A&I 2016 Meeting Report: Data Disruption Will Change CRE
On January 9th 2001 Apple introduced iTunes and, over the next few years, decimated the music industry. Within 7 years, they captured half of existing music sales. On June 29th 2007 Apple introduced the iPhone and, over the next few years, reorganized the entire mobile phone industry. Motorola, Nokia, and Blackberry were ruined by a computer company. What is the underlying root of Apple’s success? Data. With iTunes, Apple realized that people didn’t want CD’s, they wanted the data stored on those discs: Songs. They delivered songs directly to your desktop, with a simple and attractive interface, for a lower price. With the iPhone, Apple realized that if cell phones were capable of transferring complex voice data, they could transfer any data. Couple that with the fact that everyone was carrying around three separate data delivery systems (a Palm Pilot, an iPod, and a cell phone) at the same time and you had a recipe for disaster if you were only in the phone business.
“What would happen if Apple decided to get into commercial real estate?” Asked Gunnar Branson, President of NAREIM, “I have a feeling that if they, or any other data centric company, came into our space and offered higher transparency, less friction, and lower costs to institutional investors we might have to change how we do things.” We are vulnerable. We are susceptible to a disruptor like Apple discovering that we rely on fractured data without a standardized method of interpreting it. We still mainly operate on gut feeling but the data can give us a much more accurate understanding of how to invest. “What accounting does is really at the heart of the value we can offer to the investor. In the next ten years there’s a good chance we will be real heroes in this business, or obsolete, depending on how we approach data.”
That was just one thought introduced during a robust NAREIM discussion with NAREIM member accountants, controllers, and data managers in Chicago, on May 4th of this year. Data, the importance of data, and the impact it is having on our process and our industry was the common thread of the discussion. To set the stage, however, we started with a discussion of the general real estate economy.
“Real estate is above the tree line,” declared Mary Ludgin, Managing Director and Head of Global Research for Heitman, “We are in rarefied air where only certain things can grow.” Interest rates are at historic lows and our current economic expansion is the second longest in history. “The US FED is tightening while the rest of the world is easing.” There is a growth problem. “Countries aren’t worried about economic growth as much as they are worried about ‘what’s my piece of the pie?’” We are not growing at anywhere near a pre-GFC rate. In fact our 2016 first quarter GDP growth was only .5%, “But that does not necessarily mean we are facing a recession now. Within a five to ten year hold however, it’s probable.”
New construction inventory has grown on average at about 1.6% across the country over the last 50 years but since the downturn we’ve been closer to 1.1%. Ludgin reassured everyone “that our modest amount of construction matches the modest amount of debt and the modest economic growth so it actually indicates a healthy market.” This “ho-hum” growth comes mostly from two sectors: multi-family and industrial. Commercial and retail construction is down overall since the GFC. “There is opportunity in the commercial sector especially because our office buildings haven’t been updated in a long time.”
According to Ludgin, “Despite the rarefied air, real estate is fairly priced at the moment, even with compressed margins. Especially compared to the rest of the world. International money has nowhere else to go.” There is fear about an impending recession but there is no hard economic reason to expect one soon. We are comparatively balanced. There is frustration about pricing and margins but current levels are stable and cap rates look small only in comparison to pre-GFC rates. We went from a period of massive, unsustainable growth that felt really good, to a period of very slow recovery that feels laborious.
Whether we are in slow growth or recession, data collection is only becoming a bigger and bigger concern for investment management. We asked Dan Dierking, Chief Information Officer at NCREIF to discuss their efforts to standardize data collection across the industry. According to Dierking, “I went to several managers with this idea and they all said ‘Great idea. Not interested.’ Maybe they didn’t want to be first. But, more likely, they considered their existing data collection to be a competitive advantage and because of that had no interest in leveling the paying field.”
“NCREIF today is essentially a data collector and an index provider,” said Dierking. “We have three property level indices and we have five fund level indices.” They collect data sequentially starting with the quarter close. 15 days later farmland data comes in. Five days after that, they publish their report once the numbers are vetted. “So 20 days out from quarter close the reports are published.” The table above is NCREIF’S Q1 2016 release schedule.
“We ask a lot of our contributing managers,” admits Dierking, “This is a lot of data.” Additionally, managers contribute different data sets to different collection services. NCREIF thought that if all the data flowed through one service the whole process would be much simpler and more reliable. “The data that we needed however wasn’t even available in time for our collection deadlines. So we needed to change our process as well.” Dierking believes that we are shifting as an industry, “I think that we are going towards data collection not just by index production but for each fund. That would eliminate a lot of redundant data collection and would greatly improve our validation. It’s not just data collection, it’s data management.” Reporting four times a year might not be enough for the future of our industry. In an environment that is getting more and more constant in its hunger for governance, on going data collection and reporting on a broad spectrum will probably become the norm.
Where is all this Data Going?
“As a controller, I view the quarterly report as the main deliverable. My question is: Is that the most valuable tool that we are sharing?” Asked Ryan De Reus, the Portfolio Controller for LaSalle Property Fund. “Are we dedicating time to something that people aren’t getting much out of?”
“From the portfolio management side, the quarterly report is the primary report I look at.” Answered Carrie DeWees, Associate Director for Allstate Investments. “But each portfolio or asset manager is going to use that report differently. Some will add value by pouring over every expense and some will look at it at a global level. But there is always the opportunity to talk with your clients about how they use the report and what they might not need anymore. Most people are open to that conversation.”
Another thing to consider is that by the time any report gets to a board meeting, or wherever its terminus may be, it’s bound to be out of date. What if, instead of just quarterly reports, there was constant access to current reports of performance on a daily or even hourly basis much like other investment asset classes. What if investors could compare the quarterly report to today’s report? If that’s where the data is going then it has a much better chance of informing where we should go ourselves.
“In October the SEC sued four members of a firm, three of whom were accountants,” warned Eva Ciko Carman, Co-Head of Securities and Futures at Ropes & Gray, “What you guys do day-to-day greatly impacts whether or not you may have a problem with the SEC.” Carman has been representing managers in front of the SEC for 25 years. “The process is relatively simple. They see you as just an extension of private equity.” The benefit of this is that it has taken four years for them to get to commercial real estate. The problem is that they have had four years to perfect their process, and raise the bar. “These are all accountants doing the inquiries so they are looking at everything through that lens. If there is a problem, you’ll get a deficiency letter. If your response isn’t acceptable your case goes to enforcement. That’s when the lawyers get involved.”
Every firm is going to get examined at one point or another and “it’s like being dragged through hell,” so how can we make sure that examination goes smoothly? “Be proactive.” Says Carman, “I was doing an expenses review for a company which turned out fine, but a half-step away was an 8 figure problem. We decided the best course of action was to pay the entire sum back, which the senior management did not like at all. However, when it came time for their exam, it took 48 hours for The SEC to uncover the problem, and the earnest efforts to correct it. At the end of a 6 month investigation the SEC didn’t even issue a deficiency letter. Which is unheard of.” Now that same company leads their fund raising pitch with, “We made it through a full SEC investigation and didn’t even get a deficiency letter.” It’s a powerful message.
What are the rules? “Historically the SEC looked at fraud cases: at the point of sale in equities it is easy to identify fraudulent behavior.” But in real estate we maintain relationships with investors for decades. “So what they are looking for in your case is primarily a potential breach of fiduciary duty. Conflicts of interest.” There are only two questions: “is it a conflict of interest?” and “Did you disclose it?” According to Carman, “The first question always comes back ‘yes.’” Affiliates are a particular weak spot. “If you hire an affiliate to manage a property, that’s a conflict. A very common conflict.” How do you know that they are priced competitively? Are they really the best management company in the eyes of the investor? “So you can use an affiliate, but you have to disclose it. Disclose, disclose, disclose.” They need proof that your affiliate is charging market rate. “Knowing the market because you’re in it and you know it intuitively does not fly with the SEC. You need to show proof that your affiliates are fairly priced.”
Another weak spot is charging services to a fund. “If you expense things to a fund the investors need to know. If someone sits in your office but they are paid by a fund, you have to be very caerful about how you disclose that expense.” There is also a great focus on impairments as they relate to earnings statements. “The SEC was very focused on this years ago but they have come back to it with a vengeance.” Also important is the definition of affiliates, “These days if you had a conversation with someone on a bus, they are somehow automatically an affiliate.” You have to be very careful here.
So there are a lot of potential pitfalls. But by and large, the concerns surround disclosing conflicts. “If you are operating in the best interest of your investors and disclosing your actions to them, you are probably going to be closer to the safe side of the spectrum.”
How Should We Get the Work Done?
With added demands on data management, reporting, compliance, and analysis, it is difficult to imagine how the existing teams could manage the work in all but the largest firms. That’s why, naturally, this leads to a discussion of outsourcing. “It is our goal that a year from now, all these conversations will be about sourcing, not just outsourcing,” proclaimed Brent McFerren, Managing Director at RealFoundations, “We are in early innings here and we expect that the next ten years will look quite different from today.” The three components that will go into sourcing are, “Rigor: Why are you sourcing or outsourcing a particular type of work? Clarity: What exactly is the work that is being done? And Measurement: How effective is the work?”
Many people in this field have witnessed its very creation. “30 years ago all real estate was held privately and locally,” says McFarren. So it’s no wonder that there are some reporting issues and growing pains. “How and why we source the way we do will increasingly be a major factor. If we accurately document this process there won’t be a problem with disclosing affiliates and expenses.”
As outsourcing is becoming more prevalent it’s benefits are becoming more obvious. “If you outsource more you can focus on building your core employees,” argues Donald Morse, Managing Director for CBRE Global, “and if outsourcing increases revenue, decreases operating expenses, and keeps you on the leading edge of technology then you’re better off doing it.”
There are, of course, some traps to watch out for. Some managers make the mistake of letting the provider lead, “Having been on both sides of this equation, you have to clearly define what you want a service provider to do,” says Barry Johnson, Managing Director at State Street. “You have to understand how work gets done from A to Z and know exactly which pieces you are looking to engage someone to do. Otherwise you’re not going to engage the right firm, you’re not going to have a good way to measure their performance, and you’re not going to have a clear idea of how to integrate it back into your internal operations and reporting.”
So what is it that we are actually doing? And what are we truly delivering to our investors?
“You might be somebody’s landlord, you might even own banks, but you’re going to have to serve somebody,” wrote Bob Dylan. No matter how we approach the business, what investment strategies we might have, what expertise is in or out of house, our job is to always provide the best and most reliable outcomes to our investor clients. Investment management exists solely to service the investors and accounting is how we clarify the value of that service to them. In the last 25 years, investment management has done a good enough job of communicating with them, but the bar is rising significantly. We all have to contribute to a new kind of radical transparency that will likely transform much of what we do every day.← A&P 2016 Meeting Report: Real Estate is Adaptation How Data Can Improve Commercial Real Estate Investment Opportunities →