Introduction

Patrick: [00:01:21] 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 Sorin Capital, a billion-dollar hedge fund which specializes in commercial real estate, REITs, and commercial mortgage backed securities. Sorin is led by Jim Higgins who founded the firm and Tom Digan, 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 introduce the sector and the opportunity set, is a deep dive into a specific trade, a fairly contrarian take on the retail industry, specifically comparing different types of retail real estate.

As you'll hear the dispersion of mispricing 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 the clients want and need, instead of just selling a one size fits all commingled fund. 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 Sorin 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 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 summary of the topography of the space, what does it look like? What assets are there? How can you access them? And then, we'll use that as a jumping off point.

Tom: [00:03:22] Yeah. I think that's a good place to start. I think, just to start, I mean, it's a big space. It's a big space for sure when you look at the numbers. The US commercial real estate market cap, if you will, is around seven 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, seven trillion is obviously a massive asset class. The New York Stock Exchange alone, also to just put in perspective, 19 trillion was the last number I saw. 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 of every economy, it's not something that they always feel is accessible in the way of actually trying to access some of those returns, as you put it.

So, just to break that down and talk about how that seven trillion is 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 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-backed securities market also called CMBS, 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 REITs actually own and operate buildings whereas the mortgage REITs are either investing in commercial mortgage loans, or financing them in some capacity.

So, we focus more on the property REITs themselves. Just to break that out even further, so on seven trillion of commercial real estate market cap, there's four trillion of mortgage debt. And, that's by looking at the Fed data as of the end of last year, the CMBS 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 one trillion of REITs as well. So, you're talking about of the seven trillion market cap of commercial real estate, two trillion are what we consider to be the liquid ends that we focus on in the security side.

Jim: [00:05:31] I think I just add there, for us, we're a specialist manager. So, we are liquid commercial real estate securities, and commercial real estate loan investors, which is 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 true specialists and experts in it. So, it's a nice combination of big enough, but not too big, and a lot of inefficiencies for a manager like us to take advantage of.

Patrick: [00:06:10] The next question that that begs is the profile of the investors in the space relative to the profile of investors in, let's say, 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? Who are the owners?

Jim: [00:06:33] 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 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. 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 as we talked to some these institutional investors is when you go to the commercial real estate group, they hear CMBS, REITs, 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, which then points you back to the real estate guy. So, it's a unique combination of characteristics that they have where it's part security, and it's part commercial real estate. And again, so that sometimes makes it fall through 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 CMBS and REITs it's evolved over the years. For CMBS, the sector is really only been around since early to mid-1990s. And so, 15 years ago, primarily it was insurance companies that were the primary investors in CMBS. 10 years ago, heading into the financial crisis of '07, '08 you had a ton of structured finance vehicles, CLOs, CDOs, SIVs, and hedge funds pretty much across the board that were investing in CMBS, regardless of whether they were specialists or not. The financial crisis changed-

Patrick: [00:08:38] Washed everybody.

Jim: [00:08:38] ... all of that. You're not really seeing SIVs and CDOs, and you're not seeing as many non-specialist hedge funds playing in it. Currently, you've got a lot of big money managers, so 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. REITs, similar and how it's evolved. Going back even further, REITs have been around a little bit longer. 20 years ago 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, 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, a broad base of investors.

Patrick: [00:09:43] One of the key things always is motivation for investing in this, if you're going to carve out an asset class as something separate that's not, say, lumped in with an equity exposure, just a broad fixed income exposure, is that you're expecting some unique characteristic, whether that be low correlation, a higher average yield, more tangible underlying asset, 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, specifically?

Tom: [00:10:17] 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'll show they can also serve as some form of inflation protection. We've seen different data on the... A lot of people say there's a low correlation to other asset classes, but we know that correlations tend to increase in times of stress, so that's not always a place to hide there. But on top of that, in this environment, 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.

Patrick: [00:10:55] Let's talk about your own 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 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 some dedicated resource looking just at managers, it's kind of it doesn't fit one particular bucket. But, maybe talk about Sorin the business, how it began, maybe your background, Jim, before Sorin 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 more esoteric and 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-

Jim: [00:11:38] Yeah. Sure. 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. I 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 was pretty much of an oxymoron, because that was probably one of the worst commercial real estate markets coming out of the S&L crisis. 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, 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 capital markets and commercial real estate really, it made sense to me.

Mortgage-Backed Securities

Patrick: [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 blew up the economy in 2008 and 2009, so-

Jim: [00:12:47] Yeah. And I mean, commercial-

Patrick: [00:12:48] Talk about why it's appealing.

Jim: [00:12:49] Yeah. First, commercial mortgage-backed securities, much simpler from a structural standpoint, much more vanilla than the residential world. Usually, when people have got a bad visions in their head about mortgage derivatives, it's usually the residential world that had some 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.

Patrick: [00:13:19] Can you describe the basics of how it works.

Jim: [00:13:21] 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, 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 with a much higher interest rate, and a range of bonds and profiles in between.

Patrick: [00:14:09] The motivation for which being investors have different priorities, want different duration, want different yield.

Jim: [00:14:14] Yeah.

Patrick: [00:14:14] So, it's basically a way of taking one consistent underlying thing, or pool of things and providing a bigger-

Jim: [00:14:20] 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. I think, again, people have been attracted to it because they understand commercial real estate, and while the security is a little different, they still understand 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.

Patrick: [00:14:56] As in a swap out. Meaning they'll sell hard assets in favor of something else.

Jim: [00:14:59] Less of a swap out, and a more if they say look at 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 illiquid, and when you're in illiquid asset you're 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 opportunities, and laid awake in 2009.

And so, one thing we've talked to some of our clients about in their commercial real estate allocations is have a small portion in something that's liquid so that you're 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. Well, I don't think anybody is comfortable saying, "Oh, there's a big down trade in the market coming anytime immediately soon." Or predicting when that's going to happen.

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 downdraft 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.

Patrick: [00:16:45] It 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... 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 in 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.

Jim: [00:17:18] Sure. So, I joined Bear in March of '97. Actually, I think it was St. Patrick's Day. And, I remember March 17th, 1997. And, that was still in the infancy stages of the CMBS market. It was developing, it was evolving, and the market went from being 40 to 50 billion of annual CMBS issuance to almost 200 billion by 2007. So, I left Bear at the end of '03 at a point in time where it felt like things were getting pretty aggressive in terms of CDO, CLOs, SIVs, and little did I know that that was just at the very beginning stages, because it got much more aggressive 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, there really wasn't any relative value or long, short options. So, I felt there was an opportunity for a well-conceived long, short strategy, and that was the impetus for starting Sorin. 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, or a different 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 on 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 goals, and so having just one fund with 100 LPs in it, particularly in something as unique as structured products, and CMBS and REITs, that 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 a few dozen LPs in a range of portfolios that are customized towards individual LPs or groups of LPs that have similar profiles and similar tolerances. This really goes to the one size does not fit all, and I think it really lends itself well, particularly to a niche sector like ours, where 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. Fees structures are different, the risk parameters are different. 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."

Retail Real Estate and Malls

Patrick: [00:20:19] So, we'll use this as an opportunity to talk in-depth about a very specific trade, in this case retail. And, we're going to come at retail from all different angles, from the credit angle, from the equity angle, and from the macro viewpoint that you have as an opportunity here in the discreet period of time. So Tom, maybe you could start by at a high level outlining the situation that we're in, retail is a really... This 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.

Jim: [00:20:56] Sure. Now, retail is certainly a great example of the typical 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 exposure to the retail industry have recently come under fire. In the second quarter of this year, retail became the highest yielding sector and 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 than national chains, and you have an even larger pipeline looming.

We've had more than 10 major national retailers fill 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 number is upwards of 300, which to put in perspective is more than what we saw bankruptcy wise in 2003 to 2006 period in total. And, that's 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 REITs have declined in excess of 30%, select CMBS tranches with higher than average exposure to retail are down 10 to 15 or more percent as well. One market participant has gone so far as to label CMBS the next big short, based largely on the 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 CMBX." Thus, we have diverted a ton of resources to dig even deeper on this 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 been the case since the beginning.

Just by way of example, JP 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 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. Penney, 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, Apple, Bonobos, Athleta, Anthropologie, the list goes on.

So the point is, it's definitely a story of winners and losers. Many on the ground crew 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 conversation piece, consider that the absolute dollar of 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 US has over retailed, we're not arguing that, but I think we would make the case that it'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, there's certainly a big difference-

Patrick: [00:24:28] Five being the international average.

Tom: [00:24:30] Exactly. Looking at other developed countries, so there's a huge difference there.

Patrick: [00:24:33] We're loaded. Yeah.

Tom: [00:24:34] But, you need to you need to unpack that a little bit 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. That's when you break it down. It's really just that the US is overmalled, and frankly overappareled, and this is not new to anyone that's been following the space. And so, while malls will continue to close, not every mall is a bad mall, and I think even more importantly, not 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.

Patrick: [00:25:08] 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, REITs and of REIT ETF, ETFs as bundles of other themes or industries or whatever. And, that often the behavior that that can create is a high-level narrative washing out maybe competitors within the space that don't deserve to be, which obviously could create an 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? Macy's is doing terrible. Kohl's is doing terrible. 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?

Tom: [00:25:58] Sure. I think I'll let Rick take this one. But real quick, just to preface it, as I mentioned we did a lot of work. And frankly, Rick will tell you shortly that the price movement that we've seen in some of the regional malls makes complete rational sense. The move we've seen in certain CMBX and CMBS 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 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 REIT, it's really hard to tell the difference. And, I think what we'll get into is the difference between those businesses is really important.

Jim: [00:26:39] 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 it'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.

Patrick: [00:27:16] So, Rick, you want to flesh that out even more?

Rick: [00:27:18] Yeah. I think it's exactly as my colleagues have alluded to here, and you as well, that the retail theme, broadly speaking, has encaptured every single security and sector of securities in the market currently, and that's clearly a broad brush set of assumptions. And, I think more specifically looking at retail, the business as Tom suggested just a minute ago is, 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, 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 call it 20% 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. Okay. 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.

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 as that relates to real estate is that the mall business is very different from other retail formats. Okay, the mall business has very high concentrations 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 percentage of the square feet of a mall, so those businesses are also mostly apparel related. 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. Stepping back to your question about how do you formulate that into a trade, and separate the wheat from the chaff, and I think clearly everything retail is being sold and discounted out of fear, and the 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.

Patrick: [00:30:09] I want to give a descriptive summary of the real estate in the retail sector across the country. So, you've talked about malls and shopping centers. If there was a pie 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 is shopping centers? What are the other key categories that people should think about?

Rick: [00:30:33] 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 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 have variant mixes of smaller boxes, and small shop tenants. Some are often grocery anchored, and then you have a neighborhood center, which is a smaller scale format, which you would find in more of a residential area.

But, 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, they go to get their hair cut, they go to get their nails done, they pick up the dry cleaning there, they go and grab a bite to eat. These are typically centers that are one to two miles from the typical customer's home, typically on their daily commute to work, to school, to wherever, and that is why these types of assets, these shopping center assets, especially grocery anchored assets are still performing very well. The real estate is very well located, the businesses are not under siege from the internet.

I think we were 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 center. 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 of the individual securities and businesses, you can see that there's really a lot of opportunity.

Patrick: [00:32:43] This raises a ton of questions, the first of which is to describe how the malls, so the thing that's being most affected, how their business model works. Why is their success so integrated with some of these, the Macy's of the world that we've talked about that have gotten their butts kicked in public markets?

Rick: [00:32:59] 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. So, the department store anchors are now closing stores, they're not the drivers of traffic anymore.

And I think, 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 why they should pay 35 or 40 or $50 rents when Sears who's not driving any traffic is about to close the store, and 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.

Patrick: [00:34:09] For the malls themselves, you've seen some interesting speculation that say Amazon should buy Nordstrom, or Amazon should buy one of these big box department stores maybe even only as distribution points, because the real estate that these places own I'm thinking about Macy's tends to be prolific. It's in the best locations all over the country. So, what do you view as the future of malls themselves? If the business model is predicated on these 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 an Amazon coming in and buying one of these things?

Rick: [00:34:48] It's an interesting question. I think again, we have to take a step back down to 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 it has a department store anchor that is struggling and needs to close the location, it's likely very easily backfield. I think again, 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's Sporting Goods, or whoever is in it. But, it's a well located piece of real estate in a demographically attractive area, they'll be able to backfill it.

One of the trends we've seen is in some of the better located real estate, is we've seen 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 smaller spaces and other anchors that are paying higher rents. 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 personally I wouldn't rule that out in the future.

Patrick: [00:36:15] You did a good job describing the different types of retail real estate. How much of that is accessible through public market vehicles? 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.

Rick: [00:36:33] Right. No, 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 100,000 retail real estate assets we discussed earlier, the public REITs probably own the top 7,000. So, in terms of what is available in public markets, it's generally the top 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 and public markets is almost by default not going to be very accurate.

Patrick: [00:37:13] So, how high, just specifically high has the correlation been with the shopping malls relative to say grocery anchored shopping centers? Are they literally down the same amount in contrast to that foot traffic that you gave us?

Rick: [00:37:28] 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. They were both down about 40% from peak to trough. So clearly, indiscriminate selling and fear pervasive.

Patrick: [00:37:44] One of the things I always like to dig in on is, so if you've got a contrary thesis for some sub component of this retail story, in this case shopping, not malls, but shopping centers, grocery anchored, and 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 the apparel and maybe electronics as a second one, why doesn't the same fate... Is Amazon just going to figure out some way of doing the same thing with these other categories?

Rick: [00:38:12] Well, 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. I think Amazon's recent acquisition of Whole Foods validates the fact that that category is probably not ever going to be a large share of online sales. And, I think that the principal reason is, as I mentioned, in the survey data that comes back is, most people just don't want to... 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 there's plenty of room for that business to be online, and it already is, I think, even among the traditional grocers. But, 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.

Patrick: [00:39:09] 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 how you approach this same problem. So, first what is your mission, overarching goal? Where are you searching for inefficiencies, and what is the process by which you're doing so?

Joel: [00:39:28] Yeah. So basically, I think as we've harped on a little bit already, it's all about the real estate. 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 what we're trying to find out. We will get on a plane and go, 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.

Patrick: [00:39:55] Real estate brokers.

Joel: [00:39:55] Yeah, with real estate brokers. And, we try to get there, we rent 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 and egress, we're looking at how's the neighborhood? Does it make sense for a Nordstrom anchored center to have... If the houses are much lower end, you have to use common sense to some degree. So, it's all about the real estate, and that's what we're trying to figure out. Sometimes a lot of people in our industry take a more macro view, top down approach, but we're definitely bottom up. We actually go, look at the real estate.

We were just offered a bond the other day, a 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, looked great, but they had lost a couple tenants. So, we talked to a pretty good contacts in Chicago, and found out 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 the center, so we ended up figuring out why this bond was being offered to us made no sense based off the risks, where somebody just top down would have been like, "Oh, this checks all the boxes."

Patrick: [00:41:10] It makes me think of those scenes in The Big Short where the guys fly down to Florida, and they're asking the same course of questions of like, "What the hell is going on here?" You can't believe that this isn't priced into securities. Maybe give your favorite example of one of these 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.

Joel: [00:41:32] I was just going through head, I was just tried to think about a bunch of examples. There's been a lot of crazy stuff we saw. One was a 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-

Patrick: [00:41:49] St. Louis? I think-

Joel: [00:41:50] Yeah. I didn't want to call out any market. But, we sent an analyst down there to look at those-

Patrick: [00:41:55] Wait, I'm from St. Louis.

Joel: [00:41:56] Yeah. Exactly.

Patrick: [00:41:57] And, my wife is from St. Louis.

Joel: [00:41:59] We sent an analyst down there look at it, and they told him, frankly, at the front desk, "Don't venture out more than one block from this building-"

Patrick: [00:42:06] This guy is a little soft, though.

Joel: [00:42:07] He actually put a chair in front of his door at night, he felt so unsafe. So, it looks great on paper, right in the middle of where you want to be, seemingly. But, we went and it was just an absolute disaster-

Jim: [00:42:17] Joel is very smart about sending his analysts to the site inspections where you have to bar your door at night.

Joel: [00:42:22] Yeah, I opted out of that one.

Patrick: [00:42:24] 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, you might define public real estate beta. So, how long do these things tend to persist? Is this the sort of a trade that for your clients would be on for three months, or three years? And, how do you assess when things have normalized? What are the variables that you're looking for to say, "Okay, the inefficiency 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."

Rick: [00:43:01] Yeah. I think it's difficult to put an exact time horizon on the trade, but I think realistically, there are a number of catalysts that we're looking for that we think will 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 the some of the catalysts that we're looking at are one, in shopping centers, given they're much smaller sized assets, there's regular price discovery. These assets are, call it, 10 to 25, $30 million dollars, maybe $50 million. 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 Bear 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, 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.

Patrick: [00:44:39] So, just to close out this section, this really deep dive on an individual idea or trade without giving the actual positions, just give a flavor for how you actually positioned 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 two categories, how does it actually come together in a portfolio?

Tom: [00:44:58] At least in CMBS, and I'll touch on REITs. I mean, CMBS we definitely tend to construct the portfolio at least a little bit more top down thematically, originally based on, 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 CMBS, when you're planning 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 on the REIT side?

Rick: [00:45:31] Sure. I think the portfolio construction is driven by, one, the bottom up individual security analysis, and 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 risk versus the reward. And so, we want that asymmetry, and where it is largest based on our analysis, we size positions accordingly.

Jim: [00:46:14] And, 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 REIT equity market which has 150, or 200 names across a lot of different property types, and 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.

So for example, this shopping center theme, and there's some select shopping centers that we feel are 30 to 40% 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 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.

Patrick: [00:47:31] Yeah. That's exactly what I was getting at, which is as I hear you guys talk about the dislocation, what the opportunity sounds like is effectively a market neutral pair trade. That you get exposure to things that have... The baby that's been thrown out with the bathwater, and can benefit regardless of what happens at the macro level. But, it begs the question then, why is this persisted? Why haven't others come in and taken similar positions with enough size to close that gap?

Jim: [00:47:57] Yeah. I mean, you asked before about, 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 CMBS 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 hidden value as you would think. So, these types of opportunities in CMBS 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 CMBS 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.

Patrick: [00:49:03] 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 over which maybe some of those inefficiencies would be corrected. And, 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 used when I read hedge fund quarterly letters, this is a common excuse, I'll say, which you could argue hedge fund managers should be updating their expectations based on this change in market dynamics. But, how do you think about the role of people say buying VNQ, or buying beta in these spaces affects the timeliness of your edge? Do you think that's right, that it's distorting things, and maybe it'll happen eventually, but timing is a bigger question?

Rick: [00:49:58] From my perspective it'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 is, definitely had an impact. And, I think your assessment that it has probably lengthened time horizons in general is probably also correct. That said, 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.

Jim: [00:50:35] And, the other angle to that too, Patrick, is now being aware of that it can create opportunities, because those flows can be powerful. I mean, we've got a couple of examples of 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 we think that the REIT has a price that almost 100% premium to the reality of its underlying real estate. But right, you got to have the timing right, and you better be aware of those flows, because... There is a great comment you made, 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.

Business Cycles

Patrick: [00:51:28] 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. 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, really early. Wait for a little bit of a turn. Do you care about momentum when you're thinking about these things?

Tom: [00:51:52] Just to comment on CMBS, and then we can talk REITs. In CMBS, this relates back to your last point. So obviously, the passive flows dominate. And, I think when you're trading a credit instrument like CMBS bonds, you don't have a liquid functioning market, you have runs to figure out where you should be that morning, but frankly most guys are looking at what the corporate credit market is 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 S&P 500.

And, I think that the reason that a lot of people get hurt in CMBS, is because they don't understand this phenomenon that CMBS is typically 10 year loans, so it's a long duration asset. And, looking at the underlying loans, what you'll see is that CMBS will tend to trade very macro. You're trading macro, so the momentum is important. So, which way is the S&P 500 going? What are credit spreads doing? That's important for the first seven years. The last three years though, is where you're trading the credit, 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. All right. So, here we stand today with the 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 CMBS, you're seeing a totally different story. If you look at just even the indices, there are all probably 15 points from their high over a year ago, despite being over a year shorter. So, I think 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, it's, "Okay, now I need to think, how are these pools going to perform through a cycle? What's going to happen? Where my losses? Where's 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 other bond for various reasons. And so, that's where we definitely have more of an edge. When 2011, 12 it wasn't hard to make money in CMBS. I think, right now you're seeing a lot less active management on the hedge fund side in CMBS for one, because spreads are so tight. Well, actually, I guess I just told you we're at 15 points off the highs from 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 an illiquid 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.

Patrick: [00:54:18] Yeah. That's super interesting. How evenly distributed are the vintages of these 10 year cycles. So, do they tend to cluster? 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 this closing three-year opportunity? Or is it pretty evenly spaced through time, so every year you've got some batch that's coming into this last three years of its cycle?

Tom: [00:54:40] So, 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 tearing in between the different vintages, for example 2012 within CMBS was very retail heavy. So, that's where the guys were coming in and trying to express that negative view on retail, or are looking to short and express that view by getting short that particular vintage, just because retail was as much as 40% of some of these deals, whereas now what you're seeing is that in the 2017 origination, there's effectively no retail.

There's definitely very little malls. Retail is a very small component. But, the tradeoff is, we have more suburban office, we have more lodging at a time, late in the cycle. And so, I think there's always a tradeoff. I mean, Joel, do you have any comment about over the years? And, Joel has been following CMBS since the beginning of the product like Jim, so he definitely has a good perspective on it.

Joel: [00:55:29] Yeah. Retail is the bread and butter. One of the major is typically, if not the, it was the top or the second highest concentration in CMBS over the years. And, they really had a lot of mall loans, were one of the big... They'd be a lot, at least maybe two or three more loans in every deal in the previous cycle. But 2012, the market effectively shut down after the crisis, and then the CMBS market gradually started each year to get a little bit more issuance. So early on, you saw a lot of malls, 2012 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 CMBS market is pretty reactionary.

Everybody's afraid of retail now, it's gone from 30% ish to now it's down to 20%, and I suspect that's going to come down even further. But, you have to be careful what you wish for because, as Tom mentioned, we're getting more exposure to sectors that aren't necessarily much better. Like suburban office right now is greatly increasing, we're having lodging, things that were a little more concerned about longer-term, a little bit more multifamily. Yeah.

Tom: [00:56:34] But as an active long, short manager, this is what we want, right? We don't want all the vintages to look the same. It's great when the when they price the same, because then we can put on other 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 CMBS, that we have a pretty liquid CMBX market. You have 10 different series, you have triple A 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 right now post crisis 60 different bets we can make right at one point, and there's 10 series right now, so you can effectively have 60 different tranches.

Patrick: [00:57:16] 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, may be a fun example of one that you've done a deep dive on, and specifically the kinds of things that you're looking for. Again, I'm coming at this from a more traditional... I'm used to the 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'd be interesting to hear what factors you're specifically looking at. What is that actual process for deciding from the bottom-up whether a particular security is attractive or not?

Jim: [00:58:00] So, we have an 11-person investment team, which for a firm of our size, which is about a billion of capital under management, that's a pretty big investment team. And, just to put that into perspective, some of the world's largest money managers, some pretty 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 just getting sector exposure, and they're not really necessarily true credit investors. So, 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 particular deal might be backed by 100 loans on 100 different properties, and maybe the top 10 largest loans account for 40 to 50% of that pool by balance. And, you're looking at the top 20, maybe top 30 properties, some of what 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, 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, you can't really have an opinion on the intrinsic value, recovery value of a bond, or the NAV of a REIT equity.

Patrick: [00:59:32] Any favorite stories from the boots on the ground site visits to different securities over the years from either of you?

Tom: [00:59:39] Yeah. I would say that, what's unique about our approach is that being involved in both CMBS 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 loans. At this point it had 12 loans left, this bond was originally rated triple B-, so it was you know what you considered to be a fulcrum security.

Patrick: [01:00:14] Describe fulcrum security.

Tom: [01:00:15] 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 higher up, the triple A bonds have much more credit enhancement than the more subordinated bonds that are going to be generally thinner, and have less cushion from loss. And so, depending on the 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 you're either... It's either going to be-

Jim: [01:00:47] It's the demarcation line-

Tom: [01:00:48] Yeah, exactly.

Jim: [01:00:49] Above that line bonds are safe, and we're going to get par back, below that line they're going to take losses, maybe 100% loss, so it's that-

Tom: [01:00:57] 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, and had recently taken a loss, and was 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." All of us equal, after the loss has come through, you're actually looking at a cleaner pool of loans, and so the bond should actually trade higher in price. That's just basic bond math.

In reality, though, given that these are illiquid assets that we're talking about, we're looking at this bond, it was clear that they were a motivated seller, 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 coop loans. Historically, New York City coops have never taken a loss in CMBS, so it's pretty safe to say that those we didn't really need to look at-

Patrick: [01:02:03] Even through the crisis.

Tom: [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-

Patrick: [01:02:12] One loan.

Tom: [01:02:13] ... a loan, and it was on a shopping mall. And, it was on regional mall I should say. And, the important thing here is that a lot of people would say, "Okay. I don't really want to do the work here. This is very difficult. Now I'm first loss effectively on a mall." If you're sitting at your desktop in New York City, or here in Stamford, Connecticut, and trying to underwrite this, it's pretty difficult because at the time we were still... The market has since recovered more sense, but at the time this asset had probably 80% occupancy, which isn't that strong. If you looked at the notes on Trap, which is the service provider people use in the space, there wasn't very many positive things to look at

But, it was a mall that had been spun out of GGP, which is a REIT, had spun out a portfolio of some of their lower quality malls into an entity called Rouse. We're familiar with it, because we also invest on the REIT side. And so, one of our analysts said, "Oh, that's 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 REIT investor you spoke to probably could have uncovered that they had a decent plan to continue to put money into the asset. They had already had some pretty big leasing progress and brought four pretty solid tenants in.

And then, when you actually looked at the fact that it was clear that there 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 on 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 they ended paying off I think in under nine months on that one. So, that's unique example there of being involved in both REITs and CMBS, and being able to piece together something to put-

Jim: [01:03:59] And, all the info is out there in the public domain, you just got to dig.

Patrick: [01:04:03] 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.

Tom: [01:04:12] From or Jim, I don't even know which-

Patrick: [01:04:13] Which is funnier?

Tom: [01:04:13] You can hear both sides. For me, so as you mentioned, you and I are same year at Notre Dame, and I was one of those kids who worked my butt off in high school, but once I got to the college going Notre Dame I was like, "I'm done." Checking out. And, 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 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 went and saw a college advisor, he's like, "Well, no one's going to hire you, your grades aren't that good." He's like, "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, whether it's Goldman or someone else, I was sitting across the table at the Notre Dame Career Center with a kid that was-

Patrick: [01:05:30] 23.

Tom: [01:05:30] ... 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, I just go through the interview process, nothing is clicking, and then I see a that I'm interviewing with Sorin Capital. I can't really figure out for the life of me what it is, so I figured it must be a hedge fund, and then I'm googling it, and I see the name Jim Higgins. Why is that name familiar? I'm like, "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 say in the interview. It was basically just all that cliché stuff about running through walls, and don't look at my resume, I'll work harder than the next guy, and he fell for it.

Jim: [01:06:13] Well, I don't know if I fell for it. So, this was fall of 2006, and we at this point had pretty strong views that there was major problems going on in the structured finance markets and particular residential, and that there was potentially a big disaster coming up. You're hearing about people getting mortgages left and right, people are originating mortgages out of nowhere. So, I'm interviewing Tom, and then I see something about mortgage origination, and I said, "Well, what is this in your resume?" He 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 and then I go, "Our thesis on shorting the residential mortgage market is right, I got a kid here who is selling mortgages out of his dorm room. It is as bad as we think it is." So yeah, we had a good conversation, and I looked past the... Well his grade point average was probably around-

Tom: [01:07:09] He still bought it.

Jim: [01:07:09] He got it up... I saw the-

Tom: [01:07:12] I was a three.

Jim: [01:07:12] I saw the upward trend, and-

Patrick: [01:07:16] Value in momentum.

Jim: [01:07:17] ... so I said all right, he looks like he hustles, let's give him a shot. So, we had our own version of a super Saturday, and we called six candidates back. I think it was two or three Notre Dame kids, and two or three Princeton kids, and then afterwards we're all going through it, and I didn't want to be a Notre Dame homer and support the Notre Dame kid only, so I was 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 us said, "No, I like him, I think he's going to hustle." I said, "Okay." And, he was a Princeton guy too, which is the ironic part. So as they say, the rest is the rest is history.

Patrick: [01:07:52] 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 the worst crash that we'd all seen. So, what was that experience like working together early on? And, 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? I know commercial real estate weathered the storm better than residential, but what must have been a really incredibly hard time.

Tom: [01:08:19] Yeah. I mean, so many lessons coming out of the crisis. It was definitely a young guy on the desk working at a hedge fund, you get a lot more responsibility than you probably should get, just because there's only so many guys on a desk so everyone is got to carry their weight. I think that there's plenty of 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 fiduciary of investors capital, is that I remember in the depths of the crisis, speaking with colleagues at other firms and they were talking about how they weren't using mechanisms that would allow them to basically put up a gate, or prevent funds from leaving.

And, 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 to back then we have to do the best we can to get it back for them with the highest recovery possible, in a very difficult and challenged market." And, that's something that certainly resonated with me. And yeah, I would say that was probably one of the bigger lessons.

Patrick: [01:09:24] How about you, Jim, coming through the crisis?

Jim: [01:09:29] 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 thesis 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 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 eating away all of our profits on one particular long-short trade. So, don't take illiquidity risk on the head side of a trade. And then also, know what you're good at, and stick to it. And, 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 do some investing in the residential and 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 a way 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 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."

Patrick: [01:11:20] 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, where the history has been, "Here, buy my product." It's trying to jam an individual product or set of products to every investor. We talked earlier about the motivation behind CMBS, 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 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, and we can 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-

Jim: [01:12:13] So, it really all started in 2010, which is we had returned all the capital. We had liquidated all the assets and returned capital to the investors of that original fund. And a client, a very, very large, one of the world's largest pension funds, their alternative group, which they manage money out of New York, said, "Look, we want you to manage money for us, but we don't go into commingled 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." 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.

They were really very clear on defining what they, or 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. 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 timeframes." And, to us this was like manna from heaven. They were big, they were sophisticated, they thought in appropriate timeframes. They gave us very clear guidance on what it is their tolerances were, and then they left us alone to do it.

We talked with them once a month or so, just to give them updates on what's going on. But, that's what 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 matches with what they're looking for.

Patrick: [01:14:04] I wonder if that's how the industry will go in general not just in one particular asset class, but basically a return profile that people are after where it's not the most upside, 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 you the most upside you can but do not breach that 15% downside."

Jim: [01:14:23] Yep. There's this one client, I think they're looking for 10 to 12% returns over time uncorrelated, and they can withstand 15% drawdowns, if it makes sense. And it's more... It's not mistake driven, it's just, "Hey, the pricing of the assets can come and go." We have another client, a very large Asian bank that is looking for six to 8% 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're able to solve for them and it's very different, and the fee structure is different. 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.

Not everything should be one and a half and... I don't think anybody's getting much of a 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. 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. So yeah, we probably have six different profiles that we're delivering to a range of clients currently. Some are value investing, there's another strategy we have now tying back into the regulatory topic.

Regulatory changes can create opportunities. 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 in particularly, in fixed income structured products securities like CMBS, broker dealers have to hold an extraordinary amount of capital today relative to what they did three, four, or five years ago, and that has completely changed the secondary trading landscape.

So, for decades, the secondary trading desks on Wall Street were principal secondary traders, meaning they would buy and sell bonds, and they would hold pretty 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 ROEs 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 how we were doing some things in our portfolio, because the liquidity wasn't there the way it had been.

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 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, where as the broker dealers have 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, that's more of an active trading strategy, where we're doing some of the activities that... 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 performing a service or a function for the market and getting paid for it. All right, that's an example of how regulatory changes changed the landscape pretty dramatically in terms of liquidity-

Patrick: [01:18:18] Yep. And, we can jump on it.

Jim: [01:18:19] ... but then it created an opportunity because something had changed. And, that's probably one 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.

Patrick: [01:18:31] Do you guys see other traditional hedge fund firms or hedge fund firms that are making this same transition from, "Here's our commingled fund, we're just going to do our thing." To more, I don't know what you want to call it, solutions based or client demand driven investment strategies? Are we still in fairly early innings of that transition happening?

Tom: [01:18:53] I can't say that we've seen in 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 came about in reverse inquiry for us. 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.

Jim: [01:19:22] Yeah. My sense is that it's slowly heading that direction. But again, it's going to take a while, and it's not going to be that obvious. 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 commingle 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 as recently as even three years ago to do customized managed accounts, and do individual portfolios for clients, and they've just acknowledged that look, "If you want to maintain and attract investors, you got to meet their needs." And, this is what more and more the big investors are saying, "This is what we want."

Tom: [01:20:19] Yeah. I mean, the old days of having one large master fund, having everyone in it, it's nice, it's simple operationally, you certainly don't need as much infrastructure. But, if you do that in your hedge fund, and you're marketing 15% returns, or whatever it is, and 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, from a business standpoint it makes sense for us to do more.

When there's capacity in 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, as Jim mentioned, we have an 11-person investment team, that's definitely unique in our space, and a luxury. And so, it allows us to look at a lot of different parts of the CMBS and REIT market that we maybe otherwise couldn't if we were just focused on 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 fulcrum bond investing, it applies all the way up higher up the capital structure.

Maybe you need some more traders, and you certainly need more operational infrastructure. But there is definitely, economies of scale there, where it makes sense to go after them. And then, speaking back to this new active trading strategy, that becomes very powerful because that becomes the nucleolus, or engine for what we're doing, in that we're programmatically reping to the street and the market that we're here to price risk, and that's what we're looking to do. We're not looking to do it for free, 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 even higher up the capital structure as well than others would.

So, if you're running a global bond fund, and you know you have a small... The Barclays Agg exposure to CMBS might only be, I think it's 1.8%. You're not going to put a ton of resources into CMBS, just a 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 non-agency also wear a CMBS hat, which doesn't make a ton of sense, especially if you're putting a lot 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, we can do that better than others as well.

Patrick: [01:22:52] So, last question before we move in and talk a bit about the history and opportunity set within REITs 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 old school, almost like I think of tiger cub type hedge funds, the go anywhere model, where they arguably it could be better at seeing dislocation across sectors, and coming in and taking advantage. So, the question is, what would the generalist tend to miss in this space? Like what is the persistent advantage of being a specialist versus someone that's coming in and approaching this opportunity set for the first time?

Jim: [01:23:36] We believe pretty strongly in the specialist model, but even within that we're involved in a few different sides of the commercial real estate market, which we do think is important. So, I guess we're saying two different things. We are specialists and network commercial real estate focused. 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 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 in sector allocation decisions. But, when you're actually trying to get 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 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 for managing risk.

Patrick: [01:25:08] Very cool. Well guys, my goal with this conversation was to let people see the depth with which teams devote effort and human capital to understanding inefficiencies in very specific parts of the market, and I think we definitely did that. So, this has been eye opening, certainly from a retail perspective, from real estate more broadly speaking as well. So thank you for your time.

Jim: [01:25:29] Thanks, Patrick.

Tom: [01:25:29] Thank you, Patrick.

Transcript by @ScarrottKalani