Webcast transcript
Willy Walker: Thank you Susan and good morning everyone and thank you for joining us for another Walker Webcast. This is going to be a fun one and, hopefully, a very engaging discussion with two incredibly smart and insightful friends. I think it's noteworthy to focus on their two firms for a moment before we dive into today's discussion. I have a long history with Morgan Stanley from having worked there way back when to asking their wonderful Investment Banking and Equity Capital Markets teams, run by Seth Weintrob and Raj Dhanda, to help take Walker Dunlop public back in 2010. What James Gorman has done with Morgan Stanley since he took over in 2010 is truly amazing; I can give you one data point that I think says it all. Morgan Stanley's market cap is $151 billion today versus Goldman Sachs at $113 billion. Morgan Stanley has scaled quicker, it's built an incredible asset management platform, and has entered the broader asset management market by its highly strategic acquisition of E*trade earlier in early in 2020.
It’s also astounding what Jamie Diamond has done as CEO of JPMorgan over the past two decades. Many of us remember when Jamie and other bank CEOs were “invited” and I use that term generously to the Treasury Department in 2008, in the depths of the financial crisis and having to sign on to TARP, and as you looked at the CEOs of JPMorgan, Wells Fargo, Citigroup, and Bank of America I thought to myself well they're the leaders of the mega cap banks and they basically control our financial system. You fast forward 12 years and there really is only one, JP Morgan. JP Morgan's market cap almost eclipsed half a trillion dollars last week and sits at $463 billion today what's amazing about that number is that that's $140 billion more than the second largest bank, Bank of America, or put in a different way that difference in market cap between BofA and JP Morgan is slightly less than the total market cap of Wells Fargo at $160 billion and Citigroup at $150 billion. So, think about that, you need to add all of Citigroup to BofA to get to JP Morgan today.
If any of you have read have not read Ron Chernow’s amazing book The House of Morgan I would strongly recommend it and, as I reflect back on that book I don't think that the House of Morgan has ever been stronger than it is today, since the passage of Glass-Steagall in 1933 which separated the commercial and investment banking operations of JP Morgan.
The equity markets continue to soar, and I am very much looking forward to my two guests’ thoughts on how long this bull run will last. Clearly, in the commercial real estate industry everyone's just focused on, mostly focused on rates. The 10 year has rallied a little bit over the last week and is sitting at 1.64 percent today. A couple quick thoughts on that. I saw a big Walker & Dunlop client up in Aspen this weekend and he said to me, I wish I had locked more. And my response to him was you know you put in place great floating rate debt with extremely tight spreads and while the 10-year can and may run you are LIBOR SOFR based, and as long as the short end of the curve stays down, you will be fine. I think it's also important to keep in mind that most economists believe the 10-year will move from its current 164 level up to somewhere around 350 over the next three to four years. First of all, unlikely it just kind of slowly ticks up there we'll see some fits and starts on that. But I think it's important to keep in mind that if it gets to 350, which in today's world sounds incredibly high, it will still be significantly below where the 10-year was in 2004 and 2005 when it sat in a range between 4 percent and 450 and I would point out that the US economy, the commercial real estate industry, and the homebuilding industries, all had a very, very good two years in 2004 and 2005. So that's my 30,000 foot now I’m going to turn to the real experts in Rich and Rick.
Richard Hill is Managing Director at Morgan Stanley and head of the US commercial real estate research group. Richard graduated from Georgetown University and Rich and I have 57 mutual connections on LinkedIn. As I was looking at his bio and other things in preparation for this. That, then, sets me up for a comment about my buddy Rick Shane who is head of JP Morgan's Consumer and Specialty Finance team. He has received many accolades is one of the world's best financial services analysts. Rick is a graduate of Johns Hopkins University undergrad, BC law school, the University of Chicago where he has an MBA, one of those highly highly overeducated people and I couldn't find Rick on LinkedIn. We might we might need to send a memo out to JP Morgan to allow you Rick to get on LinkedIn. It's an incredible new technology platform that will help you spread your word about the research you're doing.
So, first of all to the two of you, thank you for joining me. It's really fun on this webcast because the two of you typically are asking me questions and I get to turn the tables and ask the two of you questions which is a real joy for me. So, both of you went to fantastic universities in Georgetown and Johns Hopkins yet interestingly they are both one trick ponies with regard to college athletics, Georgetown with basketball and Hopkins with lacrosse. So right out of the gate I need both of you to give me your one stock or one sector that you are all in on right now. So, Rick let me start with you since I think I know where you're going to head with this response.
Rick Shane: Sure, thanks Willy and I'm chuckling about the LinkedIn comment. With this audience everybody's familiar with the concept of leverage -- I don't need LinkedIn. Willy I can call you that's my that's my leverage. So, anyway, when we look at the world right now, we have turned particularly bullish on the consumer. Specifically, the credit card issuers our thesis there is actually pretty simple. If you go back to last year, it would have been inconceivable that consumer credit from a from a pure credit performance perspective would be approaching its best levels ever. And the contrast is that if you go back and look at the reserves that the companies built in anticipation of an incredibly challenging environment versus the reality that they're experiencing it's going to be a catalyst for reserve releases, excess earnings, repurchases, higher dividends, and it's just a very clear path in my mind over the next 12 months.
Willy Walker: So, Rich to you.
Richard Hill: Yeah well, first of all Willy I'm gonna take exception to Georgetown being a one trick pony in basketball we barely made the NCAA tournament. I ran on the track team and our soccer teams, the defending NCAA champion so maybe the basketball team will get back there one day.
Look at the at the risk of pandering to you I'm going to give you one subsector and one stock, but the subsector is apartments. Specifically, coastal apartments. Coastal apartments were left for dead by myself, almost a year ago to the day when we downgraded the sector on April 1, 2020. We had a really simple thesis rent growth and job growth are highly correlated. Where we stand 12 months later is we're seeing real green shoots emerge in the coastal apartments, occupancy is stable to improving rent growth is less bad. What we think the market underestimates is that a lot of the rent growth decline, so when you hear New York City's down 25 to 30 percent that's driven by rent concessions, that's driven by three to four months of pre-rent. As demand bounces back in these major markets, which it will in the second half of the year, we see a real scenario where same store revenue growth is going to be called in the mid to high single digits and, dare I say, in the first half of 2022 it can be in the low double digits. So, when you look at these sectors are really beginning to rebound and they look, they screen is very cheap to the S&P 500. We think that there's a real chance that the generalist investor base is going to get behind them, not only because revenue growth is accelerating but the hedge against inflation. In terms of a stock, Simon Property Group. I have never been overweight Simon Property Group before. The company lost $20 billion of NOI in 2020 versus 2019 and we think the market is assuming that none of that ever comes back, it is a great pull forward and retail rationalization. I think you will see the company beat and raise in multiple, rise in the coming years. I'll stop there.
Willy Walker: That’s great I want to, I want to come back to both of those themes in a moment, but before we do Rick let me wind, the clock back a little bit. As I was doing research for this discussion, I noted that in October of 2019 you basically took down your entire coverage universe, saying that you didn't like what you were seeing in the specialty finance space and you brought everything down by 10 percent which included Amex, Cap one and Ally and you stated, “our outlook headed into 2020 becomes more cautious.” I just want to know; did you get some memo that there was a pandemic that was going to arrive on the shores of this country at the end of January back in October of 2019?
Rick Shane: Well, thank you for kindly editing what I said next, which is that part of our thesis was that the market based on a series of unprecedented events, going back to the GFC basically assumed whatever was going to happen next would be unprecedented. And our hypothesis was you can't have everything be unprecedented. So, we may have gotten a little bit lucky in terms of being more cautious headed into 2020 but certainly the second part of that, in terms of being a more normal downward cycle, we weren't anywhere close. I think what we saw headed into 2020 was a labor market that had really no additional room for improvement. We were facing an accounting change that was going to force companies to take procyclical reserves and that we had some concerns about the combination, both in terms of fundamentals, in terms of valuation. In hindsight, obviously the pandemic was the intervening event that no one anticipated. The consequences of that as I touched upon before completely unexpected. If we'd sat here on April 1, 2020 and said that charge offs in credit we're going to be at all-time lows 12 months later we would have been wrong. We spent most of the summer arguing that reserves in the space we're not high enough, that companies needed to be more cautious than then they were behaving. The reality is that economic stimulus has been successful, programs on behalf of lenders in terms of forbearance, in abatement, in flexibility, have been very successful. And we are entering a recovery with the consumer, who is well positioned to participate in that recovery particularly when you see the labor markets go with it.
Willy Walker: So, Rick, on that, you talked about if we were sitting around on April 1st of 2020 we would have never predicted where we are. When was it then you started to see green shoots? All of us kind of replay 2020 and it appeared as if everything went from, you know, sort of March, April, even into May was sort of, the world might be coming to an end, to then all of a sudden starting to see sort of shoots and opportunity where actually people were starting to invest capital. Markets obviously rebounded quickly. But what was it specifically that you saw? What was that data point that started to surprise you that said, hold it, this might not be what we thought it was going to be?
Rick Shane: Sure, it's a very fair question. So, we spend a lot of time looking at credit card trust data. And obviously, the charge-offs are kind of a lagging indicator, but what we started to see in particular was delinquencies declining on a year-over-year basis. There's a tremendous amount of seasonality, so you can't compare delinquencies from tax refund season versus delinquencies from holiday-spend. But what we started to see was a pretty significant decline in early-stage delinquencies. The way that we, from a temporal perspective, sort of went through this was in September, October, we started to say, look, there are two possibilities here. One is that losses are simply being delayed; and the second is that losses may be averted. And we didn't come to the conclusion in September, October, they were going to be averted, but what we basically said is the reserves are starting to price in the worst-case scenario. And so, you have this asymmetry that if losses are in fact averted, you've got upside, and if losses are delayed, you're fully protected. And as we moved into the end of the year, I would describe that the sort of balance between delay and averted, started to shift more and more to averted. And I think where we stand right now is the probability that losses are going to be lower than normal correlations would predict, is much higher. We have a new piece out today where we show this. We talk about the rebound in spending, which we think is another really important catalyst. I think that'll tie in with a lot of what we're just talking about, and I suspect you'll have some questions related to outlook on retail related to that as well. So, I will turn it back to you.
Willy Walker: So, Rich, a similar question. You know commercial real estate stocks got hammered right as the pandemic started to unwind. What was your biggest concern for the sector? And then as you think back on it, what was your most, if you will, unfounded concern? In other words, which was the concern that you thought was going to be there, and all of a sudden, just turned into not being something you should be worried about?
Richard Hill: Yeah, it's the right question be asking. We were quite concerned that the integrity of the commercial real estate lease was going to be challenged at the onset of the COVID crisis. We had never seen anything like this before where shopping centers were closed; people were moving away from apartments; you couldn't go into your office building. And we thought there was a probability, a high one, that tenants of all types would say, I’m not going to pay my lease under force majeure clauses. I have to elaborate on what that means. That ended up being the biggest boogeyman ever. It didn't happen. It didn't come to fruition. Yeah, there were some issues associated, some tenants not paying their leases, but it was not nearly as bad as feared. So, to answer your second question: “What's the big concern that turned out to be unfounded?” That, of course.
But I think the bigger point is how the debt markets really responded to this COVID crisis, where there was unprecedented stress on the tenants, which put unprecedented stress on the borrower's ability to pay their mortgages. Lo and behold, lenders actually met at the table with their borrowers and worked through the crisis. They provided forbearance. They provided loan modifications. So, as we sit here today, distressed sales are less than 1 percent of total transactions. I wouldn't have told you that 12 months ago. I would have anticipated distress was going to be pretty high, because we hadn't seen anything like this before. But it's an important point, because if you go back to the GFC, property evaluations only began to decline when distressed sales began to accelerate, and property evaluations only troughed when distressed sales peaked. So, we're not going to see the distress. We’re just not going to see a decline in property evaluations. And guess what? Property evaluations, at least headline property evaluations, are up on a year-over-year basis and have increased for the past six to eight months on a consecutive basis.
Willy Walker: So, Rick, on what Rich just said. Think about that for a moment, in the sense that the banking system went into the pandemic better capitalized than it's ever been. And obviously, this crisis didn't emanate from the banking sector. Hindsight’s 20/20 vision, but shouldn't all of us take in a deep breath and thought about exactly what Rich just said? Look at the banking system saying they didn't cause this like they did 2008. They're better capitalized than ever. We're going to make it through this.
Rick Shane: Yeah look, I think it's totally fair. There was an element of blamelessness to what occurred last year that made it easier for parties sitting across from one another to choose to collaborate and be thoughtful in their responses. You know my colleague, Charlie Arestia, focuses on commercial real estate and commercial mortgage REITS for our team, and he and I have partnered on that coverage for a long time. One of the things that we really focused on last year is the behavior of the sponsors related to commercial credit. You had a system where not only where the banks were well-capitalized, the sponsors were well-capitalized, and they were looking at their properties and saying, OK, we have the resources to support this. And again, one of the things that we struggled with conceptually last year was, how long a bridge that capital can provide? And the reality is through a combination of disciplined behavior by sponsors; policy initiatives; and frankly, you know, collaborative behavior on the part of creditors. You didn't have the problems that you had last time. Now that said, one thing that does resonate in the back of my mind is when I think back 2007, 2008, commercial real estate, as we move through the crisis, because of the nature of the types of loans with the extensions that were available, there were less evident cracks early, and there were longer cracks as we emerged from the cycle. I don't think that's where we're going to be today, but to the extent past is prologue, it is something that we do talk about think about a little bit.
Willy Walker: So, Rich on that, I just want to stay on this for a moment. Because I think, you know, all of us are going to experience financial crises going forward. We're all going to see market sell off, and maybe not exactly as they did in 2008, or exactly as they did in 2020, but I think for all of us who are investors, figuring out when you really need to pull it in and hunker down versus when you can get on the front foot and start to invest again is super, super important. I mean, it's like if you missed March and April, you know, if you were fully invested in March, you took a pretty big hit on the chin. If you are out of the markets for April and May, you missed a lot of the of the rebound here, and you had to have some real conviction to putting fresh capital to work during that period of time. And I think it is so helpful to look back at the GFC versus the pandemic and try and figure out what we can learn of going back to the root cause of the problem. And so just as Rick just said, you know it wasn't caused by the financial services sector; and therefore, with the actions that the government took, with the not only capital structure of banks, but also of the borrowers, we really were set up for success if a couple of things came together properly. Is there any additional element that you think, either I or Rick haven't mentioned, that was fundamental to how quickly the markets came back?
Richard Hill: Yeah, I think there's a couple things. First of all, do not discount how cheap borrowing costs were and what that allowed distressed borrowers to do. We saw a pull-down of revolving lines of credit. We saw issuers tap the credit markets. There was an ability, given that balance sheets were really strong heading into this crisis, that they could actually have increased leverage to shore up their balance sheets and make sure they have ample liquidity. That is not something that happened during the GFC. In fact, the debt markets froze up entirely. So maybe it's causation versus correlation, but the ability to increase leverage and have liquidity, I think, significantly staved off what could have been a really bad problem. This would have lasted another two, three – never mind a month.
Willy Walker: And so just from both of you, a grade to the Trump Administration, and if you will, broadly speaking, Washington's response to the pandemic from a financial standpoint. Rick?
Rick Shane: Sure. So look, I think Rich nails it. The playbook that they learned from 2007 was executed perfectly in 2020. The intervention immediately in terms of the repo markets, you know, essentially QE4 created stability in what I would argue are less-risky asset classes. And then there was a cascade over time into the riskier asset classes. Willy, you touched on something that I do think is important in terms of timing. And having done this for a long time, one of the things that you learn to do is to sort of deprogram your own biases as an investor. And like everybody else, I know that I get caught up in the sentiment of what's going on in the markets. That when everything is going well, I’m ebullient and want to own everything. When things are terrible, you get on the phone with clients, and you can't think of anything to recommend because you're so scared. We essentially keep a list of stocks that we want to recommend on the days when you don't want to talk about anything. And it's a pretty good discipline to have as an investor just to have that list of: OK, when I'm really scared and I know that I should be buying things and I don't want to, these are the stocks I want to buy.
Willy Walker: And as I said at the beginning, JP Morgan and Morgan Stanley should probably be two of them on that list. Rich, let me, I want to get the final thing. I need a grade from you, Rick, on the administration's response to the pandemic from a financial standpoint.
Rick Shane: A minus.
Willy Walker: A minus. Rich?
Richard Hill: God, he took my answer.
Rich Shane: Sorry, dude.
Richard Hill: I'm going to say a B+. And look, I was debating between an A and a B_, only because I can't do A minus. But I will say I think one of the things that the government did that was really, really good, is they figured out who exactly needed the money and who didn’t. My discussions with various different people throughout the crisis suggested that they recognized commercial real estate did not need a bailout. And I think that is extremely sharp. I was critical of it at the time, but it was the right decision.
Willy Walker: And I'm right there with you. As you can imagine, I was very involved from an industry standpoint, of not only saying that the industry needed help, but then also that we as servicers of commercial mortgages needed a facility with the single-family servicers that the government ought to set up so that we could all tap into the facility when we started to have massive, massive forbearances where we were having to advance to bondholders. And you look back, and you know, Dr. Calabria, who runs FHFA sat there and said, “You're not going to need it.” And there wasn't a person in my industry who didn't say, oh we're going to need it. And why wait until the crisis arrives? Why not put it in place so we can tap it now so we're good? Well, guess what? Nobody ever needed it. Even the big RESI servicers never needed it. And so, I think to your point, it is quite something. They saw something or knew something that few of us were seeing at the same time. And I do take my hat off to them that they knew exactly who needed what kind of relief at the time, and sort of who didn’t.
So Rick, let me just quickly look at sort of the 30,000-foot, and I then I want to dive into a couple more things specifically as far as themes and where we are on consumer debt, and credit cards, and student loans, etc., etc. But if you look at the backdrop today, we've got a Dow that's at 32,000. We've got, as I said previously, a 10-year at 163. We've got unemployment at 6.2 percent. You look at those three indicators and you say, Things are pretty darn good. I mean, it's hard to sort of look at those three and say, Wow. Just look back a year, as you said. Who would have ever thought that we'd be there? Is that… are we seeing the real picture, by looking at those data points and saying things are good? Or is that a veneer over something that is behind the scenes a little bit more troubling to you?
Rick Shane: Yeah look, I mean, everybody talks about the K-shaped recovery and there is an element of that, but I do think that the stimulus that we've seen has done, to Rich’s point, been effective from a consumer perspective of putting money in the accounts of the consumers who need it most, and that has been the foundation of what we've seen. At the same time, we also need to acknowledge that the lenders have been smart and fair in terms of how they've treated consumers. I think one of the lessons that they learned from the crisis is a little bit of the prisoner's dilemma, by trying to put yourself ahead of the system, you actually do more systemic harm and what's happened this time is through programs like loan forbearance consumers have been given a chance to breathe. I do think that there's one big difference, though. If you think about what happened in 2007 and 2008, there was to some extent a perception that lenders had contributed to the pain consumers were feeling and you think about the ads that you're hearing, that you know you should strategically default on your mortgage, that you should work out your credit card debt, it almost reached a point where the historic ethos in this country of paying your debt was being diminished and there was a lot of messaging around that. We didn't have that this time, and so the willingness to pay, it's always about ability to pay and willingness to pay, the willingness to pay was much greater this time because, to the point that you made upfront, no one was at fault here this time.
Willy Walker: But on that, let me push you a little bit on that then. Let's just jump into student loans for a second, because there is a lot of talk in Washington about some big student loan forbearance forgiveness program; Elizabeth Warren being the biggest advocate of that right now. You cover the student loan lenders; you're, I would say kind of sideways on that, right now, given the political uncertainty behind it. Do you think that we get some type of student loan forgiveness program and any of this either tax legislation or straight-out legislation? And at what level do you think we get it?
Rick Shane: Sure, so it's a really complicated issue, and I think in some ways it's a little bit lost that people see it as a left-right issue and, to be honest, we see it more as a demographic issue. If you think about my folks who are in their 80’s, or me, I'm sort of right in the sweet spot of Gen X. Our generations paid for, or parents work hard to pay for our education. And again, I'm sitting out here in San Francisco, generously a Moderate, but the idea of a program that essentially asks me to pay for the next generation of education, having paid for my own, isn't really a political issue, it's more of a generational issue. And it's funny you cite Elizabeth Warren, I think the two people who we would consider to be the biggest proponents of student lending reform are Bernie Sanders and Elizabeth Warren, and it is noteworthy when you think about their age and the demographic of the voters who have been most supportive of them. Yes, it's a very liberal voter base, but it's also very, very young. All of that as a way of saying that I think that getting this through is a lot more challenging than who's in the left-right majority than people necessarily give it credit for. We had a call coming into the year that we were, actually before the election, and without knowing that the democrats would end up controlling both houses and the executive branch, that this was going to be a sort of fear that was overdone, and I continue to believe that. The other problem with the student lending reform is that it doesn't solve the problem going forward. If you forgive debt today, what does that mean for someone who is 15 who's entering college down the road? Do they enter college borrowing money, knowing that they're not going to have to pay it back? There are some real unintended consequences of this that are very complicated. So, I think there will be a modest reform, but of the $1.6 or $1.7 trillion of debt that's outstanding, I don't think you're going to see most of that for long.
Willy Walker: Rich, are you of similar thinking to Rick on no real movement on student debt relief? And the reason I think it's so important to commercial real estate is that $1.6 or $1.7 trillion that's sitting out there keeps many renters renting. They don't have the ability to put a down payment on a single-family home, and if you walked in with a magic wand and wiped away $1.6, $1.7 trillion, there is a huge demographic in the United States that could walk out and put down a down payment because they've now lost that $50 or $75 or $100,000 of student debt. So, it could have a massive implication on the housing markets if something happened there. Do you concur with Rick that it's unlikely it does, or are you actually thinking that something might happen that could influence the commercial real estate in single-family markets?
Richard Hill: Yeah, well there's a lot to unpack there. I have a reputation of wearing my heart on my sleeve, so let me get on my soapbox for just a quick second. I firmly believe that we've sold our younger generations a bag of goods about going to college. I think it should be the right, but not the obligation to go to college. That said, another way, look, my grandfather would roll over in his grave if he knew that I didn't know how to change oil in the car. Don't laugh at me Willy, you might know how to change your oil in the car - I don't. But the point being you don't have to go to college; you can be a tradesman. Those are noble occupations that can actually pay a lot of money. So, I think Rick brings up some great points about the generation that does have student debt and I'm going to come to that in a second, but I also think we need to just completely rethink as a society, what makes someone valuable? It doesn't necessarily mean they have to go to a four-year college to be a contributing member of society and make a living wage. So, I'll put that aside.
So, two points I want to make. First of all, I do think we have a problem with student housing in the United States. We have overbuilt student housing in the United States over the past decade, maybe even two decades. And, unlike the apartment sector that was prudent and rational by giving rent concessions in the face of rising supply, student housing went into an amenity war and, unlike when I was in college these people started competing with lazy rivers at spas, wine rooms, I can see what Rick laughing, “that's not my college experience,” I don't think it was yours, Willy.
Willy Walker: We've lent on some of those Rich, so I know exactly what you're talking about.
Richard Hill: Look the valuations are just too high when the new flavor the month is built down the street. So, we have too much of that. But to answer your question, you know I’m less concerned about the amount of debt and people's ability to buy a home. What we are focusing on is a significant number of younger people that are now moving into their household creation years. The Gen Z's and the Gen Ys in totality are bigger than the baby boomers. That's a remarkable statement. There is more than enough demand coming for housing of all types, whether it be manufactured housing, single-family housing, apartments, ownership, to satisfy the amount of housing, that we have. In fact, I actually don't think we have enough housing relative demand coming. So, from a real estate perspective, yea look, I mean reducing debt loads will be a cherry on top, but it's not going to change my preference for multifamily versus homeownership. I actually think there's more than enough demand coming down the pipe that can support all of it. Said another way, that the demographic tailwinds remain very, very supportive and I would point blank say any trends that we've seen on housing on the heels of Covid are not a fad, they’re the trends that are here to stay.
Willy Walker: So, let's dive into that a little bit deeper. Rick, you cover the auto finance industry as well, and you're moderately constructive on auto finance, given improving Labor markets offset by lower used car prices. As I think about this, what's happened over the last year, where the urban cores have sort of been vacated and everyone's moved to either suburban housing or suburban multifamily, we're now in this sort of re-igniting phase where everyone's sort of like, “Okay, we're going to move back to the cities, we're going to get back to schools in Center cities,” people are going to come back for the cultural experiences of the city, what's your take as it relates to the lasting impact of this sort of urban flight? Are you right now looking at models and saying, “It's going to remain a suburban focused country going forward,” or do you believe that the city sort of comes back and actually might even go beyond where it was before?
Rick Shane: Yeah, so a couple things and the one thing I might tweak a little bit as I think we're a little bit more sanguine on these used car prices then maybe what you'd looked at depending on timing,
Willy Walker: You sent it to me, so I mean, if this is a this is outdated over a month, I'm sorry.
Rick Shane: Look, I think what we've seen is really, really strong used car prices with some downward pressure from what I would describe as sort of really, really high levels, but what you have to remember is with the factories having shut down in 2020, you will permanently have fewer 2020 model year cars in the aftermarket than you would have had but for Covid. And when you think about supply-demand, supply is going to be permanently constrained, at least on that particular model year, and so that actually has a pretty favorable impact on price. In terms of where we stand for suburbanization versus sort of a return to the city, at this point I don't have a particularly strong view. What I would point to is that I think about the events we've seen over the last 20 years, whether it was everybody leaving New York after September 11th, and slowly the migration back into the city. I don't think that this is going to be a permanent shift. I think that it will probably be balanced going forward. And you raise a really interesting point in terms of demand for cars, but the flip side of it is a lot of people are staying suburban because they don't have to drive as much as they used to. So, there's a little bit of a tradeoff there as well. You might be able to get away with more conversations in forums like this and one car.
Willy Walker: Yeah, at some point I'm pulling the two of you together into a studio and we're sitting around with live cameras because as much as I can see the two of you very well, and get your facial expressions on here, there is nothing like sitting face-to-face with somebody and seeing that human interaction and those little things that happen as you ask a certain question.
But Rich, play off of that theme as it relates to sort of the reignition of the city. You came out and said, you know, one of the stocks that you like the most is Simon Property. That’s very, I don't know whether it's a counter-intuitive, but there’s not a lot of people going long retail right now, and clearly, if you'd said that two months ago, everyone would be like, “What? Where's he going? You know big box-retail is dead, for all practical purposes.” So, we're seeing things change, I think, very, very quickly. What's your current sense of when we're back at it, and you're clearly quite bullish if I read correctly on multifamily and Simon Properties in retail, that the urban cores come back to life?
Richard Hill: Yeah, sure. Well, let me answer your last question first. Candidly, I am as constructive as I've been. I typically don't think you're supposed to be long real estate and long REIT at the end of the cycle. I mean, we haven't been recommending people broadly pound the table buy REITs for as long as I’ve covered them, which is since 2015. It's been a late cycle. I agree with what Rick has said. We didn't know something was going to happen, but we do know hundred-year events seem to happen every 10 years. I clearly didn't know Covid was going to happen, but you know ’88, ’98, 2008; we were three years late, but it happened. So, we are bullish.
On population migrations specifically, I would argue that the market was really complacent about population migrations prior to Covid. We saw all these trends that are playing out in Covid-19 in the years leading up to Covid-19. I think one of the more interesting facts is net out migrations of 35-year-olds from New York City have been there for two or three years. 35-year-old’s have not been moving to New York City for quite some time. So, we did see this move to the Sun Belt, and the Southwest, and the West Coast for a variety of different reasons. I am not a believer that the great cities of the United States are dead and never coming back. I think that they will come back as different, more vibrant, and dare I say grittier cities. That's okay, right? New York City was a very expensive city that didn't appeal to a lot of people. San Francisco was probably to the same degree. So, I think this will attract a new type of person back to the market and I actually think it's one of the reasons that we're seeing Class A apartments in coastal markets bounce sooner than what we were anticipating. There are people selectively moving back, opportunistically moving back right now, which is because rents have dropped so much.
But look, Willy, to answer your question, we write annual state of the series cycle report every October, and we titled this one “Darkest Before Dawn”. I am a steadfast believer that Covid-19 was a really, really good thing for commercial real estate. I know that's hard to believe but let me unpack that for a second. Commercial real estate, not just retail real estate, but commercial real estate has been overdeveloped and overbuilt for decades and decades and decades. What this is requiring the market to do is think about the rationalization of overbuilt real estate, take their medicine earlier, and by the way, inject CapX into their properties. It's not going to be easy; it's going to be a little bit painful. But I'm firmly of the belief that the remaining commercial real estate, on the other side COVID, whether it be a year, three years, five years from now, are going to be in a much better position from where they are today. So, I come out of this thing, this is a good thing. Fundamentals are rebounding, and I think the asset classes are going to emerge much stronger because the weaker aspects of it will effectively be prudent.
Willy Walker: So, Rick if you take that as the sort of backdrop what's going to change here? In other words, as you think about consumer finance, as you think about the banking system, as you think about a bullish view on the equity markets, a bullish view on commercial real estate. You know, one of the reasons you downgraded consumer finance in October of 2019 is you couldn't have everything going perfect at the same time, so what's the element we're missing here?
Rick Shane: Sure, so again, I really agree with the point that rich just made about sort of the normalization or the reversion that we would expect. Six months ago, I think everybody was working from home and thought working from home was the greatest thing and everybody wanted to work from home forever and you saw all those announcements and employees were excited about it. The number of people I have encountered in the last month who are relieved to be back in their office, Rich is in the office today, perfect example, there's something to it. Also, personally I am part of the urban exodus or the suburban flight having lived in San Francisco for 20 years, we moved out last May and I have not been to the office. I’ve been to the office one time since last March. I was in the city last week, for the first time in ages and it was a 45-minute drive. My commute went from 15 minutes to 45 minutes. I think Rich is right, when I go back to being in the office more often, not only because JP Morgan's going to ask me to be there, but because I want to be there, because of all the benefits of being in the office. That additional commute is something that I am going to need to rethink, and I think that if you’re…go ahead, Willy.
Willy Walker: No, this is exactly where I got to last week in a conversation internally at Walker & Dunlop. This flexible work schedule: I am going to be in the office today from 8:30am until probably about 1:30, 2:00 in the afternoon. I am going to hop in my car out of rush hour traffic and I am going to be home in 20 minutes. If I had moved to an hour and a half from my office, that flexibility of doing in face meetings in the morning and then going on to a Zoom call in the afternoon to be ready for a dinner, a workout, a kid’s concert recital, whatever the case might be, you lose. So, I think that one of the things a lot of people have thought is the technology is sort of permanent and you're either at home or in the office and my thinking about it is, is that the office is still going to be where culture and creativity happen. We're all going to need to get back into that environment to share ideas, share a common sense of purpose. And then, at the same time, be able to benefit from what the three of us are doing right now. But if you live an hour and a half, from your office you lose that flexibility. And I think people like you are going to be challenged to stay that far out versus moving back closer to the office to get access to that flexibility.
Rick Shane: I think that's absolutely right and again when you think about that young urban, traditionally urban professional, that's going to be even more acute. So, I agree with you fundamentally there. And I also agree with the premise that what we're basically going to see is more of a hybrid, best of both worlds type approach, which is you're in the office on the days you need to be, you can work from home on the days where it works well and when you're doing your meetings online. The same goes for corporate travel. We're looking at the same way in terms of our coverage of the credit cards. You know it's been nice not to be on a plane all the time, but I have to admit at a certain point I’m starting to miss that interaction. I've traveled you know 150,000 miles a year for 20 years. I have a lot of friends that I have not seen in 12 months and I’m looking forward to seeing them. And the other thing is this, the first time I’m on the phone with a client and I’m having a great conversation and that client says to me “hey Rick, I really appreciate the time, but Rich Hill is coming in for lunch in five minutes and I got to get off the phone”. I’m going to be on a plane. So, we're going to see this in a series of waves, it's going to take a little bit of time, but over and over again we've seen that we get back to the norms.
Willy Walker: I completely concur on that one. I've been saying that for a while and I think that we do see a snapback. It's the competitive environment. It's to exactly what you just said. If someone's going to have lunch with Rich and they're buying his research versus yours you're going to go have that exact same lunch. I think that's something that a lot of people have forgotten that right now this is the medium at which we are all competing. We're all using the same medium to compete to get clients and maintain client relationships. The moment that someone is capable and willing to go meet face to face with someone, and that makes them either successful or makes you not successful. Your competitive landscape is shifted, and you've got to modify it here to what the new competitive landscape is.
Rick Shane: Well, there's another factor too, which take Rich for example. Morgan Stanley has been investing in his travel and his relationships since 2015. They were in a position last year where they could harvest that, but the reality is you can't harvest that indefinitely. Especially because there's always going to be someone who is coming up, who's willing to do that, and if you don't participate in that part of the market and this isn't true for just research analysts. This is true for people who are selling medical supplies or whatever it's going to be, once the ball starts rolling, it'll roll fast.
Willy Walker: So, Rich let me ask you something as it relates to inflation rates and the dollar. So, there's a huge amount of capital chasing commercial real estate most specifically right now multifamily and industrial. Clearly the data that you publish shows that, as far as multifamily and industrial did the best as it relates to aggregate sales volume, price appreciation or lack of losses. Whereas the other asset classes of office, retail, and hospitality all suffered, hospitality suffering the most. As you look at the inflation outlook, everyone's freaked out that inflation might actually surge beyond the 2 percent number and that the Fed might have to raise rates. That's really good for fixed assets right, so as an inflation hedge fixed assets look pretty darn good. If you think about rates being relatively low, yes, they may go up, but you still got positive spread between what you're buying at and what you're financing at. And then finally the dollar, the strength of the dollar and as far as putting any currency to work if the dollar continues to appreciate. Having a bet in a fixed asset in the United States looks pretty good. Am I speaking my own book or do all those data points check out with you as it relates to why commercial real estate in the U.S. should do well? And I see Rick is laughing at me and I’m guilty as charged on that one, so take me down off with speaking my own book if that's not correct.
Richard Hill: Well, first of all, this is your webcast.
Willy Walker: I've been accused a number of times, particularly during the political season by people saying “oh well Willy’s got some agenda below it” and we had someone come on to the webcast who said “I like single-family and not multifamily”, and I said “if I was trying to curate where the conversation was going I would not have had that person on the webcast” so you tell me the truth and nothing but the truth.
Richard Hill: So, let me back up and tell you where we think the market has historically, maybe looking at the wrong fact patterns to why commercial real estate has done well into a rising interest rate, rising inflationary environment. And then I want to check myself as to why this time might be different.
If we go back to 1980, we've been in a secular decline in 10-year treasury rates. Believe it or not there has been less than five months since 1980 and I’m not great at math but that's a lot of months where the 10-year treasury has not been lower than where it was a decade prior. So, in January 1990 it was lower than where it was in January 1980 and January 2000 it was lower than where it was in January 1990. Secular decline i 10-year treasury. That is constantly allowed commercial real estate borrowers to refinance into lower and lower interest rates. Important because commercial real estate's inherently a levered asset class. So, you could make the argument that these temporary blips, these rising interest rate environments we've seen over the past four decades are actually small blips on a secular decline in 10-year treasury rates. And of course, commercial real estate would do really well into a rising rate inflationary environment because financing costs are actually coming down from where you finance 10-years prior. NOI growth is accelerating, and lending conditions are loosening. So, if we were speaking 24-months ago I would have told you a rising interest rate environment was a really, really big challenge for commercial real estate. Particularly given $2.3 trillion of commercial mortgages maturing of the next five years.
Let me fast forward though and tell you where we are today. I am questioning if that thesis was wrong, not because it was wrong, but where commercial real estate sits today. Rates are actually doing really well in the face of a rising interest rate environment. They’re up around 8 percent year to date. That’s almost what we were expecting for full year returns five months ago. Why has that happened. Well, it's happened because the IRR you apply to own commercial real estate is coming down despite interest rates rising because the risk premium is coming out of the market. Said another way, commercial real estate whether it be REIT, debt or real property is pretty cheap compared to the S&P 500. Is pretty cheap compared to $15 trillion negative yield fixed income and as the market has more conviction in the recovery, the discount rates have gone down. And so, there is a good chance that, if we stay in this rate environment and even go a little bit higher commercial real estate does perfectly fine because of the amount of money that you've seen on the sidelines. And that leads me to my next point.
I think there is a sea change happening with commercial real estate where it is becoming increasingly attractive for long term permanent capital. Primarily active managers and private equity. Why is that the case? Well, you have passive management that's becoming increasingly competitive with active management. They're having moved into alternative strategies, commercial real estate being a big beneficiary of that. But, more importantly, I think commercial real estate is becoming a true surrogate for traditional fixed income given that the traditional 60/40 equity fixed income mix is not as attractive as it used to be. So, when I speak to institutional investors, they're largely telling me that their allocations of commercial real estate that stand at the 10-12 percent range are going higher for a number of different reasons. So, look it's not as though it's super cheap, we're clearly not at the bottom here. Property evaluations have continued to rise but we live in a relative world and there's a lot of reasons to suggest commercial real estate can do a lot better than what we were expecting two years ago.
Willy Walker: So Rick, as I think about where we're going from here, and you cover a lot of big financial service companies as well as specialty finance companies, how big is fintech as far as a differentiator between the winners and the losers? And as you look at card issuers, if you look at auto finance etc., etc. there are Fintech firms that are gaining market share, they're stepping in between and sort of disintermediating the old relationships with new relationships. As you look out right now how important is Fintech to the industry you're covering and who's really on the cutting edge as it relates to Fintech?
Rick Shane: Sure, so I’m going to pass on naming specific names to that question but look, I think it’s a mix. You take a company like American Express and American Express is 175-year-old company, yet it has technology that we all rely upon on a daily basis. It has a closed loop network that frankly provides a high degree of security and transaction confidence, and enormously good customer service and all-around. That's something you can replicate. On the other hand, they have looked at a trillion dollars of transactions a year for the last 20-years or close to a trillion dollars in excess of over that time. The data that they've gathered associated with that they haven't been standing still not looking at that information. So, I think it is a little bit dismissive to say there's fintech and there's traditional financials because the reality is that those traditional financial companies are building incredible technology underneath what they're doing. And at the end of the day, replicating the ability to fund a trillion dollars of transactions or in the case of CapitalOne, hold a hundred billion dollars of credit card loans on your balance sheet, that’s very, very hard to replicate. Those are real competitive, those are barriers to entry. So, I think you will continue to see companies innovate and they will compete, but I don't think they're going to displace the big traditional finance companies. And again look, I may just be the old fuddy duddy who's not on LinkedIn but that is one hypothesis here. But at the same time, what I've seen over and over again over the years is that it's really hard to find a loan and an opportunity that someone can make a better decision and price more efficiently than CapitalOne. Rich Fairbank who founded CapitalOne has been a technology innovator for 35 years. And to find the margin that he's not making in that space, to make a decision that he's not making, yeah in the short term, you can mis-price risk and take out a loan in good times that he doesn't want, and it'll look good, but over time that's pretty hard to do. So, it's going to be, I think it's going to be balanced. You've seen a tremendous number of successful innovators, but at the same time, the top six credit card issuers still have dominant market share.
Willy Walker: So, Rich in closing, because we're running out of time and I could keep talking to the two of you all afternoon long; I’ve still got about five more pages of questions for the two of you. I might just ship them off to the two of you in a quiet moment and you can respond to them for me. But as you look out on commercial real estate, you said you like Simon Properties that says a rebound in retail. You know were you bullish and were your sort of holding back, not on specific names, but so you like multi, you like retail, what's your take on hospitality rebound and office rebound in summary fashion, if possible?
Richard Hill: Yeah sure, office, the jury is still out. We think that there will be structurally higher vacancies on the other side of COVID-19 because there will be some flex for all the reasons that we have all mentioned. That leads me to be bullish on new, clean and green Class-A office, particularly well positioned Class-A office. I don't think that's going away, there is a need for it. God, I can tell you how nice it is to have my team in the office with me and see someone and talk to someone. I am much more concerned about old Class-B and C office that needs a lot of CapX to just survive. That has some similarities to Class-B and C malls to me. I think the jury's out and maybe we're going to turn around 12 months from now and say it's better.
Hotel is a really interesting asset class. The debt markets really like it here because they can underwrite with a pound of flesh where the recovery is going, the equity markets have been behind it. I'll tell you that we're much more bullish on gaming rates that we are hotel rates. I look at gaming rates that are triple net structures on really strong land, backed by strong tenants, and I don't understand why that's a six and a half percent cap rate asset. That to me feels like it's more like a four and a half percent cap rate asset. So, I would tell you in hotels, regional hotels, limited-service extended stay, I can really get behind. The white-collar hotels, the Ritz Carlton Atlanta, Georgia I’m not as bullish because I think it'll take some time to come back. So hopefully that is a nutshell, but I can keep blabbing on if you let me.
Willy Walker: No, it's all great. I try and keep this thing tight and close at the bottom of the hour and I've got as I said, plenty more questions for the both of you. But I want to thank both of you for joining me today. And both of you are so insightful in your markets and I love reading both of your research.
Thank you to both of your firms for the partnership that both of you have with Walker & Dunlop and thanks for taking the time to share your thoughts in the markets with me today.
We are back next week with another Walker webcast. Thank you everyone for joining us today and Rich and Rick, thanks very much and have a great, great Wednesday.
Richard Hill: Thank you, thanks for having me.
Rick Shane: Thank you guys.
