Oct 27, 2016

Jon Gray on the global economy, the real estate opportunity and alternative investing

Jon Gray, Global Head of Real Estate, recently sat down to discuss the short-term concerns and long-term opportunities he sees in the real estate market today.

Published in the September 2016 Merrill Lynch CIO Report


What is your outlook for the global economy and some of the key risks you see going forward?

We think more of the same—subpar but steady growth—is a reasonable base case for the global economy over the near term. Headwinds persist in developed markets from significant leverage and aging demographics. The slowdown in the Chinese investment cycle continues to impact emerging markets as well. That said, strength from technological innovation, the fall of energy prices, continuing recovery of housing markets—most notably in the U.S.—and highly accommodative central bank policies are all supportive of growth.

In terms of potential risks, I would identify one for each major region around the globe. For the U.S., the presence of wage inflation could emerge to spook bond investors and overall asset values. In Europe, unforeseen political developments, like what we witnessed with Brexit but more severe, could create a crisis of confidence for the European Union. Finally, in China, the slowdown of the economy combined with escalated debt levels could lead to larger challenges than anticipated. We don’t believe these are likely outcomes, but as investors we have to be constantly looking out for potential storm clouds on thehorizon.


Central banks have adopted creative policies such as negative deposit rates. How do you view such strategies and their ability to bring growth and inflation? Also, what is your view on rates going forward?

I am not an economist, so it is difficult to comment on the full consequences of these policies. As an investor, however, the concept of negative interest rates seems odd and ultimately unsustainable as it rewards borrowing and punishes savings. Low rates are also resulting in a global hunt for yield that distorts capital allocation. I do understand policy makers’ desire to try to restore growth — I’m just concerned about the unintended impact.


“It is difficult to know how and when this experiment will end.”


It is difficult to know how and when this experiment will end. I believe investors should expect some mean reversion in the future with higher rates even if it is likely to take some time, particularly in Europe and Japan. Guessing when this happens is not easy and I’ve been wrong on this for some time, but interest rates will not stay at 0% forever, and we have to be prepared for that eventuality.


Let’s shift to real estate and the housing market. On August 16th the Commerce Department report showed housing starts unexpectedly climbed in July to the second-highest pace of the economic expansion, indicating the housing industry remains an area of strength for the economy. What is your outlook on the housing industry?

We have a very positive outlook on the U.S. housing market. As background, our real estate business is one of the largest owners of residential properties in the U.S. with approximately 50,000 rental apartments and 50,000 single-family homes for rent. Our confidence is supported by the basic law of supply and demand: 

Last year 1.1 million dwellings were built in the U.S. which was about 1/3 lower than the historic average and 1/3 below what is required to keep up with population growth. We believe this shortfall will continue to be positive for rents and housing prices. 


US Housing Completions

Source: U.S. Bureau of the Census, October 2016.

Ultimately, as pricing rises further, new construction should pick up to meet this unmet demand. We are looking for more ways to get exposure to this multi-year recovery in housing.


What are some of the secular trends you have seen in real estate and housing? For example, do Millennials prefer to rent rather than buy and baby boomers prefer downsizing and moving to urban centers? Also, are there specific geographic regions which are faring better than others given such changes?

There is a significant urbanization trend underway in the U.S. Lower crime rates, improved quality of life, the benefit of mobile devices and the sharing economy are drawing young, educated professionals back to urban environments. You can see it in disparate places like Brooklyn, Downtown Dallas and the Arts District in Los Angeles. Companies have reacted to these geographic shifts. For example, G.E. is moving its headquarters from suburban Connecticut to Boston, while McDonalds is going from Oakbrook, IL to Chicago. They are moving to where the talent is located.



There is also a powerful megatrend around cities that are home to innovation, many of which are on the West Coast. The dynamism these days in places like Northern California, Seattle, Austin, and Lower Manhattan is extraordinary. As new technology continues to revolutionize nearly every corner of the economy, cities at the forefront of innovation are seeing enormous increases in job growth and tenant demand.


“Cities at the forefront of innovation are seeing enormous increases in job
growth and tenant demand.”


In the residential area specifically the scar tissue from the housing crisis, less credit availability, more urban living and declining marriage rates, all lead to a shift towards renting versus owning. We have seen that reflected in homeownership levels which have declined from 67% to 63% over the last few years. The American dream of homeownership is alive and well but it may just be at a lower level going forward.


Investors have varying risk tolerances, from conservative all the way to aggressive. Given this, how do you recommend investors approach getting exposure to the real estate space? Also, do you view real estate as an income, growth or diversifying asset in the total portfolio? Or some combination of these?

We believe an allocation to real estate in a diversified portfolio can improve a portfolio’s overall return while reducing volatility. Real estate provides both current income like bonds or utilities, but also appreciation more like traditional stocks from rising rents and values.


“Real Estate provides both current income and appreciation”


Given the favorable supply/demand picture in both commercial and residential real estate in the U.S. today with new supply well below historic levels, we think it continues to make sense to have exposure to this sector. The major risk in real estate investing is generally from reckless use of leverage that forces a sale at the wrong moment.

Commercial real estate investment vehicles are available to accommodate a range of risk tolerances and investment objectives. Overall, we believe investors tend to under allocate to real estate, gaining access to it, if at all, primarily through listed equity REITs. There are other options. For example, investors interested in current yield may want to consider public mortgage REITs, private REITs or “core” real estate funds that offer income-oriented solutions.

And for investors looking for higher returns, private equity-oriented real estate, sometimes called “opportunistic” real estate, might be appropriate.


We live in an increasingly uncertain world. Disruptive technology, rising debt levels, market volatility, lower interest rates and increasing geopolitical risks seem to be the norm. At the same time, we expect returns from traditional investments like stocks and bonds to be lower. All that being said, what is Blackstone’s advice to clients on portfolio construction as it relates to achieving one’s goals?

We agree that investors increasingly are structuring their portfolios with an eye on their longer term goals — whether it’s their children’s education, retirement, a financial legacy or other priorities. But uncertainty in the global economy coupled with record low interest rates is making those goals seem ever harder to reach. Institutional investors like pensions and university endowments gradually have incorporated significant allocations to alternative investments in order to reach their objectives. Alternative strategies such as private equity, venture capital, private credit and real estate have allowed them to achieve solid results by trading liquidity for higher-returning strategies. Manager selection in this arena is obviously critical. If done correctly, it is our view that individual investors will begin to see the benefit of incorporating more alternative strategies in their portfolios going forward.


The views expressed herein are those of Jon Gray and do not necessarily reflect the views of Blackstone as a whole.  The views expressed herein reflect the views of Mr. Gray as of September 14, 2016 and neither Mr. Gray nor Blackstone undertakes to advise you of any changes in the views expressed herein.  None of the information contained herein constitutes an offer of any Blackstone fund.