HFF Inc. (NYSE:HF) Q4 2016 Earnings Conference Call February 23, 2017 6:00 PM ET
Myra Moren - Director of Investor Relations
Mark Gibson - Chief Executive Officer
Greg Conley - Chief Financial Officer
Brad Burke - Goldman Sachs
Jade Rahmani - KBW
Brandon Dobell - William Blair
Good evening and welcome to HFF Inc.'s Fourth Quarter 2016 Conference Call. At this time all participants are in a listen-only mode. Later we will conduct a question-and-answer session with instructions being given at that time. As a reminder this conference is being recorded.
I would like to turn the call over to your host, Ms. Myra Moren, HFF’s Director of Investor Relations. Ms. Moren, please go ahead.
Thank you and welcome to HFF, Inc.'s earnings conference call to review the company's operating performance and production results for the fourth quarter and full year of 2016. Earlier today we issued a press release announcing our financial results. This release is available on our website at hfflp.com. This conference call is being webcast and is available on the investor relations section of our website, along with a slide deck you may reference during our remarks. This call is being recorded.
Please turn to the slide label disclaimer and reference to forward-looking statements. This presentation contains statements that are forward-looking within the meaning of the Private Securities Litigation Reform Act of 1995, including statements regarding our future growth momentum, operations, financial performance and business outlook.
These statements should be considered as estimates only and actual results may ultimately differ. Except to the extent required by applicable securities laws, we undertake no obligation to update or revise any of the forward-looking statements you may hear today. For more detailed discussion of risks and other factors that could cause results to differ, please refer to our fourth quarter 2016 earnings release filed on Form 8-K and our most recent annual report on Form 10-K, all of which are filed with the SEC and available on their website.
We may make certain statements during today's call which will refer to a non-GAAP financial measure. And we have provided a reconciliation of this measure to GAAP figures in our earnings release.
With that in mind, I will introduce our senior management team. Conducting the call today will be Mark Gibson, HFF's Chief Executive Officer, and Greg Conley, our Chief Financial Officer. I'll now turn the call over to our CEO, Mr. Mark Gibson.
Thank you, Myra. Good evening everyone and welcome to the call. As highlighted on our earnings release, revenues totaled 155.7 million in the fourth quarter of 2016, a 7.9% decline when compared to the same period in previous year and 517.4 million for the full year of 2016, a 3.1% increase over the previous year. HFF's increase in revenues for the full year of 2016 is particularly noteworthy given the challenging capital markets environment investors faced throughout the year.
HFF would define challenging as an unsettled settlement among investors due to general economic uncertainty regarding domestic and global growth, uncertainty regarding domestic fiscal policies and effects of regulatory oversight among financial institutions. These concerns resulted in the institutional commercial real estate market entering a period of price discovery for the formation of bid/ask gap between buyers and sellers which is best evidenced by the 10.7% decline in investment sales transaction for calendar year of 2016 as reported by Real Capital Analytics.
But some of these headwinds are expected to persist into 2017. It does not change our long-term favorable view of the fundamentals supporting the commercial real estate industry nor future transaction activity. Accordingly, we continue to invest in our core business as evidenced by the following points. A 10% increase in headcount over the past 12 months resulting in 81 net new associates joining the firm in 2016. As we have mentioned on previous earnings calls, our headcount growth is a result of both our organic and external recruiting efforts. The firm will balance these two approaches based on a strategic needs in the operating environment.
In 2016, HFF announced the opening of our Phoenix office as well as initiating a presence in Seattle through the hiring of investment sales transaction professionals. In aggregate, HFF has opened seven offices in the U.S. over the past six years as illustrated on Slide 7. Additionally, in the fourth quarter HFF announced plans to enter the London, UK market with the acquisition of Leon Partners Limited, an independent real estate advisory firm based in London. We closed that transaction in January 2017 and are actively building this business.
In keeping with the firm’s long-term strategic plan, we will continue to add personnel to our offices, property verticals and business lines throughout 2017, subject to the overall performance in the U.S. economy as only one of the firm’s 24 offices offers a complete compliment of the firm’s business lines and property sectors in the related synergies they generate. In order to accommodate both our recent and future growth, we have significantly invested in the firm’s general infrastructure, including additional administrative personnel in our accounting, human resources, research and information technology support functions.
Related to technology, the firm made a significant investment in expanding our infrastructure to allow our transaction professionals to more efficiently and effectively conduct their business. The combination of these investments contributed to a 230 basis point compression of our 2016 adjusted EBITDA margin and a 300 basis point compression in our 2016 operating margin. We view these investments as capital expenditures to support the future growth of the firm, given the service nature of our business and a reflective leap in the positive fundamentals of the commercial real estate industry.
For a commentary on previous earnings calls, the link of the current economic cycle combined with the previously mentioned institutional investor concerns resulted in the redefining of risk relative to underwriting metrics for the majority of investors. In essence, investors have taken a more conservative underwriting approach relative to rent growth, expense recognition, exit assumptions et cetera. While the total return targets of investors have remained generally consistent relative to one year ago, the aforementioned changes in underwriting metrics utilized to achieve their return have resulted in marginally lower prices on many assets which has created the aforementioned bid/ask gap.
Stated differently, the market experienced price discovery in 2016 whereby seller - to determine the appropriate price given investors’ perception of increased risk. Additionally, the investor market remains concerned about economic cycle risk and aside from utilizing more conservative underwriting metrics is also opted in some situations to contail investing large amounts of equity in transactions of scale in favor of diversifying the invested equity over multiple assets in separate geographic regions and across property verticals.
The combination of price discovery and diversification strategies played a significant role in the previously mentioned 10.7% decline in transaction volumes in 2016 and importantly the 30.2% decline in large entity level transactions as reported by RCA. However, consistent with our commentary herein, individual asset sales declined only 1.4% in 2016 as reported by RCA, demonstrating resilience in the longest composition of commercial real estate transactions. Despite this risk off commentary, the commercial real estate industry at large and HFF in particular have benefited from several positive events in 2016, which acted as an offset to the previously mentioned challenging macroeconomic environment. Those events are as follows.
In regard to the industry at large, commercial real estate has an asset class remains in favor with investors. Additionally, the composition of ownership is becoming increasingly institutional, which we believe will positively impact transactional volumes in the future subject to the health of the heath of the global economy. This is best illustrated by the following points. Effective in the third quarter of 2016, commercial real estate was re-categorized from the broader financial sector and became standalone categories in eleven global industry classification standard trading vertical, the first distinct trading vertical created since 1999.
HFF believes the emergence of commercial real estate as the core investment holding ensures the industry will continue to benefit from consistent annual allocations of capital and that investing in the asset class is necessary in order to attain a diversified investment portfolio. This is best illustrated on Slide 17, showing an approximate 85% increase in the allocation to commercial real estate since 2010. Additionally, Domestic institutional investors are active in the private commercial real estate market, have in the past been consistently under invested in commercial real estate. Actual investment in the asset class is approximately 140 basis points below target as a percentage of AUM.
However, if a future devaluation in the public equity markets is not met with a corresponding price adjustment in the private commercial real estate market and/or commercial real estate continues to outperform other asset classes on a relative basis, this resulting numerator-denominator conundrum would affect allocation models within institutional investors. Such an event may require rebalancing, which could temporarily reduce fund flows in the commercial real estate similar to what occurred in the first and second quarter of 2016. In the event, rebalancing occurs in scale, the probability of sustained period of price discovery would increase.
As illustrated on Slide 18, the domestic investor participation in the private commercial real estate market continue to multiyear increase in 2016, further illustrating commercial real estate becoming a core institutional holding. Capital managed by institutional investors in real estate measured by assets held within closed end and open ended funds has increased approximately 105% since 2007 or approximately 83% net of price appreciation, suggesting both increased demand for the asset class and a larger denominator of assets which should be a positive relative to future transactional volume.
Interestingly for the year of 2016, transactional activity as reported by RCA is down 14% from the 2007 transaction market peak of 571.2 billion. Therefore, the increase in AUMs since 2007 mentioned previously should be a positive catalyst for future transaction volumes. An important source of capital for the U.S. commercial real estate industry is the participation of a retail investor. Given changes implemented by government regulators of this industry in 2016, a significant number of no load or low load real estate investment funds from private best in class real estate operators and investment management firms are merging or are already investing.
HFF believes there is considerable demand from the traditional retail investor universe, as few retail investors have exposure to best in class private commercial real estate investment managers. Given the political and social interest in many parts of the globe, the flow of foreign capital into the U.S. commercial real estate market increased more than two fold from approximately 43 billion in 2014 to 97 billion in 2015 as shown on Slide 20. However, foreign capital flows in the U.S. totaled 65 billion in 2016, a 32% decrease from the previous year, largely due to the same investor concerns previously mentioned.
However, there are additional factors impacting foreign investment flows in the U.S. commercial real estate industry, the majority of which were centered on currency risk and in particular the recent relative strength of the U.S. dollar. To date we have not witnessed a reduction in foreign investors’ interest to continue participating in the U.S. commercial real estate market and believe these investors will maintain or increase the allocations to the U.S. in 2017. However, the currency risk mentioned has resulted in lower prices being paid by overseas investors in some situations.
Finally, as mentioned on previous earnings calls, commercial real estate in effect houses the U.S. economy and therefore its health is correlated to U.S. job growth. Another significant factor affecting the overall health of the U.S. commercial real estate industry is the supply of new assets being delivered. As shown on Slide 29, supply remains largely in balance with demand relative to previous economic cycles. Therefore, given the constrains currently being imposed by commercial banks and construction lending and the existing relatively modest supply being delivered an argument could be made that if the U.S. continues to produce job growth over the next two to three years, landlord pricing power might well be the outcome.
In the year the prices of U.S. commercial real estate will largely be determined by the investors’ perception or conviction of the leasing for commercial real estate across all property verticals as investors are not underwriting future capitalization rate compression and/or multiple expansion relative to potential total return expectations. In order to put this commentary into perspective relative to the performance of HFF, we believe it is important to reiterate a few key themes from previous earnings calls.
First, it is important note that HFF is not in the real estate investment business, but rather the real estate transaction business. HFF does not invest, lend or provide any services other than those of a capital markets intermediary. Therefore, the firm is not directly impacted by price movements of commercial real estate assets relative to investment gains or losses from an HFF sponsored investment fund, given its lack of participation inside. Additionally, some volatility above the norm in U.S. capital markets has generally been beneficial to the firm, given HFF’s role as a real estate transaction intermediary because it can result in an increase in demand for capital markets knowledge, advisory services and execution capabilities.
Our results are important, note that period of sustained volatility in the U.S. capital markets could result in the development of a prolong diversions in bid/ask prices, which could adversely affect U.S. investment sales transaction volumes, which occurred in 2016. In the event a bid/ask gap persists in the U.S. sale business of viable alternative for owners, we’ll be refinancing in the private debt market which will remain very liquid in 2017.
Second, HFF has virtually no corporate debt, a relatively low fixed cost structure and minimal working capital needs, allowing the firm’s significant flexibility in terms of adjusting to any market environment and to take full advantage of potential growth opportunities. Third, the firm is highly diversified relative to its client base. In the 12 months period ending fourth quarter of 2016, no one client accounted for more than 3.5% of capital market services revenue and our top 10 clients combined represent 11% of our capital market’s services revenue.
And regard to future transaction volumes, the aforementioned increases in AUM for both the closed end and open end fund market, suggest the market has the potential to sustain current transaction levels absent a significant deceleration in economic activity. A particular note is the transaction volume likely to emerge from the closed end fund market.
As illustrated on Slide 21, the average hold period for 64% of the participants in the closed end fund market is less than five years in duration due the value add investment objectives. The underlying compensation of these funds and the need to post realized returns for future fund raisers. This notion is further supported by the list of top sellers in 2016, which is dominated by investment advisers managing closed end funds.
Finally, as shown on Slide 23, the 1.07 trillion of maturing commercial real estate loans through 2019 should serve as a catalyst for investment sales, refinancing transactions, particularly given the percentage represented by CMBS maturities. In regard to HFF, our investment sales transaction volumes for the fourth quarter 2016 totaled 11.8 billion, a decrease of 8%, when compared to the same period in 2015. As reported by RCA, the industry experienced a decline of 20.4% in the fourth quarter of 2016 versus the same period in 2015.
For the full year of 2016, HFF’s investment sales volume totaled 36.7 billion, an increase of 7.6% over the previous year. As reported by RCA, the industry experienced a 10.7% decline in 2016 versus the previous year. As illustrated on Slide 24, HFF’s investment sales volume for the full year of 2016 increased 115% from 2007, as compared to a decrease of 14% for the industry.
Turning to our debt business line, our debt volumes for the fourth quarter of 2016 totaled 13 billion, an increase of 14.8% compared to the same period in 2015. As reported by the Mortgage Bankers Association, the industry experienced a decrease of 7% in the fourth quarter of 2016 versus the same period in 2015. For the full year 2016, our debt volumes totaled 40.6 billion, an increase of 6.7% over the previous year. As reported by the MBA, the industry experienced 1% decrease in 2016 versus the prior year. As illustrated on Slide 25, HFF’s debt volume for the full year of 2016 increased 73% from 2007, as compared to a decrease of 2% for the industry.
In summary, we believe there’s ample availability of capital in both the debt and equity markets to sustain current real estate transaction volumes as it relates to [ph] decline in global economic activity.
With that let me turn the call over to Greg.
Thank you, Mark. The information I'll discuss today is also set forth on slides 34 through 44. Beginning on slides 34 and 35, during the fourth quarter our revenue was 155.7 million as compared to 169 million in the fourth quarter of 2015, which is 7.9% lower year-over-year.
Total transaction volumes grew 3.3% in the fourth quarter led by an increase in debt transaction volumes of 14.8% year-over-year. Operating income was 37.2 million in the fourth quarter of 2016, compared to 47 million in the same period last year.
Operating income and margins were impacted in the fourth quarter due to the year-over-year decrease in revenue coupled with our decision to continue to strategically invest in our business through growth in head count and other operating expenses such as infrastructure support and technology, which increased our cost base.
We continue to maintain healthy levels of liquidity and operate a highly diversified and full integrated capital markets services platform as it relates to both consumers and providers of capital.
As shown on slides 36 and 37, revenue for the year ended 2016 was 517.4 million, which represents a year-over-year increase of 3.1%. The revenue growth for the nine months is driven by 7.9% increase in transaction volumes, with investment sales volume up 7.6% and debt volume up 6.7% year-over-year.
For the full year of 2016, operating income was 95.8 million, compared to 107.8 million for the full year of 2015. Operating income for the year was impacted by the increase in the company's compensation related cost and expenses associated with in part of 10% increase in headcount of 81 net new associates over the past 12 months, including the related costs necessary to support this growth such as office expansion, related occupancy costs, an increase in stock compensation expense and increases in other operating expenses.
Operating margin for the fourth quarter of 2016 was 23.9% compared to the operating margin of 27.8% for the fourth quarter of 2015. Operating margin for the full year of 2016 was 18.5% compared to 21.5% for the year ended 2015. This decline in operating margins for both the quarter and full year of 390 basis points and 300 basis points respectively is attributable to the increase in the company's operating expenses, primarily related to the strategic investments we are making in our business as previously stated.
Company's adjusted EBITDA for the fourth quarter of 2016 was 47.8 million, down 16% as compared to adjusted EBITDA of 56.8 million in the fourth quarter of 2015. For the full year of 2016, adjusted EBITDA was 133.6 million compared to 141.3 million for the full year of 2015. This decrease in adjusted EBITDA for the fourth quarter and for the full year was primarily driven by the decrease in operating income, excluding non-cash depreciation and amortization and stock based compensation expense and to a lesser extent reductions and other income related to our agency business.
Adjusted EBITDA margin for the fourth quarter was 30.7%, compared to 33.6% for the fourth quarter of 2015, while the adjusted EBITDA margins for the year ended December 31, 2016 was 25.8%, compared to 28.1% for the same period last year. This decline in adjusted EBITDA margins for both the quarter and the full year of 290 basis points and 230 basis points respectively is primarily attributable to the decline in operating margins.
Cost of services as a percentage of revenue was 56.3% in the full year of 2016, compared to 55.9% in the same period of 2015. This percentage is slightly up by approximately 40 basis points for the comparative years, which is directly related to our strategic decision to increase headcount in 2016. The result is that our fixed cost component associated with our direct production cost which is primarily related to an increase in salaries and other payroll related expenses is increasing at a faster pace than the revenue increase in 2016.
Operating, administrative and other expenses were up by approximately 14.2 million or 13.6% in the full year of 2016, when compared to 2015. This increase is primarily due to increased compensation related expense and other operating expenses due to higher transactional activity and the growth in headcount. In addition, other operating expenses have increased due to the company making strategic investments in technology in 2016 through the integration of a customer relations management software system to our IT environment which includes our proprietary CapTrack database.
Also as shown on slide 35 and 36, interest and other income increased 400,000 in the fourth quarter and 1.5 million for the full year of 2016, when compared to the same periods in 2015. This increase is primarily attributable to the increase in the initial recording of mortgage servicing rights and offset by decreases in other income related to our agency business which includes decreases in securitization income and the gain on sales of cash sharing portion of the Freddie Mac servicing rights related to securitized loans. Beginning in 2017, the firm has elected to forgo the sale and retain the cash here in portions of its Freddie Mac mortgage servicing rights on securitized loans due to a number of factors.
We had a record year in Freddie Mac originations in 2015 with over 5.2 billion in originated loans. Originations continue to be strong in 2016, however Freddie Mac originations for the full year of 2016 were 4.6 billion or down approximately 600 million when compared to the same period last year. It is important to note that originations for the full year of 2015 included one transaction of nearly 1 billion that was originated in the second quarter of 2015.
Earnings per share on a fully diluted basis was $0.70 for the fourth quarter of 2016, compared to $0.88 for the same period in 2015 and was $1.99 for the full year of 2016, compared to $2.18 in 2015. The company’s effective tax rate for the year ended December 31, 2016 was approximately 40%.
Slides 38 through 40 relate to the balance sheet and liquidity. Our cash balance net of client advances at December 31, 2016 was 230.7 million, compared to 225.1 million at December 31, 2015. As shown on slide 38 during the full year of 2016, the company generated 83.2 million in cash from operating activities excluding $3.9 million decrease in client advances as compared to 94.3 million excluding 16.6 million in decrease in client advances during the same period in 2015.
The company’s use of cash is typically related to the modest working capital needs during the year and the payment of taxes. The company has virtually no corporate level debt to service other than that related to our Freddie Mac business which is offset with the mortgage notes receivable.
As shown on slide 39, and as previously stated our balance sheet as of December 31, 2016, included 291 million of outstanding borrowings on 14 loans under our warehouse credit facilities to support our Freddie Mac multi-family business and we also had a corresponding asset recorded for the related mortgage notes receivable. Since the end of the year, all these loans have been purchased by Freddie Mac.
Also subsequent to the year end on February 21, the company paid a special cash dividend of $1.57 per share. The aggregate dividend payment totaled $16 million and since December 2012, the company has returned capital to our shareholders in the form of 5 special dividends totaling $320.7 million.
I would like to make a few comments regarding our production volume and operational measurements which can be found on slides 41 to 44. As noticed on slides 41 and 42, on a year-over-year basis our transaction volume increased by 3.3% or approximately 830 million for the fourth quarter of 2016, and increased 6 billion or 7.9% for the full year of 2016. The total number of transactions decreased by 6.6% or 43 in the fourth quarter of 2016 and was fairly flat for the full year of 2016 with the decrease of three transactions.
The company’s loan servicing portfolio grew by 9.3 billion or 19.1% in 2016, when compared to the portfolio size at the end of 2015. The loan servicing portfolio balance is 58 billion as of December 31, 2016.
Slide 43 provides historical summary of our headcount and also shows the fourth quarter comparison to the same period in 2015. Total headcount and transaction professionals as of December 31, 2016 were both up 10% respectively year-over-year.
Slide 44 provides a summary of the select reduction in operational measures. The revenue per transaction professional decreased 5.2% for the full year 2016 compared to full year of 2015, due to our decision to continue to strategically invest in our business.
In summary, overall, despite the challenging capital markets environment as mentioned by Mark, we are pleased with the company’s performance in 2016, as increases in our transaction volumes across all of our business lines drove revenues higher. As we continue to make strategic investments in our business through investments in people, infrastructure and technology, which are consistent with our growth strategy, operating cost increased which compressed margins for the full year of 2016.
We continue to work to be very disciplined, efficient and strategic as it relates to the management of our expenses and always mindful of balancing our long-term strategic growth initiatives with the current operating environment.
I would now like to turn the call back over to Mark. Mark?
Thanks Greg. As we look into 2017, we think it's important to convey the firm's strategic plan remains largely unchanged from previous years in terms of continuing to build out the company's platform to ensure the HFF offices domiciled and major markets have a full complement of our existing business lines and property vertical specialties. Further, our future growth will continue to be premised on our core guiding principles which we believe significantly differentiate HFF in the real estate industry. These core guiding principles are briefly described as follows.
First is our client centric business model which avoids business lines and product services that directly compete with the business centers of our clients such as investment management, landlord incentive representation, and/or property asset management practices.
Our transaction professionals appreciate this lack of conflict of interest with their clientele. Additionally the firm sole focus on the capital market's business eliminates any internal competition with other business lines for resources to both conduct and grow their business.
Second is our player/coach leadership style where by the firm's leadership, mentors are transaction professionals who being engaged in generating revenue for the firm by actively originating and executing real estate transactions. Our transaction professionals prefer to lead them toward through transaction deal flow versus managed in a corporate context.
Third, is our pay for performance compensation structure, which aligns the interest of HFF leadership with the performance of the firm through our profit participation and omnibus compensation plan?
Fourth is maintaining an owner mentality versus employee mentality which is illustrated by the fact that HFF employees own approximately 12% of the outstanding class A common shares of HFF, highlighting the importance of our adherence to an owner mentality is the firm's granting of 750,000 shares in 2014 and an additional 250,000 shares in February 2015 and February 2016 and February 2017 to our leadership team and transactional professionals based on value added metrics which vest over five years.
Our fifth guiding principle is risk mitigation. Company has virtually no corporate level debt to service. And we continue to maintain significant cash balances to fund our working capital needs, our future growth and to mitigate downside risk as occurred in 08, 09. Once we have met these needs and have sufficient capital reserve to not only survive but thrive in a down market, the company led by the board of directors looks at all options regarding the best use of its capital. This has been illustrated by returning capital to shareholders in five previous occasions in 2012 and 2014, 2015, 2016 and most recently in February 2017 in the form of special dividends in aggregate totaling $320.7 million or $8.52 per share.
The sixth guiding principle is the maintenance of our partnership mentality whereby the governing of HFF, its executive committee is elected by the firm's leadership team, which is comprised of 68 individuals who run the firm's 24 offices, its business lines and its property type verticals. This approach to governance reinforces our team partnership culture and significantly differentiates the firm from the industry at large.
And finally our seventh core guiding principle is the maintenance of the firms value-add philosophy which permeates every aspect of the HFF Culture, all leadership positions, compensation awards and executive appointments are based on long held value add principles which were developed internally and are communicated to all employees.
HFF's ability to differentiate and build its platform in a consolidating industry as well as the continuous expansion into the real estate industry at large remains a primary focus of management. We believe these guiding principles allow the firm to recruit and retain best-in-class industry professionals.
Evidencing the statement and as illustrating on slide 43, since year end 2009 the company has increased its headcount by about 515, representing a 137% increase and we've grown our total transaction professionals by 160, representing an increase of 100.6%. We have accomplished this profitably and at a sustainable measured pace. HFF remains committed to protecting its culture via unwavering adherence to its deliberative hiring practices.
Operator I would now like to turn the call over to questions from our callers.
[Operator Instructions] Our first question comes from the line of Brad Burke with Goldman Sachs. Your line is now open.
Good evening guys. Greg I know you touched on this, but I wanted to ask about the revenue versus transaction volumes in the fourth quarter. Transaction volume was up over 3%, loan balance is almost 20% and I realize there is a mix shift between investment sales and debt placement where I still would have expected there to be at least slight increase in revenue, so trying to understand what the disconnect was?
I mean, I think you heard that’s pretty much just the mix of business. The disconnect on a quarter basis you can see kind of an outside impact like that and I think it gets a little less when you look at it on a full 12 month period. It is pretty much the issue as it is just a mix of change.
Where there any larger lower commission transactions that would have skewed the historical ratios that we usually see?
Brad I know you touched up on because in the past, we have highlighted and identified some larger transactions and typically there were transactions above a billion dollars. As we have grown in size and double the number of transactions that we do over the years, we found that measured to be less meaningful as we gone forward and having highlighted it. There was if we were to do that again this year, one transaction that would have impacted the fourth quarter and what if impacted investments sales had been down 8% and that would have been 1.7% from a volume perspective.
Okay. And then Mark you touched on obviously the heavy investments you have made in the business in 2016. Can you give us a sense of how you are thinking about that investment run rat going forward whether that’s still priority and also surprised to see a slight tick down in headcount versus the third quarter? Is there anything to read into that or is it just normal choppiness between quarters?
Yeah, on the quarter to quarter I wouldn’t read into it Brad at all. And in terms of the investment in the business as we do our best to tell you know, knowing that we don’t give forward guidance, the best way to think off, a margin compression is capital expenditure into our business. We are a service firm so our CapEx investing in primary people to take advantage of opportunities that we see. And if you look at the data that we have presented in this report and you have seen this several times when you look at the transactional volumes and where they stand currently from the peak in 2007. So roughly a 14% decline from the $571 billion peak in 2007 to where we are today. And you look at the 100% increase in AUM as measured in the open end, close end fund markets. We view that math as compelling and therefore are reacting in terms of opportunities that we see in the marketplace, we are investing in the business.
Having said that there will be periods of time as we have mentioned in the script where a bid/ask gap will form or price discovery will form and that varies in time of its duration. But generally it will slow process down maybe as you saw in the fourth quarter change the mix between investment sales redundant. Fundamentally I would the quarter, the quarter and in terms of the investment we are making it our business that should be as just that and investment in people based on opportunities we see.
And actually to the point you made about bid/ask gaps I recognize that interest rates don’t have a great correlation with transaction volumes over the long run but interested in what kind of conversation you are having on the back of the election in seeing 75 basis point increase in ten year over a five week period, that caused people to reassess and move it to the sidelines?
We have tracked that very closely Brad and the conclusion that we would have is that it was a marginal impact I think more importantly are the factors that we outline in the script which were more of a global economic uncertainty in terms pace of play going forward. Some physical uncertainty relative to tax changes and trade changes and various other components that are there and generally uncertainty in terms of is the riskier or is this going to be a continued path of moderate job growth overtime and I think that is beginning to settle up if you look at the open end of fund market in the United States which is a good parameter in terms of interest in the space you had a negative queue from, in the open end of fund market in the first and second quarter of 2016 to the tune of roughly 5 billion which hadn’t existed since the downturn. That is now being extinguished and you have had marginal increases of - some fairly significant increases actually in queues coming into the open ended fun market.
So I believe what largely occurred we discussed this throughout 16. We had an event in the first quarter of 2016 where economic cycle risk became the topic today and it impacted investor confidence across the board which impacted the full year and you see that manifesting itself lower transaction volumes in this bid/ask gap emerging. I think that somewhat came for play in the fourth quarter midway through where large institutional investors had determined that session is not eminent and investment is necessary in order to meet various total requirements where actuary rates. Long but it did answer to your question but that’s what we are seeing.
I appreciate the thought thank you.
We got our next question comes from the line of Jade Rahmani with KBW. Your line is now open.
Thanks, very much. Let me start with 1Q and 2017 visibility, based on pipelines that are building, what can you say about say the first quarter, would you anticipate by product line, similar year-over-year changes as last quarter and for full year do you expect similar amount of volume as plenty negative growth for the market.
Jade, we don’t give forward guidance in HFF so I can’t answer for the first part of your question. In the second part of your question as we stated in the script just mathematically I leave it to you to determine but what really is compelling to HFF is to look at the significant increases in AUM Assets Under Management since 2007 and 2008. Due to the fact that the market the transactional volumes at peak of roughly 571 billion in 2007 and roughly half AUM that we currently have in the industry. And it is over the 4.63% average bond for the year in 2007.
That is an interesting factor for us and you also look at the relative fund flows coming through the institutional market and as we stated in the scrip the allocation on the institutional front to commercial estate is almost double, it is up 85% since 2010 showing real estate becoming this valid asset class designation both in terms of capital raised and in terms of capital allocated to spend. So the combination of being 14% off peak in 2007 with an almost doubling of the denominator of investments in commercial real estate we think is positive.
Okay in terms of the maturity while your slide shows - market color from participants are you seeing anticipated spike into maturity play out for part in 2017?
Well that is a very good question. And as I stated couple of times over the last several years, we don’t necessarily see one to one correlation in transactional volumes of the maturities schedule we include. The reason for that is the banks are very liquid and I think that they will do all they can to keep earning assets on book and I do believe that the bank’s balance sheet relative to commercial real estate in extraordinarily good shape.
However of note, and we called it out in the script is the largest component of those maturities or larger component of those maturities have been CNBS and we do believe that it is a much higher correlation in transactional volume over time closer to one to one versus perhaps 0.5 to 1 in the bank maturity schedule. So netting that in our view that is a fairly significant positive going forward in terms of transactional opportunities.
Just a follow up to Brad’s question about the revenue and transaction mix, are there any pressures on transaction fees currently in the market than investment sales since investment sales volume for the industry are down?
That is a good question Jade. The answer is we have seen no change in terms of operating environment or competitive environment now versus one year or two years ago.
And just that some color on sort of the strength of market in terms of non-disclosure agreements and sort of a number of bidders on transactions has the level of activity been consistent say over last two months or at least in the early part of this year that would give you sort of confidence on the long term outlook. Are you seeing any changes there and thanks for taking the questions.
Well I think any time you have a bid/ask gap in or a price discovery bid fields normally decline, which they have been doing over the last 24 months generally speaking. That’s not really metric that we focus on in terms of transactional volume, that is strictly related to pricing and during this play of what level, people will become more tactical so it is not what we look at relative our business model and predicting transactional flows. I do think you should look at the data that I have already talked about in terms of the denominator real estate assets currently exists from an investment standpoint the commercial real estate but also look at the amount of dry powder to deploy that currently exists in discretionary funds ready to deploy, it is at an all-time high.
So in terms of our statement where we believe there is ample debt and equity availability is directly correlated with that metric in terms of dry powder in the industry begin at all time high and closed end and open end fund markets primarily in closed end fund markets and if you also look at the increased allocations in the fact that we are approximately 140 basis points under investing. One of the points here that might be interested is maybe investors in the institutional space have looked very hard at real estate over time and consistent cash on cash with inflation hedge is compelling.
So a percentage of normally allocated dollars in investment portfolio to fixed income is broad category is being redirected in the commercial real estate either in the form of investing in debt funds so we call it shadow bank market or investing in real estate assets to deliver consistent cash on cash over time as a surrogate for fixed income in this environment. That is also a favorable trend that we see in terms of capital available.
Thanks very much, appreciate it.
You are welcome.
[Operator Instructions] Our next question comes from the line of Brandon Dobell from William Blair. Your line is now open.
Thanks. Good evening guys. Maybe one for Mark if you are to stop opening or adding new offices across the network and just to fill out I guess the empty spots in terms of property types and service offerings what is the ball park number on what the producer headcount would look like, if that was to come true.
Brandon it is a very good question. We just don’t disclose that type of information. I think perhaps away from meeting and sort of that will give you some clarity and we have touched on this in prior earnings calls, and that is we are very fortunate as a company to have no debt and very high variable cost option which we translated into meeting ultimate flexibility.
We could rapidly expand margins if needed, simply by making some very fundamental changes in our view here going forward. However again when you see compressing margins from us and you also see difference in the dividend that we declared in February this year. It generally means we are investing in the business and see some opportunities based on macro changes or macro fundamental that we see in the market place.
Not to say that we were right but it is surely how I would view it in terms of investment. In the event that we are wrong and things do not materialize as expected in terms of growth that we see. Due to our flexibility both from a leverage standpoint and a variable cost structure we can quickly make adjustments and adjust our pivot quickly if we see it. So it doesn’t quite answer to your question in terms of if we stop opening offices and fill out a platform and what I was look at headcount but it should give you some indication of what we see in terms of opportunity.
Okay that makes sense. Just going to macro question for a second, you mentioned a number of things that I guess column uncertainties or just points of contentions debate around the industry. In your view what would cause those things to not see bigger of an issue for the commercial real estate participants as it was in 16. Is there a path forward or people are going to be less worried or these things just so structural and given the timing around the cycle is that they are going to be beaming and kind of maintain or remain top of my people and continue to generate place discovery as oppose to more risk taking.
It is a good question. Here is my view, recall that the conversation that we are having about this time last year was in a quite different environment. Bonds gapped out at 100 bp, we have margin compression of almost 30% across the real estate spectrum and in general shareholders and equity investors had concluded that end of cycle had come much sooner than anticipated where we are heading into recession. And that effective the institutional mindset across the board, speaking which cause the market to pause and that is really what started and it was the catalyst behind price discovery and bid\ask gap forming. Sign of that similar event is happening.
You have always uncertainties out there, you perhaps that more today with geopolitical risk and other things and everyone is very aware of all the risks that are there however most investors have concluded that recession is not a near term event. And they are acting that slow process by increasing allocations at least again anomalies peak into real estate to real estate and we are beginning to see the manifest itself both in the closed end and open end of fund markets.
So our conclusion is that sounds a similar event in 2017 where you had a very significant market reaction that occurred in the first quarter of 16, there should be, we would call it more business as usual and normal activity versus what we saw again as an industry in 2016 to be determined but that is our take on it, relative to the industry at large.
Okay and maybe as a quick final tangent question here, you talked about all the dry powder out there whether it is close or open end funds or various vehicles. That’s kind of stands in contrast to the allocation perspective or maybe just points to me that people have a lot of money but they are putting it work and is that is because prices are too high or maybe uncertainties or just going on people psyche little bit too much was seen that there shouldn’t been as much dry powder at this point given that the space had a pretty good run for subsequent years.
It is a good point. I think people - I mean generally speaking people generally ask about underwriting metrics and I think people have been measured over time and this cycle rolls over a cycle for the last seven years, almost eight now. Prices were up 3.4% according to Moody’s and actually across the board so that has people thinking about things from their but that is not unusual. So I think what we are finding Brandon is real estate has grown up as an asset class both as defined as the new gigs [ph] vertical which is quite out of it as you know as well as the coupling of allocations in the private market we call it the institutional markets and state plans and the endowments corporate plans and overseas sovereign investments. Those are big events, those are structural big events.
The fact that we have dry powder is I think nothing more than result of what happened in the first and second quarter of 2016 and elongation of the cycle and people are doing exactly what we stated in the script are moderating and underwriting assumptions. They are being more conservative and if you just keep your total return target the same which is largely is one year ago or even 18 months ago. So if you keep your total return target the same but you change the metrics in a more conservative fashion to achieve that total return you have moderately lower prices across the board and in some cases more the moderate lower prices depending up on the product vertical we are talking about or the geography and that is your priced discover.
So in general you have seller buyer conundrum on who is right relative to perceived risks over the next three years, generally those days - six months to work themselves out one way or the other. So I think that’s really the simple answer to your question and again we tend to go back to availability of capital in commercial real estate to deploy as well as available inventory of commercial real estate available to transact relative to HFF and we have already gone over those facts.
Okay, great thanks guys.
We do have a follow up question from Brad Burke with Goldman Sachs. Your line is now open.
Hi I will just ask a quick one and it is for Greg, you mentioned that you are going to be retaining the cash portion and some of your service rates and I am just trying to understand the implications to your other income line.
Sure, as you know the other income line is where a lot of the ancillary income we are earning on our agency business as were as recorded it somewhat lumpy and it has been lumpy for years just because once loans gets securitized we don’t control the timing of when or once we close the loan, we are afraid that we don’t control timing when securitized so when we are in securitization income or when we have an opportunity to sell the cash earning portion of those loans the master services is not within our control and on average it may happen anywhere from you know six months or longer after the loans have closed. So it has created the lumpiness in that line item.
As a rebate for the cash clearing portion, the economics have changed over time and we saw it in a big way at the end of this year where the amounts we were being offered relative to the value of the servicing rights have become less favorable than they have in the past. So that’s is what it drove those numbers down this year, I think in 2015 that number was 4.6 million and in 2016 it was 2 million, so we saw a big swing there. So next year given that we made a decision to not part to retain the cash here large part of it are clients have come to us and asked us to maintain the cash hearing portion, so we have primary servicing responsibility on those loans and have more touch points with the client and the economic issues they are going on with it.
We made that decision, so the implications part that if we have none of that coming through that other income line next year that will be a 2 million differential of what it is this year and that is the most of the impact will be year-over-year. Now having said that while forgoing the sales and servicing impact that interest and other income line, going forward though we retain those rights and we will continue to get servicing income from that servicing strip. Only that will be reflected in the servicing revenue over the life of the loan. So there is a difference in timing but we don’t lose that it just comes in over a slower longer period of time.
Got you and the biggest hit would be obviously be upfront you think it’s about $2 million.
Well, as it relates to what has been recorded in 2016 was 2 million and if that goes zero next year. That’s your differential.
Got it. Thank you very much.
I'm showing no further questions at this time. I’d now like to turn the call back over to Mark Gibson for closing remarks.
Thank you everyone for attending our call. We are looking forward to seeing everyone again in first quarter of 2017.
We appreciate you joining us today. And hope they join us again for our first quarter 2017 call. Thank you.
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