By Mario Marroquin
Jason Malinowski, the chief investment officer of the Seattle City Employees’ Retirement System, says that while the real estate landscape in the U.S., Europe and Asia is markedly different today from when the system began
investing in non-U.S. real estate six years ago, global diversification may
continue to provide some respite to regional market shocks.
Since joining the retirement system in 2014, Malinowski has
added infrastructure and credit asset classes to the city’s $4 billion retirement
system. And while hikes in energy prices and inflation – and the effects of the
COVID pandemic – have changed property markets around the world, he says there
is still room for skilled managers to earn excess returns in real estate in
Europe and Asia.
In a recent interview with Markets Group, Malinowski discussed
his work at the retirement fund, real estate trends among institutional
investors, and how to tread lightly in challenged markets.
Markets Group: As I understand it, you have been at the
Seattle City Employees’ Retirement System since 2014 when you joined from
BlackRock. Can you tell us a little bit about the last eight years and how the
fund has evolved under your tenure as the system’s CIO?
Jason Malinowski: When I joined, the system was going
through a transition from a consultant-led process. I joined as our inaugural
CIO and benefited from having some great staff that were already here and stayed
until they recently retired. We added a few asset classes like infrastructure
and credit to our portfolio and otherwise have been continuing to build out the
portfolio to our strategic asset allocation target.
MG: How have those two asset classes, infrastructure
and credit, performed on their own and relative to the rest of the portfolio?
JM: The infrastructure asset class has done
tremendously well and outperformed our expectations. We hoped it was going to
play a role of diversifying our large allocation in equities – and it has done
that – but also from a return perspective, it has been very generative.
On the credit side, it has been a tale of two market segments.
Private credit has done reasonably well while tradeable credit has been mixed,
so we are going through a process of revaluating our approach to the credit
asset class.
MG: Speaking more broadly and going back to the fund
itself, can you tell us more about the system’s performance over the last 12
months? It is no secret the first six months of 2022 were tough for public
equities and fixed income, but how has the retirement system fared overall?
JM: It has been a very challenging market environment
over the last six months in particular. We have experienced negative returns
during that period and that is consistent with our benchmark and peers.
I would say the silver lining is that performance was above
expectations the prior three years, so we have a large deferred gain in terms
of our actuarial funded status. We are also sitting at a place right now where return
expectations are much higher than they were at the beginning of the year, which
is helpful on the liability side. So, it has been a challenging year from an asset
performance perspective, but, not necessarily from a total plan perspective.
MG: One of the things we have seen over the last year
is that despite the market downturn, private equity and real estate have not
been as affected as other asset classes like public equities and fixed income.
Can you tell us more about those two asset classes and how they are evolving?
JM: It is too early to tell is the basic answer. We are
still receiving marks for June 30 for both private equity and real estate.
Most of the public market drawdown occurred in the second
quarter and it is going to take several quarters for private market valuations to
fully reflect the market environment. It is just too early to tell if private
equity and real estate provided the level of protection that you suggested.
MG: The impetus of this Q&A was a presentation the
retirement system had a few months ago about opportunities in global real
estate. Can you tell us more about how you define global real estate and how
opportunities in global real estate differ from domestic real estate?
JM: I mentioned the two asset classes that have been
added to our portfolio since I joined. Another difference is that when I joined,
our real estate allocation was almost exclusively invested in U.S. core real
estate. We have been going through an effort to diversify that both by strategy
as well as by region.
On the strategy dimension, we are shifting our portfolio mix
to 70% and 30% between core and non-core. On the regional side, we are trying
to have a more globally representative real estate portfolio because the real
estate market, in the same way as the public equity market, is global.
Our public equity portfolio is 60% invested in the U.S, and
40% invested internationally to benefit from geographic diversification. And
that split is consistent with how the global equity market cap is broken down
between U.S. and international.
If you look at academic studies of the institutional quality
investable real estate market, it is even more international than public
equities with about a third in the Americas, a third in EMEA and a third in
Asia.
And that is an interesting question: if we feel that
regional diversification is important in public equities, then should it be important
in real estate too? That was the line of thought that got us down this path. I
think the benefit of regional diversification is even greater in real estate
than it is in public equities because they are local assets that are sensitive
to their own demographic trends or fundamentals between supply and demand. There
is no global, multinational real estate asset; it is a collection of truly local
markets.
A lot of property types that exist in the U.S. exist
internationally, but not all. For example, residential or apartment buildings
are typically less institutionally owned in other countries than in the U.S.,
but by and large, there are similar property types available to investors.
We are investing internationally in both core and non-core although
the reasons differ somewhat. Core real estate really benefits from regional
diversification. Non-core real estate benefits from the fact that markets
outside the U.S. are less efficient and less transparent, so they should offer
greater potential for excess return.
MG: On the topic of real estate, one of the regions
that you mentioned and that has been in the news lately is East Asia because of
the downturn in the property sector. It looks like the Chinese government is
stepping in to try to address some of the turmoil in the property market, but I
wanted to ask you, as a global investor in real estate, what do you make of the
property sector in this region and what types of opportunities do you see in
light of such turmoil?
JM: Clearly there are a lot of issues that have taken
place over the last couple of years with Chinese property developers like
Evergrande. I don’t have any unique insights into that sector – our real estate
portfolio is not invested in the Chinese residential sector – but what I do
know is that Asia has much less efficient real estate markets than the U.S. So,
I do think there are opportunities for skilled managers to generate excess
returns. There are also some countries and locales where real estate is in such
high demand by high-net-worth investors as a store of value that it does not offer
a competitive return for a financial investor. Hong Kong has historically been
such an example. So, as a financial investor as we are, it’s generally best to
avoid those areas.
Another point about East Asia that is worth mentioning that
came out through COVID is regional diversification. At the onset of COVID,
there were lockdowns in the U.S. and Europe and very few lockdowns in Asia.
Therefore, the retail sector continued to perform reasonably well unlike the U.S.
and Europe.
The work-from-home trend is also not as prevalent in Asia as
it is in the U.S., so that trend is not hurting the office sector as much.
So, while I think there will always be episodic challenges
that local property markets face, diversification suggests that those
challenges will not be the same across all markets.
MG: You mentioned there are dynamics in Asia which
may or may not be comparable to market dynamics in the U.S.; so, I wonder if
you think there are any signs that the mass exodus that we saw from Gateway
markets towards the Sunbelt in the U.S. due to COVID can be compared to any
market dynamics in Asia after COVID?
JM: There has been a long-term trend of urbanization
in Asia and Europe. Even though certain countries have had declining
populations, like Japan or Germany, urbanization has tended to offset declining
population growth. But we haven’t really seen that urbanization trend reverse.
MG: Switching over to Europe, one of the biggest
issues that continues to plague the continent is the rise in energy prices. There
is also an expectation of an economic slowdown in the short term while the
European Central Bank continues to raise interest rates. How do you account for
those market forces when modeling for viable institutional-grade real estate
investments in the region?
JM: There is clearly no shortage of risks facing the
European market and I think you uncovered a few of them without even mentioning
the direct impact of the war. There is also a potential for spillover on that
front.
I have a pretty basic view that when there are clear and
present risks, there is typically a higher risk premium that investors should
earn by investing in that market.
With that said, we have not gotten to our full allocation of
European real estate. We have been slower to deploy capital than we otherwise
would have because the valuations that these core funds are being valued at doesn’t
fully reflect those risks yet. It will take a few quarters for that to flow
through the appraisal process.
So we have pushed our timing back to next year in reaction to
some of those risks that Europe is facing.
MG: Within that same vein, I have noticed there has
been a shift of institutional capital going towards European real estate. There
have been a few sizable industrial, multifamily and even student housing deals
that are getting done despite all of the numerous factors afflicting the
European economy. How do you think that informs future investments and how
quickly you are deploying capital in Europe?
JM: There have been instances like you mentioned of
large investments in Europe no doubt. However, I think that really pales in
comparison to the amount of institutional investment in real estate in the U.S.,
the level of transparency of real estate markets in the U.S., the amount of operating
partners and brokers, and all the things that exist in the real estate
ecosystem in the U.S. that are far deeper and larger than it exists in Europe
or Asia.
So yes, there have been some movement of institutional
capital to Europe, but I still think that it is a less transparent market, a
less efficient market and I’m not worried about chasing deals or crowdedness in
that area.
MG: This global real estate strategy is something
that you started at the city employees’ retirement system, so what advice would
you give to CIOs of comparable funds that are trying to look to diversify their
real estate strategy by going global in either one of these regions?
JM: The first question I would ask is similar to our starting
point, which is, if global diversification is helpful in other return-seeking
classes like public equity, why is it not helpful in real estate?
I think a lot of those same reasons may be stronger for real
estate than they are for public equity, so I think there’s a clear case for
global investing in real estate.
There are some downsides to be cognizant of, but there are
ways to manage those. Currency risk is one of them and we manage that through one
of our investment managers, but it is a risk that CIOs need to consider.
Another consideration is that since we started down this
path, the universe of investment managers available to investors has grown
significantly. Whereas that was a constraint five or six years ago, it no
longer is a constraint.
And the last point is I am generally averse to adding
complexity to our portfolio. We are a $4 billion portfolio and have relatively
limited staff resources. There is some complexity involved with globalizing a
real estate allocation, so a CIO needs to consider where you want to take on
that complexity and whether you have the resources to do so. Luckily, we
collaborate with our investment consultant, NEPC, on this project.
They are very supportive and they have been able to help us
in sourcing this project, and that’s been a phenomenal addition to what
resources we can apply at the staff level.