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.