10 Questions with a Real Estate Executive
Interview conducted by Ashley Rogers (FT '21) and Dan Sandbrink (PT '23) on 3/8/2021
1. David, I saw that you graduated from the University of Illinois with a degree in Civil Engineering – so you were not classically trained in real estate or real estate finance. Maybe you could help us understand how you got your start in the real estate industry?
You have done your research! I was a civil engineering major with a specialty in structural engineering. But while I was in a structural beam design class my junior year, I decided I did not want to spend my life trying to figure out beam deflection! I was interested in buildings, so I decided I wanted to find a way toward the building business. My first job out of college was selling elevators for Otis Elevator Company. We were a subcontractor, and I was working with architects on trying to get our elevators into their buildings. Interesting fact – As part of my training I helped install the elevators for the Hyatt Regency and Three Illinois Center in Chicago, so I was out there in the elevator shaft putting these things in. At the time I thought that the real estate developers had all the money because they were the ones paying the subcontractors, and the elevator contractor was the last one to get paid. So I went to business school with development as my desired career. Coming out of U of C, Prudential was the largest owner of real estate in the United States, other than the U.S. government and the Catholic Church - it was the Blackstone of 1982. So, Prudential came and interviewed on campus, I got a job there, and that is how I got into the business. Ironically, while I wanted to be a developer I did not end up doing much of that until after I retired, but that is how I got started.
2. We understand you worked a long time at Prudential, primarily on the debt side. How would you describe your career and the various roles that you served at Prudential?
I'll try and make that a short answer. It's been a spectacular experience working with Sam. He sees things differently. He's very direct and we've probably bought $75 billion of real estate since I got here. I always talk about how there's clarity when you talk to Sam; there's no ambiguity. He's got a view. And he's committed to it. He wants you to take him on, wants you to give your view. And that's how you manage risk. I've been lucky to be able to travel the world and see things I would have never seen, things I would have never been able to do without being a part of EGI and working with Sam.
I was there for 31 years (1982-2013), and I had "multiple careers" during my time at Prudential. When I started in the 1980s, it was a quite different environment than it was after the crisis of the 1990s, which we can get into. I started off as just a trainee doing everything - some of the things you guys have done, acquisitions, asset management, and when Prudential started up a lending business on 1984 I was one of the first people "drafted" into the new group. That opened a playing field to advance my career quickly.
By the 1990s, I was one of the senior executives in the business, and I got a full dose of the financial crisis, both in the debt and the equity side of real estate. The early 90's were all about workouts, bankruptcies and foreclosures. By 1995 I ended up leading the business responsible for all of the equity real estate assets held on Prudential's balance sheet. I would call that my second career. It was my first role as the leader of a business unit. At the time Prudential was planning to go public and they decided to sell the wholly owned real estate portfolio and take back REIT stock to have more predictable earnings. I led that effort, and it was transformational for the company and one of the highest profile strategic steps across the real estate market.
After the equity portfolio was sold, I was in charge of the debt business which was my "third career". I did that for the last 14 years at Prudential. That was a transformational experience, too, because until that time we had primarily been a portfolio lender, and Prudential was trying to create business revenue beyond the portfolio returns. So we ended up going into the CMBS business, and bought a Fannie Mae/Freddie Mac/FHA multi-family lender, which is still one of the largest lenders in that business. I think we were the first large institution to do that. And so that whole last 14 years was essentially building and running a business versus just a lending portfolio. By the time I retired we had over $70 billion of assets under management and administration. So I had multiple careers at one company.
3. During your career at Prudential, you witnessed (and were part of) several innovations regarding balance-sheet lending, the CMBS market, and high-yield debt. What is your take on the evolution of these advancements?
Booth is an amazing environment filled with really smart people and professors who are interested in you if you're interested in them. At Northwestern I did not take academics seriously. By the time I was in business school, I wanted to understand the tools needed for success.
I think the key evolution is that, from the beginning to the end of my career, the diversity of capital sources, and not just debt, but equity as well, dramatically improved for the commercial real estate space. It was essentially insurance companies and banks in the 1980s, and the 1990s changed all that – whether it was REITs, private equity, opportunity funds, the CMBS market, Fannie Mae/Freddie Mac, or high-yield debt. They all came about to address the lack of liquidity and efficiency in some part of real estate market. I think the great thing about this is it is a more diverse capital base. It is also more efficient because it is more diverse.
However, the further the capital is from the property and the less transparency there is in understanding the real estate, the greater the risk that the capital is blindly going into things that the investors don't understand. In the 2002-2007 timeframe the securitization and derivative financial engineering that was being applied in residential real estate was being applied in commercial real estate with about a one to two year lag. And if we would have had another two years before the global financial crisis, all the things that happened in single family would have happened at a much larger scale than they did in commercial real estate. I think the one thing to watch is whether there is an alignment of capital with the ultimate performance of the property and if there is transparency in that alignment.
4. Continuing the subject of the financial crisis, you have lived through multiple crises during your career. What would you say has changed in how the industry has navigated through those, and do you see anything different about the COVID-19 pandemic response that we are currently working through?
The broader your exposure, the more you see common themes. Anyone at Booth has the intelligence to understand real estate. Real estate is sort of 10th grade math over and over. It's not that hard. But it is about judgment, it's about trying to understand a dimension of risk and trying to manage that risk. So, when we are sitting around talking about a deal, when we run the numbers, we run the numbers to determine the sensitivities. What bet are we making? How do we feel about that bet?
Because of all the diversity of capital, I think things have changed a lot. In the first crisis I went through in the 1990s, there was literally no liquidity. There were commercial real estate brokers who did not do a deal for three or four years. It is hard to fathom that today, but it was just a complete lack of any transactions. All the financial institutions pulled out of the market. It was just a very deep cycle of real estate depression. And every cycle since then, to some degree or another, the owners of property have learned that the capital returns more quickly. In the 1990s, it did not return for five or six years. In the words of Sam Zell, "Stay alive until 1995." It was a five-year experience. Every cycle since then, there has been more patience, and the capital has come back more quickly.
The COVID crisis is quite different for two reasons. First, generally people believe that real estate is going to snap back when life gets back to normal so there are very few distressed asset sales. Everyone is confidently waiting for vaccination to bring normalcy. But I think the unknown of the COVID crisis is that it has changed so many of our daily lives, whether it is work-from-home, Zoom meetings, online shopping, or where people live. Nobody really knows how those things are going to impact commercial real estate for the next 10 years, and I think that is the biggest unknown coming out of this crisis. I think when things get back to normal, which they will, there will be a return to real estate. But I think the unknowns relate to the lifestyle changes we have all experienced and how those will affect our sector.
5. After a storied career at Prudential, you obviously could have pursued a diverse range of interests or projects. What have you decided to do in your post-Prudential career? Why did you decide to get into real estate development? What sort of projects attract you?
I had some good advice from one of my mentors who said, "Once you retire, take six months to do nothing, and then don't do anything that you can't stop." I have not quite followed that advice. I really do three different things. I do board and advisory work. I am on the board of Boston Properties, which is the largest office REIT and an S&P 500 company. I became connected with that company through the real estate sales experience in the 1990s when we sold them some of our prime assets and took back stock as part of the transactions. Second, I make limited partnership investments where I have friends that raise money for specific assets or small funds. I stay connected to my friends that way and stay involved in their projects, and that has been fun. Third, I have my general partner activity where, interestingly, I have focused primarily on a portfolio of assets within a couple mile radius of where you guys sit at the University of Chicago. We purchased several real estate tax delinquencies, took them to deed, and have essentially rebuilt those projects. I have a partner who is very connected to the South Side and he has done an excellent job of generating high cash returns. Especially in this low interest rate environment, that is very attractive to me. I also like it because, in addition to the real estate component, we are really having an impact on some neighborhoods. We have done daycare centers. We have done a lot of low-income housing deals with Section 8 vouchers. Just seeing property go from near the wrecking ball to attractive real estate in these neighborhoods is really gratifying. All of that keeps me busy but gives me enough flexibility to enjoy my personal time.
6. Over the course of your career, you have worked on an all types of different deals and property types. What are some of your favorite property types right now, or which ones are you staying away from?
Over the course of my career, we saw a lot of volatility in some of the property types, but the two property types that I think have been most stable for 40 years are industrial and apartments. When I say industrial, I am referring to warehouses, not flex office/industrial. Those core property types are where we have found the best opportunities, and I think that those remain rock solid places to be going forward. They have stable income and strong long term demand characteristics.
Successful office investments are very driven by specific market characteristics. Because it's a capital intensive sector, it requires a very disciplined approach and deep pockets. There are certainly markets where you can succeed but it's more volatile than apartments or industrial.
For me personally, as I said earlier, I like affordable multifamily today more than I ever realized. I think there is a strong need there. I also like single-family rental. I was a skeptic early on, but I think there is going to be a sector of our population that is going to want to rent and enjoy the single family lifestyle while maintaining the flexibility around where they live. I also like self-storage as a long-term prospect. And I think student housing, if it does not get overbuilt, will be interesting as well.
8. A lot has been discussed about the gateway primary markets versus secondary markets, especially some of the fiscal situations that some of these markets are facing. What is your view on that dynamic as well as the difference between CBD and suburban markets?
This is a big issue right now. I mentioned earlier the uncertainty coming out of the COVID crisis, and I think that this is one of the fundamental questions. I think it is more complex than just gateway versus non-gateway. Let's just talk about it in terms of supply and demand characteristics. Demand for real estate, in my experience, is driven over time by the concentration of jobs in high-growth and high-income sectors. There are markets where there are clusters of college-educated people in sectors like tech, biotech, life science, and finance. Those cities have generally demonstrated excellent demand characteristics for real estate. And among those are some of the gateway markets - Boston, New York, San Francisco, Los Angeles - those all have those characteristics. But there are other markets that also have them, like Seattle, Dallas, Austin, and the Research Triangle. These job concentrations make it easier for employers and employees to manage their business/lives.
On the supply side, what I think distinguishes the gateway markets is they typically are more difficult to develop. That has not always been the case. For example, in New York, with the opening of the West Side and Hudson Yards, there has been a lot of supply added – particularly in the office sector. But gateway cities are expensive and hard markets to build in.
So I believe that the concentration of high growth/high income jobs are going to remain in gateway markets. I do not think they are going away post-COVID. I do not think work-from-home and dispersion are going to destroy those markets. I think it is going to come back, but I acknowledge it is the biggest question coming out of this cycle.
Considering suburban versus urban, there is no question that work-from-home will become a perk that is offered by most companies after the COVID crisis. Some executives may want to have an office suite near their house if they do not want to be in their house for their work life every day. You may have hub-and-spoke work arrangements for companies. I think that may benefit the suburban markets, but I do not think it excludes the urban markets from recovery.
9. Maybe we could step back a second and get your macroeconomic views. Over the last few years, interest rates have remained at historic lows. However, with economic improvement, the vaccine rollout, and the $1.9 trillion debt relief package that was recently passed by Congress, interest rates are rising rapidly with the 10-year Treasury recently hitting 1.6%. If these factors continue to drive inflation and interest rates higher, what do you think that does for the outlook of REITs and the real estate industry more broadly?
We were early investors in the shared office space. What we learned then, is what the market will learn again. We Work blew up on its own accord. It didn't blow up for the reason that everyone thought it would, and the reason all the others will, which is this. It's an up-market business, and when people need space, they're willing to pay a premium for flexibility. However, when the downturn comes and you're the real estate facilities guy and your CFO says I need you to cut back on real estate exposure, you go back to your CFO and say, "well I have an eight-year lease, and I have a 30 day lease." Which one do you think they're going to give back? There's no mystery, right? They're just fundamentally mismatched, and you'd say well why would anyone be in that business? Because it's heads they win tails you lose or tails the landlord loses, rather. When they can't pay anymore they move out. Well, when can't they pay anymore? When no one else wants the space. It's at precisely the time everyone's giving back space. So mostly owners say you know what I'll do a percentage deal with you. I'll let you stay until I have another tenant. We did that shared office deal, and we learned all those lessons early on.
To put it in perspective, we have had declining interest rates for 40 years. That makes a lot of people in real estate look smart. So there has been a great tailwind for commercial real estate for 40 years. Think about that. I had a borrower in 1985 who wanted to lock up a 15-year interest rate at 12%, which they did. Then we had to renegotiate the deal, and as part of the renegotiation, they wanted 17 years at 12%. Let's think of the mindset that says I want to lock up a 17-year loan at 12 percent. People get caught up in the mindset of the rate environment that we are in, so there is a risk that we are doing that now.
Having said that, I do not actually expect massive increases in interest rates. And I think in order to really impact real estate the 10-year Treasury would probably have to go above 4%. But real estate as a sector is more highly levered than the corporate market in general. Six times debt to EBITDA is low leverage in real estate and high leverage in the corporate debt market. Interest rates rising would hurt real estate more than it would hurt the broader corporate economy. REITs are actually lower leverage than the real estate sector as a whole, so I think the REITs might actually benefit in a rising interest rate environment. The opportunity fund and private equity players have done very well at trading, and interest rates are not a huge part of their return. The question is, "What would it take for cap rates to go up?", which would really hurt them. And again, I think that would be 10-year rates above 4%. So, my perspective is that it would be a tougher environment for real estate, but it would take a pretty big increase from here to have a meaningful impact.
10. What qualities do you look for in young real estate professionals when hiring? What skills do you think makes someone successful in the industry? What skills can MBA students focus on during their time at Booth?
Probably the most misunderstood part of the real estate industry is how much it has changed from when I was your age in 1983. We had four major food groups: apartments, industrial is still interesting, offices is okay, and retail is a dirty word. But nowadays you have cold storage, you have data centers, towers. American Tower Corp has had some of the best returns. So, it has changed. And one of the things I challenged my team with is to say, what's the next thing? And so the question is what asset heavy business could you find that today isn't thought of as traditional, but has those characteristics we talked about: granular, good fundamentals, that if you brought into the industry and demonstrated over time, the performance of the underlying flows that people would really price. And I don't know yet. If you guys know what it is, I'll buy you lunch.
I think most people come out of business school with the basics, the quantitative skills that are necessary, the analytical skills, and the ability to think through investment decisions. I think the thing that distinguishes people who are most successful in a business are those people that can build relationships. In this business you must be able to sell both yourself and your project. There is a certain innate need to get out there, network, market yourself, and have a level of entrepreneurship that you are willing to take a risk and to be decisive. Those are all critical skills.
As for skills to develop, most students tend to think of real estate as a quantitative effort, and ultimately anybody can do the numbers, but real estate has got a lot of art to it. If I were to say one thing about what I think people need to develop during and after they get out of business school it's an understanding of the art. How does the project lay out? How functional is it? How does it relate to its competitors? Really understand the location, the transportation nodes, and all the things that go into a specific real estate project. It is really about the users and whether they are going to want the project. That is the key. Understanding real estate from the perspective of a user is the element of the business that people need to develop over the course of their career, that they do not come with right out of business school.
