate and that is the value to the tenant, and then they’re operating their business within the four walls.

SI: If you’re developing a portfolio and you’re sitting down talking to a client – let’s leave aside for the moment whether we as a firm want to put this into our core portfolio, except at the margins – does it really make any meaningful alpha contribution to overall returns?

SU: You’re asking the right question, because there are certainly plenty of groups who are looking at adding specialty sectors as a diversifier to reduce risk, but whether or not these specialty sectors add alpha to your total returns is I think really a function of which specialty sectors you are entering. So for example, today, life sciences, it’s relatively thin on the demand side, it’s an expensive price per square foot, and if you’re making an investment in life sciences or have an existing investment in life sciences, it’s helping your diversification, but it’s certainly not adding any alpha to your returns. So it’s really about is there an ability….

SI: Actually, it’s creating a negative today.

SU: Exactly. So, an ability to drive cash flows, drive NOI growth – it really determines, I think, whether or not these specialty sectors, adding them into a portfolio, creates some additional alpha.

SI: But when you start talking about specialty sectors, one of the challenges that I personally feel, and I think our Investment Committee talks about as well, is the whole idea that when you’re moving into it, there seems to be a migration of lemmings going into the product type all at the same time, and it becomes very overbought and very pricey. And in fact your comment about risk goes up not down. So how do you think about that?

SU: One of the things that we look at is capital flows relative to fundamentals, and if we think about it like a clock – so when the liquidity leaves the space, when there’s a bit of a vacuum, but fundamentals seem to be turning a corner – that feels like an optimal entry time. But then it requires discipline on the backend where you start to see a flood of capital go into the space. Fundamentals may still be healthy, but they may not have as much built-in momentum left, and that may be a situation where you either say, this feels a little too frothy, we’re going to take a pause, or alternatively, that might be a good environment from which to divest of an investment that you might already have.

So thinking about it in terms of progression of: where is the liquidity flowing relative to fundamentals and being really disciplined about your buy and your sell in that timing.

SI: Well, this has been terrific and hopefully we’ve demystified the conversation for our listeners today.

This transcript of the ARA In Conversation discussion has been edited for clarity.