Exploiting Public Real Estate Valuation Asymmetry With Long-Term Horizon

Deep Dive

John Khoury, founder and managing partner of Long Pond Capital, discussed his background in real estate, beginning with his father's immigrant ethos of hard work and property ownership in eastern Canada. This foundation led him to study at Wharton's Zell/Lurie Center and subsequently work in real estate investment banking at Lazard. He noted that in 1999, REITs were unpopular, trading at significant discounts to their underlying asset values, which he identified as an early opportunity to exploit valuation differentials between public and private markets.

The discussion then shifted to Khoury's transition from private equity aspirations to the public real estate securities market. After working at DLJ, a chance encounter at a party led him to Art Rubel, who had recently launched one of the first hedge funds focused on real estate securities. Rubel presented an entrepreneurial opportunity to be an early mover in a growing public market, which resonated with Khoury and prompted him to pivot from his private equity path to join Rubel at the beginning of 2002.

Khoury elaborated on the evolution of the public real estate investable universe since his entry. He described it as approximately $300 billion then, more concentrated in traditional sectors like office, industrial, retail, and residential, with higher correlation across real estate assets. He contrasted this with the present, where secular risks like e-commerce's impact on retail and the shift to remote work affecting office space have become significant factors, meaning real estate no longer reliably rebounds simply by waiting.

The conversation moved to further changes in real estate investment opportunities, highlighting that public markets represent only about 10% of the total real estate market in the U.S. Khoury identified two major capital movements impacting the sector: the shift from active to passive investing and the rise of the "pod" model. He explained that passive investors focus solely on index replication, while pod traders are hyper short-term focused, creating a dynamic where Long Pond, with its two-year internal rate of return (IRR) paradigm, operates differently from the majority of market participants. This divergence, he argued, creates opportunities.

Khoury then detailed Long Pond's core investment philosophy: identifying and exploiting asymmetry, defined as the disconnect between intrinsic value and stock price. He believes volatility and asymmetry are linked, and firms with a longer investment horizon can capitalize on this. The increased volatility in the REIT space, with average moves being twice what they were previously, allows for larger disconnects from intrinsic value that Long Pond aims to exploit. He emphasized that their process is designed to be offensive, taking advantage of volatility and valuation discrepancies.

The discussion touched upon specific instances where this strategy was applied, such as a REIT missing earnings by one or two percent but experiencing an eight to ten percent stock price drop, which Long Pond capitalized on. Khoury recounted an anecdote where a pod trader dismissed a stock's attractiveness due to its cheapness, which Khoury viewed as a compliment, reinforcing his belief that valuation is a critical, though not sole, factor.

Khoury explained his decision to form Long Pond in 2010, stemming from a desire to run his own business with a clear vision and investment philosophy focused on exploiting asymmetry in publicly traded real estate securities. He sought to control the culture, investment process, and philosophy to systematically analyze and exploit market inefficiencies.

He then described Long Pond's current investable universe, which extends beyond traditional REITs to include companies like hotel management firms, home builders, and real estate service providers such as CBRE and JLL. Khoury defined this as encompassing "full 100% real estate companies," noting that while REITs have grown, the non-REIT sector has also evolved, with business models becoming less cyclical and more asset-light. He provided examples of hotel management companies like Hilton and Marriott, which he believes offer better earnings growth potential compared to hotel REITs.

Khoury quantified the total market size, stating REITs are just under $1.5 trillion, with the non-REIT portion being larger. Long Pond covers approximately 325 companies. He explained their process involves an "asymmetry ranker," where analysts model companies to derive an expected IRR, which is then discounted based on business model risk. This yields a "Long Pond warranted value" that is compared to the current stock price to rank companies by asymmetry. This tool is used for idea generation and resource allocation, focusing on companies disconnected from intrinsic value due to market disfavor, with a clear path for that disconnect to compress over their holding period.

He elaborated on portfolio construction, indicating that while the asymmetry ranker is quantitative, qualitative overlays like management quality and capital allocation history are crucial. The goal is to find cheap stocks with growing earnings, conservative balance sheets, and a two-year path to realizing their IRR. Decisions are made when a security's price movement creates a disconnect significant enough to alter its risk-return profile within the portfolio. Long Pond aims for speed in allocation during volatile periods but desires duration in their holdings, using short-term market reactions to enter two-year IRR investments.

Khoury discussed portfolio turnover, describing it as episodic. During periods of significant dislocation, like "Liberation Day," they might sell stocks down slightly to buy those down significantly with compounding characteristics. In less volatile times, turnover can be minimal. He also stressed the importance of respecting factors and correlations, noting that while the asymmetry ranker is purely quantitative, portfolio construction considers these elements, contrasting it with environments where being long cyclical and short defensive stocks led to significant losses in Q4 2018.

Regarding shorting in the real estate sector, Khoury acknowledged the dividend factor but noted that passive capital can sometimes support dividend-paying securities beyond their fundamental value. He categorizes shorts into alpha-driven shorts, where the expectation is for significant gains based on market recognition of issues, and shorts used as a hedge to a long position, citing the example of shorting lower-quality hotel REITs against a long position in Hyatt. He stated that short positions are generally smaller than long positions, typically around 3% of the portfolio.

Khoury then provided his perceptions of various sub-sectors. For data centers, he noted that better opportunities are often in private markets, with public companies having large existing footprints but less exposure to development economics. He expressed caution regarding the terminal value of data center assets. He highlighted apartments, industrial, and self-storage as high-quality, secularly winning sub-sectors that have faced challenges due to a supply problem exacerbated by low interest rates and zero cap rates pre-2022. The subsequent rate increase led to a multiple repricing, and the deliveries of projects started during the boom created a supply overhang. However, he sees an inflection point as new construction has slowed, leading to attractive valuations in the public markets, with implied cap rates for sunbelt apartments around 6.5-7% compared to private market cap rates of 5-5.25%.

Moving to office space, Khoury noted a reversal from the "work from home" narrative during COVID, with markets like New York City and San Francisco showing resilience. He emphasized the distinction between A+ office buildings, which are attracting capital, and lower-quality assets, which remain dicey.