Prudential Real Estate Investors’ Long-Term Perspective

J. Allen Smith is the chief executive officer of Prudential Real Estate Investors (PREI), the real estate investment management and advisory business of Prudential Financial. With over $50.1 billion gross and over $33.8 billion in net assets under management worldwide (as of June 30, 2012), PREI offers a broad range of investment opportunities and investment management services through specialized operating units in the United States, Europe, Asia, and Latin America.

PREI’s business is the execution of real estate investment strategies in markets throughout the world, for a global client base, including core, value-added, and opportunistic strategies; real estate securities strategies; and debt platform investing. PREI has been investing in real estate on behalf of institutional clients since 1970.

Smith, who has been with PREI for more than 20 years, oversaw PREI’s U.S. business prior to assuming his current role. He has held positions in portfolio management, asset management, equity research, corporate finance, and strategic planning. Smith is a member of the Pension Real Estate Association’s board of directors, is a trustee of the Urban Land Institute, and serves on the advisory board of Cornell University’s Program in Real Estate.

This interview, conducted by Stephen R. Blank, ULI senior fellow for finance, is the second in a series of interviews with leading real estate investors that is being undertaken by the ULI Center for Capital Markets and Real Estate.

How did you get into real estate?

I got into real estate through the hotel industry. I went to the hotel school at Cornell and joined a hotel developer shortly thereafter. I ultimately made my way to Prudential, which at the time was the largest institutional owner of hotels with over 125 properties. From the hotel sector, I made my way through other parts of the real estate industry.

How long have you been with Prudential?

I have been with Prudential for 25 years. A lot of people tend to be amazed that someone would stay at an institution that long. One of the things that marked my career here and a reason I stayed is that I had an opportunity to do a lot of different things while at Prudential. And the capacity to do a wide variety of things has certainly helped in the role that I am in today.

One of my observations from doing business with Prudential for 15 years as a banker is that they grow their management really well. You are the third in this tradition that started with Bernard Winograd, and then with Charles Lowrey, and now you. All these people started from the inside and have grown into larger positions. Is that something that Prudential does consciously and something that people should try to emulate as they think about running their companies?

I think so. I was fortunate to have some terrific sponsors in Bernard and Charlie and to develop a relationship with them over time. The topic of succession planning in corporate life gets a lot of attention, but I do think that within our organization people take it very seriously. Many of our clients invest with an institution like Prudential because they perceive that we can handle succession well and invest time and money into developing people so that we have continuity of staff over time and limit disruption.

This has been a difficult few years from 2007 to today. What has been the biggest change that you observed over that time?

The globalization of our business continues at a very healthy pace. The influence of very large global investors over how we raise and invest capital has grown over that time. The institutional affiliation that we have positions us as a trusted partner and counterparty with whom people want to do business, and that has been really important.

One of the things that served us well is that Prudential started its first fund in 1970. We have been in this business for over 40 years and we take a long-term view of it. We focus on the long term in both the products that we create and the client relationships that we try and develop. Even when we make mistakes, clients give us an opportunity to get it right. We are all going to make mistakes in this business. We get the cycles wrong or underestimate the impact of an event. When you have relationships with your clients that are based on transparency and trust, people give you an opportunity to fix it. We have been very fortunate in that regard.

If we say that we are probably at the bottom of the current cycle, that we may not have turned the corner but are at the corner, how are you starting to shape Prudential’s efforts for the next five years?

We started that process—believe it or not—back in 2009. We felt like if we solely focused on reacting to the crisis of the moment without looking forward, we would find ourselves coming out of the financial crisis in a position where there were new opportunities and strategies that we might want to pursue but not be in a position to take advantage of them.

Around 2009, we were very aggressive in bringing new talent to the organization to address areas we thought were key opportunities. Foremost among those were opportunities to invest in debt in both the U.S. and Europe. That has been very successful for us. Given the dysfunction in the capital markets, it is an opportunity that we think will be sustainable over time and one that we are optimistic about in terms of how it will continue to evolve.

In other aspects, generally speaking, we are trying to simplify what we do. We are focusing on fewer things where we can really build market distinction and scale. Debt strategies are one example. Among emerging markets, we are focused on China for now. We are building off the credibility and experience we have as an investor in shopping centers in Southeast Asia to create a platform for investing in shopping centers in China. So, again, we are not trying to do everything in that market but are focusing on one thing that we have done well, doing it in scale and over time. But it is very much about taking a relatively patient approach to building it right and in a way so that we are comfortable in managing the multitude of risk that comes from doing business in a market like that.

Prudential has set very ambitious goals regarding sustainability. How were these goals developed, and how are things going?

Obviously, sustainability has become a very important topic. It relates to a philosophy associated with what our investors expect of us. They clearly expect us to deliver good investment performance, but they also care about how we do it, and sustainability is one aspect of that. We felt it was important to take steps to lend greater substance to what sustainability programs were all about.

Ultimately, it is about creating value and saving energy. If you are not very explicit in setting financial targets that are important to meet, it can lack substance in some regard. In many respects, we wanted to make sure that as it pertains to the low-hanging fruit associated with sustainability that we were meeting those financial goals. That is where you start.

Even the process of taking advantage of the low-hanging fruit is not an easy undertaking. A lot of what you are talking about is changing human behavior and how people act at the property level, because the accumulation of little things that people do ultimately has meaningful impact.

It is important to have taken these steps and established some accountability. This is not about good public relations but about creating tangible financial results.

I think one of the great issues has been people trying to figure out how to capitalize the savings or the profit, however you want to define it. To say that we have created value, it is real; it is relevant; it is measurable; and it is a standard to which we can hold ourselves.

There are passive things you can do—sensors and things like that—but you really have to change behavior and get people to actively participate to have a meaningful impact.

As we go into 2013, are you hearing from clients and investors that they are looking for a change in strategy? Do they want to become more active—be in more emerging markets, more Europe, more Asia, more secondary?

On one hand, people are flirting with wanting to take more risk, but on the other hand they are finding it hard to do so. If you looked at where we have been successful raising capital over the last 24 months, it has been disproportionately—and this is around the world—in strategies that are corelike in their character or debt-related strategies. What they generally have in common is preservation of capital and yield.

Even in the debt strategies that we have been pursuing, one of the appealing features is the relative yield that is available. I certainly continue to see a lot of capital flowing to those types of strategies. European debt is clearly a favorite sector right now, but even in the U.S. we have seen a very healthy level of interest in those strategies.

I hear discussions of people wanting to move to secondary markets and take advantage of that arbitrage between prime gateway market pricing and secondary market pricing. But what is not entirely clear to me in the vernacular of people talking about secondary markets is whether they are really talking about nongateway markets. I think what they are really talking about is moving out of the top five to the next five to 15 MSAs—not the top 20 to 30 MSAs. A lot of people will not think of Atlanta and Dallas as secondary, but in this environment they are not gateway cities by any means.

But it is hard for people to get their heads around doing that because of the lack of economic momentum. Ultimately, we need good fundamentals. While it is great that there is no construction, and even at low levels of economic growth fundamentals improve, making a bet on some of these secondary markets that remain relatively thin, in terms of tenant demand and investor appetite, remains a bit of a crapshoot.

Speaking of raising capital, it appears that we are seeing a real differentiation in the market between relatively new firms and the firms that have been in it for a long time, have deep roots, have been transparent, have brought bad news to the table early, and have not been afraid to tell investors and other firms that they have legacy issues to work out. Size matters. That is part one. Part two is you need to be the most local of local sharpshooters. If you’re not in those two games, you could find yourself having a very tough time.

In this environment, regardless of who you are, track record and credibility are what matters. We’ve been around a long time; we have a good track record and good client relationships. We’ve handled our missteps well. We have the capacity to coinvest in funds, which in this environment is important. We continue to launch new funds and strategies. For us, there is no boutique alternative; we must be a global firm. To be in the middle is a no-man’s-land for an organization like ours.

But I think there are some folks who find themselves in a period of time where their track records may not be perfect; they made some missteps in handling client relationships; they don’t have capital to put into funds. I think it is really tough. And startup firms are really tough propositions for people right now. So again, I think it comes down to track records, client relationships, and that sort of thing.

Let’s go back to the debt strategy so that I have that clear. I presume you are talking about acquiring existing debt.

We are buying debt in two places, the U.S. and Europe. Not exclusively but by and large, it is subordinated mezzanine debt. In Europe, it is almost exclusively a new-origination strategy; in the U.S., it is primarily new origination, but we do have the capacity to buy paper. The strategy in the U.S. is a bit broader.

We see the large institutional investors talk about their need for yield and current income for beneficiaries and the huge gap between what they are getting and what their actuarial assumptions are. But surprisingly, I haven’t heard many instances when they come to Prudential to put a lot of money into the mortgage market. It may not hit the bigger investment return hurdle, but it gets a solid return on a relative basis. Have I missed what’s going on?

No. Our sister organization, Prudential Mortgage Capital Company [PMCC], would handle that. They have seen some activity, but not a lot. I think part of it is the dilemma of where to put it, and what’s the benchmark. Is it handled by the fixed-income team, or is it handled by real estate? They don’t have a place for it. Where we have seen it happen is when you have a chief investment officer who looks at it and says that it is good relative value and tells the fixed-income team and real estate team to “get together and figure this out.”

Where we have been able to raise much more capital is in the mezzanine space where, for whatever reason, as a real estate strategy it has a higher return. Even the more conservative-positioned mezzanine, which produces an 8 to 10 percent yield, is compelling for many people. Even though it is not long-duration paper, given what is available in the market today for yield-oriented investors it is a very attractive position.

Someone said to me that they are looking at anything that has an R in it. I asked what he meant and he said: “refinance, rehabilitation, renovation, and reposition.” That is a strategy today because investors want to back good properties in which the owner might be a little upside down.

The strategies that we are pursuing are a little bit different between the U.S. and Europe. In Europe, the focus is on high-quality collateral, high-quality sponsors, and capital structures that need fixing. In the U.S., we tend to take a little more risk in terms of market location and asset quality. This is all relative, of course. In Europe, it really is a focus on high-quality assets and sponsors. We are not taking risk on those things.

We’ve seen a little M&A activity in the investment manager business, and everyone keeps talking about eventually seeing M&A in the REIT business. Do you see opportunities for large firms like Prudential to expand their assets under management and their platforms because there will be opportunities from firms that are not capitalized well enough?

I think there may be opportunities. The question in my mind is if it is an effective growth strategy in the sort of business that we are in. The complications around growing this sort of a business through M&A are significant. Among the most important things for a business like ours is to know who you are, to have a culture around investing and managing risk, and to deal with clients who have a lot of integrity. It is hard to maintain and cultivate all of that through an M&A-style approach.

We are much more likely to grow organically. That is not to say we will not bring in teams like we did for the debt strategy; we continue to be very active in recruiting talent. We have been approached by people who are looking for an institutional sponsor, coinvestment, or greater access to clients, but how that plays out is not entirely clear to me.

It’s a regulatory maze out there—Dodd-Frank, Basel III, and Solvency II for insurance companies in Europe. What is that doing to your business?

Like everyone, we have to respond to the heightened regulatory issues. We spend more time on it, it is more costly—all that stuff. The ongoing banking issues with Europe and Basel III actually help some of our strategies because they heighten the need for the sort of capital, particularly on the debt side, that we can provide. That is part of why we view that opportunity to be relatively sustainable for the time being. But we are dealing with it like everyone else. It is part of the world we operate in, and it is not going to get any easier.

If we look at the sources of equity and debt—the REIT story is pretty well told—CMBS are gaining traction and coming back slowly; insurance companies are just about as active as they can be, and for them to allocate more capital to real estate above the amount they have would take a lot of work. It is not as simple as saying, “Let’s put in another $200 billion.” And commercial banks are starting to heal slowly. Is that a fair summary of where the capital markets are?

It feels like it, yes.

Are there any new sources on the horizon?

In terms of the debt capital markets, I don’t think so.

Are yields too low to attract private sources of debt?

The materiality of what we need is huge. The CMBS market was coming back and people were saying the predictions for this year were around $35 billion to $50 billion. So when you look at the scale of what we need and who can fill that, it is not going to be the insurance companies; it is not going to be sovereign wealth funds. The scale is too big. I am not quite sure where it does come from. Presumably, the CMBS market should gain traction. I am not the expert on that market, but it seems to me volatility is the enemy of that market and we are still in a highly volatile market.

Are you seeing stronger competition from offshore investors here in the United States?

I am not aware of that for the kinds of assets we have been bidding on. Having said that, two-thirds of what we have done this year has been apartment-related, either development or acquisition. The development stuff is through programmatic development with our partners, so it is not competitive like the core space. In the core space, you are fighting it out with the normal institutions around here that are bidding for that stuff.

Allen, thank you.

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