Invest Like the Best with Patrick O'Shaughnessy - Sorin Capital – Retail Contrarians - [Invest Like the Best, EP.68]

Starting point is 00:00:00 This podcast is sponsored by CFA Institute, the Global Association of Investment Professionals whose mission is to lead the investment profession by promoting the highest standards of ethics, education, and professional excellence for the ultimate benefit of society. CFA Institute serves a global community of investment professionals working to build an investment industry where investors' interests come first, financial markets function at their best, and economies grow. The chartered financial analyst credential is the most respected and recognized investment management designation in the world.

Starting point is 00:00:30 The views expressed in this podcast do not necessarily represent the views of CFA Institute. Hello and welcome, everyone. I'm Patrick O'Shaughnessy and this is Invest like the Best. This show is an open-ended exploration of markets, ideas, methods, stories, and of strategies that will help you better invest both your time and your money. You can learn more and stay up to date at investorfieldguide.com. Patrick O'Shaunicey is a principal and portfolio manager at O'Shaunicee Asset Management, all opinions expressed by Patrick and podcast guest. are solely their own opinions and do not reflect the opinion of Oshamacy Asset Management. This podcast is for informational purposes only and should not be relied upon as a basis for

Starting point is 00:01:14 investment decisions. Clients of Oshonasi asset management may maintain positions in the securities discussed in this podcast. So far, I've spent no time in this podcast discussing real estate, so I was excited to get the chance to talk to the team at Soren Capital, a billion dollar hedge fund which specializes in commercial real estate, reits, and commercial mortgage-backed securities. Soren is led by Jim Higgins, who founded the firm and Tom Deacon, who coincidentally was a college classmate of mine at Notre Dame. This conversation has two angles. The first, which starts about 20 minutes into our talk after we introduced the sector and the opportunity set, is a deep dive into a specific trade,

Starting point is 00:01:50 a fairly contrarian take on the retail industry, specifically comparing different types of retail real estate. As you'll hear, the dispersion of mispricings in the sector may be huge, creating opportunities for specialists to earn real alpha, by doing bottom-up work. The second angle we explore is what I believe to be a strong model for the future of asset management businesses. That is, tailoring products, strategies, and even specific trades to the needs and risk return profiles that clients want to need, instead of just selling a one-size-fits-all commingled fund.

Starting point is 00:02:21 You probably heard me joke that this podcast should be called This is Who You're Up Against, and this episode is a good example of why. I always enjoy exploring a niche part of the market, and this conversation on real estate is a perfect example of the type of work that firms do on behalf of their clients. Please enjoy my conversation with the team from Soren Capital. All right, Tom and Jim, this is going to be the first time that I've spent any time on the podcast exploring real estate specifically. We've done a decent amount of quant research into just REITs, which I know is just one

Starting point is 00:02:53 component of the real estate world. So for my own edification, I thought the best place to begin would be for you both to outline this world, broadly speaking. It's a nice one because the underlying assets here are something very tangible that everyone can appreciate, office buildings, residences, real estate of all kinds. But it would be great to get a sort of summary of the topography of the space. What does it look like? What kind of assets are there? How can you access them?

Starting point is 00:03:20 And then we'll use that as a jump off point. Yeah, I think that's a good place to start. I mean, I think just to start out, I mean, it's a big space. It's a big space for sure. When you look at the numbers, the U.S. commercial real estate market cap, if you will. is around $7 trillion. So to put that in perspective, the single-family home market is around $22 trillion. Obviously, the housing market is going to be bigger. But $7 trillion is obviously a massive asset class. The New York Stock Exchange alone also just put in perspective is around $19 trillion. It was the last number I saw.

Starting point is 00:03:51 So it's a big sector, but I think that while people can really appreciate commercial real estate in that it's at the center of most every economy, it's not something that they always feel as accessible in the way of actually trying to access some of those returns, as you put it. So just to kind of break that down and talk about how that $7 trillion has really broken out, or more importantly, I guess, how you would get access to some of those returns, there's really four ways. One would be going out and buying a building. The other would be originating or participating in some way,

Starting point is 00:04:21 lending on a commercial real estate asset. And then the two liquid ways to access it, the liquid commercial real estate that we really focus on, would be the commercial mortgage back securities market, also called CNBS, and then the REIT market. The REIT market is broken up in two. The actual property reits are the bigger of the two groups. The second group would be the mortgage reits. The property reeds actually own and operate buildings, whereas the mortgage reeds are either investing in commercial mortgage loans or financing them in some capacity. So we focus more on the property reeds themselves. Just to break that out even further,

Starting point is 00:04:57 So on 7 trillion of commercial real estate market cap, there's 4 trillion of mortgage debt. And that's by looking at the Fed data as of the end of last year. The CNBS component, which is what we look at, which is at the liquid end is a trillion. So it's around 25% market share of the mortgage debt. And then in looking at REITs, you have 1 trillion of REITs as well. So you're talking about of the 7 trillion market cap of commercial real estate, 2 trillion are what we consider to be the liquid ends that we focus on in the security side. I think I'd just add there, you know, for us, we're a specialist manager, right?

Starting point is 00:05:34 So we are liquid commercial real estate securities and commercial real estate loan investors, which is, you know, it's very specialized and it's a niche. But at a trillion market cap for CMBS, a trillion market cap for REITs, they're big enough where there's quite a bit to do and they're interesting, but they're small enough where not everybody is participating in it and there's not that many kind of true specialists and experts in it. So it's kind of a nice combination of big enough but not too big and a lot of inefficiencies for a manager like us to take advantage of. The next question that that begs is sort of the profile of the investors in the space relative

Starting point is 00:06:15 to the profile of investors in, let's say like the broad equity markets or debt markets. So is there a different profile of people that tend to own, I guess, real estate more broadly speaking, whether it's institutional investors, individual investors with different motivations, versus a more traditional investor sets. So, like, who are the owners? Commercial real estate is an asset class. Pretty much every institutional investor out there probably has an allocation to commercial real estate just because it's such a major asset class. So, you know, you've got pretty much any major institution, they've got private equity, they have alternatives, they have commercial real estate. and then they have your traditional fixed income and traditional equities. So most every institutional investor is exposed to commercial real estate and has a regular allocation.

Starting point is 00:07:00 When you start getting into the liquid end of commercial real estate, CMBS and REITs, that drops off a lot. So one of the interesting things is we talk to some of these institutional investors is when you go to the commercial real estate group, they hear CMBS REIT's liquid securities and they point you down the hall. to either the equities or the fixed income guys. And then when they hear it's commercial real estate related, sometimes they point you back down the hall to the real estate guy. And then if it's a long short strategy, they'll point you to the hedge fund guy,

Starting point is 00:07:34 which then points you back to the real estate guy. So, you know, it's a unique combination of characteristics that they have where it's, you know, it's part security and it's part commercial real estate. And again, so that kind of sometimes makes it fault. the cracks for some investors, which again goes back to creating opportunities. It's not an overcrowded space with people that are really looking to do deep dive credit work. The investor base for CNBS and REITs, it's evolved over the years. I mean, for CMBS, I mean, the sector has really only been around since early to mid-1990s. And so 15 years ago, primarily it was insurance companies

Starting point is 00:08:15 that were the primary investors in CNBS. 10 years ago, heading into the financial crisis of 0708, you had a ton of structured finance vehicles, CLOs, CDOs, SIVs, and hedge funds pretty much across the board that were investing in CNBS, regardless of whether they were specialists or not. The financial crisis kind of changed all that, right? I mean, you don't, you know, you're not really seeing SIVs and CDOs, and you're not seeing as many non-specialist hedgehogs.

Starting point is 00:08:45 funds playing in it. Currently, you've got a lot of big money managers, so kind of your traditional asset managers that have allocations across all aspects of fixed income, mutual funds, hedge funds are still playing. You do have non-specialist hedge funds that are still playing. But the most common characteristic is in CMBS, the investor base, it's dominated by beta investors, and investors really just looking to get sector exposure. Reets kind of similar in how it's evolved, going back even further, because REITs have been around a little bit longer. 20 years ago it was primarily retail individual investors, probably over 85% of the market. 15 years ago, you started getting more dedicated retail mutual funds, a lot of Asian investors

Starting point is 00:09:29 and Asian mutual funds, particularly Japan. And now you're seeing some hedge funds, some generalist hedge funds playing in it, along with retail, dedicated mutual funds. So, you know, kind of a broad base of investors. One of the key things always is motivation for investing in us. If you're going to carve out an asset class as something separate that's not, say, lumped in with an equity exposure or just a broad fixed income exposure, is that you're expecting some unique characteristic, whether that be low correlation, a higher average yield, you know, more tangible underlying asset, you know, asset intensive type businesses. So maybe highlight for each of those or for the two main categories being, I guess, individual investors and more institutional investors. what are the structural attractive characteristics of a liquid real estate portfolio, a liquid

Starting point is 00:10:16 real estate portfolio specifically? I think when it comes to real estate, the reason it's so attractive is that it's dynamic. Properties can be both offensive and defensive. It can grow like equity, but also can provide as much security as a bond. I think that there's a lot of data that will show they can also serve as some form of inflation protection. We've seen different data on the core, you know, a lot of people say there's a low correlation to other asset classes, but we're a lot of people say there's a low correlation to other

Starting point is 00:10:39 asset class is, but we know that correlations tend to increase in times of stress. So you're not always, that's not always a place to hide there. But on top of that in this environment where, you know, a zero interest rate environment we've been living in for a while, there's significant yield in the space. And I think that's very attractive. Let's talk about your own kind of evolution, given that you guys have been operating in this space for a long time. I think that like any niche where your story about, you know, people pointing you to other parts of the hall resonates. If I was an investor in this niche, that makes me happy, that there's not like some dedicated resource looking just at managers. It kind of doesn't fit one particular bucket. But maybe talk about Sorin the business,

Starting point is 00:11:17 how it began, maybe your background, Jim, before Soren, as a precursor to us getting into structural inefficiencies here because of the conversations I've had on the podcast, some of the most interesting ones have been these kind of more esoteric niche parts of the market, where perhaps there are more inefficiencies that are more lasting than, say, the S&P 500. So some background I think would be good. Yeah, sure. So, I mean, my entire career has been commercial real estate related, and so that goes back to the late 80s, which makes me feel pretty old. Started my career at a commercial bank in Chicago as a construction lender right out of the credit analyst training program. And being a construction lender in the late 80s, early 90s,

Starting point is 00:11:57 was pretty much of an oxymoron because that was probably one of the worst commercial real estate markets coming out of the SNL crisis. You know, banks were having major struggles, some banks went under and the main reason was their commercial real estate loan portfolios. And out of that crisis, you know, the RTC started using the securitization model to try to get rid of some of the loans and to help out some of these bank balance sheets. And so that whole securitization business model that had already been applied to residential mortgages, started to be applied to commercial mortgages and that intersection of kind of capital markets and commercial real estate really, it made sense to me.

Starting point is 00:12:35 Can you expand on that notion a little bit? So most people, when they hear securitization of real estate, are going to think about one thing, which is residential securitization that kind of blew up the economy in 2008 and 2009. I mean, commercial mortgage. Talk about why it's appealed. Yeah. Commercial mortgage-backed securities, much simpler from a structural standpoint, much more vanilla than the residential world.

Starting point is 00:12:58 Usually when people have kind of bad visions in their head about mortgage derivatives, it's usually the residential world that had some, you know, pretty. esoteric, funky structures that created some very unique, some high-risk profiles. CmbS is pretty basic, pretty vanilla. There's not a lot of structural complexity in it. Could you describe the basics of how... Yeah, so securitization, really what it does is it takes a particular asset, in this case, it's commercial mortgage loans that used to be really just held by insurance companies,

Starting point is 00:13:31 banks and pension funds, and it expands the investor base by taking those loans. and creating different profiles of securities with those loans as raw materials. So rather than having just one 10-year commercial mortgage loan with a 6% coupon on it, you can take a bunch of those loans and create a three-year bond that's much more senior than anything else in the structure and have a much lower rate on it, create a much more subordinate bond that's a much longer 10 or 12 year bond, which with a much higher interest rate and a range of bonds and profiles in between. The motivation for which being investors have different priorities, want different duration, want different yield. So it's basically a way of taking

Starting point is 00:14:16 one consistent underlying thing or pool of things and providing a bigger measure. Yeah, the ultimate motivation is to bring more capital into a sector by expanding the access to more investors and to create different profiles. So there's more investors with different profiles that can participate in it. You know, I think, again, people have been attracted to it because, you know, they understand commercial real estate. And while security is a little different, they still understand that, you know, the underlying fundamental analysis is commercial real estate. We're also seeing that more institutions are starting to consider the liquid real estate investments in their more traditional commercial real estate bucket.

Starting point is 00:14:56 As in a swapout, meaning they'll sell hard assets in favor of what? Less of a swap up, But more, if they say, look, you know, 10% of our overall portfolio is allocated to commercial real estate, that they might take 10% of that 10% and say, we're going to have that portion be in liquid commercial real estate related assets. I think especially coming out of the crisis, they see that while commercial real estate is attractive in a lot of ways, it's also very ill-liquid. And when you're in ill-liquid asset, your short opportunity options. And so for those that had cash or liquid investments that when the storm clouds started gathering in 2007, when some people started to get to cash, they were then in a position to take advantage of some fantastic investment

Starting point is 00:15:41 opportunities in late 2008 in 2009. And so one thing we've talked to some of our clients about in their real estate, commercial real estate allocations is have a small portion in something that's liquid so that your long opportunity options. I mean, we're, what, eight years now into a pretty historic asset inflation cycle, driven in large part by historically low interest rates and a lot of involvement in the markets by central banks around the globe. I think there's a lot of investors out there that are a bit nervous and have a hard time finding a lot of deep value out there. And while I don't think anybody's comfortable saying, oh, there's a big downtrade in the market coming anytime immediately soon or predicting when that's going to happen,

Starting point is 00:16:24 I think we are finding more and more investors wanting to be cautious and having some ability to be tactical when and if there is a down draft of the market. So having that liquid component in a commercial real estate portfolio, I think, is starting to gain a little bit more traction amongst institutional investors. It kind of reminds me of the research papers showing that levered small cap equities, public small cap equities or mid-cap value equities could replace your private. equity allocation and that there's no real reason that the illiquidity premium maybe isn't what it once was and that you're seeing something similar in reits today. So you were in the midst of it

Starting point is 00:17:02 in sort of the creation phase of the CMBS sector in the 90s and then you moved, I believe, to Bear Stearns. So talk a bit about Bear and then the transition to, I guess, the motivation for founding your own business that's doing something very specific in the space. Sure. So I, you know, I joined Bear in March of 97. Actually, I think it was St. Patrick's Day. I remember. March 17th, 1997. And that was still in the infancy stages of the CNBS market. It was developing. It was evolving.

Starting point is 00:17:31 And the market went from being 40 to 50 billion of annual CNBS issuance to almost $200 billion by 2007. So I left Bear at the end of 2003 at a point in time where it felt like things were getting pretty aggressive in terms of CDOs, CLOs, SIVs. And little did I know that that was just at the very beginning stages because it got much more progressive heading into 06 and 07. But what I saw was in commercial real estate investing, there was only one option, which was to be long and to be exposed to the market. And there really wasn't any relative value or long short options. So I felt there was an opportunity

Starting point is 00:18:10 for a well-conceived long short strategy, and that was the impetus for starting Soren. And we got pretty good interest early on where there's a lot of investors in the alternative space that are looking for something different, where they're looking for a different risk factor, return driver. And so a long short strategy in commercial real estate securities was unique. There just really wasn't anything out there like that. So when we launched, we were really the traditional hedge fund. Here's our fund. Let's try to get 50 to 100 LPs all in one fund and do what we do. And it worked fine in the bull market. But what we found heading into the crisis was every LP has different views, different philosophies, different tolerances, different

Starting point is 00:18:54 goals. And so having just one fund with 100 LPs in it, particularly in something as unique as structured products in CNBS and REITs, that, you know, there was a lot of risk of value transfer with investors wanting to come in and out, especially during challenging markets. And then also everybody wanted something a little bit different. So coming out of the crisis, our firm evolved to where rather than the goal being, let's have 100 LPs in one fund, we'd rather have have a few dozen LPs in a range of portfolios that are customized towards individual LPs or groups of LPs that have kind of similar profiles and similar tolerances. So it really kind of goes to the one size does not fit all.

Starting point is 00:19:38 And I think it really lends itself well, particularly to a niche sector like ours, where, you know, there's lots of different profiles that we can create. I mean, we have one very large institutional investor. It's probably one of the largest allocators to alternatives in the world. we're doing four different things for them. And the profiles are very different. Fee structures are different. The risk parameters are different.

Starting point is 00:20:01 And so that's really the way that our business has evolved to where we're trying to be much more customized, much more of a bespoke provider and being more than just a here's our product. We're saying we're really good at this space. Let's talk about what's interesting and what it is we can do for you and what it is your goals and your needs are. So we'll use this as an opportunity to talk in-dash- about a very specific trade. In this case, retail. And we're going to come at retail from kind of all different angles, from the credit angle, from the equity angle, and from the kind of macro viewpoint that you have as an opportunity here in a discrete period of time. So Tom, maybe

Starting point is 00:20:36 you could start by at a high level outlining the situation that we're in. Retail is going to be popular because retail is a popular topic today in markets, in large part because of one stock Amazon. So maybe just give your general impression. And then we'll go into a trade like this so that everyone can get an idea of how specific something like this comes together inside of a hedge fund. Sure. No, retail is certainly a great example of the typical kind of thematic dislocation that you'll see in commercial real estate securities. So just by way of background, take a step back for your listeners. As many of them will know, the retail industry and frankly anything with perceived exposures to their retail industry have recently come under fire. In the second quarter

Starting point is 00:21:16 of this year, retail became the highest yielding sector in high yield, officially overtaking energy. We stopped keeping track, at least in the last two months, but as of a couple months ago, we already had over 1,500 store closures. That number is definitely over 2,000. And that's really just looking at more of the national chains and you have an even larger pipeline looming. We've had more than 10 major national retail file for bankruptcy in 2017 alone, countless more companies on watch. I saw a stat that if you include some of the smaller, more local players, the numbers upwards of 300, which to put in perspective is more than what we saw bankruptcy-wise in 2020.

Starting point is 00:21:52 2003 to 2006 period in total. And that's, you know, in the span of half a year. So it's pretty impressive. So on top of that over the last nine months, many retail-related property reeds have declined in excess of 30 percent. Select CNBX tranches with higher than average exposure to retail are down 10 to 15 or more percent as well. One vocal market participant has gone so far as to label CNBX the next big short based largely on a negative retail industry thesis. The impending death of malls has been a popular media storyline that is constantly in the headlines. Frankly, every institutional investor we speak with is asking about retail, tell me about malls, tell me about CNBX. Thus, we have diverted a ton of resources to dig even deeper on this

Starting point is 00:22:34 subject. So what's our take? Our take is that this isn't new. Retail has always been the sector that we were most concerned about and the sector that we spent the most time on relative to other sectors, especially being credit investors. The retail industry, frankly, it's constantly evolving. Some tenants are failing, some are thriving, and new ones are coming on the scene. That's just, that's been the case since the beginning. Just by way of example, J.P. Morgan had a great slide in a research piece a couple months back, and it depicted Simon Property Group's top 10 tenant roster since their IPO in 1993. And what you'd see is that that tenant roster has turned over more than three times since their IPO in 93. So I think that just puts in perspective.

Starting point is 00:23:13 that retail industry is frankly always changing. Retailers are coming and other retailers are going over time. I mean, frankly, Sears, Macy's, J.C. Penny, and even some of the smaller struggling apparel retailers seem to attract most of the headlines. But many other retailers appear to be growing and thriving. Some examples that we all know, Warby Parker, Abel, Apple, Bonobos, Athleta, Anthropology, you know, the list goes on. So the point is it's definitely a story of winners and losers. you know, many on the ground creep professionals that we speak with reject or at least question the death of shopping centers and malls narrative. While the prospect of online retail sales making physical stores obsolete is certainly a good

Starting point is 00:23:53 conversation piece, consider that the absolute dollar of traditional retail sales is actually higher today than it was in 2007 and e-commerce sales still represents only 8.3% of those total sales numbers as of the end of last year. So we agree that the U.S. is over retail. We're not arguing that, but I think we would make the case that's a lot more nuanced than that. The headline number that everyone likes to reference is 23 square feet per capita of retail square footage in the United States. When you compare that to other developed countries at five square feet per capita, certainly a big difference. Five being like the international average.

Starting point is 00:24:30 Exactly. Looking at other developed countries. So there's a huge difference there. But you need to unpack that a little bit and actually look at the composition of retail here. And what you'll find is that more than half of that square footage is made up of malls, department stores, and other large anchor tenants. Thus, when you break it down, it's really just that the U.S. is overmalled and frankly over appareled. And this is not new to anyone that's been falling in the space. And so while malls will continue to close, not every mall is a bad mall.

Starting point is 00:24:57 And I think even more importantly, not all retail real estate is a mall. We believe this is a healthy, natural evolutionary process. And it doesn't mean that all malls are bad or high risk necessarily. It's an important point that this is one big trend. And one of the key things we've seen in markets is bundling of securities, you know, reads and of read ETFs as bundles of other kind of themes or industries or whatever. And that often the behavior that that can create is a high level narrative sort of washing out maybe competitors within the space that don't deserve to be, which obviously could create an

Starting point is 00:25:33 inefficiency or an opportunity. So maybe let's dive, again, deeper into the composition. of an example of a trade. So an example of where markets are, you know, Macy's is doing terrible, Coles is doing terrible, kind of the big headline names. Yeah, they're doing badly shutting stores, but you mentioned some are thriving. So from an investing standpoint, how do you actually take advantage of that? What's the positioning of the portfolio that allows you to take advantage? Sure. I think I'll let Rick take this one, but real quick, just to preface it, you know, as I mentioned, we did a lot of work. And frankly, Rick will tell you shortly that the price movement

Starting point is 00:26:07 that we've seen in some of the regional malls makes complete rational sense. The move we've seen in certain CNBX and CNBS cash bonds makes sense as well. But one area of the market that doesn't make sense, and we think represents a massive buying opportunity, is that select shopping center reits are actually extremely attractive, and it's a classic baby thrown out with the bathwater, where if you look at the chart between Select Shopping Center REITs that Rick has identified relative to a mall reet, it's really hard to tell the difference. And I think, you know, what we'll get into is the difference between, you know, those

Starting point is 00:26:37 businesses is really important. And also highlight that while they're related, the retail industry and retail real estate are two completely different things. I mean, obviously there's a connection and a relationship between the two, but real estate is a hard asset, which is occupied by retailers, but the dynamics that are affecting certain retailers, you know, that's a little different animal than what's going on in real estate, but getting back to the high-level narrative can impact anything that has the word retail attached to it, even if it's real estate. That's where we're seeing some opportunities being created. So, Rick, you want to flesh that out even more?

Starting point is 00:27:18 Yeah, I think it's exactly as my colleagues have kind of alluded to here and you as well, that the retail theme, broadly speaking, has sort of encapsured every single security and sector of securities in the market currently. And, you know, that's clearly a broad brush set of assumptions. And I think, you know, more specifically looking at retail, the business, as Tom suggested just a minute ago, is, you know, there's really a delineation that has to be made within retail. If we look at the 13 categories of retail and the penetration of e-commerce since its inception 20 years ago, okay, we have three categories that are losing a lot of share online.

Starting point is 00:27:57 And those are apparel, electronics, and books and music. clearly those are easily adaptable and scalable within that format, and so it makes sense. And those market shares have gone from roughly high, single digits to low double digits about five years ago to, you know, call it 20 percent today over the course of five years more than doubling their share. But the rest of the categories, which includes grocery stores, autos, et cetera, have barely budged from very low single digit penetration. So I think the story here is not the death of retail, but it is the death of apparel. and I think we have to be very specific about that because apparel lends itself to the online model. It's got a very high cost to weight ratio, which makes it easy to ship. You can order multiple items at a time.

Starting point is 00:28:41 So that business is under siege from online competition, and structurally that's likely to continue, we think, for the indefinite future. I think the key is that relates to real estate is that the mall business is very different from other retail formats. Okay, the mall business has very high concentration. of apparel exposure, typically 50, 60% or more. And then add on to that, you have department stores attached to the malls, which are typically 60, call it plus percentages of the square feet of a mall. So those businesses are also mostly apparel related.

Starting point is 00:29:15 So all of a sudden you have this very large-scale format of real estate, and its exposure is highly concentrated in one retail category that is under siege. That's problematic, we think. And so, yes, there is a structural. element to the mall business that we think is going to be a challenge for some time. Kind of stepping back to your question about how do you formulate that into a trade and sort of separate the wheat from the chaff? And I think clearly everything retail is being sold and discounted out of fear and the

Starting point is 00:29:47 broad narrative. But there are other formats of retail real estate, such as shopping centers, grocery anchored shopping centers, which have been sold off equally. And we think represent very compelling opportunities. have been sold well below their intrinsic net asset values and are businesses that are structurally much better situated to continue to perform well and thrive. Can you give, I want to give like a descriptive summary of the real estate in the retail sector kind of across the country.

Starting point is 00:30:18 So you've talked about malls and shopping centers. If there was a pie, right, that represented all the retail real estate out there, the hard assets itself, the actual buildings and real estate, how much is malls, how much much is shopping centers, what are the other key categories that people should think about? Right. So you have, call it, 100,000 retail assets, retail real estate assets, if you will, in the United States. Roughly 1,200 of those are what we would refer to as a regional mall, the mall that everybody is familiar with that is, call it half a million to a million square feet, anchored by two or three department stores. And then you have variations below that,

Starting point is 00:30:55 which include power centers, which are typically anchored by a number of big box retailers with small shop tenants in between. You have regional and community shopping centers, which, you know, have variant mixes of smaller boxes and small shop tenants. Some are often grocery anchored. And then you have kind of a neighborhood center, which is a smaller scale format, which you would find, you know, in more of a residential area. But, you know, all of these formats generally are suited towards people's everyday life. Other than the mall, that is, okay, the shopping center format is focused on lifestyle. People go there to do their grocery shopping.

Starting point is 00:31:35 They go to get their hair cut. They go to get their nails done. They pick up their dry cleaning there. They go and grab a bite to eat. These are typically centers that are, you know, one to two miles from the typical customers home, typically on their daily commute to work, to school, to wherever. And that is why these types of assets, okay, these shopping centers, center assets, especially grocery anchored assets, are still performing very well. The real estate is

Starting point is 00:32:00 very well located. The businesses are not under siege from the internet. I think we just, we're looking at some data very recently from a group I'll not name right now, but it showed foot traffic for malls versus shopping centers and also broken down by grocery anchored shopping centers. So mall foot traffic is actually in the second quarter down about 5% year over year, whereas shopping center traffic is up about 2% year over year, and grocery anchored shopping center traffic is up about 3%. So very clearly, you can see that this narrative about the death of retail requires a lot more nuanced analysis. And if you really dig down into the individual securities and businesses, you can see that there's really a lot of opportunity. This raises a ton of questions. The first of which is to describe

Starting point is 00:32:46 how kind of the mall, so the thing that's being most affected, how their business model works. Like, why is their success so integrated with some of these, you know, the Macy's of the world that we've talked about that have gotten their butts kicked in public markets? That's a fantastic question because the mall format really was born out of the department stores. So the department stores typically pay virtually no rent. And the subsidy is, in theory, or at the onset of the business model, was to the anchor department stores were the drivers of traffic, the primary shopping. destinations, therefore that traffic would be to the benefit of all the small shop tenants who pay much higher rents. And that's typically the business model. But today, that's been totally turned on its head, right? So the department store anchors are now closing stores. They're not the

Starting point is 00:33:36 drivers of traffic anymore. And I think, you know, again, this is another element of the business and the structure of it, I think, that presents a risk and a challenge going forward, because now you're in a position where the mall owner has to go and explain to their small shop tenants and justify, you know, why they should pay $35 or $40 or $50 rents when Sears, who's not driving any traffic, is about to close the store at the end of the mall, is paying $3. That dynamic, and the leverage in that relationship seems like it's likely to change at some point. For the malls themselves, you've seen some interesting speculation that, say, Amazon should

Starting point is 00:34:13 buy Nordstrom or Amazon should buy one of these big box department stores, really as maybe even only as distribution points, because the real estate that these places own, and I'm thinking about Macy's tends to be prolific. It's like in the best locations all over the country. So what do you kind of view as the future of malls themselves? If the business model is predicated on these kind of anchor tenants to pull people in and they're subsidized, what happens in the future? I mean, malls take up some enormous real estate and some really interesting spaces. How do you think that might be advantageously carved up by other players like, say, in Amazon coming in and buying one of these things? It's an interesting question. I think, again, we have to take a step

Starting point is 00:34:52 back down to the, you know, the individual asset level and, again, realize that there's great real estate and not great real estate. And so the great real estate will probably continue to thrive in whatever format it's in, or if, you know, it has a department store anchor that is struggling and needs to close the location, it's likely very easily backfilled. You know, I think that's, again, you know, to Jim's point about retail is not real estate, great real estate will always be in demand. It will retain pricing power, whether it's Macy's or Sears or Dick Sporting Goods or whoever is in it. If it's a well-located piece of real estate in a, you know, demographically attractive area, they'll be able to backfill it. One of the trends we've seen is in some of the

Starting point is 00:35:35 better located real estate is we've seen the mall owners be able to go and backfill some of those anchor boxes with smaller spaces. It requires a little bit of redevelopment, but backfill them with with smaller spaces and other anchors that are paying higher rent. So it's actually, in some cases, been a net benefit to well-located real estate. I think to your question about Amazon and perhaps their desire or need, some might say, for physical distribution and a footprint, I think there was a lot of speculation prior to the Whole Foods deal that perhaps they would acquire one of these department store companies for that very reason. And I personally, I wouldn't rule that out in the future. So how much of all of this, so you did a good job describing the

Starting point is 00:36:17 different types of retail real estate, how much of that is accessible through public market vehicle? So if you've got bonds that you can buy and sell, you've got reits that you can use for exposure, how much of it is accessible to a hedge fund to be able to trade and potentially arbitrage on this insight, assuming it's correct? Right. Now, that's a great question, and I think it really highlights the public reits and their portfolios represent the cream of the crop, if you will, of the commercial real estate market. So of those, kind of 100,000 retail real estate assets we discussed earlier, the public reits probably own the top 7,000. So in terms of, you know, what is available in public markets, it's generally the top

Starting point is 00:36:59 tier of that spectrum of the entire asset base, which makes it all the more interesting when you have a theme like this. The expression of these views in public markets is almost by default not going to be very accurate. So how high, just specifically high, has the correlation been with the mall, you know, shopping malls relative to, say, grocery anchored shopping centers. Has it been, are they down the same amount, literally down the same amount, kind of in contrast to that foot traffic stat you gave us? Yeah, in this recent episode, they have been down from the peaks, call it nine months ago. They were down almost the exact same amount.

Starting point is 00:37:37 They were both down about 40% from peak to trough. So clearly indiscriminate selling and fear pervasive. One of the things I always like to dig in on is, so if you've got to, a kind of contrary thesis for some subcomponent of this retail story, in this case, shopping, not malls, but shopping centers, grocery anchored, maybe anchored by somebody else, to ask the question, why won't the same thing happen to those retail categories? So if so far it's been primarily apparel and maybe electronics as a second one, you know, why doesn't the same fate, is Amazon just going to figure out some way of doing the same thing

Starting point is 00:38:11 with these other categories? Well, I think, I guess the data would suggest in some of these other categories that have proven more resistant to internet adoption is, let's take grocery for an example. And I think Amazon's recent acquisition of Whole Foods sort of validates the fact that that category is probably not ever going to be a large share of online sales. And I think the principal reason is, as I mentioned in the survey data that comes back is most people just don't want to, You know, they want to go and they want to pick out their own meat. They want to go and pick out their own dairy and produce. I mean, for packaged goods, I think that's, there's plenty of room for that business to be online. And it already is, I think, even among the traditional grocers.

Starting point is 00:38:57 But, you know, the meat and produce and dairy categories, I think people are always going to want to go and touch and feel their own food and not have that be in the hands of somebody online. So, Joel, so your role is as head of research. And obviously that's a different angle than specifically focusing on one little niche of the market or other. And I'm really interested kind of how you approach this same problem. So first, what is your mission, kind of overarching goal? Where are you searching for inefficiencies and what is the process by which you're doing so? Yeah. So basically, I think as we've kind of harped on a little bit already, it's all about the real estate.

Starting point is 00:39:33 You know, you have this broad narrative. You can't paint it with a broad brush. If you have good quality real estate, and that's really at the end of the day, but we're trying to find out. we will get on a plane and go, like if we find a pivotal property to a particular CMBS bond we're looking at, we're not afraid to get on a plane, go look at the market. We try to establish connections in all of these markets with brokers that know these markets very thoroughly. Real estate brokers. Yep, with real estate brokers.

Starting point is 00:39:57 And we try to get there. We try to, we run a car. We'll go around to the property. We'll not only look at the assets. We're looking at the market, the competitors, the ingress, we're looking at how's the neighborhood? Does it make sense for a non-zeroing. Nordstrom's anchored center to have, you know, if the houses are much lower end, you know, you have to kind of use common sense to some degree. So it's all about the real estate, right? And

Starting point is 00:40:20 that's what we're trying to figure out. Sometimes you, a lot of people in our industry kind of take a more macro view, top-down approach, but we're definitely bottom up. Like we actually go, look at the real estate. We were just offered a bond the other day. Like great example. It was a community center, shopping center in a very affluent suburb of Chicago. On paper, it checked all the boxes. Great household incomes. Household densities were great. It was on a highway with pretty good traffic counts. Look great, but they had lost a couple tenants. So we talked to a pretty good contacts in Chicago and found out that there's brand new centers going to the north and the south. This is old money in this area. Traffic is definitely moving away from this center.

Starting point is 00:41:01 So we ended up figuring where this bomb was being offered to us made no sense based off the risks. Whereas somebody just topped out would have been like, oh, this checks all the boxes. It makes me think of those scenes in like the big short where the guys fly down to Florida and they're asking them to same course of questions. They're like, what the hell is going on here? You know, you can't believe that this isn't priced into securities. Maybe give your favorite example of one of these kind of on the road examples of something crazy that you saw that maybe demonstrates the inefficiency that can exist once you get down to the very specific asset level. I was just going through my, just trying to think about a bunch of examples. There's been a lot of a lot of crazy stuff we saw.

Starting point is 00:41:37 Like one was hotel, major. market hotel, major brand right in the heart of the downtown. So on paper, it seemed like it made sense. You're close to all the businesses and everything. St. Louis? Yeah. I didn't want to call out any markets. But we sent an analyst down there and look at those hotels. Yeah, exactly. And my wife is from San Luis. We sent an analyst down there to look at it and they told him, frankly, at the front desk, don't venture out more than one block from this building at night. This guy was a little soft though. He actually put a chair in front of his door at night. He felt so unsafe. So this was, it looked great on paper, you know, right in the middle of where you want to be

Starting point is 00:42:14 seemingly. We went and it was just an absolute disaster. It was very smart about sending his analyst to the site inspections where you have to bar your door at night. Yeah, I opted out of that one. So let's talk a bit about the duration of something like this. So a lot of people talk about how markets have become so incredibly efficient, so difficult to source any source of excess return above, say, real estate beta, however, however you might define real estate, public real estate beta. So how long do these things tend to persist? Is this a sort of a trade that for your clients would be on for three months or three years? And how do you assess sort of when things have normalized? What are the variables that you're looking for to say, okay, the inefficiency

Starting point is 00:42:54 has been corrected. The relative pricing of malls versus other opportunities has closed. That inefficiency is gone and we need to look for another trade. Yeah, I think it's difficult to put an exact time horizon on the trade. But I think realistically, there are a number of capital. that we're looking for that we think will sort of cause the reversion, if you will. And that time horizon is probably anywhere from six months to a couple of years. It could be. And I think some of the catalysts that we're looking at are, one, in shopping centers, given their much smaller sized assets, there's regular price discovery. These assets are, call it $10 to $25, $30 million, maybe $50 million.

Starting point is 00:43:37 They trade regularly. almost every day. And you can see what's happening with the pricing in the real world in various markets all over the country. So one, you have regular and pretty visible price discovery that ultimately, I think, will, assuming no changes and there haven't been so far, that will continue to wear on the bare case, if you will. Some of the other catalysts are, one, just the operating results of the public companies that are owners of portfolios of these assets. They've been very solid, better than expected, continuing to perform well. And I think as that continues to play out, particularly relative to some of the mall owners whose results have not been very good and have been below expectations and trending negatively.

Starting point is 00:44:17 I think the longer that divergence continues to be visible in public markets, that will drive the reversion over time. The last catalyst is we think that the disconnect here is so extreme that we would be not surprised to see either public-to-private M&A or public-to-public-m-a. frankly. So just to close out this section, this kind of really deep dive on an individual idea or trade, without giving the actual positions, just give a flavor for how you actually position the portfolio across these different securities. So if you've got REITs and you've got bonds as ways of being long and short these kind of two categories, how does it actually come together in a portfolio? At least in CNBS, and I touch on REITs, I mean, CNBS, we definitely tend to construct the portfolio at least a little bit more top-down thematically, originally.

Starting point is 00:45:08 based on, you know, what's our goal here, risk return-wise, what's our view of the market? We then go bottom-up the security level. At the end of the day, it's all about security selection, especially in CNBS when you're playing the bottom of the capital structure. But you first need to understand how the different themes and securities in the portfolio are going to interact, especially under stress. With REITS, it's the same way. I mean, Rick, can you give a little window into how you think about portfolio construction

Starting point is 00:45:30 on the REIT side? Sure. I think the portfolio construction is driven by, one, the bottom-up individual security analysis and we we go very very deep down to the asset level which is frankly one of the benefits of having a team that looks at all parts of the capital structure having Joel and his team available as a resource to help analyze individual assets so we look at a portfolio in a very granular way and formulate our own sense of net asset value and then from there we're really focused on the you know the risk versus the reward and so we want that

Starting point is 00:46:07 asymmetry and where it is largest based on our analysis, we size positions accordingly. We have a lot of tools available to us that allows us to construct a portfolio to get the risks and exposure to those risks that we want and to hedge out the ones that we don't. So between the CMBS market, which has a very large and liquid derivatives market with about 30 different tranches that we can use to either be long or short. and then the read equity market, which has 150 or 200 names across a lot of different property types and individual, you know, individual operators. And then you bring in certain ETFs and other liquid market indices. You can craft a portfolio that really allows you to be pretty specific and pretty direct on the exposures that you're seeking.

Starting point is 00:46:56 So, for example, you know, this shopping center theme, and there's some select shopping centers that we feel are, you know, 30 to 40 percent discounts to their, underlying real estate value. That's what we want exposure to. And so we want to isolate trying to capture that huge discount, but we really don't want equity market beta. We don't want broad REIT market beta. We don't want exposure to more big headlines in the retail and apparel industry. But we have enough tools that we can manage a portfolio of hedges against what it is we're seeking to get exposure to where we can really isolate. Yeah, that's exactly kind of what I was getting at, which is, as I hear you guys talk about the dislocation, what it sounds, what the opportunity sounds like is effectively a market neutral pair trade that you get exposure to things that have

Starting point is 00:47:43 the baby that's been thrown out with the bathwater and can benefit regardless of what kind of happens at the macro level. But it begs the question then, why has this persisted? Like, why haven't others come in and take in similar positions with enough size to close that gap? Yeah. I mean, you asked before about, you know, is the market efficient? Eventually, markets, I think, are reasonably efficient, but defining how long eventually is depends on the specific sector. When you get into the liquid end of the commercial real estate sector, which is CNBS and REITs predominantly, I think we talked about it earlier. It's dominated by a lot of indexers and people that are just looking to get sector exposure, and there's not as many true specialist investors seeking out

Starting point is 00:48:29 hidden value as you would think. So, you know, these types of opportunities in CNBS and REITs, they can persist for a while, but eventually the fundamentals bear themselves out or eventually the non-sector specialists find it and get enough expertise through other formats to get involved. But I think it does come back to both the CNBS and the REIT sectors have predominantly beta-oriented investors that are just seeking sector exposure, which leaves a lot of opportunity for specialists seeking mispriced value. I would love to hear your guys' take on this meme that I've heard from a lot of people, which is that the growth of passive ETFs and passive investing style has lengthened the time

Starting point is 00:49:14 over which maybe some of those inefficiencies would be corrected. There's always this idea that being too early in our business is indistinguishable from being wrong. And so you may have identified the proper trend, but the timing of it could last so long that your clients don't stay the course, you don't stay the course. And I've heard this use, like, when I read hedge fund quarterly letters, this is a common excuse, I'll say, which you could argue this is hedge fund managers should be updating their expectations based on this change in market dynamics. But how do you think about the role of, you know, people say buying VNQ or buying beta in these spaces affects the timeliness of your edge? Do you think that it's, that's right, that it's distorting things and maybe it'll happen eventually, but timing is a bigger question. From my perspective, that's absolutely true. I think there's no question that the influence of the passive flows have had, particularly in more concentrated spaces, such as REITs and real estate, has definitely had an impact.

Starting point is 00:50:11 And I think your assessment that has probably lengthened time horizons in general is probably also correct. That said, kind of thinking about this particular theme and trade as we're thinking about it, being cognizant of those factors as we are, we also think that the catalysts that we've identified are likely to make that time horizon more tangible probably than generally would otherwise be the case. And the other angle of that, too, Patrick, is now being aware of that, it can create opportunities because those flows can be powerful. I mean, you know, we've got a couple of examples of things. reits that we think are very overvalued, but when there's big flows coming into a sector and they're part of the index and you start getting those ETF flows that have to buy everything, you can see some things that we think are very overpriced, become ridiculously overpriced. I mean, to the tune where, you know, we think, you know, that the reed has it priced at almost 100% premium to the reality

Starting point is 00:51:11 of its underlying real estate. So, but right, you got to have the timing right, and you better be aware of those flows because it's a great comment you made. You know, being early sometimes is indistinguishable from being wrong. But you've got to factor these things in when you're trying to express some of your value-oriented investment themes. I mean, all that you guys have talked about has been very bottom-up in terms of structuring the portfolio. I'm curious how much, if at all, you care about momentum.

Starting point is 00:51:36 Like, one of the things we found in the quantitative world is, for, say, a value strategy. If you just overlay a momentum strategy into those value names, it can be a really, powerful way to get rid of that problem of being really, really early, wait for a little bit of a turn. Do you care about momentum when you're thinking about these things? Just a comment on CNBS and then we can talk REITs, at least in CNBS, this kind of relates back to your last point, right? So obviously, the passive flows and dominate. And I think when you're trading, when you're trading a credit instrument like CMBS bonds, you don't have a liquid functioning market. You have runs to figure out, you know, where you should be that morning. But frankly, most guys are looking at what the corporate

Starting point is 00:52:13 credit market's doing and they're definitely looking at what the S&P futures market is doing. And so it's funny because we're in this illiquid long duration product yet guys are pricing risk based off of the SMP 500. And I think that the reason that a lot of people get hurt in CNBS is because they don't understand this phenomenon that CNBS is typically 10 year loans, right? So it's a long, it's a long duration asset in looking at the underlying loans. What you'll see is that CMBS will tend to trade very macro. You're kind of trading macro. So the momentum's important. So which way is the S&P 500 going? What a credit spread is doing? That's important for the first seven years. The last three years, though, is where you're trading the credit,

Starting point is 00:52:51 where you're trading the idiosyncratic risk. And I think that's where we have the most edge at those points. We're in one of those inflection points right now. So here we stand today with the, you know, S&P 500 within basically at the highs. And you have corporate credit pretty close. It's definitely been underperforming because it's hard to keep up with stocks here. When you look at the bottom of the capital structure in CNBS, you're seeing a totally different story. If you look at just even the indices, there are probably 15 points from their high over a year ago, despite being over a year shorter. So I think that what that tells you is that you get to a point, especially with credit, where people start to look at loss adjusted spreads. It's no longer just trading momentum.

Starting point is 00:53:28 It's, okay, now I need to think, how are these pools going to perform through a cycle? What's going to happen? Where are my losses? Where is the fulcrum part of the capital structure? Am I on the right side of that or am I on the wrong side? And so that's when you can see the capital structure steepen. You start to see a lot more dispersion in between one bond and another bond for various reasons. And so that's where we definitely have more of an edge. In 2011-12, it wasn't hard to make money in CNBS. I think right now you're seeing a lot less active management on the hedge fund side in CNBS for one because spreads are so tight. Well, actually, I guess I just told you we're, you know, we're 15 points off the highs from

Starting point is 00:54:00 18 months ago. So that isn't necessarily the case. But there's still a lot more people involved because it just requires so much more work now. Because back to your question, you can't trade momentum right now. You're in a liquid credit market, and at some point here, we're going to see the other side of the cycle, and you need to be a specialist when that happens. Yeah, that's super interesting. How evenly distributed are like the vintages of these 10-year cycles? So do they tend to cluster?

Starting point is 00:54:25 Like, are there periods where in a given year there's a ton of origination of the loans and 10 years out there's going to be kind of this closing through your opportunity, or is it pretty evenly spaced through time? So kind of every year you've got some batch, it's coming into this kind of last three years of its cycle. So, I mean, I think it's best to just talk post-crisis for now because we can talk pre-crisis. So that's a very different story. You certainly see a lot of tiering in between the different vintages.

Starting point is 00:54:49 For example, 2012 within CNBS was very retail heavy. So that's where the guys who are coming in and trying to express that negative view on retail are looking to short and express that view by getting short that particular vintage. Just because retail was, you know, as much as 40% of some of these deals. Whereas now what you're seeing is that, you know, in the 2000, 2017 origination, there's effectively no retail. There's definitely very little malls. Retail's a very small component.

Starting point is 00:55:14 But the tradeoff is we have more suburban office. We have more lodging, you know, at a time, you know, late in the cycle. And so I think there's always a tradeoff. I mean, Joel, do you have any comment about, you know, over the years? And Joel's been following CNBS since the beginning of the product like Jim. So he definitely has a good perspective on it. Yeah, no, retail is kind of the bread and butter. One of the major, is typically, if not the, it was the top or the second highest concentration in CNBS over the years.

Starting point is 00:55:38 And they really had a lot of mall loans were kind of one of the big, you know, there'd be a lot of at least maybe two or three mall loans in every deal in the previous cycle. But 2012, like the market effectively shut down after the crisis. And then the CNBS market gradually started each year, get a little bit more issuance. So early on, you saw a lot of malls, 2012 kind of being key. And then there became a little more pushback over the years. And now you're seeing one mall in a deal. And it's really like the CNBS market's pretty reactive. actionary. Everybody's afraid of retail now. It's gone from 30%-ish to now it's down to 20% and I suspect

Starting point is 00:56:15 that's going to come down even further. But you have to kind of be careful what you wish for because as Tom mentioned, we're kind of getting more exposure to sectors that aren't necessarily much better, like suburban office right now, is greatly increasing. You're having lodging, like things that we're a little more concerned about longer term, a little bit more multifamily. But as an active longshore manager, this is what we want, right? We don't want all the vintage. it look the same, you know, that it's great when they price the same because then we can put on other, you know, relative value trades. And there's always different ways to try and take advantage of that, which is why it's important to have the index, which is unique to CNBS, that we have

Starting point is 00:56:51 a pretty liquid CmbX market, which have, you know, you have, you have 10 different series. You have AAA down to double B. So you have six tranches of each. And it's 25 deals that are supposed to be representative of that given index or that given vintage. So we have, you know, kind of right now, post-crisis, 60 different bets we can make right now on, you know, at one point, there's 10 series right now. So you had effectively have 60 different tranches. You mentioned this idea of deep, fundamental, bottom-up, value-oriented work. Can you describe, you could use a mall, you could use any piece of commercial real estate or any real estate security, maybe a fun example of one that you've done, a deep dive on and specifically,

Starting point is 00:57:30 like the kinds of things that you're looking for. Again, I'm coming at this from a more traditional, like I'm used to the other public equity sectors and even more specifically, quants like us, typically exclude REITs completely because the notion of earnings really doesn't make sense. A lot of the things that you would normally care about for equities just don't apply to REITs. So it would be interesting to hear what factors you're specifically looking at. Like, what is that actual process for deciding from the bottom up whether a particular security is attractive or not? So we have an 11-person investment team, which for a firm of our size, which is about a billion of capital, under management, it's a pretty big investment team. And just to kind of put that into perspective,

Starting point is 00:58:11 you know, some of the world's largest money managers, some pretty household, big household names, their CMBS investment group might have two or three people. And again, that's more of a commentary that they're really out just getting sector exposure and they're not really necessarily true credit investors. So, you know, we have an 11-person investment team of which four or so are spending all of their time looking at properties. So we view ourselves as commercial real estate investors that operate at the liquid end of the spectrum. So if we're looking at a CMBS bond, we're looking at the underlying real estate. So a bond might be, a particular deal might be backed by 100 loans on 100 different properties.

Starting point is 00:58:53 And maybe the top 10 largest loans account for 40 to 50 percent of that pool by balance. And you're looking at the top 20, maybe top 30 properties, some of which you can do a desktop underwriting, a lot of which you're getting on airplanes and you're going and visiting properties. So it is a blocking, tackling, grinding, grinded out, intensive research process, but there's no way around it because the building blocks for CMBS and REITs are individual properties. And if you don't have an opinion on the underlying individual properties, can't really have an opinion on the intrinsic value, recovery value of a bond or the NAV of a REIT equity. Any favorite stories from the kind of boots on the ground,

Starting point is 00:59:35 site visits to different securities over the years from either of you? Yeah, I would say that what's unique about our approach is that being involved in both CNBS and REITS. There's a lot of synergies and positive externalities to being in both spaces. There's information sharing and things that you're seeing on the public side that may be on the public equity side that is very good information for a given bond investment we're looking at. One that comes to mind is a more seasoned bond they were looking at. So it was a pre-crisis bond that at one point had 196 lawns. At this point, it had 12 loans left. This bond was originally rated triple B minus. So it was, you know, what do you consider to be a fulcrum security. Describe

Starting point is 01:00:15 fulcrum security. So when we think about it, we're looking at, okay, you have a cash flow waterfall and you have bonds with various levels of subordination. The bonds, you know, higher up, the triple A bonds have much more credit enhancement than the more subordinate bonds that are going to be generally thinner and have less cushion from loss. And so depending on the VIII, vintage, the loss might be higher or lower. But when I say fulcrum bond, it means that it's going to be the key bond right around where the losses are going to be. So generally, it's going to be the bond where it's either going to be.

Starting point is 01:00:47 Kind of the demarcation line. Yeah, exactly. Above that line, bonds are safe and they're going to get par back below that line. They're going to take losses, maybe 100% losses. So it's kind of that. So it creates a lot of opportunity. And this particular bond had recently taken a loss. It had probably been trading up close to par.

Starting point is 01:01:04 and had recently taken a loss and was now, you know, now the first loss piece, so the most junior piece as losses all flow, reverse sequential, up the waterfall. And so this bond was owned by an insurance company, and the insurance company was not in the business of owning first loss bonds, is my understanding. And so the portfolio manager said, sell the bond. You know, all else equal after the loss has come through, you're actually looking at a cleaner pull of loans. And so the bond should actually trade higher in price. That's just basic bond math. In reality, though, given that it's a, these are illiquid assets that we're talking about. We were looking at this bond and it was clear that they were a motivated seller.

Starting point is 01:01:42 And we went and looked at the loans. So you had 196 loans originally. At this point, there were only 12 loans left. And it was pretty easy to figure out which loan was going to define the outcome of this bond. 11 of the 12 loans were New York City co-op loans. Historically, New York City co-ops have never taken a loss in CNBS. So it's pretty safe to say that those we didn't really need to look at. Even through the crisis.

Starting point is 01:02:05 Even through the crisis. So on top of that, though, those loans only represented 2% of the pool. So really, what was left was a loan. And it was on a shopping mall. And it was on a regional mall, I should say. And the important thing here is that a lot of people would say, you know, okay, I don't really want to do the work here. This is very difficult. Now I'm first loss effectively on a mall.

Starting point is 01:02:26 If you're sitting at your desktop in New York City or here in Stanford, Connecticut, and trying to underwrite this, it's pretty difficult. because at the time we were still, the market has since recovered more since, but at the time, you know, this asset had, you know, probably 80% occupancy, which isn't that strong. There was, you know, if you looked at the notes on TREP, which is the service provider, people using the space, there wasn't very many positive things to look at. But it was a mall that had been spun out of GCP, which is a REIT had spun out a portfolio of some of their lower quality malls into an entity called Rouse. We were familiar with it because we also invest on the REIT side. And so, you know, One of our analysts said, oh, that's, you know, Rouse, I've actually seen the property, have spoken with management. It's clear, based on conversations we've had that they're actually committed to the asset and that if you actually just did some digging, which any reinvest you spoke to, probably could have uncovered that they had a decent plan to continue to put money into the assets. They had already had some pretty big leasing progress and brought four pretty solid tenants in.

Starting point is 01:03:27 And then when you actually looked at the fact that it was, you know, it was clear that this, this was a high probability of being a layup refi in the next 12 months. We bought this bond based on all that information at 50 cents in the dollar. We were owed nine points of coupon that had yet to be paid to that bond. So effectively your new PAR is now 109. And it ended up paying off, I think, in under nine months on that one. So, you know, that's a unique example there of being involved in both, you know, REITs and CNBS and being able to kind of, you know, piece together something to put.

Starting point is 01:03:59 And all that, all the info is out there in the public. domain. You just got to dig. Tell me your story about how you guys connected at first. I know all three of us are Notre Dame guys, so that's part of the story. But I'd love to hear what the origin story was for your partnership. From me or Jim, I don't even know which is much which is funnier. I guess it's probably, it's probably you can hear both sides. For me, so, you know, as you mentioned, you and I were same year at Notre Dame.

Starting point is 01:04:25 And I was one of those kids who worked my butt off in high school. But once I got to college, going to Notre Dame, I was like, I'm done. second out, and I had other interests, I had other interests in school until I think it was summer between sophomore and junior year. I just started reading a lot, and I was reading about finance, and I read Ugly Americans and Liars Poker and Barbarians at the Gate and all those good ones, mostly from the 80s and 90s, and I said, wow, this seems fun. It didn't seem like what they were talking about in corporate finance class. It was actually, it was hard hitting and fast, and it was work, hard, play hard, and I was like, I could do that. That sounds fun. And then I,

Starting point is 01:05:01 And then all of a sudden I went and saw, you know, college advisor. He's like, well, no one's going to hire your grades aren't that good. He's like, you've been, you know, it says here you didn't go to half your classes. And so then I started really applying myself and I got good grades junior year. And then sure enough, senior year, I was interviewing because I thought I wanted to go into investment banking because that's what you're told in college. And every investment banking interview, you know, whether it's Goldman or someone else, I was sitting across the table at the Notre Dame Career Center with a kid that was maybe a year. older than me telling me that my grades aren't good enough. And I'm telling them, hey, can I talk to your boss? Because I have no interest in talking to you. And to go through the interview process,

Starting point is 01:05:39 nothing's clicking. And then I see a, uh, that I'm interviewing with Sorn Capital. I can't really figure out for the life of me what it is. So I figure it must be a hedge fund. And then I'm Googling on it. And I see the name Jim Higgins. I'm, why is that name familiar? And I'm like, oh, I'm, I'm meeting with that guy. I'm like, I'm finally meeting with someone who's not 23 years old, who has the ability to make a call on someone's character. And then I finally said all the things my father told me to see in the interview was basically just all that cliche stuff about running through walls and, you know, don't look at my resume. I'll work harder than the next guy. And he fell for it. So, well, I don't know if I fell for it. But so this was fall of 2006.

Starting point is 01:06:18 And we at this point had pretty strong views that there was major problems going on in the structured finance markets in particular residential and that there was potentially a big a big disaster coming up right you're hearing about people getting mortgages left and right people are you know originating mortgages out of nowhere so I'm interviewing Tom and then I see something about mortgage origination and I said what is this in your resume goes yeah I'm originating mortgages out of my dorm room and I literally said can you hold on for a second I went out and called back at the I go, our thesis on shorting the residential mortgage market is right. I got a kid here who's selling mortgages out of his dorm room.

Starting point is 01:06:58 It is as bad as we think it is. So, yeah, we had a good conversation. And, you know, I looked past the, well, his great point average was probably around your mind. He got it up. I saw the, I saw the upward trend. Value and momentum. So I said, all right, you know, he looks like he hustles. And let's let's give him a shot.

Starting point is 01:07:21 We had our own version of a Super Saturday, and we called like six candidates back. I think it was two or three Notre Dame kids and two or three Princeton kids. And afterwards, and we're all kind of going through it. And I didn't want to be a Notre Dame Homer and, like, you know, support the Notre Dame kid only. So I was kind of leaning towards one of the Princeton kids. And one of my junior guys who was going to be the one that was going to have Tom Work for him said, nah, I like him. I think he's going to hustle.

Starting point is 01:07:46 Said, okay. And he was a Princeton guy, too, which was the ironic part. So as they say, the rest is history. Love it. So then what was the experience, Tom, just like me, started with a couple months. I guess in real estate, it started sooner. But in equity markets, I had a couple months of bull market and then, you know, the worst crash that we'd all seen.

Starting point is 01:08:03 So what was that experience like working together early on? I think at the time you were primarily doing trading. So what were the lessons learned in obviously a really sensitive part of the markets? And I know commercial real estate, whether the storm better than residential, but what must have been a really incredibly hard time. Yeah, I mean, you know, so many lessons coming out of the crisis, it was definitely a young guy on the desk working out of hedge funds. You get a lot more responsibility than, you know, you probably should get just because there's only, you know, so many guys on a desk, so everyone's got to carry their weight. I think that there's plenty of

Starting point is 01:08:35 lessons that we could talk about trading and investing, but I think the more important lesson, especially as I sit here now as a portfolio manager and a fiduciare of investors capital, is that I remember, you know, in the depths of the crisis, you know, speaking with colleagues at other firms and they were talking about how they had, were using mechanisms that would, you know, allow them to basically, you know, put up a gate or prevent funds from leaving. And, you know, there's obviously different rationale for that. And I remember talking to Jim and he said something that I'll never forget, which is that, Tom, this isn't your money, never forget that. We don't know what's best for the investors. If to their money, if they want it back, then we have to do the best

Starting point is 01:09:13 we can to get it back for them with the highest recovery possible in a very difficult and challenge market. And that's something that that certainly resonated with me. And yeah, I would say that was probably one of the bigger lessons. How about you, Jim, coming through the crisis? Feels like a few lifetimes ago. Lots of lessons, both as a manager of people and also as a manager of money and a fiduciary of money. Overall, again, I think we definitely would have done some things differently on the investing side. We had, I think, the big themes and the big feces right. We probably ended up in some investments, both on the long and the short side, that we convinced ourselves were liquid. They were generally liquid in a bull market, and then they weren't liquid

Starting point is 01:09:57 at all when things turned. And so we couldn't adjust the portfolio as quickly as we would have liked to. It's okay to take illiquidity risk on the alpha side of the trade, if you feel you're really being compensated for it. We took some illiquidity risk on the hedge side of a pretty big trade, and that got us trapped and ended up, you know, kind of eating away all of our profits on one particular long short trade. So don't take illiquidity risk on the hedge side of a trade. And then also know what you're good at and stick to it. I mean, I think this industry can lead to some hubris at times. And when you're good at one thing, you start to extrapolate that it applies to a bunch of other things. And so we did doing some investing in the residential

Starting point is 01:10:44 in the ABS space where we actually did okay, but it wasn't our pure expertise. And so stick to what it is you really have a definitive defined advantage in. And then it also led us to the evolution of our business model, which was away from the commingled hedge fund manager-centric model, where it's saying this is what we want to do and we're trying to get you to do what we want, what we want you to do and go more towards the client-centric model and saying, here's what we do, here's what we find interesting, how can we help you with your goals, your needs, and let's see if we can do something customized to it? Can you talk a little bit more about that because this is a big trend in asset management in general, and just your particular experience is probably good evidence of this,

Starting point is 01:11:27 where the history has been, here, buy my product, right? Like, it's try to jam an individual product or set of products to every investor. We talked earlier about the motivation behind, and CNBS the entire asset class is that different investors want different things and tranching things out and having different securities can meet different needs. So what does that look like? When someone comes to you, let's say a big institutional allocator or something, what's kind of the range of when you say, we'll give you what you want or we can effectively take our brain in this space, which is to understand real assets but also structured finance.

Starting point is 01:12:02 And we can kind of tailor that to a particular outcome that you want. what are the things that people want? What is the demand or the range of demand from institutional investors or any investors that you're talking about? So, I mean, it really all started in 2010, which is we had returned all the capital, we liquided all the assets from return capital to the investors of that original fund. And a client, very, very large, one of the world's largest pension funds, their alternatives group, which they manage money out of New York, said, look, we want you to manage money for us. We don't go into commingle funds. We'll give you X hundreds of millions of dollars into a fund of one. And here's what we would like you to do. But it wasn't, oh, invest in this, invest in this, invest in this.

Starting point is 01:12:48 It was more parameters in terms of the returns they're looking for. Their risk tolerances and the types of risks they don't want exposure to, right? Meaning they were really very clear on defining how they defined alpha. They didn't want to be short a GDP tail. They didn't want to be really have a lot of true beta exposure. But what they also understood was to achieve alpha, you can't think in monthly, quarterly, or even annual timeframes. They said to us, think in two to three year timeframes.

Starting point is 01:13:22 We're okay with drawdowns if it makes sense. We understand that in order to achieve high quality returns, you can't be thinking in short time frames. And to us, this was like manna from heaven. They were big, they were sophisticated, they thought inappropriate timeframes. They gave us very clear guidance on what it is their challenges were, and then they left us alone to do it. We talk with them once a month, you know, so just to give them updates on what's going on. But that's where it really clicked to us is we need to find the right investors, the right partners, because that's really how we view them, where what it is our philosophy is and what it is we can deliver.

Starting point is 01:14:02 matches with what they're looking for. I wonder if that's how the industry will go in general, not just in one particular asset class, but basically like a return profile that people are after where it's not the most upside. It's maybe it's more defined by, I can withstand a 15% drawdown and that's it. And I can't go worse than that. So just like give me the most upside you can, but do not breach that 15% downside. And that's kind of, you know, this one client, right?

Starting point is 01:14:24 I think they're looking for 10 to 12% returns over time uncorrelated and they can withstand And 15% drawdowns, if it makes sense and it's more, you know, it's not mistake-driven. It's just, hey, the pricing of the assets kind of can come and go. We have another client, a very large Asian bank, that is looking for 60% returns with very low price volatility, carry-driven, not a lot of leverage and not taking a lot of duration risk as well. And so we were able to solve for them. and it's very different and the fee structure is different.

Starting point is 01:15:02 Again, ultimately, we should be trying to deliver a high quality value proposition to clients. And that means delivering what it is they're looking for at appropriate pricing, right? Not everything should be one and a half and 20. I don't think anybody's getting much of full fees like that anymore. But not everything is incentive fee driven. Some stuff should just be management fee. Some should be lower incentive fee. Some should be lower management fee and much more higher incentive fee driven.

Starting point is 01:15:27 So really, again, it all depends. on the amount of complexity, the amount of alpha, the scarcity. I mean, there's a lot of factors that go into how you price some of this. And so, yeah, we probably have six different profiles that we're delivering to a range of clients currently. Summer value investing, there's another strategy we have now kind of tying back into the regulatory topic. Regulatory changes can create opportunities.

Starting point is 01:15:54 And one of the big regulatory changes that's happened over the last few years has been increased regulatory capital requirements on banks and broker dealers. And so basically what that means is for certain assets that broker dealers and banks hold, they've had to hold a lot more capital against them than they have in the past. And particularly in fixed income structured product securities like CMBS, broker dealers have to hold an extraordinary amount of capital today relative to what they did three, four, five years ago. And that has completely changed the secondary trading landscape. So for for decades, right, the secondary trading desks on Wall Street were principal secondary traders, meaning they would buy and sell bonds and they would hold pretty

Starting point is 01:16:40 good size inventories. And when you wanted a bid on something, they'd say, sure, here's our bid, and they'd position it, and they'd hedge it and sell it later. And they made good money doing that. With the capital reg requirements going up so much, they can't hold the kind of inventory that they used to because they just can't make the ROE's work. And so what you've seen is the secondary trading desks have gone to being almost exclusively agents and intermediaries and no longer principal secondary traders. We noticed that a couple years ago and it changed, you know, how we were doing some things in our portfolio because the liquidity wasn't there the way it had been.

Starting point is 01:17:15 And then we started thinking about, okay, things have changed. Is there an opportunity here? And so we saw an opportunity, much like the shadow banking industry arose to to fill in some of the blanks in the lending universe where banks pulled back from. A similar thing has arisen on the secondary trading side, whereas the broketeers are pulled back from principal secondary trading, there's opportunities for private funds, private firms, non-regulated firms to step in and to do some of those activities. And so we have a strategy or a theme that we're delivering to some of our investors.

Starting point is 01:17:49 That's more of an active trading strategy where, you know, we're doing some of the activities that, you know, being willing to price risk, hedge market risk, and get paid for doing it. So it's not really a prop trading strategy. It's not saying, oh, we're going to make big bets one way or the other. It's really performing a service or a function for the market and getting paid for it. So, all right, that's an example of how regulatory changes change has changed the landscape pretty dramatically in terms of liquidity. But then it created an opportunity because something had changed.

Starting point is 01:18:23 And that's, you know, probably one of the way. of our highest conviction themes that we have at the moment and have raised a decent amount of capital for it just in the last 12 months. Do you guys see other traditional hedge fund firms or hedge fund firms that you know that are making this same transition from here's our commingled fund? You know, we're just going to do our thing to more, I don't know what you want to call it, like solutions based or client demand driven investment strategies? Or are we still in like fairly early innings of that transition happening?

Starting point is 01:18:53 I can't say that we've seen it. our space and I'm sure it is happening to some extent. I think that we're just taking a much more proactive approach with it because it became clear to us with some of our clients, which are unique in that we have very large, sophisticated investors who do need a range of different profiles. So it kind of came about a reverse inquiry for us. But I think, yeah, so I can't say that we're seeing it in our space as much, but I have to imagine that the industry is going there in some way. Yeah, my sense is it is slowly heading that direction, but again, it's going to take a while, and it's not going to be that obvious.

Starting point is 01:19:29 But Tom and I both spend time talking with other firms in the industry, including some of the really large, very household names in the alternatives industry. And there's one in particular. I know that is definitely their philosophy has changed much more towards managed accounts, custom portfolio. I mean, they run a lot of vehicles, and they run a lot of big commingled vehicles as well. but their mindset has changed from, hey, this is what we want to deliver the clients. You have to come into our fund, and they're much more willing than they have been,

Starting point is 01:20:01 as recently as even three years ago, to do customized managed accounts and do individual portfolios for clients, and they've kind of just acknowledged that look. If you want to, you know, if you want to maintain and attract investors, you have to, you've got to meet their needs. And this is what more and more, more of the big investors are saying, this is what we want. Yeah, I think, I mean, the old days, of having one large master fund, having everyone in it. And, you know, it's nice.

Starting point is 01:20:25 It's simple operationally. You certainly don't need as much infrastructure. But if you do that, right, and you're a hedge fund and you're marketing 15% returns or whatever it is and you're where we are on the cycle, it's a quick way to get in trouble. If you're solving for an outcome that may not be there without taking some risk that your clients probably didn't sign up for, it's a quick way to get in trouble. On top of that, being a specialist manager, right, we're doing, from a business standpoint,

Starting point is 01:20:49 it makes sense for us to do more, right? When there's, when there's capacity and things outside of what we're already doing for our clients, it makes sense for us to actually go after some of those opportunities because, you know, as Jim mentioned, we have an 11-person investment team. That's definitely unique in our space and it's sort of a luxury. And so it allows us to look at a lot of different parts of the CNBS and REIT market that we, you know, maybe otherwise couldn't if we, if we were just focused on, you know, one single hedge fund type mandate. And so that's definitely powerful. though, because all of the work we're doing to invest in the first loss and, you know, fulcrum bond investing, it applies all the way up higher up the capital structure. Maybe you need, you know,

Starting point is 01:21:29 some more traders and you certainly need more operational infrastructure. But there is definitely, you know, economies of scale there where it makes sense to go after that. And then speaking back to this new active trading strategy, that becomes very powerful because that becomes the nucleus or kind of engine for what we're doing in that we're programmatically repping to the street in the market that we're here to price risk and that's and that's what we're looking to do we're not looking to do it for free where you know we're going to charge for it but as a result of that if you can do it in the right way where you really protect the information protect your relationships it's powerful because you see a lot of information and that allows us to have better access to supply and demand

Starting point is 01:22:12 even higher up the capital structure as well than other than others would so if you're running running a global bond fund and, you know, you have a small, the Barclay-Zag exposure to CNBS might only be, I think it's like 1.8%. You're not going to put a ton of resources into CNBS just to match that. You're either going to be underweighted and have no exposure or you're going to have the guy who trades CLOs and not agency also wear a C&BS hat, which doesn't make a ton of sense, especially if not if you're putting a lot of capital to work. And so we think that even in some of these profiles that otherwise might be higher up in the capital structure might be more yield, maybe it's a little bit more beta plus type stuff.

Starting point is 01:22:50 We can do that better than others as well. So last question before we move and talk a bit about the history and opportunity set within wreaths very specifically. I'm always interested in the relative advantage of the specialist model, so spending all of your time on one sector of the market or even one industry within that sector versus the generalist model, the sort of old school, like almost like, I think of like Tiger cub type hedge funds, the kind of go anywhere model where they arguably could be better at seeing dislocations sort of across sectors and coming in and taking advantage. So the question is,

Starting point is 01:23:25 what would the generalists tend to miss in this space? Like, what is the persistent advantage of being a specialist versus someone that's coming in and sort of approaching this opportunity set for the first time? We believe pretty strongly in the specialist model. But even within that, we are involved in a few different sides of the commercial real estate market, which we do think is important. So I guess we're kind of saying two different things. We are specialists in that we're commercial real estate focused, right? We don't, we're not experts in residential. We're not experts in corporate credit, but in the world of commercial real estate, liquid investing, we are indeed a specialist. And in a world where markets are becoming increasingly tight in terms of trying

Starting point is 01:24:08 to find value and arguably more efficient. It's harder and harder to find value and extract alpha. And we think that the only way to do that on a consistent basis is to be a specialist. Generalists are fine when you want to allocate across and you want to have more of a top-down macro approach and sector allocation decisions. But when you're actually trying to get kind of true alpha, we think that being a specialist is absolutely an advantage. Now, that doesn't mean you can just have your head in the sand and not pay attention. We pay attention to other sectors and are aware of flows, aware of trends, aware of themes. It doesn't drive everything that we do, but at least colors some of our thinking. And then being involved in CMBS, the debt side of

Starting point is 01:24:52 commercial real estate, reits, the equity side, and then commercial estate loans, the pure loan side, that does give us a pretty good perspective on the broader commercial real estate world, which we do think is an advantage, both to allocate to the best. opportunities and also from managing risk. Very cool. Well, guys, my goal with this conversation was to let people see sort of the depth with which teams devote effort and human capital to understanding inefficiencies in very specific parts in the market.

Starting point is 01:25:20 And I think we definitely did that. So this has been eye-opening from, certainly from a retail perspective, but from real estate, more broadly speaking as well. So thank you for your time. Thank you, Patrick. Hey, everyone. Patrick here again. To find more episodes of Invest Like the Best,

Starting point is 01:25:36 go to investorfieldguide.com forward slash podcast. If you're a book lover, you can also sign up for my book club at investorfield guide. com forward slash book club. After you sign up, we'll receive a full investor curriculum right away and then three to four suggestions of new books every month. You can also follow me on Twitter at Patrick underscore Oshag, OSHAG. If you enjoy the show, please leave a quick review for us on iTunes, which will help more people discover Invest like the Best.

Starting point is 01:26:05 Thanks so much for listening.

Invest Like the Best with Patrick O'Shaughnessy - Sorin Capital – Retail Contrarians - [Invest Like the Best, EP.68]

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