Issue 27: 2014

Investment Spotlight

U.S. Energy and Real Estate
In a Transforming World

As once-unimaginable forces reshape how people live, two investment experts share insights on where their sectors might be headed.

Robert Stuckey (left) Photograph by Andy Ryan, Kenneth Hersh (right) Photograph by Misty Keasler

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We call it A Transforming World, and for good reason: The demographic, technological and economic changes under way across the globe are remolding almost every industry. In the United States, for instance, powerful generational shifts are leading to vastly different needs in real estate. And the energy sector is in the midst of an unprecedented, technology-driven renaissance.

With property and energy central to A Transforming World, our interviews in this edition of Investment Spotlight are with experts in those two sectors. Robert G. Stuckey is a managing director and head of U.S. real estate funds at The Carlyle Group, a global asset management company. Kenneth A. Hersh is co-founder and chief executive officer of NGP Energy Capital Management, an investment group specializing in natural resources.

 

REAL ESTATE

The Carlyle Group

Robert G. Stuckey, Managing Director, Head of U.S. Real Estate Funds

Capital Acumen: Rob, please tell us a little about Carlyle’s real estate investment strategy.

Robert G. Stuckey: Basically, real estate has about 10 product sectors. There are the more conventional sectors, including office, hotel, retail, industrial and apartments. There are less conventional sectors like data centers, self-storage, manufactured housing, senior living and for-sale residential properties. Our approach is to look for market opportunities in any of these sectors, and these opportunities usually involve pricing inefficiencies.

Could you give us an example of pricing inefficiency?

Stuckey: Imagine a target, with the bull’s eye being high-quality, low-risk properties — what’s often called “core” real estate. If you move one concentric circle off that bull’s eye, the pricing becomes less efficient. In mid-2013, for example, about 75% of the equity investment in real estate was focused on core real estate — the bull’s eye — because many investors were unwilling to take on the risk of investing in less-efficient properties. In cases like that, what we do is take calculated risks by investing in those less-efficient properties; and then, typically as economic conditions further improve and these properties move into the bull’s eye, so to speak, we move to sell them for a profit. It’s one form of arbitrage between core and noncore real estate.

We take calculated risks by investing in those less-efficient properties, and then we move to sell them for a profit.

Where else in the sector might you look to benefit from arbitrage, the difference in pricing of similar assets?

Stuckey: Arbitrage also exists in cases where credit markets virtually shut down, as they did for about three years after the Great Recession. Even now, although the credit markets have recovered nicely, they have yet to fully recover. As a result, capital structures might have trouble getting the kind of equity they need. And that creates an opportunity for us, to provide the necessary funds. Notably, over the next four years, an estimated $1.4 trillion of real estate debt will be maturing, creating a need for capital investment, and we are confident that will create investment opportunities.

What opportunities are being created by the “aging of America” and other demographic trends?

Stuckey: Demographic trends are important to investors because they can occur irrespective of macroeconomic trends. So if we can invest in an asset class that is benefiting from a demographic trend, the income it produces will often be more predictable, or involve less risk, than if the class is highly correlated with gross domestic product (GDP).

So, the question then becomes, of the 10 sectors I mentioned earlier, which have a higher correlation with demographic trends? Certainly, senior living is one of them. And within that sector, there’s traditional senior living, which caters to people 80 and above; and there’s what we call independent living light. This is a lighter form of traditional independent living, and with it, we seek to cater to a younger demographic, aged 65 to 75. We are developing both types of property.

How do the two property types differ?

Stuckey: The senior format is focused on assisted living, with the ability to care for people with Alzheimer’s and other age-related issues. Within the independent living light format, our goal is to create a youthful, vibrant feel by locating properties in urban locations that ideally are within walking distance of retail shops. With something like 75 million baby boomers in the United States today, it’s an important demographic trend.

Toward the other end of the age spectrum, how are millennials affecting the real estate market?

Stuckey: The cohort aged 20 to 30 has had a positive effect on the multifamily apartment sector. One consequence is that although there’s been a lot of construction in the sector, increasing supply considerably, we think that the millennials are keeping demand high, giving the sector room to further strengthen.

What’s your outlook for the various sectors over the next 12 months or so?

Stuckey: While it’s true that core properties have recovered to peak pricing, overall real estate values are about 15% below where we think they should be. One result is that within certain sectors there should be a reversion-to-mean opportunity as those valuations recover further, as we expect they will.

We think there is pent-up demand for new property, especially for single-family homes.

We think that within the residential market, single-family homes for sale should experience price appreciation of 5% to 8% over the next 12 months, while multifamily rental apartments should undergo rent growth of 5%. In the commercial market, the office sector will probably grow at about 2%. The retail sector is highly situational, in that property valuations can vary greatly depending on a building’s proximity to high-traffic locations. Within industrial, there’s typically a high correlation with GDP, so it should grow about 3% over the next year.

We think there is pent-up demand for new property, especially for single-family homes, because of the slowdown in construction in the aftermath of the Great Recession — in fact, you’d probably have to go back many decades to find similarly low rates of construction — and we like the idea of benefiting from that demand.

 

ENERGY

NGP Energy Capital Management

Kenneth A. Hersh, Co-founder and CEO

Capital Acumen: Ken, please tell us a little about your company.

Kenneth A. Hersh: My partners and I founded the business in 1988 to invest in the natural-resources sector. Nowadays we are acknowledged as a pioneer of what is now the common methodology of how companies are formed and grown in the industry. We provide private equity capital commitments to emerging and established producers who are growing their production and their asset base in a particular area. We then continue to fund our commitments when they need the equity to enhance the value of their assets.

The U.S. is producing more natural gas than Americans can use, and companies are exporting it.

While we look for companies with strong potential and a need for capital investment, we initially tend to focus on the people involved, people who ideally are the kind of entrepreneurs who can grow the business.

Why are entrepreneurs so important to you?

Hersh: Many people think that the major integrated energy corporations brought about the energy revolution that has transformed the U.S. energy picture. But that’s not the case. For the most part, it was the three to four thousand independent oil and gas operators in the United States that advanced the unconventional extraction technologies such as horizontal drilling. In short, America’s energy entrepreneurs have helped transform the U.S. economy; and now that the nation is less dependent on the Middle East for crude oil, they’ve also basically transformed geopolitics.

Your main focus is “upstream” companies?

Hersh: That’s right, upstream. In other words, companies involved in the production and development of oil and gas properties. To a lesser extent we invest in companies in the midstream industry, which is the gathering, processing and transportation of oil and gas.

Where are your investments geographically?

Hersh: We have investments in about 70 companies that operate on-shore, mainly in the 48 contiguous states but also in parts of Canada. We’re particularly active in the American Southwest and throughout Texas, Oklahoma and Louisiana. We invest in a few companies in the Marcellus Formation in the Northeast, and in the Rocky Mountain region. We also invest in a good number in and around Alberta and Saskatchewan.

Could you talk about technological advances such as fracking that have helped boost production volumes?

Hersh: We’ve certainly heard a lot recently about the benefits as well as the concerns that come with hydraulic fracturing, or what’s commonly known as fracking. But in fact the energy industry has been using fracking techniques since the 1950s. What’s really made a difference, particularly in geologic formations such as shale, is a combination of fracking and horizontal drilling. The ability to drill down and then sideways has allowed the industry to access oil and gas reserves that were once considered inaccessible. Other technologies such as surface sensors and three-dimensional mapping have also helped.

The United States at its core is a country that believes in trade, in the benefits of trade, and in innovation.

What’s going on with natural gas exports?

Hersh: There are some commentators who believe the nation should hoard its natural resources. That makes little sense to us. The United States has always sold grain and other resources abroad. Why should energy be any different? Actually, the United States is currently producing more natural gas than Americans can use, and companies are exporting it to Mexico. Will we perhaps sell more than we should to other nations, leaving the United States lacking? That’s highly unlikely, in our opinion. To transport natural gas overseas is expensive. You must freeze it to create liquid natural gas, then use specialized tankers, then re-gasify it at the other end. It’s almost always going to be easier and cheaper to sell natural gas within North America than abroad.

And oil exports?

Hersh: With respect to crude oil, laws to restrict exports were put in place during the Arab oil embargo in the 1970s as part of the failed price control laws of that time — and for the most part those laws are still in effect. For many years this wasn’t necessarily an issue, since we were so dependent on imports and our production was declining. The United States has exported refined products for a long time, but more recently, drillers have been producing huge volumes of lighter, sweeter, low-sulfur crude oil. The problem with that is that U.S. refineries were built for the heavy crude oil, not for the lighter oil. So now producers would like to export it to refiners abroad, but they’ve been hamstrung by the old regulations. We think it’s time for the export laws to be revisited — and struck down. We think this is inevitable because the United States at its core is a country that believes in trade, in the benefits of trade and in innovation.

What’s your view of U.S. energy over the long term?

Hersh: We believe that in terms of realizing the potential of its natural resources, the United States is, to use a baseball metaphor, in the second or third inning of a nine-inning game — with the game lasting 20 years or longer.

We think the next inning will usher in a renaissance in U.S. manufacturing brought on by the plentiful supply of not necessarily cheap, but certainly reasonably priced oil and natural gas. As an industry, energy has become a very ripe investment arena, with possibly 100 years of development opportunities. We’re very bullish about the energy industry.

For more information on these real estate and energy trends, or on investing in certain strategies offered by Carlyle or NGP, please contact your U.S. Trust advisor.

IMPORTANT INFORMATION

Projections made may not come to pass due to market conditions and fluctuations.

Some of the featured participants are not employees of U.S. Trust. The opinions and conclusions expressed are not necessarily those of U.S. Trust or its personnel. Any of their discussions concerning investments should not be considered a solicitation or recommendation by U.S. Trust and may not be profitable.

Past performance is no guarantee of future results. Asset allocation, diversification and rebalancing do not ensure a profit or protect against loss in declining markets.

Always consult with your independent attorney, tax advisor, investment manager and insurance agent for final recommendations and before changing or implementing any financial, tax or estate planning strategy.

OTHER IMPORTANT INFORMATION

Equities
Equity securities are subject to stock market fluctuations that occur in response to economic and business developments.

International Investing
International investing involves special risks, including foreign taxation, currency risks, risks associated with possible differences in financial standards, and other risks associated with future political and economic developments. Investing in emerging markets may involve greater risks than investing in more developed countries. In addition, concentration of investments in a single region may result in greater volatility.

Commodities
Energy and natural resources stocks have been volatile. They may be affected by rising interest rates and inflation, and can also be affected by factors such as natural events (for example, earthquakes or fires) and international politics.

Other
Nonfinancial assets, such as closely held businesses, real estate, oil, gas and mineral properties, and timber, farm and ranch land, are complex in nature and involve risks, including total loss of value. Special risk considerations include natural events (for example, earthquakes or fires), complex tax considerations and lack of liquidity. Nonfinancial assets are not suitable for all investors.

Real Estate Investment Trusts (“REITs”) involve a significant degree of risk and should be regarded as speculative. They are only made available to qualified investors under the terms of a private offering memorandum. Holdings in a REIT may be highly leveraged and, therefore, more sensitive to adverse business or financial developments. REITs are long term and unlikely to produce a realized return for investors for a number of years. Investments in real estate securities can be subject to fluctuations in the value of the underlying properties, the effect of economic conditions on real estate values, changes in interest rates and risks related to renting properties, such as rental defaults.

We call it A Transforming World, and for good reason: The demographic, technological and economic changes under way across the globe are remolding almost every industry. In the United States, for instance, powerful generational shifts are leading to vastly different needs in real estate. And the energy sector is in the midst of an unprecedented, technology-driven renaissance.

With property and energy central to A Transforming World, our interviews in this edition of Investment Spotlight are with experts in those two sectors. Robert G. Stuckey is a managing director and head of U.S. real estate funds at The Carlyle Group, a global asset management company. Kenneth A. Hersh is co-founder and chief executive officer of NGP Energy Capital Management, an investment group specializing in natural resources.

 

REAL ESTATE

The Carlyle Group

Robert G. Stuckey, Managing Director, Head of U.S. Real Estate Funds

Capital Acumen: Rob, please tell us a little about Carlyle’s real estate investment strategy.

Robert G. Stuckey: Basically, real estate has about 10 product sectors. There are the more conventional sectors, including office, hotel, retail, industrial and apartments. There are less conventional sectors like data centers, self-storage, manufactured housing, senior living and for-sale residential properties. Our approach is to look for market opportunities in any of these sectors, and these opportunities usually involve pricing inefficiencies.

Could you give us an example of pricing inefficiency?

Stuckey: Imagine a target, with the bull’s eye being high-quality, low-risk properties — what’s often called “core” real estate. If you move one concentric circle off that bull’s eye, the pricing becomes less efficient. In mid-2013, for example, about 75% of the equity investment in real estate was focused on core real estate — the bull’s eye — because many investors were unwilling to take on the risk of investing in less-efficient properties. In cases like that, what we do is take calculated risks by investing in those less-efficient properties; and then, typically as economic conditions further improve and these properties move into the bull’s eye, so to speak, we move to sell them for a profit. It’s one form of arbitrage between core and noncore real estate.

We take calculated risks by investing in those less-efficient properties, and then we move to sell them for a profit.

Where else in the sector might you look to benefit from arbitrage, the difference in pricing of similar assets?

Stuckey: Arbitrage also exists in cases where credit markets virtually shut down, as they did for about three years after the Great Recession. Even now, although the credit markets have recovered nicely, they have yet to fully recover. As a result, capital structures might have trouble getting the kind of equity they need. And that creates an opportunity for us, to provide the necessary funds. Notably, over the next four years, an estimated $1.4 trillion of real estate debt will be maturing, creating a need for capital investment, and we are confident that will create investment opportunities.

What opportunities are being created by the “aging of America” and other demographic trends?

Stuckey: Demographic trends are important to investors because they can occur irrespective of macroeconomic trends. So if we can invest in an asset class that is benefiting from a demographic trend, the income it produces will often be more predictable, or involve less risk, than if the class is highly correlated with gross domestic product (GDP).

So, the question then becomes, of the 10 sectors I mentioned earlier, which have a higher correlation with demographic trends? Certainly, senior living is one of them. And within that sector, there’s traditional senior living, which caters to people 80 and above; and there’s what we call independent living light. This is a lighter form of traditional independent living, and with it, we seek to cater to a younger demographic, aged 65 to 75. We are developing both types of property.

How do the two property types differ?

Stuckey: The senior format is focused on assisted living, with the ability to care for people with Alzheimer’s and other age-related issues. Within the independent living light format, our goal is to create a youthful, vibrant feel by locating properties in urban locations that ideally are within walking distance of retail shops. With something like 75 million baby boomers in the United States today, it’s an important demographic trend.

Toward the other end of the age spectrum, how are millennials affecting the real estate market?

Stuckey: The cohort aged 20 to 30 has had a positive effect on the multifamily apartment sector. One consequence is that although there’s been a lot of construction in the sector, increasing supply considerably, we think that the millennials are keeping demand high, giving the sector room to further strengthen.

What’s your outlook for the various sectors over the next 12 months or so?

Stuckey: While it’s true that core properties have recovered to peak pricing, overall real estate values are about 15% below where we think they should be. One result is that within certain sectors there should be a reversion-to-mean opportunity as those valuations recover further, as we expect they will.

We think there is pent-up demand for new property, especially for single-family homes.

We think that within the residential market, single-family homes for sale should experience price appreciation of 5% to 8% over the next 12 months, while multifamily rental apartments should undergo rent growth of 5%. In the commercial market, the office sector will probably grow at about 2%. The retail sector is highly situational, in that property valuations can vary greatly depending on a building’s proximity to high-traffic locations. Within industrial, there’s typically a high correlation with GDP, so it should grow about 3% over the next year.

We think there is pent-up demand for new property, especially for single-family homes, because of the slowdown in construction in the aftermath of the Great Recession — in fact, you’d probably have to go back many decades to find similarly low rates of construction — and we like the idea of benefiting from that demand.

 

ENERGY

NGP Energy Capital Management

Kenneth A. Hersh, Co-founder and CEO

Capital Acumen: Ken, please tell us a little about your company.

Kenneth A. Hersh: My partners and I founded the business in 1988 to invest in the natural-resources sector. Nowadays we are acknowledged as a pioneer of what is now the common methodology of how companies are formed and grown in the industry. We provide private equity capital commitments to emerging and established producers who are growing their production and their asset base in a particular area. We then continue to fund our commitments when they need the equity to enhance the value of their assets.

The U.S. is producing more natural gas than Americans can use, and companies are exporting it.

While we look for companies with strong potential and a need for capital investment, we initially tend to focus on the people involved, people who ideally are the kind of entrepreneurs who can grow the business.

Why are entrepreneurs so important to you?

Hersh: Many people think that the major integrated energy corporations brought about the energy revolution that has transformed the U.S. energy picture. But that’s not the case. For the most part, it was the three to four thousand independent oil and gas operators in the United States that advanced the unconventional extraction technologies such as horizontal drilling. In short, America’s energy entrepreneurs have helped transform the U.S. economy; and now that the nation is less dependent on the Middle East for crude oil, they’ve also basically transformed geopolitics.

Your main focus is “upstream” companies?

Hersh: That’s right, upstream. In other words, companies involved in the production and development of oil and gas properties. To a lesser extent we invest in companies in the midstream industry, which is the gathering, processing and transportation of oil and gas.

Where are your investments geographically?

Hersh: We have investments in about 70 companies that operate on-shore, mainly in the 48 contiguous states but also in parts of Canada. We’re particularly active in the American Southwest and throughout Texas, Oklahoma and Louisiana. We invest in a few companies in the Marcellus Formation in the Northeast, and in the Rocky Mountain region. We also invest in a good number in and around Alberta and Saskatchewan.

Could you talk about technological advances such as fracking that have helped boost production volumes?

Hersh: We’ve certainly heard a lot recently about the benefits as well as the concerns that come with hydraulic fracturing, or what’s commonly known as fracking. But in fact the energy industry has been using fracking techniques since the 1950s. What’s really made a difference, particularly in geologic formations such as shale, is a combination of fracking and horizontal drilling. The ability to drill down and then sideways has allowed the industry to access oil and gas reserves that were once considered inaccessible. Other technologies such as surface sensors and three-dimensional mapping have also helped.

The United States at its core is a country that believes in trade, in the benefits of trade, and in innovation.

What’s going on with natural gas exports?

Hersh: There are some commentators who believe the nation should hoard its natural resources. That makes little sense to us. The United States has always sold grain and other resources abroad. Why should energy be any different? Actually, the United States is currently producing more natural gas than Americans can use, and companies are exporting it to Mexico. Will we perhaps sell more than we should to other nations, leaving the United States lacking? That’s highly unlikely, in our opinion. To transport natural gas overseas is expensive. You must freeze it to create liquid natural gas, then use specialized tankers, then re-gasify it at the other end. It’s almost always going to be easier and cheaper to sell natural gas within North America than abroad.

And oil exports?

Hersh: With respect to crude oil, laws to restrict exports were put in place during the Arab oil embargo in the 1970s as part of the failed price control laws of that time — and for the most part those laws are still in effect. For many years this wasn’t necessarily an issue, since we were so dependent on imports and our production was declining. The United States has exported refined products for a long time, but more recently, drillers have been producing huge volumes of lighter, sweeter, low-sulfur crude oil. The problem with that is that U.S. refineries were built for the heavy crude oil, not for the lighter oil. So now producers would like to export it to refiners abroad, but they’ve been hamstrung by the old regulations. We think it’s time for the export laws to be revisited — and struck down. We think this is inevitable because the United States at its core is a country that believes in trade, in the benefits of trade and in innovation.

What’s your view of U.S. energy over the long term?

Hersh: We believe that in terms of realizing the potential of its natural resources, the United States is, to use a baseball metaphor, in the second or third inning of a nine-inning game — with the game lasting 20 years or longer.

We think the next inning will usher in a renaissance in U.S. manufacturing brought on by the plentiful supply of not necessarily cheap, but certainly reasonably priced oil and natural gas. As an industry, energy has become a very ripe investment arena, with possibly 100 years of development opportunities. We’re very bullish about the energy industry.

For more information on these real estate and energy trends, or on investing in certain strategies offered by Carlyle or NGP, please contact your U.S. Trust advisor.

IMPORTANT INFORMATION

Projections made may not come to pass due to market conditions and fluctuations.

Some of the featured participants are not employees of U.S. Trust. The opinions and conclusions expressed are not necessarily those of U.S. Trust or its personnel. Any of their discussions concerning investments should not be considered a solicitation or recommendation by U.S. Trust and may not be profitable.

Past performance is no guarantee of future results. Asset allocation, diversification and rebalancing do not ensure a profit or protect against loss in declining markets.

Always consult with your independent attorney, tax advisor, investment manager and insurance agent for final recommendations and before changing or implementing any financial, tax or estate planning strategy.

OTHER IMPORTANT INFORMATION

Equities
Equity securities are subject to stock market fluctuations that occur in response to economic and business developments.

International Investing
International investing involves special risks, including foreign taxation, currency risks, risks associated with possible differences in financial standards, and other risks associated with future political and economic developments. Investing in emerging markets may involve greater risks than investing in more developed countries. In addition, concentration of investments in a single region may result in greater volatility.

Commodities
Energy and natural resources stocks have been volatile. They may be affected by rising interest rates and inflation, and can also be affected by factors such as natural events (for example, earthquakes or fires) and international politics.

Other
Nonfinancial assets, such as closely held businesses, real estate, oil, gas and mineral properties, and timber, farm and ranch land, are complex in nature and involve risks, including total loss of value. Special risk considerations include natural events (for example, earthquakes or fires), complex tax considerations and lack of liquidity. Nonfinancial assets are not suitable for all investors.

Real Estate Investment Trusts (“REITs”) involve a significant degree of risk and should be regarded as speculative. They are only made available to qualified investors under the terms of a private offering memorandum. Holdings in a REIT may be highly leveraged and, therefore, more sensitive to adverse business or financial developments. REITs are long term and unlikely to produce a realized return for investors for a number of years. Investments in real estate securities can be subject to fluctuations in the value of the underlying properties, the effect of economic conditions on real estate values, changes in interest rates and risks related to renting properties, such as rental defaults.