Andreas Calianos has been in the real estate industry for nearly 30 years and serves as an outsourced CIO. Ten years ago, in the wake of the financial crisis, Institutional Real Estate, Inc., parent company of this magazine, sat down with Calianos to discuss the long-term implications of the crisis. Recently, Calianos spoke with Institutional Real Estate Americas editor Loretta Clodfelter to revisit his calls from that time and update his views on current opportunities within the market and how the latest cycle might unfold.

We appear to be at the top of the cycle, so what should investors be doing now? Stock and bond markets continue to post strong results. Should real estate investors be worried?

Every cycle is a bit different; that’s why history rhymes rather than repeats. U.S. real estate values cycle around a long-term, upward-sloping trendline that’s getting steeper because long-term replacement cost is increasing faster than inflation. There are four primary factors that anchor the long-term return of illiquid real estate and infrastructure, broadly what I call DISH assets: dollar-denominated, income-generating, supply-constrained, and hard. The U.S. dollar is still king and provides stability. Income is in short supply, and the risk aversion and shorter duration demanded by most bond investors in their liquid fixed-income portfolios limits real return. Supply constraints are key, especially because replacement-cost inflation for construction is a high and rising hurdle for new supply. By hard, I mean anything that is not a paper asset; it must be difficult to replace and have intrinsic value. So, on the one hand, even if the business cycle is peaking, a much longer-term cycle for DISH assets is only beginning. Broadly speaking, illiquid DISH assets will outperform liquid paper assets for the next 10 to 20 years.

In that context, what individual property types and execution strategies appear best? Do you still like multifamily?

I can’t tell you that stabilized core apartments in gateway markets bought at a 4 cap are a great investment. I can tell you that middle-market opportunistic and value-add apartments in secondary growth markets are a much better bet, simply because you can get rents higher, faster. Long-term structural demographic and social change — including younger people delaying marriage and starting smaller families, the lack of savings for down payment for houses, together with a broader acceptance of rental housing by older adults — is driving a new kind of demand. And not just multifamily; I still like a number of sectors. Decades of data tell us that investing over the cycle in virtually any sound real asset strategy works better than other alternatives, as long as the asset is prudently levered.

What is the reason for this long-term outperformance?

The reason is that real assets are expensive to replace, and that cost keeps compounding faster than core inflation. Construction costs are rising at two to three times the rate of CPI. Remember that when we look at how diverse portfolios are constructed, most have a massive bet against inflation due to their exposures to equities and fixed-rate debt. I think of this as investors selling inflation short. This isn’t a problem until it is recognized as such. We’ve become conditioned to a cost environment that isn’t sustainable long term. The reality is, we have two competing forces: inflation and deflation. These average out to a small positive number for headline inflation. We have inflation in stuff we need (food, medicine, skilled labor, education, construction materials) and deflation in stuff we want (phones, TVs, cars, anything that embodies technology). It is widely recognized that, due to all the various hedonic adjustments that the government makes to the CPI, the deflationary forces are overstated and the inflationary ones are understated. I don’t know anyone who has looked at the cost pressures college endowments and pension plans face and believes they experience anything close to 2 percent inflation, which is where the CPI is today. Every property type should be viewed in the context of replacement-cost inflation in order to understand a key driver of long-term return.

Are you suggesting investors should continue to invest in real estate because inflation
is around the corner?

Well, I’m saying there’s a bit more inflation today than we actually measure, and that illiquid, supply-constrained real assets provide investors with a unique portfolio benefit that offsets the risks embedded in liquid paper assets. Inflation is already here, but we pretend it’s not. The best part is that real assets also win in low inflationary environments because, by definition, if the increase in costs to construct new competitive supply exceeds the rate of core inflation, then you have a built-in arbitrage on rents versus buying power. That’s just another definition of making money. And, of course, you are more supply constrained than you might otherwise think.

So going back to apartments, what does this mean for execution?

Deal flow is everything. I look for structures that drive compelling deal flow from great managers into my inbox. I execute via operating partners who have defined expertise in specific markets. I’ve been an advocate of secondary and tertiary markets for 30 years because the growth dynamics are exciting and at least as predictable as large markets. I like multifamily operators who fly under the radar, especially in the middle market. I’m attracted to operators where our capital is strategic to their growth, and we can forge programmatic JVs that deliver expertise in a few select markets — sometimes only one market. The bigger you are, the tougher it is to source deals. In our industry, sometimes economies of scale work against you, and with deal flow, that is an unfortunate reality. If you are in 20 markets, you cannot know them as well as someone who is in two. My ideal structure requires more work but is repeatable once we’ve underwritten the team, their operations and track record. We pledge half of all GP and LP capital under well-defined investment parameters, so our operating partners still must raise money for each deal, but they can count on us to cover at least half. And they need certainty of close, so we will often warehouse whatever portion they have not syndicated, giving them 90 days to take us out after we close. We stand by as a resource at all stages of the deal, sometimes looking over their shoulder and making suggestions, but I bet on people and expect them to run the deal their way. In exchange, they give us first look and a significant piece of the GP. The downside is that, sooner or later, a small operator becomes a big one and no longer needs us. But that’s OK.

What about other property types?

Same structure but more selective on the buy. I’m not afraid of vacancy, especially in well-located suburban office. We’ve seen success in turning traditional suburban office into medical office, and that can be a great play. I think the best office executions today are fairly capital intensive. Similarly in the retail sector, but I’ll only do it with an operating partner who has decades of retail relationships and understands the new realities of getting people to part with their money off-line. Industrial and storage assets seem picked over, and those are only attractive opportunistically. I’ve continued to stay away from ground-up development, as I think there are a myriad of unacknowledged risks, like the impact of tariffs on final construction cost. At this stage of the business cycle, I would rather redevelop than develop. Having said that, I am evaluating a number of interesting opportunity-zone deals. I love the Hispanic strategy but have not had significant investor interest. Having said that, I am evaluating a number of interesting opportunity-zone deals with operators I know and trust, where we can get to a minimum 7 percent unlevered return on cost.

Would you describe your attitude toward real estate as bullish?

Yes, and for all the reasons mentioned. Deal flow is just as important as execution, and the big difference today is I think a lot more about JV structures that provide the right incentives to maximize deal flow. I see a fair amount of opportunity today, but investors need to be flexible and nimble, looking at a range of strategies, operating partners and geographies to source the best opportunities. How people use space is constantly changing, and the pace of that change may increase. Outperformance requires more work today than yesterday, and deal flow is critical but not at the expense of execution. It takes far more work than running a stock or bond portfolio. In that context, I think the call for lower fees by investors, similar to what has happened in liquid assets, is disastrously misplaced. This is an operating business of wildly heterogeneous assets. We’re not picking stocks. We’re running businesses.

How important is leverage?

Leverage is everything because you have to survive the bad times. The history of real assets is that if you can survive short term, you always thrive long term.

What is the biggest risk you see?

State and municipal budgets are strained. Taxing authorities view real estate as a piggy bank and have become very aggressive in revaluations. Whatever your pro forma assumes future taxes will be, it’s probably too low.

Any additional thoughts?

Real estate investors may be best served by evaluating their opportunity sets into the two broadest possible categories: liquid and illiquid investments. Technology, access and the regulatory environment are changing both areas, but they are doing so in different ways. Surprisingly, some of the big changes are happening faster in illiquid assets like real estate than in liquid assets like stocks. From my vantage point, illiquid assets are more attractive long term than liquid assets. The advent of crowdsourcing platforms, the emerging “democratization” of real estate, and even real asset–backed cryptocurrencies will push more individual investors into real assets, and this trend is only just beginning. Remember, equities really took off after the 1981 IRS ruling allowing the funding of 401(k) plans from employee salaries. It’s been a great ride, but success always breeds its own destruction. Most stock portfolios are not diverse simply because they are all diverse in the same way. When everyone uses the same techniques for diversification — what I call copycat diversification — then nobody is really diverse. This creates far more volatility in liquid markets than people have historically assumed. Volatility is risk, and liquid assets will continue to have more risk over time. REITs aren’t real estate. I like buying and owning stuff I can’t easily sell, and I think the benefits of illiquidity will soon become widely available to anyone with a 401(k). Every share of a listed stock is the same. But every private real estate deal is different, and good managers have the potential to create value every single day. I don’t experience the ups and downs that come with owning liquid securities that I can sell at the push of a button. Liquidity is neither good nor bad; it is cheap or expensive. You should know what you are paying for.