Episode 273: Going back to First Principals in a Brave New World

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Stewart: Welcome to another episode of the InsuranceAUM.com podcast. My name’s Stewart Foley. I'll be your host. Hey, welcome back. I hope all of you're having an off to a great 2025. I'm happy to report to you that things are - we're doing well on the business front. We're very happy with our podcast traffic, which continues to be consistent. We think the world of our audience and we appreciate all the kind words that we hear from you, and thanks so much for your generous comments. We certainly appreciate it, me in particular.

So the topic of today's podcast is really interesting, and it is going back to first principles in a brave new world. And we are joined by Michael Acton, who's a managing director and head of research and strategy at AEW. Mike, welcome. Thanks for being on. Thanks for taking the time. We're thrilled to have you.

Mike: Oh, great. Thanks, Stewart. Thanks for having me.

Stewart: We are excited to hear what you have to say. I want to get going where we always do, which is where did you grow up and what was the first job, not the fancy one?

Mike: Well, I grew up in a town right outside of Boston, our company's based here in Boston, a town called Framingham, about halfway between Boston and Worcester. And the first actual paying job I ever had was busing tables at an Italian restaurant in Framingham. I'm sure I was underage. I think I was about 13 or so, but that stuff didn't matter as much back then.

Stewart: Yeah, so true, right. Can you talk a little bit about your background? I think that a lot of times people who listen are in earlier stages in their career. I think it's always helpful to have someone in your seat that has achieved a level of success and seniority that you have. What was your path like, and what was your thoughts, if you can kind of take yourself back there. When you got into the business, did you see yourself going in this direction, or how did that all play out?

Mike: Well, it's kind an interesting journey, I think. My first job out of school was working for an economic forecasting company right outside of Boston, company called DRI, Data Resources. It was the company that was started by Otto Eckstein at Harvard when he was head of the Council of Economic Advisers for President Kennedy, and it was one of the first big macroeconomic forecasting shops. So I joined them right out of school, early '80s, and I got assigned to the regional economic forecasting group, and we were building models of metropolitan areas. It was kind of a new thing back then, modeling local economies as if they were like a standalone macroeconomy model.

And as part of that, I got assigned certain consulting relationships, one of which was the company I work for now, and they were a big consumer of economic data and I was really intrigued. I didn't really know much about their business, and worked with them for a couple of years and one day they called up and they said, "Look, we're spending way too much money with you guys. Why don't you come over here and do what you're doing for us, only just do it here?" And didn't fully understand their business. Jumped right into it just as the savings and loan crisis was emerging. Interesting time to start in real estate. But in hindsight, it was good, because what I was doing was sort of the future. These internal research groups were a new thing for real estate investment companies back then. So it was a really good time to join the business, and stayed with it for now... been here with AEW for 35 years. Business has changed a lot over that time.

Stewart: That's impressive. There's not many folks I've ever interviewed that have been at one firm for 35 years.

Mike: Well, it's felt like being at a lot of different ones. Like I said, the industry's changed, the business has changed. It's become much bigger and broader than what it was when I started.

Stewart: But it does speak to the culture of the firm, right?

Mike: Oh yeah.

Stewart: I think that there's a lot of times when insurance companies keep people that long, but asset management firms, typically not. I just think that when people talk about culture and culture matters and all that kind of stuff, when somebody's been in a place for 35 years, it does speak volumes about the place itself, just in my opinion.

Mike: Yeah, no, I think you're absolutely right. I remember very early, my time at AEW, I heard the founder of the company telling an investor that he had an interesting challenge every night. He had to figure out a way to get all of his people to come back the next day, because at the end of the day, it's the only asset that an investment management company has.

Stewart: Yeah, it's so true. So let's get into the real estate side of things. What role, in your mind, does commercial real estate play in an investment portfolio? It's a big broad-brush question, but I think it always is helpful to frame the discussion at a high level to start.

Mike: Yeah. So at the highest level, when you think about real estate as an asset class, I think what you really have to appreciate is that it really is a hybrid asset class. And what I mean by that is it has characteristics that are very similar to fixed income, and it has characteristics that are very similar to equity. The fixed income characteristics are really the periodic cash flows that the properties generate. We have leases with tenants. Those leases are all... look like little bonds, and you can kind of think of them as like little bonds. So you got all this cash flow coming, and then the equity aspect of it is really twofold. It's the right to re-lease the space again in the future or to sell the property. And the neat thing about real estate to my mind is that it lends itself incredibly well to financial leverage, because all this cash flow supports debt.

And the nice thing about that is you can change the profile of the asset as much as you want by putting the financing on. Effectively, what you're doing is you're shorting out the fixed-income aspects of the return and getting more exposure to the equity. So over a whole cycle you'll get higher returns, but with more risk, the residual equity would have more risk associated with. So that's the asset class. But so getting to your specific question about what it can do for the portfolio is it can actually do a lot of things. It can provide good, steady income. That's interesting to a lot of investors. It can provide outsized total returns if you pursue it in the right way.

Obviously it's a diversifier. I think all private market assets are a diversifier relative to public market assets. And at the end of the day, it can be a really effective inflation hedge, because what happens when you get inflation is the cost of replacing real estate goes up. The land gets more expensive, the raw materials, the labor, everything that goes into building. The property becomes more expensive as well. So to get new construction in the future, it'll have to be at higher rents to support the higher construction cost.

Stewart: Yeah, it's interesting. I mean a lot of insurance companies, if you think about a med mal carrier or a worker's comp carrier that has a great deal of exposure to inflation in their liability book, it's challenging to hedge that in any meaningful way or... because oftentimes, things that are... and this was actually discussed in a recent podcast, inflation-linked securities are typically linked to a part of the CPI that might not be a good match to the liability. So I think that's an interesting aspect. We've kind of gotten through... There's been a repricing cycle, and things cycle, right? They do. And the COVID pandemic definitely took its toll on real estate. Have we reached the bottom of the pricing cycle or where do you think we are, and what do you think the next cycle looks like?

Mike: Okay. So first thing, real estate's not monolithic, right? Commercial real estate in the U.S. is a big asset class. It covers a lot of things. COVID, the pandemic, was really hard on certain parts of it. It was tough for things where people congregate. So hotels were difficult, office were difficult, A lot of shopping centers, malls, things like that, things where activity was restricted by the pandemic or the policy response to it. That effect is largely gone. As an example, one of the property sectors that we're very active in, have been for many years, but are particularly interested in today, is a sector that was very directly hit by the pandemic, and that's senior housing, assisted living, things like that. That's having a very big robust cyclical recovery.

So we've just gone through two years, collectively, where property values have largely fallen in the United States. I think they've bottomed out and the last couple of quarters would suggest that they have... is a really interesting valuation cycle because it's the first time in... we have 50 years of data, it's the first time in history that values have gone down in a sustained way without an economic recession. It's largely an interest-rate phenomena. The Fed's tightening cycle really hit real estate hard. Presumably the Fed's reversing course now. We'll see how that all plays out. Markets aren't fully on board with the easing cycle just yet, I don't think.

Stewart: That's super interesting. I think that everything that's out of favor at some point is an opportunity.

Mike: For sure.

Stewart: No podcast, Mike, is complete without the following question. What do you think about the next administration with respect to your asset class? Do you see anything coming? You can way see that they could reduce bank regulation, maybe free up the capital markets. Love to hear your thoughts there.

Mike: There's still a lot to be revealed about policy and policy choices in the new administration, but I would say broadly there's four pillars to whatever you want you to call Trump 2.0. There's really four policy pillars that we're focused on. The first would be not only the extension of the current tax regime, but maybe the broadening of it. More things, more tax cuts, possibly a lower corporate tax, certain types of income, social security, wage tip income, things like that have been talked about. So there's tax changes. Those would largely be stimulative in the near term, I would think. That would be good on the demand side of property. Anything that's stimulative right now, you have to have a cautionary look at it because it could be inflationary, right, and that would weigh on interest rates and things like that.

The second pillar, of course, is things related to trade, a lot of talk about tariffs. Nobody really knows what that's going to look like just yet. There's been a lot of things sort of leaked out about is it going to be sort of a rolling implementation of tariffs? Is it going to be an all-at-once sort of thing? Again, tariffs, generally speaking, at least in the very near term, could be inflationary, so you have to have a little bit of caution around that. Anything right now that's inflationary isn't going to give you much relief on the interest rate side.

There's policies related to immigration that would be a third pillar, in particular, limiting immigration into the United States, deportation of people that are already here. With a pretty tight labor market in the United States, you have to be a little bit concerned about whether that's inflationary as well.

And then the fourth one is really expanded oil and gas production. Broadly, that's probably positive for the economy. Anything that gets costs down, energy costs in particular, would broadly be positive. So it's a little bit of a mixed bag. It's really hard to have really strong feelings about any one of these right now without any real policy to proposals to push back against. So we're taking sort of a wait-and-see look with respect to real estate. But at the end of the day, real estate can only be as healthy as the economy that it serves. All property exists to serve tenants. The more it serves tenants, the more tenants are going to be interested in it, more they're going to pay for it in terms of rent. The property will ultimately do as well as the economy that it serves.

Stewart: That's a really nice summary, and I appreciate the way you kind of structured your answer there. You're a guy that's been at this for a while. We both have, and you've seen cycles come and go and you've seen Fed tightening and you've seen Fed weakening and you've seen all of the above. When you look out right now out your window, do you think are opportunities in the commercial real-estate space, and where are you cautious, or where do you see the risks?

Mike: Well, really broadly across the U.S. property sector today, you have a phenomena of peak loan maturities. There's a lot of commercial property loans maturing. There always are every year. There's about $6 trillion of commercial property loans, something like that. There's always a lot maturing. The ones that are maturing right now are maturing at an environment where you're at trough valuations. So there's a lot of difficulty on refinancing property loans today. Where that's probably most extreme and it gets the most headlines, of course, is in the office property sector. You see it every day on the news. You can't open a financial press of any sort without seeing some story about some big office building somewhere having trouble right now, still hangover from COVID effects and things like that on tenancy. The other sector, of course, where that's true, peak loan maturities with some sort of disruption that occurred in property income, is in the senior housing sector that I mentioned, and that's probably the one where we have the most interest on the equity side today, and maybe on the lending side as well.

This whole phenomena of peak loans at trough values, that's creating a lot of opportunity in the debt space as well. There's a lot of properties that are going to need to be refinanced. There's a lot of properties that are going to need new capital to come into them, equity capital and debt capital. So it's a really interesting phenomena, very... for totally different reasons, but it's very similar to the period immediately following the financial crisis. So think back to 2010, 2011, 2012. Had a very similar situation there, but totally different reasons, right? In the earlier period, the financial sector largely collapsed. There was no liquidity. That's not the case today, but it is the case that there's been a pullback from banks, particularly smaller banks on lending and property, and that's creating a real window to step in as a lender as well.

Stewart: Yeah, it is really interesting you talk about that period. I was at an asset management firm at that time, and PepsiCo came to market with a five-year bullet at plus 450, if my memory serves, and you go, "Wow, were markets out of whack." And so it happens, right? Things get dislocated, and then they normalize, and in that period is opportunity.

Mike: Absolutely.

Stewart: There's this talk around this wall of maturities, and I'd love for you to just, for the folks who may not be neck-deep in this industry, kind of help define what a wall of maturities means, and then how do you think that it impacts real estate assets from both a buyer's perspective and also as a lender?

Mike: Okay, sure. First, with respect to the wall of maturities that people are talking about today, an awful lot of property in the United States traded hands in the 2021, 2022 time period. And when you think back to that period, what was happening? The Fed had taken interest rates to zero federal government was flooding the economy with cash, just sending checks out to households, businesses, everybody really just trying to put as much liquidity into the system as they could, keep consumption up, keep liquidity up. So in that environment, property trades in the U.S. surged to very, very high levels. Pre-COVID, steady-state property in the U.S. was trading maybe $500, $600 billion of property a year was trading hands. Dipped down during COVID itself because people couldn't get on airplanes, they couldn't travel, they couldn't visit properties, all of those things. Following that, with this surge of liquidity, transaction volume in the United States shot up to over $1 trillion in those years, in 2021 and 2022. But most of that property got financed and it got financed at very high valuations.

Fast forward to today, since that time period, the Fed has reversed course, they've tightened interest rates, property values have fallen on average, property values are down about 20% in the U.S. from that peak period. Well, if you and I, say, we bought a building together back in that period, maybe round numbers say it was a $100-million building, we put 65% financing on it, that's $65 million that we borrowed from somebody. We probably borrowed it interest only because that was very common in that window. Fast forward to today, if that building went down to 20% I just mentioned, all of a sudden you have a building that's worth 80 million, you have to refinance the debt on it.

The loans are typically about five years, so all of a sudden you're going out to the market, maybe you can get a 50% loan on an $80 million building, so you're getting $40 million in new loan proceeds, but you still owe somebody $65 million. And that in itself, you take that, you multiply it across the entire sector, it adds up to a lot of money. So this is what people are talking about, what they refer to as a debt funding gap, broadly speaking, across the property sector.

Stewart: And does that create opportunities for dry powder? And this comes from your information, so I don't want to take claim to it, but it talks about U.S. commercial property yields are at their highest level since 2014, and exceeding public pension fund discount rates for the first time since 2010, which my Spidey senses tell me those are important watermarks that we're passing. And then I think back to saying if I'm an insurance CIO, and assuming that there's some weak hands out here that may sell, but as an insurance CIO, I'm not going to swing for the fence. So is there a way that I can take advantage of some of these opportunities while maintaining my long-term liability-focused mandate?

Mike: Yeah, absolutely. You can participate in a lot of ways. Today, you can be a lender at very attractive terms, because other lenders have pulled back, and particularly as I said before, the smaller banks have pulled back on their aggressiveness in lending. Maybe they only want to lend up to 40% or 45%, 50% of a building's value. Now, remember, that value now is down 20% from where it was, so you're sizing your loan on a much lower value. And you can participate with that bank or on top of them, or there's a lot of different ways to be a lender in that situation. On the equity side as well, you mentioned weak handed owners, there's a lot of people out there who don't want to lose their building, the loan's maturing, they don't have the cash to pay it down. They're looking for a creative partner to either come in as fresh equity, again, maybe a first mortgage lender, maybe a pretty safe mezzanine-type lender as well.

And then there's just a lot of assets. They're going to trade hands in the next few years kind of because they have to. There's nothing particularly wrong with the assets. Think about the apartment space, for example. There's a lot of apartment buildings that were financed aggressively in that window that I talked about in 2021 and 2022. The properties are pretty well-leased. They're at rents that are much higher than they were, say, before COVID. They're just not at the levels that were underwritten when they were financed. People just assume rents would just keep moving up and up and up, that didn't happen in all cases. So there's a lot of weak hand owners out there that are going to be looking to somehow either recapitalize their property or just get out.

Stewart: That's super interesting. I really appreciate the education. You've done a great job of covering this. Let me just give you the opportunity... What are your one or two key takeaways here, as we close? I've got a couple of fun questions for you on the way out the door, but what are a couple of takeaways that folks can take with them as nuggets from this podcast?

Mike: Well, I think the biggest takeaway, like I said before, I've been doing this for about 35 years. I've been blessed to be in an environment where I've been in the investment management and asset management business for the time period where almost my entire life interest rates have fallen, and that has been wind at your back as an investor. I think we're in a new world. You sort of made reference to it on the introduction, this sort of brave-new-world idea. I think we're in a new space. I don't think you can count on ever lower yields to generate your return. And what that means for real estate is you really got to go back to basics. You have to pick the right properties in the right markets, you need to lease them well, control your expenses, be really thoughtful about what capital you put back into the property each year to enhance the property, make it more attractive and so on.

These are all things that anybody who's been doing real estate asset management for a long time knows how to do, understands, but there's a lot of new players in the space as there are in every aspect of investment management. I mean, for the most part, if you're under, I don't want to be all a couple of old guys talking on a podcast here, but if you're basically under 40 today, you don't remember a period where interest rates went up, at least not much. And the interest rates you're facing today, whether it's in your personal life going out to get a mortgage or if you're trying to finance an acquisition or something, these interest rates strike you as very high. They really aren’t, right? The treasury is still under 5%, and also, by historical standards, this isn't really that big of a deal. It's just there's an awful lot of people in most parts in the investment management business that don't really have any experience with it. So I think you have to be really thoughtful about who you're going to invest with.

Stewart: Yeah, it's interesting. I mean, it's arguable that the last 10 years were the anomaly, that it's arguable that it was a form of a subsidy to get some institutions back healthy again without having to write checks. You can lower the rates and that helps. But in your mind, what I'm hearing you say is don't expect that tailwind to come back anytime soon and you better have your first principles in order when you're committing capital. I think it's a great message.

Mike: I think that's right. It'll be great if you decide to go forward and you invest, you underwrite without assuming that you're going to get a lift from lower yields in the future. That's great because if it does happen, if you do end up in an environment where you do get some interest rate relief, that'll all just be gravy. It'll just be extra return for you. But I don't think you can count on it. I think we're in a different space today.

Stewart: I really appreciate it. Okay. Here's your fun ones. You ready?

Mike: Okay.

Stewart: I kind of touched on this earlier, but if you were coming out of school today or recently out of school, and I'm sure that you're asked to speak to younger members of the... or folks who are earlier in their career at AEW, what advice would you give somebody who wanted to have a career in this space and end up as the head of research and strategy as you have?

Mike: I would probably tell them to go do the CFA program, and do it early in your career because it gets harder every single year, and your life gets busier every single year. So do it as soon as you can as you're starting your career, and spend as much time enhancing your quantitative skills as you can. The investment management business, in the entire time I've been working in it, it's gotten just more and more data-centric, more and more quantitative, data analytics. I think that's where the world's going in every industry, not just real estate, but I tell young people, take as many math classes as you can, take as many computer classes as you can, and just sort of embrace all of that.

Stewart: Yeah, it's funny, I used to tell my students, I'm like, I'm not trying to tell you I'm an old guy, but my CFA charter is 000008. It's a high number, but I've had mine for a minute, and I think that's great advice. So just to close out, you can have lunch or dinner with up to three guests, you and three guests, and they can be anybody alive or dead. Who would you most like to have lunch with or dinner with?

Mike: Great question. I think I'd go with Red Auerbach, the old coach of the Boston Celtics.

Stewart: Wow.

Mike: Grew up around Boston, obviously a big Celtics fan for all those years. My wife and I used to go to... standing-room-only tickets you could get at the garden back in the 1980s, $10. It was a tough barn to play basketball in, full of smoke, and it was really uncomfortable. But got to see all those great Larry Bird teams. And I'd really want to just talk to Red and understand one, how did you pick these people you picked over the years, Cousy and Russell and Bird and Havlicek, seemingly not the obvious choice of the person you would go out and pick, but more importantly, how did he put these guys together and create these teams like the Russell teams? I mean, Russell ended up with 11 championship rings before he retired. Very, very unlikely. He wasn't the best basketball player physically. I mean, he wasn't as good as Chamberlain, I mean, things like that. But they managed to win year in and year out somehow.

Stewart: Yeah, that's super cool. Anybody else? Or just Red?

Mike: Well, I got a whole bucket list of people I'd love to spend time with. If it was dinner, maybe Churchill. I don't know if I'd go with lunch with him. He wasn't usually up, I don't think, by then. But Winston Churchill would be a hoot for sure. Bob Dylan, Jerry Garcia, maybe the two of them together. They were reasonably friendly during their lifetime. I always think of Dylan, it's kind of timely, because there was a great Dylan movie that came out at Christmastime there with Timothy Chalamet, Dylan to me is the greatest songwriter of the last hundred years, and I think Garcia was the best interpreter of Dylan. So the two of them together would be something.

Stewart: That's super cool. I really appreciate it, Mike. Thanks for being on. We've gotten quite a good education from Michael Acton, Managing Director, Head of Research and Strategy at AEW. Thanks for being on, Mike.

Mike: Great. Thank you, Stewart.

Stewart: Thanks for listening. If you have ideas for a podcast, please shoot me a note at stewart@insuranceaum.com. Please rate us, like us, and review us on Apple Podcasts, Spotify, or wherever you listen to your favorite shows. My name's Stewart Foley, and we'll see you next time on the InsuranceAUM.com podcast.