344: Brian Adams - Inflation, Commercial Real Estate, Demographics

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It's my pleasure to welcome Brian Adams. He is the founder of Excelsior Capital and he is a student like I am of demographic trends and demographic cohorts and also an operator and syndicator of office properties in I believe 12 markets around the United States. So he has some good insight into what's going on in the office property market. Brian, welcome. How are you?

I'm great. Thank you for having me.

It's good to have you. Where are you located?

I'm in Nashville, Tennessee. I'm a native New Yorker, but I married a Nashville girl. I've been here 15 years now.

Good deal. Well, Nashville's a great place. And I bet you're happy you're not in New York right now.

Yeah, it's a scary scene up there.

It sure is. It sure is. But that's a good lead in to maybe just a broad conversation, I believe. Brian, I was the first person to predict, at least that I couldn't confined that there would be this mass migration out of urban areas into suburban markets. It was really back when we were all hearing about Wuhan and then we heard about Italy. That's when I made that prediction. And then two, three months later, I started hearing it everywhere. It wasn't rocket science. It's kind of obvious, right? That density is dangerous in the current environment. What are your thoughts about that, especially as you tie it in with demographics and you study the millennial generation a lot. And I just interestingly saw an article yesterday about how millennials have a new found interest in suburbia, where the trend for decades has been back into the cities. And now that we're seeing that reverse, what are your thoughts?

Yeah, it's a great question and I think very topical considering everything that's happening. Taking a step back, millennials, roughly 75 million people total. I do barely qualify. I'm on the outer edge of it. But under the Pew and Gallup guidelines, I do qualify as a millennial. I think the narrative on Wall street and in the media was that millennials were Never going to get married, they were never going to have children. They were going to live in apartment buildings in Brook tight jeans and eat avocado toast and never leave. And the reality is because of 2008 and the great Recession, their family formation was pushed back five plus years compared to other generations. And so now that they've entered into this maturing millennial phase of life, they are having children, they are getting married, and they're making decisions about where they want to live, work and play based on quality of life, cost of living and access to single family homes and education for their children. And Covid, like, you know, impacting other aspects of the world is really just accelerating a trend that we've been seeing where they've been relocating to suburban markets. I think we all can agree that over the last hundred plus years in America, pretty much every generation has rebelled against their parents way of life and lifestyle, but ultimately has resumed that style of life and that quality of life just like their parents had. So my parents were of the 60s and the 70s. They thought they were never going to, you know, live in the suburbs and have kids and drive SUVs. Well, guess what? That's exactly what happened. And so I think we're seeing that play out in real time here. But Covid is certainly accelerating that transition. And I think you're seeing this mass migration and if you look at the U Haul numbers, it's pretty staggering. Out of New York, out of California, and part of that has to do with COVID But also it was already happening.

It's been happening for a long time.

Yeah, it's been happening for a long time and people have been tracking this and unfortunately with those markets, the tax situation is only going to get worse. And it's this pernicious death spiral of the tax base is leaving those markets. So they have to increase taxes and cut services to make up for it and it's just not going to end well. That being said, do I think New York or San Francisco are going to go away? Certainly not. This will allow younger people to have a more affordable entry point into those markets and then the cycle will continue. But I think for the next 10, 15, 20 years, the play is in suburban secondary markets, growth markets, tax friendly and business friendly territories.

I couldn't agree with you more. Years ago I interviewed Meredith Whitney who wrote a great book called the State of the States. I might have the title slightly wrong, but generally that's the title. It just talked about how there's been this mass migration for years out of the High tax, big government, intrusive, mostly left leaning jurisdictions to more business friendly, lower tax environments. And so that's true. And now we see all these benefits that these areas offered have just completely evaporated in the current environment. And we shouldn't just talk about COVID we should talk about civil unrest, race riots, all of this other stuff that's going on. And there's this crazy assumption, I think it's just a very dangerous assumption that the whole world is making that we're going to have a vaccine. Maybe we'll never have a vaccine. Maybe it'll take a long time. I was reading recently that vaccines take many, many years to come to market because you have to put them into healthy people. It's much easier to get approval and understand a pharmaceutical when you're dealing with sick people. But when you're dealing with healthy people, it's much more complicated. You know, I'm not an expert in this, but I was just reading about.

It, so that is, I think that's accurate. I'm lucky enough to have married into a family of healthcare practitioners. They all work at Vanderbilt Medical Center. My father in law is on the infectious disease pandemic committee at Vanderbilt for their response. And if you look back in history, on average it takes four years, soup to nuts, to get a vaccine widely distributed. Now the last time we did that, it was a while ago. So hopefully advances in technology will speed that up. But I think it's unrealistic to think that we can compress it from four years to six months. And so I agree with you. I think, and it's very different between having a vaccine that is effective and distributing that vaccine on a global scale.

Right.

That will take a lot of time and it will have a lot of logistical challenges and will require a lot of cooperation globally, which unfortunately the state of play right now in geopolitics is not really conducive to that kind of cooperation.

Yeah, yeah, no, that's very true. But is it possible that there will never be a vaccine? That we will simply have to reach herd immunity and that's the only hope or we'll have to live like this forever? I mean, maybe there will never be. I mean, what is this sort of arrogant assumption everybody has that humanity can solve every problem and there will be a vaccine, it just takes time, right? Well, maybe. I don't know.

I'm not sure that's, I'm speaking way out of turn here because I'm just a real estate guy. I think a more likely outcome is that on a seasonal basis, much like the typical flu that we have today.

It ties down.

Yeah, well, no, that we have a set of people that take a best guess on what the most virulent strain will be for that season and then we will get vaccinated for that strain. But they're not always going to get it right. So I think we're going to be living with COVID for a long time. And just like the seasonal flu today, we'll have opportunities to have it deferves, but I'm not sure we'll ever truly go away.

Yeah, interesting. Well, okay, so tell us more about the millennial trends and what is going on in the office space market. Because many of our listeners are residential investors, but this is all connected, obviously. What are you seeing for the office property market?

Yeah, Taking a step back, Covid impacting on commercial real estate. I think of it as really just a continuum. Obviously hospitality and retail travel, leisure are just getting crushed right now. Multifamily. You're starting to see that pain as the PPP wears off and people are defaulting and not paying. And you've got certain jurisdictions, like we discussed, that are not allowing operators or sponsors to evict people. And that's only exacerbating the problem. Office is probably somewhere in the middle. Right. I mean, we're not as insulated as data centers or cell towers, but we're certainly doing better than hotels. So we run about 2 1/2 million square feet total. It's about $350 million portfolio in 12 markets. We've had about 92% rent collection month over month, which is about average. So we've been doing okay, but we certainly have had a lot of rent relief requests and trying to figure out if they're legitimate or opportunistic. And then we have had some tenants have some real challenges and so trying to work through that. But if you take a step back, I think given that most of these assets are CMBS related on the debt.

Side, then that means commercial mortgage backed securities, Correct?

Yeah. So that is a complex financial market in and of itself and it will take six plus months for that to really wash out. So we won't really have a good sense, I think, until Q1, of what the damage has been. I do think suburban, and I'm biased, but I think suburban office is really well positioned. If you look at the trend line over the last 10 years, it was towards really dense space, really expensive build outs. Think of WeWork where sometimes it was as low as 75 square feet. Per user in those spaces, whereas the traditional Office layout is 250 square feet per employee. You'll see a return to more space and more expensive, more affordable space. And another thing that you don't hear a lot about is it's rational to think that people don't want to take mass transit to a high rise in New York. But if they're relocating to a suburban market or a secondary market, that's still quite a lot of density and you need to have an asset that can park it. And suburban office offers a really good parking ratio to take on that density.

Mm. So say that again about the transit.

I think it's reasonable to believe that affluent employees, knowledge based workers are not going to want to take. They're not going to want to drive to a train, then get on a bus and then get on a subway to walk to their office building.

Yeah, I agree, I agree.

So I think it's going to be more car centric markets. And you know, pre Covid, it was really a negative post. Covid is a positive.

Yeah, yeah. No, it's. The environmentalists must be just really upset right now because this is not going to be. This is not going to be what they want. They want mass transit, they want high density living, and everybody's just doing the complete opposite. So it's very interesting. Well, the office space itself though, maybe the bright side here is that the office space itself within the office suite has to be redesigned for more square footage per employee and wider hallways and all sorts of new concerns. If people are going to come back to offices at all, there's a new way. They've got to do it right. We can't. You know, certainly the coworking model is really out because like you said, 75 square feet per person versus 250. What do you think about that? Is that a bright spot in your eyes?

Yeah, I mean, I think you'll actually see a renaissance in coworking, but it will be a different model. I think you'll see a return towards more of the old school, conservative, Regis type layout where you're literally renting an office and there will be shared amenities and shared common areas that just won't really be used simultaneously. But I think the concept of benching hot desking, hoteling, which are all these jargony Wall street terms for jamming people into a small space, that certainly is going away.

Yeah, I agree with you. And I don't think people are going to be working at coffee shops too much anymore either.

When you see the headlines of Facebook and Twitter and some of these tech companies say, oh yeah, we're going to let people work from home forever. If you actually look at what they're doing and read the press releases, it's not that they're letting people work from home, which is different than remote working. I think it's important to draw that distinction. What they're doing is transitioning to a hub and spoke model where you still have the mothership in Manhattan or the Bay Area, but they're allowing a lot of their employees to work in support secondary markets in places like Nashville, Austin, Denver, et cetera. And I think you'll see more and more of that.

So with that mothership and hub and spoke model, and I have been reading about the hub and spoke model, how big does that mothership need to be, though? That's the thing. It all changes in terms of the size requirement. So maybe these flagship big companies that can afford it will still have the office in Manhattan or whatever, trophy city, but it's going to be a lot smaller, right?

Yeah. I mean, we've seen real rent rates in Manhattan decline 20% since COVID And so I think a lot of users and employers are going to rethink how much they spend on overhead on these type of markets. And I think to your point, there will be a need to have that trophy office in the trophy market, but it's going to be a much smaller corpus of people that are using it.

Well, what else can you tell us? What else do you want us to know? I assume the banks are very concerned about financing deals. Are any new deals going on in the office market or is that just asleep right now?

That's a great question. We actually closed the deal in June. We bought property in Kansas City on the Kansas side. We were originally supposed to close it the first week of April. It clearly didn't happen. We had to get a different lender, we had to backfill some equity. We really believe in the story there and we were excited to get it done, but it was a lot of work. And I think what you're seeing right now in real time, in transactionally, is you hear this term price discovery, which is this fancy way of saying buyers and sellers are not on the same page as the value on assets and buyers want a discount. And sellers are saying, well, my building is full and so far everyone's paid the rent. And then buyers are saying, yeah, but can we really rely on that rent payment for the next 3, 612 months? And the seller's saying, well, that's not my problem. And so that's really the disconnect transactionally. And then I think more fundamentally the CMBS market for all extensive purposes is paused. And that's a real problem. Bank lenders are trying to keep cash on their balance sheet for defaults on small businesses that they think are going to struggle in a recessionary period. It's just very hard to get debt. I always say a way to put it is that the debt market is just really soft right now. It's hard to get deals done that way.

Right. The market has largely frozen up in terms of financing is what you're saying, right?

Yeah, I mean, I just. In the office world, I don't, I haven't seen a lot of deals come across our desk and I haven't heard of a lot of other sponsors or operators getting deals done. It seemed like most people Press pause In Q1, they put their toe back in the water, but everyone's just very hesitant right now.

Yeah, I agree. So if you were to liken this to a 9 inning baseball game that the whole pandemic, you know, throw in the civil unrest and just the state of the world right now. What inning are we in? Yeah, I say third if you want, if you want to know mine, I think we're in the third inning. But you tell us your thought.

Yeah, I mean, I'm a Mets fan, so you know, the longer this, this goes on, the, the more I draw a parallel to the Mets being exciting on the early innings and then always blowing it. But I'd say probably, you're probably spot on. I'd say the first third of this whole problem is just starting to get unwound. I really think it's going to take until Q1 where a lot of these defaulting properties get flushed through the system and they can get picked up by distressed buyers before the market normalizes. So I think that's at least six months out.

Yeah. And then we'll have price discovery. I would say that's going to take a lot longer than six months. But I'm not in the office world as you are.

Bad is the economy really? It's hard to tell because it's so uneven. Some people, like myself, fortunately are doing great. You're probably doing pretty well too. But some people are really struggling and that's got to work its way through the system. I mean, trickle up, trickle down, trickle sideways. We haven't seen the impact yet. Right.

I would agree. And there's a real disconnect between the stock market and the economy.

Yeah. It's absurd.

The Fed and Congress have been flooding the capital market system with liquidity. And debt is so cheap that because the cost of capital is basically zero. And when I say cost of capital, I mean interest rates, right? Like how much it costs to borrow money to go do deals, that's essentially zero. Which means that all of that liquidity has to go somewhere. And because real assets are tricky right now, what we just talked about, and because bonds are yielding nothing, it's going to the stock market. That's why you're seeing just huge valuations and huge run ups. And the tech sector especially is just being pumped full of value because that money needs to go somewhere. And so that's the stock market, the economy itself. We could take any number of data points, but it's really doing very poorly. And you're seeing earnings season just hitting this week. And I think you're going to start to see.

Some real struggles by some big corporate users. And I agree with you, I think that's going to take a long time to flesh out as well. But it is strange because I'm lucky enough to be affluent and to your point, I've enjoyed the run up in the stock market and I have more net worth today than I did pre Covid, which is a bizarre situation, but it just, it is what it is.

Oh well, listen, I saw a chart, maybe you've seen it floating around too a couple of weeks ago about how the rich are just getting so much richer right now. And I'm talking about the ultra rich, you know, the Gates, Bezos, Musk. Even below that, just high net worth or ultra high net worth. People that are considered above $30 million net worth are really doing quite well. And not to mention a lot of us are saving a lot of money because we're not going anywhere.

It's a time that some people are actually improving their lives, they're learning new skills and hopefully there's a lot of positive effects that come. I mean there's already a lot of positive effects, affects early adoption for a lot of these technologies that have been around for a while. I don't want to say early adoption, that's probably the wrong way to say it, but people are finally adopting a lot of these great technologies we've had for years. And I think that's going to make the world a lot more efficient overall. Lower consumer prices in some areas. Right now the opposite is happening of course, but long term a lot of these efficiencies will trickle down.

Right, I agree. I mean I myself My marketing folks and business development folks were trying to get me to use things like Slack or LinkedIn and these other incredible tech tools and I just was too busy running my life. But because of quarantine and lockdown, we've really started to leverage those tools. We use Juniper Square as an investor relations CRM platform, for instance, and we've really dived into them. And it's incredible how much more efficient you can be. And I do agree with you. I think ultimately that will improve gdp. The flip side to that is it will alienate a workforce population that is not skilled. And we're going to have to figure out a way to put those folks to work and give them something to do. Because I really think this might be a secular shift in retail hospitality and some kind of entry level blue collar jobs. And we need to make sure that those folks have a means to live.

Hopefully those people have spent this last couple of months learning how to start a business from home or learning how to code or learning some skill and improving themselves. Because in many ways it's a great respite, it's a great time to be doing that. And some people are. Let's hope it's a lot of people.

I do think you're going to see a continuation of what is essentially universal basic income in order to, in order to prevent mass civil unrest.

I do too. I do too. I think the UBI thing, we had Andrew Yang, the presidential candidate, on the show a while back and, and incredible guy. Yeah, yeah, he's a very smart guy. But you know, I would never endorse UBI and I have a lot of very libertarian friends that, you know, amazingly they endorse it. Now I'm coming around and thinking, you know, I don't think, I don't know that there's another way out with automation. It was already an issue with the automation trends, but it really looks like we're going to need a universal basic income, otherwise we're going to be living in a banana republic of rich and poor and that's no fun. That's not a good environment. Office reuse and even I know it's not your sector, but shopping mall reuse, residential is in very high demand. Office space and retail are in lower demand. So what about reusing these properties and converting them to residential uses? Is that something that even works? Is it just too expensive? Have you looked at it, thought about it? What do you think?

Yeah, I thought about it. We've looked at it and I think it really comes down to vintage right so what was a 1990s or 2000s building that you thought was relatively new now seems pretty antiquated because you're going to have a massive upgrade in infrastructure requirements like air purification systems. And to your point, expanding hallways, changing layouts, and unfortunately, older product that has deferred maintenance and capex issues already, it's going to become obsolete. And so I think vintage is going to be a huge, huge issue. So for instance, on a mall that's relatively new or a retail spot that's relatively new, I think it makes sense to probably reconfigure it and then, you know, bring it to best use and value. But some of these older, older vintage products, like these old malls or the JCPenney spaces, I think you're going to see them stripped down and used as distribution centers and warehouses, et cetera. I don't think it makes a whole lot of sense to convert them to residential.

Yeah, I don't, I can't imagine converting malls to residential. That just doesn't seem to work. You know, I, I'm no expert, but that just seems it like a very tall order. Whereas it's more like, you know, the wrecking ball and just use the land. Right, but go ahead.

Yeah. Where I've seen the mall conversion really work is for outpatient medical office services.

Right.

So you know, medical centers are trying to get people out of their main headquarters and into these outpatient ancillary areas. And that's where I think the malls make a ton of sense because they're well located, great interstate access, tons of parking and lots of space. And so I think I could see that occurring. But I agree with you. I think switching back to residential when you actually run the numbers and do the math, so expensive, probably easier just to do ground up.

Yeah, I agree. Just to, just to build it from scratch is what you're saying. Yeah, I agree with you. But you know, the one area of office product that seems like it really could work as a residential conversion are these two story garden style office complexes built in the 70s or even earlier, you know, where a lot of them, the door of the office suite comes out onto an outdoor walkway or maybe indoor hallways, but you know, they're fairly wide and it seems like that would be workable. But gosh, you got to plumb those kitchens and bathrooms and remember office spaces just have a bathroom down the hall that everybody shares and no kitchens or little tiny kitchenettes that are, you know, meaningless. So you know, that's, that's expensive and there's an awful lot of glass in there. And, you know, the buildings don't lend themselves well to privacy and. And sort of the typical residential that we're used to. What do you think?

One thing to watch there is, I myself personally am terrified of inflation. I think it's. I think it's coming. I think the amount of money being pumped to the system has to at some point result in some type of inflation.

I agree, I agree. I'm glad you mentioned that. Yeah.

We could talk a little bit about money supply as well, which is always interesting. But the one area that you're seeing immediate deflationary dynamics is in construction costs, which I think were needed, considering that they were just going gangbusters during this whole run up. So some projects that didn't pencil out pre Covid now do, and some folks that I know in the general contracting or big development space are saying that developers are actually taking projects, green lighting them again because they're getting a 20% plus discount to what pricing was on materials and labor pre Covid.

Well, okay. So I don't know if it's short term and it's a result of supply demand shock, which we've talked about a lot on the show. That's sort of a rare economic malady. But I think we're in it in many areas now. But I'm reading a lot of articles saying the exact opposite. And again, maybe it's temporary, but with this building boom, I just read an article yesterday talking about how construction prices are way up and materials are getting very expensive. And as builders just struggle to find materials now, we've had supply chain disruptions, but I think those are mostly back online now. I don't know. What do you think about that you're seeing?

You know, I'm not a developer, so I can't say I can tell you anecdotally. We had a vacant space in one of our buildings in Kansas City. We were considering speccing it out or white boxing it, which is essentially, it was kind of raw space, first generation space, and we were going to put plaster up and make it look a little bit prettier, more presentable to attract a tenant. When we priced it out in Q4 Q1, it just was very expensive. We said, it's not worth it, let's just hold it. It was a very small space. The rest of the building is occupied. But the GC actually just came back to us last month and he discounted his own cost at 25% just because he said he needed to get his crews working and doing something and so we actually ended up going ahead and moving forward with that project. So that's what we're seeing. I can't speak to what's happening on a large developmental scale because that's not my space.

We'll see how that works out. But ultimately you think inflation is coming?

Yeah. And again, I'm not an economist, but when you see we're already well over the money supply that was put into the system in 2008 in the Great Recession and eventually it has to work its way into the CPI numbers, I can't envision a world where this doesn't cause some kind of massive inflation because I think from the Fed's perspective, inflation is a much better option than deflation, which is just a pernicious cycle for people.

Yeah. And that's why I say investors listening. I've been saying this for 16 years. Align your interest with the most powerful forces the human race has ever known, governments and central banks. And they do not want deflation, they want inflation. Amen. So that's you really want to align your interests with.

Yeah. Do not fight the Fed.

Because their mandate of their dual mandate, it's kind of been pushed aside. And I agree with you completely is they're terrified of deflation and they will do anything within their power to make sure we don't go down that path. And you've seen, if you take a look at Argentina and some of these other places that have experienced hyperinflation in the modern era, you know, it's not fun but it's manageable and you can restructure that debt on a five or ten year basis. And so I think it is coming. And if you look at treasuries and you look at inflation adjusted municipal bonds, I think the yields now are like 50 basis points. So people are, institutional investors are understanding where this is heading. A lot of families I know have taken money out of the market, they've taken their gains and, and now they're putting into recession proof, tax efficient and inflation adjusted or hedged assets.

Yeah, absolutely. Yes, it's a very interesting time. But you just can't create this kind of money and not have inflationary pressure. I just don't even think that's possible. And you know what's ridiculous, and maybe we'll close on this concept is that you have, I mean I interview so many people that say things like, well, look at, they've created so much new money and so much new credit out of thin air and they can't create inflation coming out of the Great Recession. And now they're saying it again. And I just don't think that's true because they never ask themselves, the people that say that, they never ask themselves. My famous question compared to what how much inflation or deflation would we have had had they not created all that new money? And there is absolutely no limit to how much they can create. If you sent everybody in America a stimulus check for a million dollars, trust me, we would have a lot of inflation very quickly if people went out and spent that money into the economy. So I don't know, people make these funny statements. They just don't make any sense to me.

Yeah, I agree with you. I am very worried about inflation coming. Hyperinflation, I think, is a real prospect on the horizon. And when you're dealing with the Fed, who essentially is the employee of the President and the President is on a really, at this point in the world and in the history of America, it's about a two year sales cycle before they're back up for reelection.

Right.

You know, Trump has the Fed in his pocket and he's using his bully pulpit very effectively. I don't see that changing regardless of who wins in November.

Yeah, no, they're both spenders, both sides. It makes a little bit of difference, but not that much in terms of the monetary and fiscal policy. Yeah, I agree. Brian, wrap it up with a closing comment. Give out your website or any resource you want to share with our listeners.

Yeah, thank you again for having me. This is a ton of fun.

My pleasure.

Yeah, so I'm very active on LinkedIn. You can look me up there if you DM me. I'm happy to get on the phone and chat and answer any questions you might have or be a resource for you. And then excelsiorgp.com is the website. And if you can log on to the site, enter in your information. Happy to set up a call, et cetera.

Brian and LinkedIn. You're Brian C. Adams. It might be easy to confuse you with a famous musician. I'm sure you've heard that before.

Yeah, the 80s pop star. There you go.

Yeah, yeah, good stuff. Well, Brian, thanks so much for joining us and take care and happy investing.

Yeah. Jason, thank you so much for having me.

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