Scott Rechler, CEO and Chairman of RXR, joined us for a wide ranging interview. We discussed the macroeconomic environment, RXR’s pivot to multi-family, the ideal capital stack, office-to residential conversions, and other timely topics.
Daily Beat: Can you please share the history of RXR?
Scott Rechler: We first had a public company called Reckson Associates Realty that was sold to SL Green Realty in January 2007. One of the reasons we sold Reckson was because the public markets were becoming too restrictive as our customer’s needs were changing at an ever-increasing pace.
We felt as if we were being forced into more of a narrow box, while believing that we needed to have the flexibility to adapt to the changing nature of how people lived and worked. This led us to decide that we’d be better off selling the company and reestablishing ourselves as a private company where we could be much more agile and focus on the future of where the real estate industry was going versus how it operated in the past.
We built a strategy that leaned into shifting demographics, new technologies, and understanding the changing needs of our customers to drive our investment decisions. We believe is not just about building a building with four walls but actively servicing the customers that live and operate within those four walls. The basis behind the RXR strategy was providing customers with differentiated real estate solutions and services that helped them meet their goals.
As a private company, we were able to take a clean sheet of paper and form a strategy based on our previous experiences as a public company. The vision was to marry the ideal organizational structure with the right capital structure and strategy so that RXR could excel.
Daily Beat: When did you jump back into the market?
Scott Rechler: Even though we sold Reckson in 2007 and started RXR on the exact same day, we didn’t make our first investment until August 2009. We were circling around, waiting for opportunities, but the fog of uncertainty remained heavy for quite some time. When we finally jumped in, we did so in a big way to take advantage of the dislocation that existed in the office market. From 2009 to 2011, we invested $4.5 billion in office properties.
Our investment strategy was to lean into the knowledge worker and buildings that appealed to them, focusing on services, community engagement, authenticity, and character. We continued to acquire office buildings but bought our last one in 2016 when we saw the sector getting too hot.
Daily Beat: And then you shifted into multi-family?
Scott Rechler: Yes. We started shifting our focus to multi-family and transit-oriented developments with projects that were within thirty minutes of New York City. These projects create an urban style of living in suburban locations but at a more affordable price point than living in the city, with rents 30% to 40% less than equivalent apartments in the city.
We have also been focusing on redeveloping and repositioning competitively obsolete properties to uses that are consistent with today’s demand. A recent example is a mall in downtown White Plains that has been vacant for almost two decades. It is a block away from the train station and a 30-minute train ride into Grand Central. We demolished the mall and we are building over 800 units of multi-family.
In addition to our focus on “transit-oriented developments,” we have capitalized on opportunities to acquire multifamily. For example, during the heat of Covid, when people were fleeing New York and apartment occupancy rates were hitting the low eighties, we invested in over $2 billion of multifamily properties. In hindsight, I wish we were able to acquire more, as residential buildings are now back to over 95% occupied, and the rents are higher than they were in 2019.
Daily Beat: What are your thoughts on the macroeconomy? How do you see interest rates playing out? I know you are on the New York Fed’s Board of Directors.
Scott Rechler: The Fed is obviously committed to taming inflation. This situation is complex as there are inflation drivers that are not directly related to the economic cycle such as supply chain disruptions, structural changes to the service sector job market, post-covid pent-up demand, and the war in Ukraine.
The Fed has been pretty clear that it’s going to focus on demand destruction to drive down inflation, which will also drive down economic growth. While people are focused on how high rates will increase, I think the bigger question is going to be how long rates will stay high.
If you go back and look at past cycles, particularly when you’ve had an inverted yield curve like what we have now, the Fed has historically started to taper back down the rates. I am not sure that is going to be the case this time, as they have made it clear that they want to make sure that inflation is fully out of the system. This heightens the risk of a more severe economic downturn.
Daily Beat: What do you see talking to your clients and customers?
Scott Rechler: Sitting in my seat watching what’s happening from a fiscal standpoint and then talking to our clients and seeing what’s happening to them first-hand, I describe it as “a pig in the snake” situation.
As interest rates rise, it starts working its way through the snake –– the financial markets are hit first but eventually, it hits the real economy. The longer interest rates stay at higher levels, the bigger that pig is, and the harder it will be for the real economy to digest it. That’s what we’re dealing with right now – the pig is getting bigger, and it’s starting to make its way into the real economy.
I speak to a lot of different CEOs, and they are approaching their 2023 business plans cautiously with the backdrop of this economic uncertainty. People are pulling back on hiring, capital investments, expansion plans, etc.
I think this will result in a more pronounced impact on the economy in early 2023. Until businesses see an all-clear that there’s not some financial shock or a deep recession ahead, they will prepare for the worse and hold back on spending.
Daily Beat: Many point to the relationship between the 10-year treasury and cap rates. Do you think this analysis sometimes overlooks the notion of convexity?
Scott Rechler: When focusing on real estate cap rates, you need to also focus on the total return of the investment, which takes into account both income growth and the exit cap rate to determine the exit value. Real estate that has the potential to grow its NOI more quickly during these inflationary times will see its cap rates less impacted by the rising rates.
While there’s a relationship between where interest rates are in terms of the risk-free return and what premium an investor needs to invest in real estate, cap rates are also impacted by externalities. If you go back and look through history, there’s not always a direct correlation between interest rates and cap rates. It has a lot to do with alternatives as to where institutions can invest, growth potential, and expectations for future economic conditions.
Take multi-family as an example. Investors view the sector as a hedge on inflation because one can increase rents on a regular basis. The same is true with hotels. It also has to do with the flow of capital. If an institutional investor is seeking to allocate big dollars into real assets, they might be concerned about investing in office buildings or malls in these uncertain times, which means they will need to allocate into multi-family, logistics, or self-storage.
Those sectors are much smaller in terms of investment size and thus require more investment in this space to meet your capital allocation. You may have to do five multifamily investments to equate to one office building. Therefore, I think that you’ll have these higher capital flows to keep cap rates lower.
Daily Beat: How do you employ leverage at this point of the cycle?
Scott Rechler: One of the things that we’ve looked at is using much lower leverage in this environment. The higher rates reduce the positive leverage and increase your overall cost basis. The lower leverage provides you with greater financial flexibility, and you can always refinance when things normalize. In addition, if there’s a higher shift in cap rates, the impact on your return on equity is not as amplified by the leverage.
Daily Beat: What’s your ideal capital stack?
Scott Rechler: We use relatively low leverage and are generally in the 50% to 60% loan-to-cost range, particularly on developments. For an investment right now, I think the sweet spot is preferred equity.
We are looking at more and more preferred equity deals similar to what we recently did with the Solow portfolio. We invested $261 million of preferred equity as part of the acquisition of three multi-family buildings on Manhattan’s east side. I believe that it’s a moment in time where you can get equity-like returns with debt-like instruments.
Daily Beat: Is there a reason you focus more on preferred equity than alternative lending?
Scott Rechler: Because a lot of the alternative lenders can’t do preferred equity. Their mandate requires them to do debt, so if you’re comfortable in our shoes of being someone that could ultimately step in and own equity or take the equity-like risk, there’s much less competition in preferred equity than there is in the mezzanine lending business.
Daily Beat: Doing for others what you did at 5 Times Square?
Scott Rechler: Exactly.
Daily Beat: What are your thoughts on Blackstone and Starwood limiting investor withdrawals?
Scott Rechler: We are seeing redemptions industry-wide, and people are pulling money out of real estate funds. You’re seeing some investment funds that are dealing with the “denominator effect” as the stock market has gone down, which by default has increased their proportional allocation to real estate, so they need to rebalance their holdings.
Daily Beat: What’s going on behind the scenes on the lending side in the secondary markets?
Scott Rechler: On the bank side, regulators are coming in and forcing banks to mark their assets and sell them at the discounted value to get them off their books. I think we’re going to see more of this which will accelerate the revaluation process.
Daily Beat: Some of these Asian investors seem savvy in pulling their money out of BREIT when valuations in the vehicle are still marked at 10% higher for the year!
Scott Rechler: There’s clearly some logic behind some of these investment decisions. If you are an Asian investor that can sell not only at a mark that’s higher, but you’re also bringing it back to your country and get the benefit of the currency gain and the higher valuation mark.
Eventually, you can get a little bit of the run-of-the-bank mentality. Retail investors that have heard the news about the redemptions are picking up steam, which probably creates an oversell on what needs to be sold.
This will clearly impact the amount of liquidity in the marketplace and takes some of the most active investors out of the market.
Daily Beat: And I gather that this is happening industry-wide, not only in retail.
Scott Rechler: It’s not just retail. Think about all the secondary funds that have been set up to buy LP interests from other funds. Institutions over the last 12 to 18 months have been redeeming or creating liquidity out of their LP interest by selling to secondary funds. These secondary funds that have been doing these recapitalizations and have been one of the biggest segments of the fund business during this time period.
Daily Beat: What’s RXR’s current portfolio breakdown between office and multi-family?
Scott Rechler: We have 25 million feet of commercial, which includes office and logistics; 11,400+ units of multifamily; a debt book; and infrastructure.
Daily Beat: Has that shift from office to multi-family accelerated after Covid?
Scott Rechler: The mega-trends that we were considering pre-Covid have become even more important in the post-pandemic world. These trends allow us to benefit from structural demand drivers outside of the cycle that’s not just tied to the economy.
In our minds, that’s investing to create affordably priced housing and e-commerce-related investments like logistics and self-storage. High-yield debt is also an area of growth.
Daily Beat: What makes you excited about investing in the U.S. over the next 10 to 20 years?
Scott Rechler: There’s a great recalibration happening that structurally is going to put the US in a spot for incredible growth when we get past this current economic moment in time.
I think 10 to 20 years of harvesting the innovation that took place during COVID and some of the drivers related to decarbonization, digital transformation, de-globalization, and onshoring will create significant growth opportunities as we go through that transition. And the knowledge worker will be at the center of that.
Daily Beat: What type of rent growth were you projecting in Denver, Phoenix, and Tampa when acquiring assets in those markets? Do you think the rent growth is sustainable?
Scott Rechler: We underwrote around 3% rent growth, so we’re getting the benefit of 15% to 20% growth that we didn’t pencil in for those projects because of such strong demand. Our focus is on cities where the talent pool wants to be.
We call it the Eds, Meds, and Well Led cities. Good education systems, good healthcare systems, and good leadership that provides the quality of life that makes it a place to capitalize on sustainable growth for the knowledge worker.
That’s really what drives us when identifying where to invest. We are executing in those locations similar to what we’ve done in the outer ring of New York. If there’s a superstar city, we focus on the next ring that’s connected to transit to help create a superstar region.
Daily Beat: What are your general thoughts on multi-family rent growth in New York City vs. the Sunbelt in the next few years? Is the expiration of 421-a an accelerant for the city?
Scott Rechler: We’ve always been big believers in New York City, even during the height of the pandemic when everyone was leaving. As I mentioned earlier, we invested in over $2 billion of multi-family with the belief that the city was going to come back, and we were proven right.
In the coming years, I think there’s going to be more demand than supply. You’ll have a little bit of a pull forward from the expiration of 421-a, which was in last June. There will be a bit of a blip of new housing, but when that supply is digested, I don’t think there will be any new supply built until there are new programs in place. That should create an additional shortage, which will result in higher rents.
The question then is when does rent become too much? How high can you raise the rents before people just say I can’t afford it and I have to move? That’s why as a public policy matter, we really need to develop policies that create affordable housing at all levels.
Just focusing on lower-income housing alternatives sometimes overlooks the fact that we need housing for young professionals and working people. We need housing for all income levels, and there are different strategies to deal with this challenge.
Daily Beat: The political tide appears to be slowly shifting, particularly with the death of member deference. Hopefully, we will have more instances like what happened with Silverstein, BedRock, and Kaufman Astoria Studios’ Innovation QNS.
Scott Rechler: You need to get ideology out of the way and focus on good public policy.
Daily Beat: From a statistical vantage point, can you please break down how you view the housing shortage in the country? A recent Newmark report found a 400,000-unit shortfall in 2021 when comparing single-family and multifamily completions to household formations. What’s your take on this?
Scott Rechler: There’s clearly more household formations versus new construction of housing. However, focusing on macro is always a little dangerous, so the focus should be micro on the types of housing in locations that meet people’s needs.
We take a submarket-by-submarket, project-by-project approach and analyze the supply-demand dynamic within that circumstance. And then, we’ll go to the outer rings of different markets and identify the growth potential because, eventually, people will move there. The process really must be micro.
With that being said, everything that we’re seeing argues that there is already a housing shortage. As the economy gets weaker, the demand for housing will also get weaker because people will stay with roommates and their families a little bit more.
On the other hand, there are also going to be fewer single-family and multi-family housing units built. We’ll absorb what comes to market in 2023 and 2024, but by 2025 and 2026, there’ll be a real shortage of supply because the debt and equity markets aren’t permitting continued development.
Daily Beat: How has the increase in office lease expenses been absorbed?
Scott Rechler: At least in New York City, office leases are structured that, at the outset of the lease, you set based on their expenses, and all the additional expenses are paid by tenants, so they get passed through. The risk you take is that when their lease expires, the new tenant comes in, and they get the higher base. Meaning if the expenses were $10 a foot when the old tenant came in and you passed it through, and now it’s $15 a foot, the landlord must absorb that new $5.
Daily Beat: Any office-to-residential conversions in the offing for RXR? Silverstein just came out and said that their acquisitions team is now solely focused on finding office buildings that can be converted.
Scott Rechler: If valuations come down, the regulatory process is streamlined, and the government offers incentives, I think it’s a great business model and a great public policy proposition, but they all need to align.
We’ve done a comprehensive review of our own portfolio, and there’s a handful where conversion could work. I’m not sure it’s a business yet, but I think you could see a case again where values come down, the regulatory environment changes, and incentives are put in place where it can become a significant business.
*The interview has been edited and condensed for clarity.