Lightly edited transcript
Louise: Hello and welcome to Navigating the Noise, a podcast by Natixis Investment Managers, where we bring you insights from our global collective of experts to help you make better investment decisions. I'm Louise Watson, and today I'll be joined by Sara Cassidy.
Sara is the Head of Portfolio Management for AEW's North American Business. Prior to working at AEW, Sara was an executive director in JP Morgan Asset Management's real estate division, and she's held other senior property roles in other firms. Sara works out of AEW's Boston office, which is in the middle of a very cold winter, so I'm sure she's looking forward to coming out to join us in the Australian summer shortly. And aside from this, Sara is super busy at home with two boys. She is constantly on the court. They play ice hockey, basketball, baseball, soccer. And we're just so grateful to have you here in this arena on this podcast with us today, Sara.
Sara Cassidy: Well, thank you, Louise, for having me. I am so excited to join you today and you are correct. It is a very special treat to leave this about 10 degree Fahrenheit weather here in Boston and I look forward to joining the summer with you in Sydney very soon.
Louise: And we can't wait to introduce you to everybody out here. And for those listeners that aren't familiar with AEW, can you tell us quickly what the firm does?
Sara: Absolutely. AEW is a real estate investment management firm. We were founded in 1981 and we are solely focused on real estate. We have a really long history offering a wide variety of investment strategies that are designed to really help our clients meet their investment goals. So today the North America platform sits at just about $40 billion of assets under management, all within actively managed real estate portfolios t hat really range that risk–return spectrum and they're held both in privately held real estate as well as listed securities.
Louise: And what exactly is core real estate and where does it sit in the context of other real estate investments?
Sara: It's a great question. Core real estate is really the lowest risk, most stable segment of commercial real estate investing. And it focuses on really high-quality, well-leased properties in prime locations. Really the goal here is to generate predictable long-term income. And so when you think about the return components, core returns should be primarily attributed to income with less of the return attributed to appreciation, and again considering it's lower risk, you're typically going to see lower leverage. So that would be maybe a 50% LTV (loan to value ratio) or lower. And also this should be your most liquid asset class, so really the highest probability of sale throughout all parts of the cycle.
Louise: And you've said there's a historically attractive entry point for US core real estate right now. Why is this the case?
Sara: Oh, I have, and it is really attractive. So just to start with, I think a little bit of market context matters. As you're probably aware in a lot of different markets, we had some comparable tailwinds here, but in the US we've really just come off what has been a pretty unique 15-year time period. It was really 15 years of mega cycle of declining rates and steady GDP growth. And so the investment markets really don't get much more benign than that.
But for better or worse, we have now exited that part of the cycle and really transitioned from that very low interest-rate environment to a much higher interest rate environment that caused some transition and really it was about a two-year time period where private real estate was in what I'll call a down cycle. Pretty challenging times for total returns within the real estate space starting really toward the end of 2022 and through the ending part of 2024 as the higher interest rates were absorbed and a higher required cost of capital was also really implemented across the asset class.
But today we're on the other side of that. We've seen a lot more stability in the 10-year Treasury and that's something that real estate prices off of. When that Treasury rate is range-bound, that means that there's a little bit more clarity for investors to price and invest on behalf of. And we've now seen the capital market metrics also remain stable for four consecutive quarters. And after many quarters of value decline, we now have five consecutive quarters of positive total return. That takes you all the way through the end of 2025.
And then there's also some pretty compelling broader metrics as we think about what's changed over that two-year time period. Property yields today are at the highest levels they've been since 2014. Going-in cap rates have increased by almost more than 100 basis points. And when you look at the discount rates, so the total returns that are underwritten in the ODCE index, those have increased by more than 150 basis points. So a lot of movement in rates over that time period that has resulted in repricing. And that repricing means that, generally speaking, current property values have declined across portfolios on average by about 25%.
So you have higher rates, you have higher expected returns, and you also have values that have declined pretty materially. And when you look at those property values and adjust them for inflation, those property values are at the level since the Global Financial Crisis.
So pretty compelling overall metrics. And then just one more to note when you look at these property values where they're priced today, many of them, on average, are very well below replacement costs, meaning that it's going to take a lot more time to see supply pressures because it's more cost efficient to buy than to build. So a lot of really interesting and compelling metrics that make this a historically attractive entry point and really particularly for quality core real estate.
Louise: And are you seeing increased capital flow to US real estate due to these conditions?
Sara: We are. We've really been talking to investors for many years now about what's been happening in the downturn and that you know, when you look back historically, it's very difficult to time the bottom of a downturn. But when you put your capital in at or near the bottom, the recovery can be really beneficial to investors.
They understand that, they recognise the downturn and they also recognised the slowing of valuation adjustments, the stabilisation of those metrics, and we have started to see new capital come in. We are really feeling that shift in investor sentiment - increasing manager searches, new allocations to core, and just generally overall, more positive expectations for the space which is bringing new capital in. So it has definitely been really positive and has resulted in increased capital flows.
Louise: And you mentioned timing. How long do you think this opportunity window will stay open for?
Sara: It's a great question. I do think that we still are reasonably early in the cycle of recovery. If you just take that singular metric that I mentioned earlier of the valuations to replacement cost, so if on average, we're about 15 to 20% below replacement costs, it suggests that there's a pretty good runway — maybe several years of growth to occur before new construction picks up materially. And real estate, you go back to the basics of it — it's all about supply and demand. And without that weight of new supply, you will see growth, and I think we'll have a good several-year runway to be able to benefit from that growth before you start to see that supply pick back up again.
So I do think that window will remain open, obviously not in perpetuity. We're still early in that cycle of recovery, but it does feel very positive for the midterm.
Louise: And we've recently seen Kevin Warsh announced as the new head of the US Federal Reserve. How do you think this will impact the future direction and speed of any rate cuts and what it might mean for US real estate?
Sara: Yes, definitely a heavily watched appointment. I think one piece to note is that the focus is certainly on the Fed chair. However, functionally speaking, rate decisions do still require the FOMC consensus, Warsh is just one vote, albeit certainly an influential one.
So while we aren't exactly certain how he will behave, there is consensus based on his history and how he has communicated in recent quarters that he does support lower policy rates, but I think the market and many investors today believe that it's not going to be aggressive or indiscriminate in terms of lowering rates. And today, as we look at base cases provided by many of our banks, as well as our peers and ourselves, we do believe that there will likely be one or two cuts in 2026, but again not with great speed and will be a bit measured. And I think overall what that means for real estate continues to be positive.
So the short-term rate's starting to come down and the long-term rate, without it decreasing, you're starting to see that yield curve being built back in, which is appropriate. So stability in the Treasury, stability in real estate, and some better access to leverage with regards to floating rates that might be more creative than they have been, as those short-term rates start to come down. So those are all positive factors as we think about real estate investing and ultimately valuations. We feel reasonably good about the appointment and ultimately about some of the anticipated moves in 2026.
Louise: The US is taking a different political direction under President Trump, and many new policies have been announced. How much is politics a factor in your decision-making and asset allocation?
Sara: It's a really great question. Just kind of thinking about the large macro trends that shape real estate. There are probably three that we talk a lot about.
- The first is technology disruption that's certainly been around for a while and has escalated in recent years.
- The second is demographics
- And the third is politics. And that third isn't a new conversation point. Politics has really been a consideration for decades.
However, today, it's actually shaping real estate outcomes probably more so than we've seen in a while. And I think what's happening and how that's really shaping out is it's really driving and resulting in diverging geographic locational outcomes. but I think even more than ever, a lot of both return and positive outcomes are also going to be driven more so by geography and location.
When you think about stronger business-friendly environments that can provide opportunities for companies to relocate, that's where you have people following; that's where you're going to see a lot of demand. But you have to balance that with a lot of those communities also situated in markets that have limited barriers to supply.
I think a really great example is the CHIPS Act that was passed several years ago, creating a really demand-side catalyst in a market like Phoenix. And so we think we're going to continue to see opportunities where we can take advantage of some of the policy changes and the positive progressive movements, and that we're going to just be very mindful of those structural and cyclical factors that can compound if the regulatory and political environment are not assessed appropriately. But bottom line, diversification matters and diversification across not just sectors but geography is going to be really important to continue to manage that risk going forward.
Louise: The rapidly aging population in many countries around the world is a challenge for society, but it's also creating business opportunities. And I understand AEW has a long history in seniors housing. How do you see the opportunity here and what solutions can you offer investors interested in this thematic?
Sara: Yes, it's actually a topic that we talk about a lot and it's what I will call one of our highest conviction strategies. I referenced earlier that demographics is one of the greatest macro trends influencing the built environment. And it's not just about the scale of demographics and where they're moving to, but it's also very specifically the aging of the population. That's clearly a driver of demand for senior housing.
That baby-boomer cohort has, over their entire lifespan, very much driven a lot of how real estate has evolved. You can think back to when the (parents of) baby boomers came home from the war, started families, moved to the suburbs, and then we had suburban malls.
But we do have a long history here at AEW of investing within the space. We have been investing in seniors housing since the mid-1990s. We have an experienced and dedicated team, so both acquisition officers as well as asset managers that are specifically focused on sourcing and managing these assets, and we have a really strong track record within the space.
So we have a great platform to source and invest and we have a great fundamental story to invest into. So you have the demand tailwinds, so again that seniors population when you look at that age cohort that's starting to turn 80 years old as of 2025 and 2026, that's really that sweet spot for senior housing living. That cohort is expected to increase 4.5% a year over the next decade. And that's a percentage of demand growth that we've never seen before - it's probably almost double what you've seen over different time periods.
And that demand is really in the face of what I'll call muted supply. Really when you look at the supply charts, it's some of the lowest levels of new deliveries that we've seen in almost a decade. So really compelling supply/demand dynamics and it's actually an even more interesting story because seniors housing is really one of the only sectors that had gone through a cyclical downturn.
So a lot of what's happened in real estate revaluation: I'll call is more of capital markets absorbing the increasing interest rates, absorbing the increasing cost of capital. But seniors went through a real demand shock associated with the pandemic. And where you saw both occupancies and rents negatively impacted, and today both of those are turning around.
So you have occupancy increasing, you have rents rising, that's driving double-digit net operating income or NOI growth. So that's really compelling. So we know how to invest. We're seeing some of the strongest NOI growth among sectors, growth that's really outpacing a lot of the traditional sectors and something that we expect to continue to be outsized in the near term. So structural demand growth, constrained supply, improving operations in a cyclical dislocation, we think it's really compelling. We've been investing certainly a lot in the space across the risk spectrum over the past 12 to 18 months and we're really excited to continue to do so in the near term.
Louise: Warehouses and data centres are increasingly a feature of the landscape in the US and look likely to become even more prevalent. How do you see these two sectors evolving and should they be part of a core portfolio?
Sara: I'll start with data centres, and I will caveat that AEW has less exposure to data centres today, so I won't be able to speak with as many clear data points, but I can speak to it as I think about investing within a core portfolio.
There, there are definitely interesting investment characteristics. So you do have long-term net leases. In many cases, you're going to have a strong credit tenant that's going to provide you some durable cash flow. But I think so that's good — what we talked about earlier. That's what we want from our core, but the other considerations to really balance are location. Many data centres are in very rural locations and they don't have an opportunity or a use for repurposing if that's required. Many data centres are very large, very, very large investments, multiple hundreds of millions or greater, and that's a very large single asset. So that can be concentration risk.
The sector still remains in its early stages, so when we think about liquidity, which is certainly paramount to a core portfolio, who that next buyer is at the end of your hold period is still a bit in question. And then finally we talked a little bit about technological disruption, and to me this is certainly a space where you're probably going to see the most evolution and change to the requirements over time. So I think it's certainly sector with a lot of growth and we're seeing capital formation across the capital stack in terms of investing in it. But I can see some hesitation as I think about it within the core space.
Now to the opposite would be warehouses, and I'll say broadly the industrial sector, that will continue to be a significant part of the US investment landscape and it's a material component to a core portfolio.
If you looked at core portfolio makeup about 10 years ago, industrial might have been about 15% plus or minus, of a diversified portfolio, but today that's actually probably closer to 35 to 40%. So a really significant increase in exposure to the sector over the past 10 years, and that increase has been driven certainly by a volume of investment and active capital moving into the space, but we also benefited from valuation increases over that time period.
Warehouses and industrial in particular have probably been the biggest beneficiary of technology disruption. When you think about the iPhone, customers now have online shopping tool in their hands at all times. And when you're online shopping, you're not going into the store. So really what you're doing is effectively buying from warehousing. So those warehouses grew pretty significantly in demand. You also saw supply chain optimisation that spurred demand, and then very much recently you started to see a bit of an onshoring trend in certain markets, again another positive demand driver to the industrial space.
So a lot of strong and solid demand fundamentals. And then when you think about the profile of an industrial investment, it's typically a triple-net lease. So that means that the tenant pays all operating expenses, so that can help offset some inflationary cost pressures. The physical real estate itself typically will require limited capital expenditures. So you have a really efficient net cash flow and with the proper investment, you can also acquire credit tenancy, which is going to give you some durable cash flow, all of which really check those boxes for core characteristics. So we do like that warehouse and industrial sector and I do continue to believe that it will be a pretty significant part of core portfolio over the near term. It might ebb and flow in terms of exposure percentages, but it is here to stay in the US.
Louise: And there appears to be less emphasis on ESG in the US these days. How important are sustainability elements in a core US portfolio these days?
Sara: Yes, there is definitely what I’ll call an ebb and flow to the broader conversation associated with ESG. However, for a core portfolio and how we invest, we think about it in terms of sustainability, and that is really key - sustainability and resiliency - that’s really key to investing and so we haven’t changed our perspective. It continues to be a significant part of our investment process, and really that’s because we view it as a risk-adjusted return discipline, not a values overlay.
We think about integrating these factors into our underwriting, into our investment committee discussions, our risk management committee discussions, as well as our asset business plans. So a really simple example is that we might spend capital in order to put solar panels on a roof, but we’re not doing that to check a box or to get points in a ranking system. We’re doing that because it will reduce utility costs - either for the landlord, depending upon the lease structure, or for the tenant directly.
And so where there is capital spent, we are going to look to see a return on that investment. We really think that where we can identify whether it's environmental, social or governance factors, that are going to positively affect the cash-flow durability, that is going to benefit the investment and it's really going to also most importantly limit obsolescence risk, as well as benefit the ultimate liquidity of the asset. And those are paramount as we think about investing within the core space.
Louise: In previous years, success in real estate investing had a lot to do with picking the right sector. Do you think this approach will be successful in the future or is a new approach needed?
Sara: Yes, you are correct. The last cycle was really driven by very large thematic bets and alpha was driven by getting your sector allocations right. Today’s market is shaped very differently. We really talked about that transition of cycle, and as a result there is less opportunity in the near term for outsized growth opportunities, maybe with the exception of seniors housing or data centres as we’ve talked about, but when all of the sectors are generally looking at plus or minus 3% growth, it is very difficult to drive outperformance by just thinking about sectors.
So really what we have been focused on — and where we’re seeing the best outcomes — is really tactical asset-level selection and thinking about those unique market catalysts that are going to be essential to driving performance and ultimately creating value.
It really starts with the right asset. Two words that really come to mind are quality as well as relevance, as well as geography. And it’s not like, oh, let’s invest in the Sun Belt or the coastal markets. I really mean the submarket and the micro-location specifically.
So when we think about driving value, it’s picking the right asset, it’s picking the right neighbourhood, and then it compounds with building income. So you have to get the leases done. You need to evaluate the credit tenancy. You need to think about operating expense management and really thoughtful deployment of CapEx.
This is a stock-picker market and really that’s what we believe is going to be the primary driver of performance going forward, and we’re really excited because that’s what we do best.
Louise: Thank you, Sara. It’s great to get the chance to chat to you at such a pivotal moment for US Core Real Estate. If you enjoyed the episode, please tune in again soon to hear more from our global collective of experts.
