CBRE Group, Inc. (CBRE) Earnings Call Transcript & Summary

Good afternoon, everyone. Thank you for joining us today at the GS Financials Conference. I'm Chandni Luthra, and I cover U.S. REITs and commercial brokers at Goldman. And I'm very excited to host this discussion with Bob Sulentic, the CEO of CBRE. Bob, thank you for joining us.

Good to be here, Chandni. I look forward to it.

Absolutely. Now these are very interesting times, so let's just dive with some questions.

I want to keep this interactive, so we will have a mic circulating in the room for some audience Q&A later. But Bob, to set the stage, let's start with capital markets. Obviously, investment sales activity has been a huge casualty of higher interest rates. And large declines have been seen across all asset classes and things have only exacerbated in September and October. There is consensus that things are about to get meaningfully worse in the rest of the fourth quarter and likely to remain tough, at least through the first half of 2023. Do you think the back half of next year will be better? And if that is the case, what makes you think that? And what asset classes have the potential to have a better second half of next year versus the first half of next year?

So we generally agree with the consensus you articulated, that things are going to be difficult. Certainly through the first half of next year, we think we're going to have a recession. We don't think it's going to be a severe recession, relatively mild. We think interest rates will start to come down midyear next year. And when interest rates start to come down, we do think that some of the buyers and sellers will start to come off the sidelines, so to speak. There'll be more capital available at better pricing to finance sales. And we do think sales will start to pick up in the back half of the year because we know that there are a lot of owners of assets that would like to trade them. There are a lot of investors that have capital that they want to put into new assets. And we just need to get the congestion out of the system that's caused by the high interest -- not only the high interest rates but the uncertainty about how high they will go. And when the Fed starts to reverse course and interest rates start to come down, we think things will change. And in terms of asset classes, we believe that at the front of the pack, you'll continue to see logistics assets. You'll continue to see multifamily assets, maybe life sciences, self-storage, some of those kind of things, office buildings are going to probably continue to be under pressure beyond that period of time. So that's how we think things will unfold.

You just talked about office buildings will continue to be under pressure beyond that time. It's been almost 3 years since the pandemic. And of course, that proverbial can of bringing people back to the office has gotten kicked down the road several times. Now we are staring into 2023 with obviously a tougher economic environment. So while there is potentially more power with the employers, but at the same time, there is also that need to perhaps talk about space optimization in a tougher economic state. So how do we reconcile those 2 dynamics, especially in the reality that we do have record leases coming due? Or the fact that a record amount of leases were sort of renegotiated for 1 or 2 years extension in the last couple of years, and now we really have to talk about whether those will get signed for multiyear periods? And then I'd like a follow-up on that.

Well, you said at least 3 things that are worth commenting on. One, you commented on more power with the employers. You commented on the need to cut cost or the focus around cost when you get into a tougher economy. And you also commented around the fact that there's a lot of renewals coming up, and all 3 of those figure into the mix as we think about our business. I want to start, though, with the mindset of employers. We have over 100,000 employees around the world, about half of them in office buildings. So we think about this a lot, right? And I think what's going on with us and what's going on with others that have office workers is that we have absolutely come to believe that the hybrid work style is here to stay. We're not going back to where we were. We started the shift away from -- I think early on, everybody had this mindset, oh, we got to get everybody back in the office. And I think now more and more, what people are saying is, no, what we have to do is get people to be effective and efficient. And that means being in the office a significant amount of time, and that means being away from the office part of the time. And I think that's what we're going to see. When we are in the office, though, we're not going to be in the office spread out ratably across the week. In other words, if we're going to be in the office, 60% or 70% of what we used to be in the office, we're not going to be in the office of 60% or 70% every day. We're going to be in the office 2 or 3 days a week, some higher portion than that. In other days of the week, the offices are going to be more empty. So that's going to create a situation where even though there's downward pressure on the amount of office space being used, the headline will be bigger than the substance. Secondly, as it relates to renewals, there is a big backlog of renewals. And one thing we know is that occupiers are in fact, taking space, some of them on a defensive basis. We don't know how much we're going to need, but we know we're going to need some so we are going to take space. The other thing that's going on is there is this very well-publicized move toward the better space, the more efficient space, the space with better elevators and better common areas and better HVAC systems, et cetera. There's no doubt that's going on. So as it relates to our business, there's quite a bit of opportunity created there. When people move from one asset to another, that creates opportunity for us to do transactions, do the project management work, other types of advisory work, et cetera. And by the way, leading up to the financial -- or excuse me, not to the financial crisis, leading up to COVID, we were in over a decade of strong downward pressure in the amount of space that was taken per person. I mean that was a very well-known dynamic, from 350 feet to 300 to 250 feet per person. But -- and during that whole era, we had record revenues around office space-related services, that we provide brokerage, project management, other consultancy services. We're going to see some of that happen here. But I will tell you, as it relates to our business, I think we first declared probably 1.5 years ago that we do expect that, in general, office building-related revenues are going to be a smaller portion of our business going forward than they have been in the past. And we have built this big diverse business across asset types, across service types, across geography and across client types. And very quickly, as things moved away from office buildings, we backfill with work we do in other areas, project management work, a lot of work in multifamily, a lot of work in logistics. So that dynamic that you're describing is very baked into our strategic view of where our business is going.

And Bob, just to follow up on that. You talked about Class A just having more demand. But right now, there is a view out there that, look, we see trade down across all segments of the economy. And there is potential for trade down within office as well because Class B and Class C come at a cheaper price tag. So is there perhaps potentially more appetite for Class B and Class C versus what, 6 months ago, we were all thinking in our heads?

It's logical, but we aren't seeing it yet. We really aren't seeing that. What we're seeing is people trying to think much more carefully about the dynamic that I described earlier. We're no longer trying to jam everybody back in the office. What we're doing is trying to figure out how to make our workforce as effective as possible. We're trying to make our workforce as engaged as possible, as efficient as possible. And by the way, we're going through a period. Even now with the economy turning down -- threatening to turn down worse, where the job situation is not really loosening up, people are working hard to keep their employees. They're paying more for employees, so they want them to be efficient and effective. And the thinking is, at least what we're seeing in our business is the better buildings, the newer buildings, the buildings with better systems, the buildings that you can create better environments are the ones that are getting the attention from occupiers.

That's interesting. As interest rates continue to stay elevated, refinancing activity will obviously be challenging. We all know that there is a lot of debt coming due over the course of next 2 years. And a lot of it is low-quality asset as well, which perhaps did have a bid 3 years ago but doesn't really have a ton of bid at this point. So as you think about that level of debt maturity coming due, a lot of it being in office, what kind of opportunities can emerge from some potentially distressed situations? Or let me rephrase that, do you see a lot of distress emerging in some asset classes?

Well, I want to start with a couple of asset classes where I don't see distress coming. I don't see distress coming in multifamily, and I don't see distress coming in logistics. The value of assets is a combination of the cap rates that people will apply when they buy them and the fundamentals, the occupancy and the rental rates. And the fundamentals in multifamily and industrial or logistics, even though they may be slightly less positive than they were over the last 2 or 3 years, they're still very positive. Rates are still -- rental rates are strong. Occupancies are strong. The dynamics that would continue to have them being strong are there. So I don't see distress in those asset classes. I don't see distress in life sciences. I don't see distress in anything in health care. With what's going on with the apartments, self-storage, you don't see distress. Where you probably are going to continue to see distress is in B and C malls, and you're going to see distress in B and C office buildings that are probably going to remind us of what's happened over the last decade with B and C malls. There's going to be challenges around those. There is discussion, can you re-purpose them to be multifamily? In some, you can. But probably, a lot of them, you can't because of the infrastructure associated with the buildings, the elevators, et cetera, and just the size of the floor plates and in some cases, the locations of them and the amenities around them.

Let's switch gears from macro to micro. So obviously, you, your peers, everybody, they have a very high level of variable costs. And with the reality of tougher economic environment that's here to stay, the focus has shifted to cost cuts. You guys have announced a formal cost-cutting plan, $400 million, $300 million of it is more permanent in nature. Help us understand this dynamic. I guess, first, if the economic environment continues to go more red, can more costs be taken out of the system? And second, what makes you comfortable that headcount reduction wouldn't cause broader disruption to the business just given that it is such a heavy people-focused business?

So I want to start by commenting on something you said about focus. You said our focus has shifted to cost. Very early on, we concluded that we wanted to shift a portion of our focus to cost. But that is not the main thing we're focused on. If you were to follow our senior executive team around, we're focused on growth. We're focused on the opportunities that are going to come from the circumstances that are likely to unfold the next year. I'm basically spending my time on 3 things: strategy, various types of investment including M&A and real estate investments, and talent. There is a real opportunity for us in some of the areas of our business we think we can grow the business. And I'm obviously, at every level of the organization, but senior level talent, what I would call strategic talent, that's where my real focus and the focus of our senior leadership team is. We put a plan in place to cut $400 million. We talked about it. Our Chief Operating Officer is running a program to get it done. We've got some really smart outside help. It will get done and it will get done by early next year. And if we decide, based on the environment that we're operating in, there's a need or opportunity to reduce costs further, we'll do it on a very surgical basis. But we've done it in a way that we're confident isn't taking away our opportunities in the marketplace. And if we thought it was, then we simply wouldn't cut that level of cost.

How should we think about the long-term margin target for the business overall?

We don't publish long-term margin targets, and they're a function of a couple of things. They're a function of the overall cost structure of the business and the scale of the business, and then they're a function of business mix. And so what we believe about our business mix, which has a big impact, is we really have -- in fact, our CFO, Emma Giamartino, is in the room here. Her and I spent half a day yesterday with our leadership from our investment management development team. We think there's going to be phenomenal opportunities, particularly the way we're situated to grow that business over the next few years to attract some incremental talent. We know where we want to go and where we want to invest. That's really, really high-margin business, and that's going to grow disproportionately. We also believe that our outsourcing business, which has some pretty substantial strategic advantages in the marketplace, will grow disproportionately. That's a lower-margin business. And then in terms of our advisory business, which is our traditional brokerage business, property management and so forth, we believe that will be a steady grower, and that's got a margin in between. So in terms of business mix, you're going to see a combination of things going on. Some are going to be pulling up the margins, some aren't -- of the weighted average margin, down. But across the business, across the business, we do believe that we'll do a few things that will help the margin. One is we'll achieve continued economies of scale, and that's very real for us. It's very real. We also think in parts of our business that are thinner margin, we're introducing some capabilities to our clients that are going to create more economics to be split between us and them, and that's particularly going to be true in our outsourcing business.

Moving down the P&L, let's talk about capital allocation. So with top line obviously slowing, how do you think about capital allocation priorities for 2023? Particularly, one, returning cash to shareholders; and two, potentially keeping some in your back pocket for future M&A if some opportunities were to emerge in a tougher backdrop? And as a follow-up to that, what is the right way to think about free cash conversion for you?

The number one place that we want to use our capital right now is in M&A. We have built a very capable M&A machine. We have built a network of leaders around the world that knows the type of M&A opportunities to go after, and we think we find unique opportunities. By the way, we also do these things that we call sponsorships, which is when we buy less than a whole company. And because of the work we do with them, we can help them do better than they would otherwise do. And in fact, the company Industrious, the flex operator, which we think is a spectacular company, we're 40% owners in them. We believe that's a great business model. We believe that's a company that ought be independent, but we made a big investment in them. We continue to invest to help them grow around the world. Things like that. We bought 60% of Turner & Townsend in the project management area, but it's not just project management. They do infrastructure, they do cost consultancy. And so we think there's going to be opportunities to buy whole companies and to invest in companies that will be the top area of focus for us. We also think that we're really well positioned to continue to invest in our investment management business to start new funds in some case, to co-invest -- to kickstart those funds like we did with our logistics fund a year ago that now has already built up to over $2 billion. And that's the equity piece of it, much bigger than that when you look at the total assets. And we have other initiatives like that, that we're pursuing with our development business. So we think that will be an area for us to invest. And then, of course, we do have a program for returning cash to our shareholders through share repurchases. And if our stock price stays at a level that we think is unrealistically low relative to the intrinsic value of the business, which it has been, you would expect to see us to continue to buy back shares.

And as we think about free cash conversion, is there a minimum threshold that you internally target?

Emma Giamartino, I'm going to let -- she's our CFO. She's here. She's the one that owns that for our company. What's our number there, Emma?

[indiscernible]

So 85% or above, if you couldn't hear what Emma said.

Yes. 85% and above, got you. Thank you. You touched on investment management business a little bit. So let's focus there. How should we think about the composition of your AUM and inflows and outflows in 2023? And then as a follow-up, given office is 20% of AUM, do you see any risk around asset dispositions there given potential portfolio rebalancing?

First of all, everybody that's in the real estate business with institutional investors or with high-net worth investors should expect some outflow pressure over the next year. And there's a bunch of things going on that would cause that. One of them is the denominator effect. I suspect almost everybody in the room knows what that is, that institutions that hold real estate and hold debt and hold equity securities have target mixes that they want to achieve. And when the values of the equities come down, then they end up with too much real estate or too much alternatives. So that's going on. And then there's this other view that this is a -- values have been high. This is a good time to get out. That's what you're seeing with the non-traded REITs. I think that whole talk tracked around non-traded REITs is a bit overblown. I think they're doing what they're supposed to be doing right now, given the way they were designed. So you're going to see some pressure on outflows. In the case -- most of what we have in our portfolio is heavily skewed toward core. In fact, we want to have more value add, more opportunistic exposure, which is why we're so excited about what we can do between our development business and our investment management business. So I think our portfolios are going to be relatively stable as a result of that. I don't think there's going to be huge pressure to rebalance the asset classes in the coming year, particularly if it's not a good time to trade assets. But over time, there are going to be choices made about what to do more, what to do less of. We've been heavily focused on multifamily and industrial. We've done life sciences. We've done some work with self-storage. And so you'll probably continue to see us focus in those areas.

And since you mentioned non-traded REITs, why do you think that whole situation is blown out of proportion?

Well, these -- so let's talk about the names that are famous in that area, Blackstone especially and Starwood especially, and KKR is well known and they're in that area. So I think it's worth just stepping back and looking at what they've done. So they put these vehicles in place because there was a big demand among retail investors, particularly high-net worth retail investors, to be in commercial real estate in a structure that was more stable in terms of the values. They also put that money in with those kind of names because they thought they were really smart investors. That gets forgotten, right? You don't hear people say, well, wait a minute. These are really smart investors. And guess what they did? Look at the asset bases that Starwood and Blackstone have. They're heavy in residential, heavy in rental single-family, heavy in industrial. When you go back to our conversation here today, what are the asset classes that are -- these asset classes, these guys made smart investments. And they didn't just pick the right asset classes, they made smart individual investments. And so now we're at a more difficult time. And exactly as those things were -- as was anticipated when they formed those things, there would be some pressure to run to the exits. Well, it's different than publicly traded REITs. The capital that flows in and out of shares in publicly traded REITs isn't the capital that's invested in the assets themselves. The capital that flows in and out of the non-traded REITs is the capital that's invested in the assets themselves. And so there has to be gates, more than anything, to protect the investors. They put those gates up and they're exercising those gates in the way they should have been exercised. So I think they had a thoughtful plan in place at the outset. They were very transparent about what they were doing. They've executed it consistent with the plan. They bought the right asset classes. And of course, there's going to be some pressure, and we've talked about it, Chandni, a little bit in the hallway out there. And whenever famous people or famous companies are under a little bit of pressure, the press loves to focus on that, in all aspects of life. That's a little bit of what we're getting right now. But I think these things are performing the way they were designed to perform.

Let's switch gears to your development business. So given inflation and cost of capital is likely to stay a little weighted, we don't know until when, construction starts are obviously decreasing across the board. So how do you think about your development business and potential for asset monetization down the line?

So I'm going to compare it a little bit to what I said about these non-traded REITs. We have a development team that is really, really good. They're very experienced. They're very good at acquiring the right sites, and they buy build-to-core sites. And because of the experience level they have, the talent they have, the reputation we have in the market, they're able to attract capital that gives them staying power. And when you develop build-to-core assets, ultimately and eventually, those assets will be very valuable. There will be a good time to trade. And I've been in the industry since 1984. Great quality assets have always had their day in the sun. And if they lost their day in the sun, their day in the sun came back. The strategy that we have in our development business, which is the biggest commercial developer in the U.S, is exactly that, that we will buy core Class A sites, build Class A product financed with great capital partners, and we will exit at the time that's favorable to exit. And if 2023 isn't a good time to exit, we won't exit, and we won't be under pressure to exit. But we will ultimately, ultimately sell those assets in a good basis. It's a part of our business. We're very excited about it. It's a part of our business that we think is underappreciated, and it's a part of our business that we're more and more going to link to our investment management business. And by the way, all -- everybody that follows the commercial real estate investment management business knows that the funds that historically, we wanted to be pure core now are tilting toward core plus. And they want some of the upside associated with development assets. So those assets are more in favor with the other investment managers that we work with and our own investment management business than they have been historically.

Anybody in the room with a question?

[indiscernible] At the time of debt refinancing, maybe like -- will we see cap rates move due to the appraisal community? Or do you have to have an actual bid-ask transaction happen? Or am I just like -- these public markets went too far?

Yes. Well, it's -- the public markets are trading to a discount to the asset values, and the private markets are trading at the asset values, basically. And we've seen cap rates go up, values come down some. And we think before everything is said and done, the cap rates may shift by a total of as much as 150 basis points. So they're going to be subject to some additional downward pressure potentially. But we don't think you're going to see what has been seen in the REIT market valuations.

Bob, let's talk about industry consolidation. Where do you see this dynamic going? I mean coming out of this potential recession, do you see potential for a merger of equals? How do you think about industry consolidation? Like where will the next leg be? Will it buy in certain geographies or in certain business lines? And then I have a follow-up around that.

Okay. So I think the -- whenever the market gets to the point where it's at now, stuff that didn't used to be for sale becomes for sale to a degree. But there's other kinds of consolidation that goes on. So big corporates, during times of stress, tend to want to consolidate the service providers they use down to the more reliable, more stable service providers. And that's played out in every cycle. That's been to our benefit in a pretty big way. Talent wants to go. When you get into an environment like this, anybody that's working, whether you're an investor or a broker, anybody that's working on an incentive basis, might be under pressure to earn less than they were previously and is looking for places where their odds of doing well go up. And that benefits us because of the brand and the capital base we have to support the network of clients we have, et cetera. And then, of course, companies that weren't available for sale before become available for sale in some cases, and we've seen that. We are actively working on an M&A pipeline that's more substantial than it has been for the last 2 or 3 years. Whether we get those deals done or not, who knows? You got to get all the way to the other end to get them done, but we think that there's some really good opportunities out there. And I would say that we're more looking at things that would be not the traditional areas we look. The notion of the big brokerage firms combining, there was a lot of that historically. We've landed at a place where the odds of that happening going forward are lower than the odds were in the past because when you try to combine big brokerage companies that already have a pretty good footprint, there is some synergies on the cost side. But there's also some, as we call it, some big breakage that might happen. So we've got a bunch of stuff that we're looking at in the M&A area that would be more consistent with the stuff you've seen us do recently than it would be consistent with the stuff you saw us do 5 or 10 or 15 years ago. And I mentioned already the Industrious deal we did, the Turner & Townsend deal we did. We just did a deal in our outsourcing business, that was a technical services for lab equipment. We're looking at a lot of different stuff now. And we think we're going to see a lot of opportunities, but the kind of the environment for the kind of legacy combinations that you've seen in our sector is -- in my mind, is what it was historically.

And how would you think about leverage if an interesting opportunity were to present itself, especially given where cost of capital is down below?

Yes. Well, we have really strong cash flows, and we have basically no leverage. Even though we've bought back a lot of stock, and we've done a good amount of M&A over the last couple of years, and we would lever up material -- we'd lever up to a couple of turns of leverage to -- which gives us capacity to do the biggest deals ever done in our industry, if we were to just go to 2x. In fact, if we went to 1x leverage, and we found a deal that was equal to what it would take to get us to 1x leverage, that would be the biggest deal ever done in the history of our industry. And so we have the capacity to not be that levered and still make pretty sizable investments.

Any last question in the room? All right. That's all for us. Thank you, Bob, for joining us. Thank you, everybody.

Thank you.