Stewart: Welcome to another edition of the Insurance AUM Journal Podcast. My name is Stewart Foley. I'll be your host. I'm coming to you today to talk about real estate equity and ESG and how they converge in insurer's portfolios – and we're joined by a couple of experts, Sara Queen and Jim Landau from MetLife Investment Management (MIM). Welcome.
Sara: Thanks, Stewart. We're so happy to join you today.
Jim: Stewart. Really thrilled to be here. Thank you.
Stewart: Yeah, it's going to be fun today. I mean, we've got a lot to cover. There's a lot that's happened in real estate, from changes in capital charges, to ‘does it hedge inflation’? And ESG. There's just a lot here. But just at 50,000 feet, why do you think real estate represents an attractive opportunity for insurance companies right now?
Sara: Well, I think overall it provides a good, diversified return. There's a lot going on in the real estate space there. We can talk a little bit as we go through about some market and opportunities that we see there. But it's also a time where we're seeing that there is significant growth in the real estate market. And because of the changes in some of the capital allocation, which I know sounds a little bit like the deadly part of a story, it should enable more growth for insurers into the real estate space.
I have to say, I started my career in real estate. I love to talk about real estate. And so, you're going to have to keep me from just talking about all the market stuff, but there's some interesting opportunities. And then when you couple that with the way that we can use real estate to positively impact ESG goals as we go forward, I think it's a real win-win for insurers.
Stewart: Can you talk a little bit about the transparency in the sector? I mean, real estate, particularly for MetLife Investment Management, you've been in this market a long, long time, right? How has it changed? And (I guess where I started) what about the transparency in the sector today versus prior?
Sara: Yeah, so MetLife started investing in real estate over a century ago. It has deep, roots in both office development, multifamily development, and the major classes of real estate over that time. And even when I started my career many years ago, there just wasn't as much data that was widely available. Today, because of a lot of the transparency on both pricing, what are assets being sold for, but also because of the open-ended funds structure and the growth of open-ended funds, there's just a lot more data and availability of understanding what the trends are and where things are trading.
And not only that, you couple that with the fact that the average institutional asset size has grown significantly over the last few years. Now I think the average asset in the ODCE Index, which is an open-end index that gets referenced a lot, is basically a $100 million. These are not small assets that people don't know what they're trading for. They're widely reported. You can see transparency and that has really opened the industry in a new way.
Stewart: So, in that way, the other big change that's gone on recently is a change in the RBC treatment. Jim or Sara, what can you tell us about that?
Sara: Well, I think, Jim, I'll save you from that. In the last year there's been some big changes in the RBC, and they particularly have implications for insurance companies. These changes had really been in the works for years and really based on the fact that the way that risk-based capital requirements were looked at were more outdated, because they were based on a time when there was less transparency in the market. As we've been able to modernize and update that RBC framework, which MIM took an active role, we've been able to reduce what the capital charges are.
The C1 RBC factor for wholly owned real estate was reduced from 15% to 11%, and the factor for JV and fund investments was reduced from 23% down to 13%. These changes should spur new investment by insurance companies into the real estate space, and we're really excited by those prospects.
Stewart: And I think too, insurance companies are forced to own a very large percentage of investment grade fixed income, right? The risk today with rates where they are is just an unmanageable rate of return from those investments. That's coupled with the fact that we've got some big inflation prints which erode the value of bond portfolios. Historically, real estate has been an effective inflation hedge. Is that still the case today? And if so, in what way?
Sara: Sure. Real estate very much can be an inflation hedge, and there's two main pieces to that. One is the fact that you have these leases that are continually being reset to market. Office – those tend to be longer. And multifamily – those tend to be shorter leases, right? You are resetting them on a regular pace. You can also manage your role, so you're trying not to have your entire portfolio roll at the same time. So, you're not over exposed to the economic market at any one point in time.
The other thing is that the leases provide adjustment for operating expense growth usually. As electric and cleaning costs go up, that also gets added into the rental stream of the building. So, you're also protected that way. The other large way that you're protected is that as it costs more to build a building because of increases in inflation, you look at the value of the buildings today versus what we call the replacement costs, what it costs to build the building, and if the replacement cost is exceeding what the current value of the building is, you see a slowdown in construction, which then slows the rate of supply and allows demand to catch back up. One of the things that we've been looking at is not just construction costs, but also as we move to more green construction costs, which I think is also a good segue. We can talk a little bit about some of the interesting work that Jim's been doing on the ESG front for us.
Stewart: I want to get to ESG, and you just mentioned that with Jim, in just a second. Before we go there, one of my questions is, if I'm an insurance investor, should I be investing direct? Should I be investing in funds? Does it matter how big I am? Does it matter what kind of insurance company I am? What's the answer to ‘do I buy direct or fund’?
Sara: It really depends on what your objectives are and how much capital are you willing to commit. The direct investing, so you'd go out, buy a building, for instance. You can target a specific asset class. You can target and start to build out a diversified portfolio for yourself or a specific geography if that's what you're most interested in. Now, the advantage is you get that targeted approach. But unless you can get to scale, then you have greater risk, so greater tenant risk, greater economic risk on the market that you're in. For example, if you bought an office building, it all comes down to who your tenants are.
Do you have too much concentration of when those tenants expire? Does all that rollover happen in one year? If there's an issue in the market, it can affect your entire portfolio, for instance, and changes in local regulations, all those things. But it does allow you to construct a portfolio on your needs, but that risk is more concentrated. That's the trade-off. There can also be some tax advantages, so you have to work through that. On the fund investing, if you go into an open-ended core fund, for instance, that's a great way for you to be able to access real estate with a much larger diversified portfolio.
You're not as incumbent on this one office building in this one locale. There you have lots of investments made across the country and all different sizes and all different asset classes. The fund manager will actively be managing buying, selling, redeveloping assets within the portfolio to determine what's that right mix to hit their return objectives.
Stewart: Thanks. We started off the podcast by talking about how real estate equity and ESG converge in an insurer's portfolio, which Jim, hey, here we go, how has ESG evolved at MetLife Investment Management Real Estate Division?
Jim: Great question, Stewart. Thank you for the opportunity. First of all, it's probably just worth noting that ESG in general has really, and we've all seen this, exploded in all investment classes, not even just real estate. For instance, at MetLife Investment Management, Sara and I work in the real estate division, but we also have public fixed income investments and private placements, infrastructure investments, capital markets, and the focus on ESG is impacting all asset classes right now. In many ways, real estate's a leading edge. We've got more experience in the field, but it's catching up due to investor demand, both domestically and internationally. At MetLife, to answer your question, we've always been focused on sustainability. Why? Because in many ways, it's historically been about net operating income, lowering expenses, increasing revenue, and largely, I believe at least, that that's really where the focus has been for the last 10, 15, 20 years.
More recently, we've really refined how we're looking at carbon and greenhouse gas emissions and reporting the G in ESG, governance, has become very important, at the state level, city level, and even at the international level, and with institutions like the United Nations taking a big lead here. At MetLife, we started a sustainability group or energy and sustainability group maybe 10 years ago. Over the years that's evolved.
And to this point, I am now the head of ESG for MetLife Investment Management’s Real Estate Group, which includes our equity and commercial mortgage and agricultural finance, which is a debt platform, both in the US and internationally. I'm building a team right now, and that's in addition to expanding the consultants that we use, external consultants, over the years. I think what we're doing is emblematic of what the rest of the industry is doing. I'd like to think that we're the leading edge and, in many ways, that we're setting the standard, but it's becoming a must-have for investors.
Stewart: There's new legislation that's out, carbon and energy legislation, that have been enacted in several US cities. How is MIM (the acronym for MetLife Investment Management), how is MIM addressing these laws, this new legislation?
Jim: Yeah, in a variety of ways. First off, yes, to your point, there is new legislation. For instance, Local Law 97 in New York City, the new BERDO law in Boston, Denver, DC, St. Louis, the State of Washington, Montgomery County, Maryland, many jurisdictions, city, state, local level, have been instituting carbon or energy legislation. I might add, this is not new. For going back at least a decade, disclosure requirements that cities have enacted have been in place in most major markets. They were rather simple. Building owners had to disclose total energy use or whole building energy use once a year.
They evolved a little bit to benchmarking laws. Cities established certain minimum requirements and you were required to benchmark against those, meaning ‘show how your metrics for your building are, compared to other similar assets’, right? More recently, these new energy and carbon laws have taken hold. We anticipate that they're going to expand and continue in most major markets. First off, they impact potentially cash flow. If an asset is going to experience significant annual penalties because its energy use or carbon emissions are too high, then that has an impact on value, and we need to know about it. We're working closely with our acquisition team and our asset management team to understand what that impact might be.
Secondly, and this is brand new, we're just rolling out new underwriting guidelines. We're looking at energy use, carbon intensity. We're looking at it versus certain metrics that we've defined. And if an asset is doing better than that metric, we might actually reduce a reversion cap rate to reflect that lack of risk both today and 10 years from now when that property reverts when we sell it. I might add that we're not just doing that in markets that have established this legislation already. We anticipate that most major markets where we're investing will enact similar legislation over the next several years. It's really something that's certainly going to affect the reversion of the property, not just the cash flow.
Stewart: Yeah. I mean, Sara mentioned it earlier, MetLife Investment Management has been in the real estate market for a hundred years. You're a major player in this space. You and your clients own and manage a lot of real estate. I realize that you're taking your ESG goals and objectives very seriously, and you've come up with something called the Met Zero Program. What is it? What are you trying to accomplish there?
Jim: First of all, it's a great name, isn't it?
Stewart: It is a very good name, I have to say. I mean, I'm a name junkie. I came up with Insurance AUM. I love it. Pension AUM, I own that. It's all good, but I got to say, kudos to you on Met Zero.
Jim: Look, it's really simple. It's what most of the industry is trying to do today. We're looking to track emissions in all of our assets and in portfolios and in aggregate for all assets that we own or invest in. We want to lower net emissions year over year. I need to say that the industry throws around terms like net zero or net zero carbon or carbon neutrality and many people interpret or define these terms differently. It's important to note that in investment real estate, multi-tenant investment real estate, it's going to be very hard, particularly in mid-rise, high rise, urban, multifamily buildings anytime in the near term to achieve true net zero, where the building is producing as much energy as it's using. That's difficult. It's going to require new technology and innovation, which a lot of very smart folks are working on over the next decades really.
Stewart: But the reality is that today it's not here, right? I mean, the technology is just not here.
Jim: If you've got a single story, 3,000 square foot bank branch in the Southeast, yes, you can put solar on the roof and that building can be truly net zero. For mid-rise, high rise, sophisticated buildings, and urban areas, no, it's not feasible today. What we are doing though, and what we can do and what's critical that we do, is that we track our emissions, and we try to lower them year over year on a same store basis. Energy efficiency and reducing demand, those have been the key things and what we've been looking at and the industry has been looking at for the last 10 years and they're still critically important.
That's the number one focus, increase efficiency, lower demand, wherever feasible. That's both in terms of landlord/owner use and tenant use. It's important to note that for most midrise, high rise, multifamily office buildings, tenants’ control anywhere from 70 to 90 or even above 90% of the energy use in that building. We really need to partner with our tenants, and we have programs in place that are enabling us to do that. Figure out where we're in alignment with our tenants. Many of them are national and regional, local law firms, tech firms, accounting firms, consulting firms, and they have ESG goals. They have carbon goals much like ours. If we can figure out where we're in alignment, we can work together and we can lower emissions.
Secondly – add onsite renewables like solar and wind, fuel cells where feasible.
Third – offsite renewables, purchasing green power and other large, maybe even district scale renewable energy projects that we can pursue. And we're looking at all the above.
Finally, once all of that is done, if we really want to achieve carbon neutrality and we are doing that today on certain vehicles, we can purchase renewable energy certificates (or ‘RECs’) and carbon offsets. That's really the last step in the process.
Stewart: I'm always the one that learns the most on these podcasts. I love it. I get a great education, and I really appreciate it. Let me ask you a question that I think is in the back of the minds of a lot of investors. There was a recent survey that was published that said 92% of who are concerned with ESG are doing it partly for a reputation, right? Which is effectively, yeah, I want to check that box, right? And I think thatthere's a certain percentage of people who say, "Well, yeah, ESG is great, but that's going to cost me return. That's going to cost me alpha somehow or the other." And yet you have put these two together, real estate and ESG. Do you think it's true that an ESG focus, or a net zero goal is aligned with better long-term performance, or do you think it's a drag?
Sara: I think it's very much aligned. I think where you said and you look at today, both... You're looking for efficiencies in your operations that reflect that. The other thing that happens is sometimes the true risk of an asset is not being adequately reflected in some of those underwritings. So, if you're like, "Oh, this ESG stuff isn't really important. It's not going to matter in 10 years," the cost to run your buildings could be significantly more than it is today. And so, if you don't take the steps today to build in efficiency, make decisions where you can, you're going to have more difficulty later.
The other thing that we find is that a lot of times when you're replacing equipment today and making decisions, you're lowering your cost of operations today. So, there's an actual payback in the short run for making these decisions. To us, it's really an alignment of both interests. It's important to us because we're people on this planet, but also because we think that it's a smarter investment decision on the long-term.
Stewart: I think that any ESG discussion has to include a piece on climate change. We see it here in Chicago. Things are different than it used to be. A lot of folks say that, especially when you're as gray as I am. Has your underwriting or your approach changed as a result of climate change?
Jim: It has. Yes. When we think of climate change, we think of two types of risk, physical risk, and transition risk. With regard to physical risk, that includes increased risk from rising heat, wind, water levels, storm surge, et cetera. There are several tools on the market today that help to measure physical risk. We've been employing one of them for a couple of years. We use it for every new equity acquisition and loan origination. And if there's an indication of high risk for any of those factors, we dig in.
Our risk manager, our internal regional architect, our asset management, and acquisition teams put their heads together and try to figure out, first – has this asset already mitigated that risk? Is mitigation in the long-term capital plan for the asset? Or in the case of this asset, are we comfortable with that risk? Secondly – transition risk. We already touched on this earlier. When we're talking about local laws and legislation and regulation, that poses transition risk, and we've already addressed that aspect of it. It's something that I think most real estate investors are considering today.
Stewart: I know ESG discussion isn't complete without climate. No real estate discussion is complete without talking about the impact that COVID has had on real estate fundamentals. I know from previous podcasts that it is very property type specific. If you would, can you talk about the major property types and the impact that COVID has had on those segments?
Sara: Sure, Stewart, I'd be happy to. If we think about industrial assets or warehouses or logistics, depending on what you want to call them, really COVID has... The rise and more people adopting e-commerce andthe speed at which everybody wants their deliveries. It used to be you were happy with you get it in three days, then it was two days. And now if I can't get it in two hours, I'm annoyed. It has really driven a growth in logistics and warehouse spaces. Both from close end to enable that what we call last mile delivery isn't always just a mile, but that close end feedback, as well as the bigger box warehouses that you see up and down the highway at times. So, for example, an e-commerce client tends to take three times the amount of warehouse space as a typical retailer. Both the growth of e-commerce and the speed at which people want things has really spurred a big increase in industrial. COVID has had a positive impact on the industrial space.
On multifamily, really driven by employment and demographic trends, at the beginning of COVID, there was a lot of concern of what was going to happen, particularly city versus suburban and all that, and that continues to play out. But what we've seen is that there's been a return of rates back to, in a lot of markets, pre-COVID levels. Some are still approaching that, but we've seen a strength in rental rates across the board, particularly in markets that have seen the most influx of people. We've also seen a focus on the amenity’s spaces in those multifamily units. They want outdoor space. People really care about their pet runs. It's not just a dog run anymore. It is a dog spa where they can get washed and everything. You cannot believe all the stuff that gets put in the amenities space for apartments today.
On the office side, obviously really driven by job growth, what's going on in employment sector. We have record low unemployment again. When we look at the markets that have been heavily tech focused, we continue to see new, large leases being done in those markets, even though physical occupancy office buildings are not back. Around the U.S., I think we're still only at 20%, 25% of physical occupancy in the building versus where we were beforehand. That will continue to come back hopefully soon as we get through this phase of the pandemic. But what you're seeing from those larger tech companies that are committing to large pieces of space is that they're saying, "We miss being in the office. We miss the collaboration. We miss the talent development. We think it's very important for us long-term for our culture and our talent development to be back in the office." I think that will continue to spur people doing that.
The other thing I would say is that for the most part, we have not seen... Although vacancies have risen, as leases have expired, sometimes tenants have let those expire and not picked new spaces, particularly on the smaller side. But you've continued to see the tenants pay their rents. So, although your physical occupancy is down, most of the office buildings are still producing the same amount of tenant income that they were before.
And then we get to retail. Very much driven by consumer spending, population distribution. Now, the shift to e-commerce has had a negative impact on a lot of retail centers. But what you've seen on the grocery-anchored centers, for instance, has been real resiliency during the pandemic. You've also seen a lot of retailers adjust to offering curbside pickup and some other innovations. Retail had been suffering a little before the pandemic. The pandemic has not helped them by any stretch of the imagination. But even within that sector, there are bright spots. You have to pick the right asset and in the right locations.
Stewart: And just kind of as a wrap up question, before we get to the ask me anything question, which is coming at the end, I don't want to show my hand. When you're making an investment decision, walk me through – what are you looking for?
Sara: I tend to look at it as, first off, is this a good investment? Does the upside outweigh the downside? Can we mitigate some of the downside risk? Do the returns make sense over the life of the asset? We have to understand how we are going to make money for our clients on the asset. Do we need to re-lease it? Do we have to upgrade it? Do we need to renew a major tenant in three years? How do we see the market changes impacting this asset in the short and long run, and how do we drive and create value?
To me, the heart of being an active investment manager is thinking about every day, how am I creating value for my clients? And how am I looking at this asset to drive its performance over time? Now, part of that is also thinking about the long-term implications that Jim already covered, that's some of the things that we think about on the ESG side. How have we incorporated that? How have we dealt with those risks? Then we think about, what is the impact the market is going to have on performance? Is this a growing market? What causes that market to grow?
Is it in decline? Is this a market that's attracting a lot of new investments? What are the economic factors going on in the market? Then I start to think about, does this investment create any risk for my particular clients? For example, my client already has a lot of warehouse space maybe leased to Amazon. They may not want to buy an office building that's also leased to Amazon or buy a multifamily building located across the street from Amazon's headquarters. There may be another client it's appropriate for, but you have to think about those more macro issues in the portfolio construction.
And then overall, you're looking at your return projections, understanding the risk in those projections, and understanding your ability to beat market over time.
Stewart: I really want to thank you both. We kicked it off saying ‘how does real estate and ESG converge in insurance company's portfolios. We've covered a lot of ground and I've learned a lot. I appreciate that. We have come to the portion of the program called the ask me anything section. I always do this for all the students out there that are potentially listening. I was a professor for a long time, and I have a soft spot in my heart. So here we go. Sara, I want to take you back to a day I know you remember well. It's the graduation day of your undergraduate institution.
Regardless of what festivities may have taken place the evening before, you are bright eyed and bushy tailed. Your last name starts with Q, so you're at the back third of the alphabet. You've been waiting a while. You go up the stairs. You make the turn and they read your name. The crowd goes crazy. I mean, crazy. You get a quick handshake. There's a photo op. They hand you your diploma, and you down the stairs. At the bottom of the stairs, you meet Sara Queen today. What advice do you give your 21-year-old self?
Sara: Oh, that's a great question. It was such a long setup, I thought we were going in a whole different direction. I would say believe in yourself and take risks.
Stewart: God love you. That's what I'd say too. I love that. I didn't mean to interrupt you. Go ahead please.
Sara: No, no. I would say like, it's very easy, particularly when you're starting out, to doubt your instincts and reinforcing that, no, it's good to observe, but you've got this. And look, if you don't take any risks, thenyou're never going to find out how far you can stretch. It's really important that you continue to challenge yourself and try new things and continue to stay curious.
Stewart: Jim, how about you?
Jim: I'm just going to piggyback off what Sara just put out there because I agree with all that. I would add run to adventure. You know what? I regret that I didn't take two years to join the Peace Corps or to backpack across Europe with no money in my pocket. You're not going to do that kind of thing once you settle down, once your career really starts to take off, once you get married, start having kids, that sort of thing. Run to adventure take advantage of all the opportunities that are thrown in front of you.
Stewart: I really love that. I think it's such good advice. I've told many, many students. They'll graduate in May and their job starts July 1. And I'm like, "Listen, I don't care if you've got the money or not. Go someplace. Go someplace you've always wanted to go because you're not going to get six weeks off again for a long time, so take advantage of it." And I love the advice to take more risks.
Jim: Is this my opportunity to ask Sara if I can take six weeks?
Stewart: This is. This is the right time. You're doing it on a podcast, so she's probably going to say yeah.
Sara: We can talk, Jim.
Stewart: Yeah, exactly. Sara Queen, Jim Landau, MetLife Investment Management, otherwise known as MIM, thanks for being on.
Sara: Thank you, Stewart.
Jim: Thank you, Stewart. Appreciate it.
Stewart: I want to thank our listeners. And if you have ideas for podcasts, please email us at email@example.com. My name is Stewart Foley, and this is the Insurance AUM Journal Podcast.