Kristen Kozlowski:

Hello, I’m Kristen Kozlowski of PineBridge Benson Elliot and I’m pleased to share with you a recording taken from our 2024 annual general meeting. This session was a discussion between Marc Mogul, Chief Investment Officer of PineBridge Benson Elliot, and Hani Redha, Global Multi-asset Portfolio Manager.

Listen on to explore the trends impacting the future of commercial real estate.

Marc Mogul:

Hani and I are going to have a conversation on some of the kind of macro issues that are kind of working their way through our sector. It's funny Hani, it says there Hani Redha: Portfolio Manager, but it could also say, it should also say: Head of strategy and research in PineBridge Benson Elliot.

If I had done the slide, it would have said smartest guy in the shop, but that's just a personal view. So I probably wouldn't be allowed to put that in. There's a bio there, but I am always super excited when Hani comes into town.

We have some wonderful conversations and we're going to do it. We're going to do it today

OK. I get, as has become our custom, I get the first question. I gave them my snapshot on how I see the market today and perhaps how I see things going forward. Can you give us a more informed view?

Hani Redha:

No, no, I don't think I can help you there. But let me share a bit of an update on what we see from a kind of top down generalist perspective. And you've heard me speak about kind of this regime shift that we started to pick up on really just after the pandemic. For us, that was the catalyst for a shift to a new investment regime. And I'd summarize it as a higher nominal world, so higher growth, higher inflation, higher interest rates, all forming, you know, this new kind of environment that we'll be in for many years to come.

We usually focus on, let's take the next few years, let's say five years at a time. And over that kind of time frame, we see this only kind of gaining traction and getting embedded. And so the “why” of all of that is a few things that I'll just touch on, OK?

So, why? I mean, you touched on a lot of this, Marc, right at the beginning, you were talking about interest rates are high, they may be coming down, but they're not going back to where they were before. Inflation has become somewhat embedded. It's not going back up.

So some of the “whys” for us are that we're in an environment now that there is a lot of investing to do, actual kind of nuts and bolts investment that was not there in the previous regime. So starting with things like the energy transition, this is a serious amount of capital that's being put to work and it is really happening. We have a lot of touch points on this and it is happening at scale and it's accelerating. I wouldn't ignore it or kind of become numb to it. This is investing that was just didn't exist prior to the pandemic really on any kind of meaningful scale.

The other is kind of restructuring of supply chains away from China. So reshoring, near shoring, shifting supply is really happening and it requires a lot of investing. This was something no one was doing before.

And then the others, I would point to our AI and you've touched on this in terms of, you know data centers and the build out. I would generalize that to say AI itself might end up being, and we'll, I'm sure we'll discuss this. It may end up being a bit of a red herring. What we're really now in the midst of doing is a build out of a new level of compute capability, right? So just the computational capability and capacity. What will that be used for? I think this kind of large language models and everything is going to be just a taste of what it can be put to work for. There's going to be a lot of use cases. We wouldn't kind of dismiss it because of, you know, maybe a lack of a killer app. Today, we're building this compute capacity regardless of what happens after that. And that's, again, investment activity that wasn't there before.

And lastly is defense. Not something great for us to be needing to do, but just look around the world, it's very clear we're going to have a step up in the amount of global investment into defense. And that also takes up investment dollars.

And as someone grounded in economics, Mark, I think you'll agree, you know, ultimately where interest rates settle is going to be the balance between savings and investment. And if we're just pumping up all this new level of investment needs, that's going to actually lead us to a higher level of equilibrium interest rates. So that's a very important aspect of why we think this regime looks very different.

Marc Mogul:

So you don't think when I put up that chart of where the 10 years are in, well, I used Germany, I used the UK and the US, you don't think the markets have got it fundamentally wrong?

Hani Redha:

No, I would say we're actually thereabouts already. So you know, we had the highs of yields reaching around 5% you know, last year and enormous revisiting of this year. We think that's too high, but if I had to pick a round Number for the 10 year yield for the US I would use the number four.

Marc Mogul:

Yeah.

Hani Redha:

Ok. We think it's going to be somewhere between 3 1/2 to 4. That's the kind of zone, but closer to four.

Marc Mogul:

I'm going to ask you a question 1B before I get to question 2.

Hani Redha:

Sure.

Marc Mogul:

Which is, so you gave us the sense as to what's driving the, kind of, the demand side: investment restructuring, AI, defense. As I was making my comment about the MSCI world up 50% and then it's because really I was coming in on the tube this morning and looking at the S&P, well, the market moved, yes.

Hani Redha:

All-time highs.

Marc Mogul:

Right and my question for you is if you actually look at each of those things you talked about. If we, because of course, what happens in sectors other than ours, it may not affect everybody in this room day-to-day, but it certainly affects the CIO’s thinking of our sector. How broad-based to you is that 50 to 60% uplift over the last two years? And how much of it is, and this is really a non tech guy, I got to teach this stuff and but I don't claim to be an AI expert. And how much of this is perhaps hope value caught up in the AI thing that's actually bleeding into the markets that creates a risk of a cold shower down the road?

Hani Redha:

Yeah, very good question. I think that was number seven. Well, it's OK, we can go there.

So look, when you're in the midst of a new kind of paradigm shift or a new level of technology that gets introduced, it's a bit of the Wild West, OK? There's a lot of capital being deployed. There's a lot of potential for misallocation of capital for sure. But the lessons we've learned from these kind of episodes before is, you know, overall, don't discount it. There's real cash flow behind all of this. And what's interesting right this time around, maybe for the first time in history, is that usually when this kind of new technology breakthrough starts to come through, it's kind of smaller companies, venture type, you know, very entrepreneurial type setups, which kind of are the ones who provide the solutions. And then you've got the risk of investing in, you know, something that doesn't make money and hoping it will make money. And there's a ton of risk in that. This time is fundamentally different. Who are the guys who are actually providing these solutions? They're the giants who are just generating incredible amounts of cash flow. And they're the same folks who are actually providing all this. So you have a backup in the sense that you're investing in a profitable business that is now exploring to what extent this will generate additional cash flows. It's a very different risk reward to where we were before.

Marc Mogul:

So you know, these things again that you've talked about, particularly the growth investment, they were there 18 months, 24 months ago in terms of we could see that on the horizon. Yet 18 or 24 months ago every well, not everyone, but there were plenty of folks who thought that the US was going to go into a recession. So square that circle for me.

Hani Redha:

Yeah. So, yeah, we used to call it recession obsession. I think you probably all remember everyone is just dying to see- I mean, they almost want to see a recession happening. That was kind of the vibe in the market.

Marc Mogul:

It's like after a night of too much drinking, you just feel better after you're able well, forget it.

Hani Redha:

I don't know what you're talking about.

Marc Mogul:

Yeah, yeah.

Hani Redha:

So why didn't this happen? Right. Because we had a spike in inflation we hadn't seen for decades. We had central banks like this, especially the Federal Reserve in the US, quite embarrassingly very late to respond and then aggressively increased interest rates by 550 basis points. That's usually a setup, a recipe for causing some real damage to bring the inflation back down after having made a policy error by being too late. So why didn't it happen?

So we think the reasons are that, yes, we tighten monetary policy dramatically, but at the same time there was a ton of fiscal policy doing the opposite, doing exactly the opposite, you know.

Marc Mogul:

We were complaining about that at the time, we were saying they were operating at cross purposes.

Hani Redha:

Yeah, they were, they were exactly, we were. And but what the net result of that is, there is an efficiency because it created a lot of inflation, which means you're really, you know, burning excesses which you shouldn't have. But at the same time, what it ended up doing is that it's smoothened the deceleration process and helped us to kind of avoid what normally happens. Why does recession happen? There are these feedback loops that make the whole process go non-linear. So you get laid off, you tell your friends, they start to worry, they pull back. The loss of demand then results in more layoffs and you get that spiral. And we avoided that because the actual deceleration was smoothened on the way down because of fiscal policy. That's one factor.

The other is that the private sector is just in much better shape than it was after the GFC. And the last time we went through a crisis, we had a debt crisis. Everybody was over levered. We spent a decade deleveraging.

Marc Mogul:

So it's not just our sector that is less leveraged this time.

Hani Redha:

Across the board. Across the board, we see that the overall economic backdrop is much less stretched in terms of leverage. That makes you less vulnerable, first of all. So hence no distressed sales that you're talking about but it also means you're less interest rate sensitive. You just have less debt. So when rates go up, you're not as impacted by those interest rates. So the whole economy became somewhat less interest rate sensitive. That also made the process more smooth as we decelerated off the sugar high from post COVID reopening. And so we avoided recession.

And the third part of it, and I'm sure we'll come on to this because there's parallels in Europe, in parts of Europe, but in the US in particular, we had an unprecedented wave of immigration, most of it illegal, but very much kind of enabled by, you know, a turning a blind eye for political reasons. What that did was, you add another source of demand again, it offsets that monetary policy. And, you know, when you increase the labor supply, you grow the economy in terms of number of people, you know, putting the politics aside from pure economic perspective, you're setting yourself up for better growth potential in the future. You're diffusing any inflation, you know, wage pressure goes down because you're adding workers to the supply.

So it's a pretty positive virtuous cycle. And so these are the things that helped us to avoid recession. And I think from here looking forward, looks like, you know, in the next few months, we're still in the kind of danger zone where the previous hikes are, you know, having its impact on the economy and things are slowing. But now we've started the easing cycle and it looks like we're going to be able to get through the next few months of weaker growth. And that sets us up to extend the life of this cycle.

Marc Mogul:

OK. So now though, that's all good and interesting for me because I speak with an American accent, even though I'm over here for 35 years. Now go through that same set of analysis for our part of this part of the world, for this part of the world.

Hani Redha:

Yeah, so here, a lot of the things that I mentioned are very much US centric, right? So that's where we see the biggest regime change and a lot of positives. You know, this immigration flow, we think of it as a positive economically speaking. It was on a higher scale in the US than it was elsewhere. And the innovation and the investment in all this, you know, technology being led by the US. In Europe, not so much, unfortunately not so much.

Marc Mogul:

You saw the numbers I put up in terms of the growth forecasts.

Hani Redha:

Exactly, so Europe has some serious structural challenges. They're not new, but they're not going away either. You know, the demographic picture is pretty abysmal, particularly in the core. And we'll talk about the what's happening within Europe I think next. But you know, the, the picture overall is not that healthy. And so we think Europe is much closer to that previous cycle where growth is a little bit better than before. You know, it's not as dire, inflation is a little bit stronger than before, it's not as weak, but there's a material difference between Europe and the US.

So to give you some numbers, you know, in Europe in the last cycle, the 10 year bond yield averaged about 1%. We think it'll probably average around 1 1/2% in the next few years, OK, slightly higher because it's a better backdrop, but not a ton.

Whereas in the US we averaged about 2.3% yields. We think that's, as I said, you know, closer to 4% because of the bigger difference in this regime versus the last regime for the US compared to what it means for Europe.

Europe's structural issues are, are pretty tough. I mean, Mario Draghi put out a really great paper looking at what needs to be done in terms of investing, innovating and deregulating. We totally agree with all of that.

Marc Mogul:

Europeans are very good at putting out papers about what needs to be done.

Hani Redha:

Absolutely. And I think in the next 5 years, they'll probably come up with a plan.

Marc Mogul:

OK.

Hani Redha:

To do something in the next 10 years, but we wouldn't hold our breath in terms of seeing anything in the near term.

Marc Mogul:

Do you want to give us one minute on the unique, seemingly unique challenges in Germany?

Hani Redha:

Sure, yeah. So, you know, Germany essentially built a business model around demand from China, particularly for industrial goods, capital goods, luxury products, you know, in autos and powered by Russian energy and a workforce that had been historically very competitive in a post the reforms that were done by Gerhard Schroeder. Fast forward to today, what do we have?

We've got China really now in a very different growth backdrop, much weaker and a shift in mindset towards command and control. Basically not even communism, outright Maoism, so not great for demand. Russian energy I don't need to comment on. I don't think that's going to change anytime soon. And a workforce that is now much less competitive, much higher unit labor costs than they were before. And so they've been resting on their laurels and enjoying the fruits of a lot of reform and hard work and now have a lot of competition coming in from the Chinese in terms of autos and the Americans in terms of innovation that makes them more competitive. It's pretty tough.

I wouldn't count them out as a nation they’ve rebuilt themselves and re, you know, reinvented themselves. But there's a, you know, really re-gutting required. And as of now, that leadership is not quite there to drive it.

Marc Mogul:

And then the bright spots in Europe?

Hani Redha:

Interestingly, the world is upside down. The strength used to be in the core, you know, Germany, France, Northern Europe. Now it's in the South where it was always, you know, a challenge to understand, you know, how this is going to add up. We see strength in places like Spain through a lot of investment, a lot of immigration. That's the other area in Europe where we've seen a lot of immigration. I think you'll hear from your team in terms of how that's feeding through into the real estate sector as well.

Marc Mogul:

I had an early slide in an early version of my presentation, but I just had too much had to get in which showed that the forecast for GDP growth 24, 25, 26 in Spain, consensus forecast, is twice the level of the EU of the overall.

Hani Redha:

Yeah, and immigration, you know, more than a million immigrants, It's a big number for Spain. So, so that's very interesting and different to the core. Italy also always been challenged in terms of growing. It's been doing really well. Some of it is because of this kind of next generation EU fund that was set up during COVID to help them to recover. And it's been working. They've been investing it well and it's bearing fruit.

But there's also been some political stability there. I was just checking, you know, when did Maloney actually come in and form a government? It's actually two years this month, Two years for an Italian government. What's going on? That's like double the average duration of an Italian government, congratulations.

Marc Mogul:

With my EBRD days when a deal came up at the board level and the Italian and the Italian director was commenting on his concern. It was in Poland, the deal and the Italian director was commenting on his concerns over political stability in Poland, it is the early 1990's. The Polish director was Jan Biletsky, who would actually had been the Prime Minister at one point, stands up and said I'll be darned if I'm going to listen to lectures on political stability from the Italian director.

Hani Redha:

Yeah, so I mean, I don't want to jinx it. I probably already have, but we'll see. I mean that stability has been a welcome change. And yeah, there's just much better positives in in the South than there is in the North right now. And so that's where actually I would turn that around and ask you, how do you see that in terms of your opportunity set? When you compare these kind of intra-European regions?

Marc Mogul:

I mean, we have an issue that that in a way you don't have. You know, one point in my comments I said about something, you know, we're in a sector, you can't decide you like it on Monday and get out of it on Wednesday, right? You can.

Right, you can buy a bond on Monday and trade out of it on Wednesday. You can buy a stock and you know, you can move around as you know, if your corns itch one morning, you can say no. That's a sure sign that I want to be in Spain or what have you.

We can't do that. And so, you know, this whole issue of liquidity becomes really important to us. And you know you can talk about the growth prospects of some of the periphery markets. You know, I mean, I'm going to go to the extreme now, but you know, Croatia, Romania, actually have actually strong, if you go look at the forecast growth in these places, they're pretty strong. But these markets have like moments. It's like looking at the property sector in terms of when it prices at a premium to NAV, it's like a leap year. It's one day every four years it trades at a premium to NAV. And the liquidity in some of these locales is a little bit like a leap year. It's generally not there.

And so we can be bedazzled by strong growth prospects in some of the periphery markets, but we're making judgements that, forget the average whole period for a moment. The aspirational whole period in our sector tends to be kind of 2, 3, 4 years. We can't know that the growth prospects 2, 3, 4 years down the line are going to be equivalent similar to what they are today.

The other thing we can't, certainly can't know is given how cyclical our business is and the importance of timing our entry and exits right, we that 2, 3, 4 years quite sensibly could become, quite sensibly could become, 5, 6, 7 and our you know the crystal ball gets a lot hazier as you move out into that time frame. So for us GDP is important. We want to be in growing markets, not in stagnating markets.

But I think as much as anything, if you look at the way we've invested over the years, we want to be in markets with deep liquidity. And that and that depth of liquidity usually means that there is a solid universe of domestic institutions that are playing in that market. And a lot of these emerging markets, they don't have that.

Hani Redha:

I see. I guess there's parallels with this in terms of at the thematic level, right. So we just talked geographically, but thematically, I mean, you mentioned you know, the data center side of things, the life sciences side as well. I mean these are themes that are running through our markets as well on the listed side. And I was curious that you are not finding these things as interesting as we are, but I think that's the common link here. Because for us we find that first of all, you know, as an equity investor, I can participate in a lot more.

Marc Mogul:

That's the key though. Who wants to be a lender to a VC firm, I mean to a VC fund, right? What is a typical VC fund look like? They make 10 investments, 8 go bust, one returns money and the other makes 20 times or something, right? My problem is if I got a building with those 10 tenants on the one that did really well, he pays his lease. The second one maybe he pays his lease and the other eight give me their space back. So I don't own the ups.

Hani Redha:

That makes sense. That does make sense.

Yeah, so I mean for our side, what we find is on the listed ability to access those markets, they have not done well as you highlighted yourself as well. But what I would push back on in terms of their performance is you need to disentangle the effective rates, OK, because with interest rates having spiked, a lot of those REITs and anything, you know with that kind of rate sensitivity got hurt badly.

What we're saying is that that's all behind you. So, you know, those losses have been absorbed. Going forward, we don't think you have that headwind. And you know if I can be liquid and access that yield from then it can be a very different position. But it sounds like, you know, that's the way potentially to play it opportunistically as opposed to playing it in the direct market.

Marc Mogul:

But you, you said 2 thing-

Hani Redha:

You agree?

Marc Mogul:

Yeah I do, but I think that you said two things that are as relevant and actually are quite encouraging. 1 is you said what distinguishes this, if can call it tech cycle, from the last one is the scale and strength of the companies that are leading it, right? So the covenants are potentially, you know, I threw, I don't need to, I assume I don't need to worry that if I'm going to lease my data center to Amazon, they're going to go bust, right?

And the other thing is your comment about, and these are two things I'm going to definitely take away from this conversation. That is the reminder that the covenant strength of the business sector overall is fundamentally better this time around than after the GFC because the corporate sector is fundamentally less leveraged than it was coming out of the GFC.

Hani Redha:

Agreed.

Marc Mogul

I think that's something we need to, we need to appreciate because you know, it is a message that I do remind people of. We are, we are in a debt position as landlords, right? And there have always been two businesses that I've always said I don't want to be in because you own the downs and not the ups.

And the one is bank lending. And I never want to be a bank. You know, you earn a margin and you know, you can wipe out there. In fact, there is a paper, if anybody's interested that we commissioned at the Bank of England, which effectively proved that the amount of money that the UK High Street banks lose at the end of every cycle on their property loans dwarfs what they make throughout the entirety of the up-swing in the cycle.

So that business I don't want to be in. The other one is the construction business. They write guaranteed maximum price contracts and get a 3, 4, 5% margin and just periodically go bankrupt and you know, as it doesn't work itself out.

Hani.

Hani Redha:

Thanks man.

Marc Mogul:

Thank you.

Hani Redha:

Good to see you. Thank you.

Marc Mogul:

OK.

Kristen Kozlowski:

Always a fascinating discussion between Marc and Hani. And great to get their insights on where we’ve been, and where we’re headed.

You can always find the latest on our views of the investment market at PineBridge.com

Until next time. Thanks for listening