Transcript
Hello, and welcome to the Download. I'm your host, Dave Richardson, and really excited about today's guest. This is a topic that is on a lot of people's minds, but we're adding in some extra stuff too. So I think you're really going to like it. I'm joined by Michael Kitt, who is the head of private markets and real estate equity investments at RBC Global Asset Management. And Michael, we were talking before about how time just seems to pass so quickly now, as we're maybe more experienced gentlemen than we were before, but I didn't realize we haven't had you on in over two years. How's everything going?
Very good, Dave. Nice to see you again. It is just a case of time flying by here and we should have connected over the last couple of years, but it's not like we haven't been busy. It seems like the world is also moving quickly, not just time passing by. So here we are facing a whole new set of challenges. COVID is behind us, but we've got a whole bunch of stuff in front of us now to incorporate into our thinking. But I'd say overall, things are very good here and we're very fortunate.
Absolutely. We're always fortunate, there's no doubt about that, just being where we are and where we live. But we were in the midst of the pandemic the last time we talked— I think it was around late 2020, maybe early 2021; I don't have the exact date. I would encourage people to go back and listen to that episode, which is still up on any of the places you get your podcast, plus, in particular, the first podcast we did with Michael. He was one of our early guests back in 2019, talking about his background, which is extensive, and why I wanted to get him on this. On the topic of commercial real estate, we were musing back then about what might happen as people come back to the office or didn't, and what happened with shopping malls, etc., commercial real estate in general. And now that we're back a little bit, I wanted to check back in with that. But Michael, before we go into that, has a new title as well. And the new part is the private market’s part. Can you tell me a bit about that?
Yeah, Dave, we talked about this before. I was fortunate to work in the pension fund business for the bulk of my career, well over 25 years. And in that world, they committed an extensive percentage of their investment portfolio— let's call it half of their investment portfolio— to what they referred to as private market asset classes. So things like real estate, which we had talked about, things like infrastructure and private credit, such as mortgages or direct lending to businesses. And within this private asset class world, the pension funds identified a number of advantages which caused them to push into it heavily over the last couple of decades, and it's really helped them stabilize their portfolio. They've been able to take advantage of some wonderful investment opportunities and really have had the benefit of being a large institution and get access to things that generally the population didn't have access to. So fast forward to the time here. That was our goal, that is basically to create or replicate a set of institutional quality investment alternatives for the individual investor to access. We talked about democratization in 2019. I think it's become a pretty common term actually, in the industry, ironically, but that's the philosophy. Make something that hasn't been accessible up until now, accessible to the individual investor. We did it with real estate. It's been very successful. It's helped a lot of people in their portfolios. It's done what we set out to do, to no one's surprised, because it was down the middle of the fairway solution. We're doing it again with infrastructure and doing it again with the private credit space and specifically commercial mortgages. And so overall, we've done this, and we've opened up the private markets and given access to people. And we really believe this is a story about building wealth. We like to talk about the difference between building wealth and making money. You can make money trading, you can make money working, you can make money betting, you can make money day trading. You can make money in all kinds of different ways. But building wealth is very different than making money. In making money, you're applying your own time. You've got your job or you're selling things on Kijiji or whatever you're doing to make some money. Building wealth is actually making your money work for you. And that is where the private markets access really starts to make sense from a building wealth perspective, because these are long term asset classes. These are asset classes that are not correlated to public markets. They help diversify portfolios and if you set them up properly, they will build wealth for you over the long term. And that's what the institutions really saw.
This is an area of the market that most retail investors— and a lot of people who listen to the podcast, Michael, are retail investors—, just weren't able to get access. They may have had it through a particular pension plan that they belong to, but it's not something you just walk out and say, hey, I want to get involved in the private credit markets. I'm going to go find an investment there today. And it's still not exactly that, but it does give people, as you say, that access to markets, investing through you and your team. That's a huge benefit to them from a diversification standpoint.
Yeah, I personally have never had the ability to invest in this kind of quality and asset. If I wanted to buy a nice big industrial building out by the Toronto airport, I couldn't do that because I'm not wealthy enough. And if I wanted to buy an airport or a port, I certainly couldn't do that because I didn't have a spare billion dollars hanging around. So it's access to these kind of investment opportunities that just offer the investors something different. The private market world is very different than the public market world in a couple of key ways. First of all, it's an inefficient market. In the private market world, there is no such thing as insider information. In fact, that's what you seek out: inside information. You sign confidentiality agreements to dig into inside information and these assets disclose all of their information. And so as a buyer you get to due diligence all of this private information to make your investment decision. That's very valuable, very different than the public markets where of course there's rules in place where you can't have access to that kind of information. You have to trade on only publicly accessible information and so instantly you have an advantage in the private market world if you have the ability and the capital strength to enter into that world to buy private market access. So it's a very inefficient market that you can take advantage of. There's also skill. It's a unique skill to find these deals. About my pension fund background, we've hired a number of people from institutions that have relationships globally and so they can speak to these wind farms and ports and toll bridges and big real estate companies and access mortgage investment opportunities that are just not listed for sale on any public market roster. These are quiet, off market, only available in the private market space. So it takes a unique skill to find them. But the benefit is you get access to all of this wonderful information to make your investment decision on. They are illiquid. And so again, that's a unique aspect of the private market space. But because you get access to this kind of quality information, you can make a good long-term decision. You're not buying a toll road, for example, to just flip it in three or four months because the transaction costs and the opportunity costs are high. To put these deals together is very difficult, but because they are difficult, you get access to great information, you can make a long-term decision and then boom, you're into a very unique private investment that very few get the opportunity to access. Now you add that to your portfolio, and you sprinkle in some stocks and bonds and now you've got a really diversified story.
Michael, are there any areas right now of private markets that you're really zeroing in on or that you're particularly excited about? Or is it, as you suggest, these opportunities that come up, you evaluate them almost one by one and determine what the best course of action is at that point?
Yeah, again, people can think about it from a buying-a-house perspective. I suppose this is the best way to describe it. You can zero in on an area and say, okay, that's the area that I would love to buy my house in and you can walk around the street and point out a few houses that you would like to buy. Truth is, if the houses that you'd like to buy are not for sale, you can't buy it. And it's identical in this private market asset space. So let's pick the infrastructure world; we do have our eye on what we call infrastructure 2.0 or new age infrastructure type of assets. And we have themes that we want to focus on. The movement of information, the movement and storage of information and people. So think new age transportation, new age digital storing data, moving data, storing people, moving people, social infrastructure, education, hospitals. Those are the kinds of infrastructure themes that we're very keen on. But then having said that, we have to wait for the right opportunity and the right global partner, and we have to build this portfolio very thoughtfully and very carefully. So maybe we'll do two or three transactions a year and it will take time to build this kind of portfolio. But the investors come along with us on this asset-by-asset approach, and we build the portfolio together, and pretty soon they have a very unique way to access power and a unique way to access energy exposure and a unique way to access data and digital exposure. And it isn't just picking the handful of stocks that are available today. They have a much broader investments that we unlock for them to incorporate into their portfolio. So I don't know if that helps explain the challenge in the private markets world, but that's the way it is.
Well, I love the analogy of the real estate market for retail investor. For someone like myself, the biggest single investment I've made by far in my life is buying my home. I also buy stocks and bonds, but buying stocks and bonds are very easy. I could sit and trade a stock here on my phone while we're having this conversation quite easily. I wouldn't do that because it's very rude. But I could, right? Whereas the house transaction is a much longer process. It's not as liquid. Canadian real estate market moves fairly nicely, but it's a big purchase. You've got to have a significant amount and it doesn't happen in ten seconds. It happens over a period of time. You're talking about ramping it up to a much larger scale. But if I continue on your analogy, there's a couple of ways, if the house in a particular area that I like, I can sit and wait for it to come on the market and just scan around and be aware of the potential for that to become available because I love it so much. Or I could just go and knock on the door and say, hey, are you ever going to sell this place? Do you do both? Do some of them come to you?
Yeah, well, in fact, the real estate portfolio was built that very way. The entire portfolio was built on knocking on the door. And if you recall, we set up that relationship with BCI. It was not on the market, it was not accessible, it was not even a concept that was around. So that entire business was set up by knocking on a door. And similarly, in the infrastructure space, we'll knock on doors, and we'll also look what's available. And the more general the approach, the less constrained approach you have, the better success you'll have. That's life. You try to avoid being constrained. And what you want to find are those opportunities that are just hard to replicate. They have a moat around them that protects them from competition and really helps you generate great long-term returns. And we've also built a team here and that's another unique difference between the public markets and the private market space. When you buy a stock, I suppose you could call up the CEO and say you'd like them to run their business a different way or you don't like the decisions they're making. But I'm not sure that they would take that call. You could try. In the private market space, you do have the opportunity to drive incremental value. In fact, after the acquisition is made, that's often when you make the strongest return. So if you buy a building, you can renovate or expand or add density to it. If you buy an infrastructure asset, you can often change the business model and expand and really grow that business and add value post acquisition. So it isn't just on the buy and the sell that you're making a return, you're also making a return on that added alpha. And I loved what the CEO of CPPIB said. He was quoted in the paper maybe a month or two ago and he called it the decade of alpha. And what he meant by that was, it isn't just about buying passive investment ideas anymore. That's not going to work with all the information available in the computer trading and now the AI that is really going to just think quicker than anyone and really synthesize all of these returns. What is going to differentiate and what investors have to focus on the most is finding opportunities where they can add value. And that's alpha. Beta is the market. Alpha is the extra value that you can create in finding these businesses that are hard to replicate or hard to access and have a moat where you can add value over the long term. And it will be a decade of that. And again, the private market space is where owning a building directly allows us to add value around leasing decisions or building a new building on some extra land that we have. The same goes for the infrastructure space so that active asset management skill can really make a difference.
And being in markets that are somewhat less efficient, as you initially described at the front end of the podcast, that helps you, if you know what you're doing, of course. It gives you the potential to find that extra alpha.
Yeah, exactly right. And another difference between public and private markets is when you buy a stock— I'm sure most people know this, but maybe not all— there is a standardized contract in place behind that transaction. So the regulatory authorities have a standardized contract in place to protect the buyer and the seller of a stock, because literally, today, you push a button, you bought a stock, you push this button, you sold a stock. But behind that are actually very controlled, efficient contracts to protect the buyer and the seller. In the private market space, those are all negotiated and there's a real opportunity to add value in the contract negotiation, build in certain rights that aren't necessarily embedded in the price, but give you benefits into the future. And we've done that in our real estate transaction. We'll do that in the infrastructure transaction. It gives us the opportunity to influence decisions in the future. It gives us the opportunity to grow in ways that you can't build into a public market contract. And so there's these non-priced opportunities or embedded values that are in private market valuations that set it apart from public market opportunities. And so, putting that all together, this is why the pension funds and the institutions invested so heavily in private market assets, because they get all of these benefits, and then you line those up beside your public market investments and what you've got is a very diversified portfolio that really starts to be able to move through these challenging times and doesn't swing up and down with the kind of volatility we've seen certainly over the past three or four years. It's been a crazy ride in the public markets.
Yeah. And again, I think what is so amazing about what you're doing is that access that you're giving to people that would not have had before and making the decision to enter into that. Michael, just before we close up, a lot of news around commercial real estate, and I know this is certainly an area along with private markets, that's an area of expertise for you. Commercial real estate, post COVID, whether it's an office tower in a downtown core, whether it's a shopping mall in a suburb, what do you think the future of commercial real estate is, in your opinion? I'm taking, from everything we've discussed already, you think it is an important part of a diversified portfolio. But where do you think we're heading now as we come out of COVID.
Well, we've talked about this before. You need to follow the population. So if you're in a market, if you're in a city, if you're in a neighborhood where there's demand— population growth, job growth, reasons for people to want to move there or live there—, real estate will always increase in value. It's a scarce resource. It is very difficult to make land. Now you can fill in things and rezone things and build higher and those are ways they artificially create more land. But at the end of the day, land is a scarce resource and well-located land is even a scarcer resource. So if you're beside a highway or a transit node or certain amenities or amenity-rich centers, you have a long-term valuable asset. Now, there's going to be economic swings. We have to live through economic cycles. That's part of life. But fundamentally, if you see population and job growth in the markets that you're investing in, you're going to be okay over the long term. The only thing that can get you trouble is borrowing too much and overextending yourself too much and maybe taking on too much development risk where you're betting on the future a little bit too much and maybe the future takes too long to play out. But if you stay conservative and you stay within your means and you buy in these central population and job growth markets, you will be fine. And you look today at the commercial real estate market overall and we tend to focus on the residential rental market, the industrial market, the retail market and the office market. A lot has been written about the strength of the residential rental market. So we'll just leave that aside. The thesis is that market is strong today and it will be strong into the future. And Canada is a wonderful country in terms of its open borders and immigration policies and job growth and commodities. We have the benefit of being in a wonderful country that's going to drive population growth, which will ultimately benefit the residential sector. So I have a strong conviction in that sector. Industrial, same thing. When you think about it, single level big buildings that need room for trucks and boy, it's hard to find land that fits that bill around airports and highways. Drive around, it's pretty much built out. So if you own it, you're going to be in good shape. I hate to use the «forever» word, but for a long, long time, because you own something that's just as impossible to replicate. You can't buy a piece of land around the Toronto airport that's of scale to build one of these buildings. It's all built out. And so, if that's what you own today, boy, that will stand the test of time. And the industrial sector will benefit from Canada's diversity around its population growth; it will drive distribution needs, its manufacturing sector. We do have embedded strength in our economy around the manufacturing sector. You've seen how this province is trying to re-energize the automotive manufacturing sector. I think long term the manufacturing sector and the distribution sectors are going to drive and maintain the health of the industrial business. So those two, I think, are in very good shape. Retail has seen an interesting ride. The pendulum swung too far towards online shopping in the early days of the pandemics. It certainly has swung back. We've seen people return. In fact, shopping traffic, physical shopping traffic is ahead of it where it was pre-COVID. So we've come all the way back. Sales have come all the way back in terms of the physical shopping center. And so I think retail, physical retail has really bounced back. Now, what's looming in the future is a recession. And will there be a little bit of pullback on the spending side? Let that play out. Certainly higher interest rates are going to cut back on what people are willing to spend on the retail sector. But from a practical purpose, I don't think the online story is going to be the one that has a significant impact on the physical store. It's going to be a recession that has a short-term pullback. And again, I think long term your money good on the retail sector and we're seeing that play out both on the enclosed mall front and the open-air grocery anchored front. So the retail sector is in great space and now what's catching all the headlines is the office. So now it's the office market's turn to bear the brunt of the headlines. And if there wasn't a news story that was negative, it wouldn't make it to the newspaper. I read all about the death of the office now and how everyone is going to be working home forever. I don't know. I've told you my theory that most of these articles are written by people that love working from home. And so what you're going to hear is work-from-home bias, and that's fine. People don't need to come back to the office five days a week for the office market to return to strength. I think what you're seeing actually is a significant hiring pullback from technology. You're seeing a bit of the leading edge from the recession and some of the softer corporate profits are pulling back on office demand. This is all normal cyclical stuff that's going to happen in the office sector and pull back office demand. Interestingly enough, what happens is people stop building office buildings and so supply stops. And ultimately what happens is, when demand comes back again— and in fact, the better buildings are actually doing quite well, it's the poorly located weaker ones that are really struggling. But that's okay. The overall headlines are about weak market, and that's true. But what you're going to see is this will cycle back and it may take a couple of years to play out. We need to get this recession past us. I know because I'm sitting in the middle of it. There is a pent-up demand building within existing office users that hired during COVID, that don't have enough seats for people to return fully to the office, that don't want to rent more office space. So there's pent-up demand that is built through COVID that I think will get filled in a year or two. Not today because of the looming recession, but in a year or two, that pent-up demand will be released. And then, the new jobs that will be created. If you believe every new job in the future is going to be remote, okay, well then, you're not a believer in the office building. I get that. But I don't think that's realistic that every new job is going to be fully remote. In fact, in every survey that I've read, about 10% of new jobs will be fully remote. 90% will have some amount of office employment. And whether that's two days a week, three days a week, four days a week, it doesn't really matter. It's going to drive some office demand. And when that starts to insert itself, you combine that with the pent-up demand, with no new supply, in two or three years, I think you'll see a bounce. The benefits are going to accrue to those who are patient. Those who are stressed that have borrowed too much or own an office building that needs capital or is in a market that isn't seeing job growth, yeah, they're going to see some stress. And you're seeing that play out in the US. It's a classic market that loves to borrow money. They borrow as much as they can. That's their philosophy. When times turn down, they're not afraid to throw the keys back to the lender. It makes for sensational headlines and so it makes the news. Canada is a very different place. We don't tend to borrow as much. Our loan to value is very low, compared to the US, on the commercial side. We don't allow lenders to take back loans. We tend to sign recourse obligations, which means that we stand behind these mortgages with our own covenant, which is greater than just the building itself. It tends to be a market where we repay our debts, whereas in the US, it is quite normal for businesses to hand back the keys and walk away from buildings that aren't able to service their loans. So bottom line is, I think the headlines are going to continue to be written. I think we've got another year or two of struggles in the office sector. It'll make for some pretty sensational stories involving some big names. But in this country where we're blessed with population growth and job growth and very strong ownership with low leverage, the buildings are in good shape, we've got the wherewithal to fight through this next year or two and actually be really well positioned for the bounce that will come.
Wow. I mean, that's one of the reasons I love talking to you, Michael. I always learn something, or at the very least in an area that I'm not as experienced in as you— and I think probably a lot of the listeners aren't as experienced—, just learn about just some of the fundamentals that drive that part of the market. And it's something that when I'm out talking to realtors— I'm doing a lot of work with realtors these days—, and I talk about that ongoing demand in a country like Canada, where we now have a target of about a half a million people. And maybe we even have more than that coming on an annual basis, that is just going to continue to drive demand. And it makes sense that if that spreads across the broader economy to include industrial, more people buying stuff that's retail, more people working in a market, that's office space that over the long haul that's going to work out. And then similar thing, we talk about the energy industry or a copper mine and say, hey, supply is constrained and then as soon as demand picks up at some point in the future, well, you can't just snap your finger and have a new copper mine there. Same thing goes with a big office tower in a major center. That's not going to be built overnight. And you have these opportunities that come up again as long as you focus on quality, and you know what you're doing and you stay to the fundamentals. And then the other big thing that comes out of this conversation that we talk about all the time on this podcast is that importance of diversification. I think most people here own stocks and bonds, they may have their own home, but these are areas that are a gap in a lot of people's portfolios. And again, we're always moving forward, but the idea that we can get that now through someone like you is pretty exciting. So Michael, as always, just brilliant. And we'll have to do this more often, but I really appreciate you taking the time. As I say, it's always interesting and my favorite guests are the ones that I learned something from, so that I hope everyone listening learned something from as well. It was a fascinating discussion.
Yeah, well, thank you Dave. It's always a pleasure. Fun to be on with you. Thank you.