Tony Paolone – JPMorgan Senior Analyst and Co-Head of US Real Estate Equity Research, joins Yahoo Finance Live to discuss the REIT situation amid the pandemic and share his outlook on the real estate industry.
BRIAN SOZZI: With the return to offices delayed for many due to the pandemic and rising yields, the REIT sector could be in the spotlight very soon. Let’s dive in with JPMorgan Senior Analyst and Co-Head of US Real Estate Equity Research Tony Paolone. Tony, good to see you here this morning. So, for those who aren’t necessarily too familiar or invested in the REIT space, historically, what has happened to the industry when rates rise, as they have over the past month?
TONY PAOLONE: Yeah, that’s a good question, Brian. So we don’t have a lot of examples because interest rates have been going down for so long. But, you know, one example was the typing tantrum, where you had a pretty hard and rapid rate movement that surprised the market, and during that time the REITs took a hit. We were down about 15% in, say, four months, and underperformed the market in this instance. So I think there’s a lot of attention on this as an example of the risk to the band right now. But from our perspective, we think there are some key differences where it doesn’t necessarily have to be this time around, as there are a lot of other good things happening in commercial real estate right now.
JULIE HYMAN: I would also ask Tony – hey, this is Julie here – what the total REIT debt level is now, compared to historical levels, and I imagine the debt servicing costs, though, I don’t know, even if rates go up another 25 basis points, for example, it will still be relatively low for these guys.
TONY PAOLONE: Yes, from a capital stack perspective, and thinking about the debt and the level of indebtedness of these companies, it’s really not a problem where we’re sitting. Leverage levels for REITs are around 30% of total real estate value, so they are low leverage vehicles when it comes to commercial real estate. When you go to the private market and see participants buying commercial real estate assets, the level of debt is usually about double. So from that point of view, companies are in very good shape. Interest rate risk, from our perspective, has more to do with whether or not it causes investors to seek other parts of the market and sell stocks that have historically been oriented towards investors. more income oriented. This is the biggest risk for us. We’re not too worried about the piles of capital themselves. In fact, what you are seeing right now across the group are balance sheets in good enough shape to allow for large-scale transaction activity. Being able to use balance sheets to stimulate growth by investing has therefore been an asset for the group.
BRIAN SOZZI: Hey, Tony, looks like we’re going to be staying in this hybrid work environment for a while. How does this change the earning capacity of the REIT industry over the next five years?
TONY PAOLONE: Yes, well, we think it’s a clear headwind for office business, and we can all debate whether 5% of people work from home or 50% of people work from home. There will be a certain amount of it that will occur. We believe this will be a bit of a headwind to the demand for office space. We therefore believe that office activities are naturally the most threatened by this change in the way people work. Our point of view has therefore been to reduce the importance of office inventories. But there’s a really interesting way, we think, of investing in the broader theme, and that’s through the commercial real estate services companies, where they’re going to sit at the table here to help the occupants. manage their space, whether they want more or less, and they will receive commissions and consulting fees, almost regardless of how the world ends up spatially. They’re going to help occupants and owners make decisions about space, and we believe that’s how you invest in changing what happens in the use of the workplace.
JULIE HYMAN: And, Tony, is Jones Lang LaSalle an example of that, that you’re trying to play the service side of the business?
TONY PAOLONE: Yeah, that’s exactly it. This is our main idea at the moment. We believe this is a business, it is the second largest commercial real estate services platform in the world, and you have the capacity to drive profit growth, over the next few years, through the return of business. transaction, both from investment sales, which have effectively doubled year over year, and the return to more normalized rental activity. Getting back to that office idea, through the pandemic many office rental decisions have been delayed and businesses, again, have yet to figure out precisely what they want to do with their space over time. These deals will happen, and when they return to more normal levels of rental activity and make those day-to-day decisions, JLL and, really, their peers, for that matter, will be at the table, earning commissions and helping these transactions. So we think there is a long way to go on the rental side. You see that the activity of selling investments is really increasing. You’re back above 2019 levels on this front, so that’s driving strong growth right now. And then, the company has a very solid balance sheet which gives it the possibility of investing as well and managing other parts of its activity. So we think that’s, overall, a pretty good setup for a company like that, on the light asset side, as opposed to owning the office.
JULIE HYMAN: Hey Tony, a little note on JLL is the sale of his property management unit in China, and it’s interesting, anything that puts the words “China” and “property” or “real estate” in the same sentence right now, I think, is under increased scrutiny. Is there a risk here that the deal will not go through, and then we get stuck with this property management unit at a time when, on the real estate side, things in China are, I don’t know, a little questioned, we could say?
TONY PAOLONE: Yes, it is possible, but from our point of view, to think of JLL as an action and as a company, this region, and this specific industry sector within the region, is very small, so whether they sell it or not it’s, frankly, it’s probably going to be a rounding error, from a profit standpoint, and that’s also the reason why, you know, it can potentially be sold. . So I think when they looked at this business, the customer base wasn’t necessarily what they were trying to achieve globally, and it wasn’t particularly important to them as a ‘business. And so, you know, we’d love to see the sale go through, because it could be capital inflows that could be redeployed into something more strategic for the business, but if that doesn’t happen, it’s not. big enough, from our point of view, to move the needle from an investment point of view in JLL.
BRIAN SOZZI: A real good idea here. JPMorgan Senior Analyst and Co-Head of US Real Estate Equity Research Tony Paolone. Happy to see you. Enjoy the rest of the week.