Stewart: Welcome to another edition of the InsuranceAUM.com podcast. I am Stewart Foley, I'll be your host. Today's topic is CRE debt and our guest says that the opportunity set for CRE debt is among the most compelling that they've seen. And we're joined today by Dean Dulchinos, head of Debt Portfolio Management, and Justin Pinckney, head of private debt at AEW. Gentlemen, thanks for being on.
Justin: Thanks for having us.
Dean: Great to be here.
Stewart: We are thrilled. Let's start this off like we start them all. Dean, what was your hometown, your high school mascot, and what makes insurance asset management so cool?
Dean: So Hometown was Holyoke, Massachusetts located in the western end of the state. Our mascot at school was a knight. We were the Holyoke Knights. And insurance asset management, I think for me is really about the end game. So when I worked at investment platform zoned by MassMutual, there was a fellow who was in our origination platform who used to say, "Everything we do is for the widows and orphans." And so I think at the end of the day, it's an opportunity to combine a very sophisticated investment career with a business that really offers a product that helps people. And that's a pretty cool combination.
Stewart: I love that. And I feel exactly the same way. And Justin, for you, hometown, first job, and what makes insurance asset management so cool from your perspective?
Justin: My hometown is Walterboro, South Carolina. It's a small city of just over 5,000 people, about 40 miles west of Charleston, South Carolina. First job was at 10 years old working for my family's business as a hard labor in the hot low country, South Carolina summers doing some landscaping, hardscaping. So it certainly taught me the lesson of a hard-earned dollar early in life.
Stewart: Absolutely. It's hot in the summer in South Carolina, man. Like crazy hot. That's rough. It's a rough start.
Justin: It's true what they say though, it's not the heat that'll get you, it's the humidity. So you got to be watching out for both in those hot humid summers.
Stewart: Absolutely.
Justin: What's cool about insurance asset management to me is the sense of community. And that's something that was revealed as a frequent attendee of a corporate pension and insurance investor conference that I attended for many years. The sense of belonging, the sense of fiduciary responsibility and the sense of the friendly nature of the relationships among the insurers and attendance really resonated with me. I think it's about collaboration and ultimately about working on behalf of policyholders that I think is very unique among allocators.
Stewart: It is so true, and I mean I've been at this for a minute, as you can see by my graying hair and beard. For example, the people who listen to this podcast, a whole lot of them know each other. And it is a really tight-knit community. It's not a big group of people, but they control $9 trillion of AUM local in the US and $35 trillion, globally, it's 30% of the world's invested assets based on the numbers that I've seen. But there is a tremendous amount of comradery, part of which I think is all of the externalities that insurance companies have to face. And I think that there is some collegiality as a result. So thanks for that. And so let's talk about CRE debt for a moment. I mentioned at the top of the show that you think it's the most compelling opportunity you've seen in over a decade. What is your current market view, Justin?
Justin: I think in general about the market opportunity and where we sit in it today, I think we are clearly moving in a regime shift type of way from a low risk, low yield environment that has been present for the vast amount of the past decade, to a higher yielding, higher risk, more uncertain economic and interest rate environment as it surrounds both fiscal and monetary policy. So we think there are certain macroeconomic headwinds that are facing us that are creating some type of valuation adjustment. We think that that has been most concentrated in commercial real estate relative to other asset classes. So in terms of a market view, we would see commercial real estate as probably leading the cycle in terms of its impact so far from a rising interest rate environment relative to other asset classes that have seen less value disruption, value impairment, and ultimate value adjustment.
So obviously the big headlines today within commercial real estate are centered around office, I think rightfully so. We think that that is truly a secular shift and ultimately how office demand will be driven, how office will be used. And we think that story will take some time to play out. But what we see elsewhere is that for other secular beneficiaries of growth, of migration, strategies like residential or multifamily logistics and even parts of healthcare, we think are clearly going to have strong longer term demand drivers. So while fundamentals are softening in many of the even desired sectors today, we still see those as the longer term beneficiaries of demand growth once we get past a period of likely heightened supply. So market view, I think more generally summed up is a more uncertain economic environment today than we've seen in quite some time. But one that rewards you as a lender unlike it has in many, many years.
Stewart: That's a great overview. And Dean, we've talked on this show in the past about the banking crisis and the fact that banks are pulling out of CRE lending for a myriad of reasons, which is going to create an opportunity for private capital in this space. Can you dig in there and talk to us about why that is the case and what you're seeing? I think that Justin's exactly right, I think that investors generally are nervous particularly about office, but those things, as one of our guests said, "Comfortable is rarely profitable, right?" So can you talk to us about the banking crisis a little bit?
Dean: I think there's a whole lot of high-level conversation around the banks pulling out, but I think if you dig in, there's a next-level analysis on this that really underpins what we think is the opportunity here. If you think about it, the banks are largely the lenders of choice or have been the lenders of choice for transitional lending along with the debt funds. And what I mean by that is lending on real estate assets that are not fully stabilized. If you think about the other typical sources of capital life insurance companies, the agencies CMBS, securitization, those strategies tend to focus on stabilized assets. They don't do well with future funding, they don't do well with changing economics at the underlying collateral level. And so as we think about the parties who are out of the market now for all those reasons you cited, regulatory issues, deposit issues, lack of round-tripping, there's not a lot of repayments coming back to banks right now. The banks are the large portion of financing source next to the debt fund, which is focused on this kind of transitional lending space.
The other sort of corollary to that is that if you're a debt fund and you've got a mid double-digit return, kind of a value add return profile, maybe focused on mezzanine or sub debt only, you also need bank financing to provide leverage to your strategy. So there's actually a component of the debt fund space that is out of the market or struggling to get all the pieces they need to put together what it is that they typically do. So as a result of that, we see an opportunity right now in the senior lending space, call it 55%-65% LTV as a position in the capital stack. And there really is not a very deep bid for that space, both on transitional assets that are existing as well as on construction assets.
That's providing an opportunity for what we see as better structure in our deals. So lower advance rates, better covenant structures, and also higher spread. So obviously we have a high base rate environment now, but combine that environment with the higher cost of capital, a higher illiquidity premium if you will, that's just creating, I would say, a moment in time opportunity for what is otherwise an all weather strategy.
You think about it, the many life insurance companies have been in this business for a long time and they've been focused on long-dated fixed rate CRE debt, but there's opportunities in shorter floating rate for P&Cs and other companies that have a need for a more liquid investment. So to kind of sum it up, the banking crisis that we see, or the banking situation that we see right now, we anticipate is going to continue for some period of time. This is not a short-term event. It's probably a multi-year event. And therefore we think this opportunity to provide capital to the senior position in the capital stack is going to continue for a period of time that enables a lot of investors to get involved in.
Stewart: And you bring up a good point, it's my own personal bias, but I always think of life insurers here, but the fact that you recognize the structural characteristics that are different about P&C carriers and the fact that they can play here too, I think is really worth highlighting. So lots of talk about private assets these days. Can you talk a little bit and expand on the private CRE debt space?
Dean: Yeah, as we think about it as an opportunity for investors, but especially insurance companies, given our topic today, there's really a lot of benefits that comes from it. It offers diversification from public investment. It's shown to be a lower correlation to other asset classes. It gives investors access to credits that wouldn't otherwise be available in other private credit strategies or public credit strategies. And it provides increased income and fees plus an illiquidity premium, especially in times of market dislocation, which is what we're absolutely seeing right now. And as we think about the way investments behave at various stages of dislocation or disruption in the market, there's sort of three stages you think about. So if you're in a lender position, the first thing you want to be able to do is curtail investment. Shut off future funding to the extent you have future funding obligations in the event that there's distress at the asset level.
So that is certainly a structural component of CRE debt. You also want to be able to rebalance or resize through good covenant structures. So that's kind of a level two. When you get to inflection points in the underlying loan such as an extension, if you've got covenant structures in place that require LTV tests or debt yield test, you can end up having a requirement to resize the loan. Reduce your level of risk by reducing your exposure to the underlying asset.
And then finally, this offers a hard asset collateral structure. This is ultimately that CRE debt is secured by either a mortgage or some kind of a pledge in a structure that owns a piece of real property. So in an extreme downside scenario, we have access as a lender to a piece of collateral which can be owned, operated, it has real value. It can be repositioned in the market to the extent that there are difficulties in the market, and ultimately lead to what we see as a much better loss given default outcome in that extreme scenario.
Stewart: That's really helpful and the collateralized nature is an important point. Justin, can you talk a little bit about CRE debt versus direct lending and can you just draw some comparisons and maybe some things that are similar?
Justin: Happy to Stewart. So this is an area that I have some background in as a consultant and have private debt which encompassed really all non-public fixed income instruments and funds. So I think both have a place in investor portfolios, both have been adopted by the allocator community over the course of many years, I think increasingly so for direct lending as that industry as a whole has grown. So I think they can diversify each other. I think in a way commercial real estate debt is just part of private credit in general, distinct from direct lending in a number of ways that Dean just described. At the outset I'll say they both have a place, they both offer diversification opportunities from traditional fixed income, even from equity strategies. They both are very much in demand by borrowers today. They're both areas that the banking community has largely turned their back on in some sort of way.
Direct lending really more from the great financial crisis where banks truly curtailed their CNI lending desk in a meaningful way and more recently with commercial real estate debt. So banks have been there, they have had abundant liquidity to lend on commercial real estate debt, whether that was money center banks or regional banks or anything in between for some period of time. We think that landscape is shifting. So we think that both of these types of credit strategies will be growth areas for the market and ultimately we think lead to additional opportunity on behalf of limited partners. But I think to us the credit quality for all the reasons Dean just mentioned, you have real hard collateral that is more commodity in nature versus an operating business. It's easier to take it over in the event of a foreclosure. You have a more, I think, market-accepted form of valuation for these assets too.
I think for a private business, I think ultimately it's what somebody's going to be willing to pay for it. But you've got a well-built out appraisal community. You've got lots of market comps with like-for-like assets across the street if it's an office building or multifamily apartment complex or a warehouse within real estate, so far more market acceptance into what a real value is that serves as your collateral. So the ability to intervene when a credit goes off plan and ultimately if it defaults, the ability to intervene, and then operate that property, we think is a stronger case for commercial real estate debt. You've got property management that's there today that can continue on or be replaced, and if you have a lending practice with an associated equity platform beside it, you can take that over in-house. You can special service your own loans, you can then own and operate it. And ultimately we think that leads to better recovery rates and more limited loss given default ratios.
For direct lending, certainly lending a broad landscape, but we also think that credit quality is likely a step-down. I think admittedly so for a lot of the direct lending shops, they probably call their first lien, unitranche strategies generally in the double B to single B credit rating range if you had to imply a credit rating on those. I think for a commercial real estate debt, it certainly spans a variety of credit ratings just like direct lending can. But in terms of commercial real estate debt today, because of the lower advance rates, because you are lending on reprice collateral, we do think that those are gravitating more towards an implied credit rating of investment grade. We don't think that there is a substantial spread premium to be had from direct lending versus commercial real estate debt, at least in our experience in 2023 and what we're seeing in the pipeline.
But we do think that the credit quality is a real piece that investors would be wise to zoom in on. Again, both have placed in portfolios, but we think the ability to intervene certainly greater in commercial real estate debt and we think the illiquidity premium and risk adjusted return potential. Again, we're biased, but of course we do think that that's certainly more in favor for commercial real estate debt today than it is broadly for direct lending.
Stewart: Thank you, that's very helpful. What about optionality in CRE debt? Can you talk about it? I hadn't really associated optionality with this asset class and I'm really keen to know how you view it.
Justin: So on the optionality side, absolutely we think that because markets are not static, you constantly have to assess the market cycle, the phase of the market cycle that you're in at any given point in time. And today, we think the optionality is fairly positive for commercial real estate debts. I think I'll just use some broad generalizations for what could happen moving forward. And I think in a more polarized environment, if interest rates go higher, I think largely that will be due to a hotter-than-expected economic environment. And so in that case, commercial real estate debt, at least those that have floating rates loan exposures, those will participate in higher interest rates. So that's good in terms of the income that it can provide to investors. I think it's also good at the asset protection level that the vast majority of lenders in the market for floating rate loan instruments require their borrowers to enter into interest rate swaps or more likely buy interest rate caps.
And so your borrowers are protected also from rising interest costs, and we've seen that become a valuable protection for existing assets where these caps start to kick in and they pay the lender these spread of difference between the stated cap rates and what the prevailing market interest rate is. So that's provided a level of protection to the borrowers and their underlying cashflow on those properties. So I think that's one potential outcome. Higher interest rates, commercial real estate can benefit from. Commercial real estate debt can benefit from that. Arguably higher interest rates will create some more valuation adjustments. I think all risk assets have to consider the risk-free rate. Commercial real estate's no different. But the reality I think of new loans today is that you have substantial equity subordination embedded in your loans.
So advanced rates 6, 8 quarters ago were routinely 70%, 75% loan to value. Today they're 50%, 60%, maybe 65%. So even in that higher interest rate, higher economic growth environment, you still have a lot of equity subordination to protect against declining property values. I say as the corollary, if you have a situation where interest rates decline very, very steadily and go back to the old interest rate regime, we've all become accustomed to since the financial crisis, I think commercial real estate debt will be well insulated there as well. And I say that because you will have interest rate floors that are being set today routinely in the three to mid 4% range that will protect the yield on your investments in the event that interest rates decline below those rate floors. Certainly you'd be open to more prepayment risk in those environments. I think it's a wonder if interest rates decline. I would argue that the economic environment is probably struggling, so it's a matter of what liquidity will be there.
But if it does exist, we think that commercial real estate originated today or commercial real estate data originated today will also be protected by prepayment lockouts that are better than we've seen in quite some time or through other structures like minimum interest or minimum multiple. So rates decline, you're protected in a number of ways, that protection wanes the longer that interest rates stay low. But we do think that that optionality is very important to consider in terms of yield protection or yield enhancement. And either scenario, if you pull Dean and me and probably most others, we think the reality is probably somewhere in between of probably still high rates, maybe muted economic growth, but not necessarily depression-level negative growth rates. But we think that today, senior mortgages with much larger than we've seen in recent memory equity subordination and high income yields provide a lot of protection and a lot of return potential, particularly on a risk adjusted basis to investor portfolios.
Stewart: That was a great explanation. Thank you. And so Dean, when we think about credit cycle evolution, when you think about CRE debt, where are we in the credit cycle? You mentioned earlier that CRE you think is leading, and if I'm a CIO at an insurance company, how do I stay nimble enough to adapt to it?
Dean: Yeah, it's interesting. In Justin's comment, he touched on the opportunity to invest in floating rate position. In a normal period in the cycle, you're seeing maybe 33% of your book turnover on an annual basis if you have deals that average sort of a three-year term. So as we think about this going forward, I think there's an opportunity here for investors who want to stay nimble, perhaps want to have the ability to move capital around and redeploy it with a floating rate lending strategy. To be able to invest now to take advantage of what we see in the marketplace as an outsize return for the risk position, but also to have a natural liquidity in their portfolio.
So I think in the equity world, there's a lot of discussion around liquidity and how you create liquidity, for instance, in an open-ended fund structure. In a debt position you have this natural liquidity so that you're always getting a portion of the portfolio repaying. And again, that can speed up or slow down depending upon what's going on in the broader markets. Those borrowers can execute additional extensions if they have rights to them, they can come back and ask for non as of right extensions. But generally speaking, an investment in a debt strategy entails a constant sort of turnover of your capital, and that gives investors an opportunity to continually make an allocation decision, a redeployment decision or a decision to deploy elsewhere into another strategy that might make more sense for them at that point in time.
Stewart: That's great. And I mean, I think it's important to acknowledge that CRE debt is an investment in real estate and not a fixed income instrument. What kind of asset class expertise do I need as a manager given the choppy markets that we're in today?
Dean: Yeah, this is something we think a lot about and talk a lot about at AEW. I think as we approach the market, we see investment in debt, whether it's senior debt or subordinate debt as an investment into a position in the capital stack of a piece of real estate. And so at the end of the day, it's a debt instrument. Ultimately we are supplying cash flows from a property to fund payments under a debt instrument. But the underlying reality is that the success or failure of that property is really what drives that cashflow stream. And so it's very important from our viewpoint to make sure that you're thinking about real estate aspects. As you build your investment strategy, you're thinking about who you should be investing with, where you should be investing. So diversification not only geographically, but with respect to the partners that you're investing with as borrowers, the kinds of markets you're getting exposure to, the kinds of businesses and demand drivers that exist in each one of those markets.
Modern portfolio theory says that diversification is a critical factor in successful investing, and there's multiple levels of diversification as you think about investing into real estate through a debt position. So personally, I believe that investing through a manager who has both equity and debt capability, is a critical part of the decision, because in an extreme downside scenario, you might have to take back and own a piece of property. That's something that happens pretty rarely in real estate lending, but that's kind of the extreme scenario. I think before that happens with respect to how you underwrite and how you structure and how you asset manage debt investments, that equity capability on the platform becomes critical. And so we talk about those three things that we do all the time on our platform. When you're making a loan secured by real estate, you're underwriting, which means you're understanding what the risks are of that particular investment. You're then structuring, meaning you're building a set of covenants, you're building a loan document set that governs and manages and mitigates that risk over time.
But then you're asset managing for the life of the deal for the full term of the loan, and that's the thing you do the longest. It might take 60 to 90 days to underwrite and structure and close a deal, but then you might live with that deal from anywhere from 2 years or 3 years to 7 or 10 years. And so that asset management function of what we do as a lender, managing that loan, making sure the business plan stays on track, making sure the borrower is being responsive to its contractual obligations under the loan documents is really a critical aspect. And that can only be driven by a successful manager who has that capability on their platform. I like to say that when you document the loan, it's sort of like playing a game of chess all upfront before your opponent makes a move, because everything you get with respect to your set of rights, your set of covenants, everything that governs the outcome of that investment, gets built into the loan documents and documented in those loan documents.
Even though you might have opportunities going forward for negotiation or adjustments, generally speaking, you've already played your game of chess at the time you sign those loan documents. And so therefore becomes critically important to kind of think about these three components and the importance of each of them as you document the deal. I'd add one other point, I think, just because I think something we think a lot about, and that is leverage in a structure and what creates leverage. I think we all think about leverage generally as financial leverage, meaning that the manager or the fund you're investing in is becoming a borrower. For instance, a borrower on a warehouse line that's providing leverage for a pool of first mortgages, and we think of it in terms of leverage. One-to-one, leverage two-to-one, three-to-one, et cetera. But there also is leverage that flows structurally from deals.
So if you may be in a sub debt position behind a senior lender, a mezzanine position behind a senior loan, and even though as the mezz lender, you're not becoming a borrower on that senior loan when you sign up the deal, you are structurally leveraged. And so if you take that senior loan amount and divide it by the amount of your mezz, it's going to give you a number. It might be one-to-one, two-to-one, might be four-to-one or even higher. That is the structural leverage to your position, and it has a lot of the same impact on your position as financial leverage does with respect to the risk that it adds to the structure. So I just think that as we think about these key factors, manager diversification, how you're investing structurally, that leverage piece is something to really keep in mind and to keep straight between financial and structural and potentially the risks of either one of those.
Stewart: That was very helpful and a great explanation. I want to talk about one of the things that our listeners always want to know: implementation. Whenever we're talking to CIOs, it's a matter of implementation. And we've kind of touched on this, but if you think about P&C health and life, if I'm the CIO of one of those three, there's reinsurance too, of course, how do I play if I'm a P&C investment professional life or health? What are my options?
Justin: Stewart, should we start by saying that this is not investment advice, this is just general recommendations?
Stewart: Yeah, you can.
Justin: All kidding aside, we think there are a number of ways that you can create the right exposures for behalf of all investors. It doesn't necessarily have to be explicitly for insurance, but I think if you think about the types of liabilities and the duration of those liabilities for various pockets of insurance capital, certainly the life goes have been longtime investors in longer duration, lower loan to value, higher credit quality, liability, immunizing type of fixed rate, commercial real estate debt loans. So we think that that will be a space that continues, particularly if the CMBS market is sidelined, like it has been. Certainly back a little bit in the second half, but generally is much lower loan production. So we think that's an area where that will continue to provide a benefit to life insurance portfolios. I think on the property and casualty side, typically shorter duration liabilities, you need to maintain a more liquid stance.
From what Dean said earlier, that if you're a floating rate investor with some level of transition or some type of bridge loan that you're providing to the market, you typically have quite a bit of turnover in that portfolio. So you have a reliable liquidity source and you also pick up quite a bit of yield along the way across the market cycle than what is achievable and across public credit. And so we think that they can play a variety of roles in terms of diversification to insurance portfolios. They can also immunize liabilities, and they certainly can be a yield enhancement relative to public fixed income. Which regardless of life cover or P&C, you're certainly going to have the majority of your portfolio in those publicly available daily liquid fixed income instruments.
Stewart: That is fantastic. And I will tell you that I have got one question... I've learned a lot, and I've got one question for each of you on the way out the door. But I can't ask to both, because it's going to take too long. So you guys figure out who's going to do what. What's the best piece of advice you've ever gotten? And who would you most like to have lunch with, alive or dead?
Justin: I'll take the latter. Dean, you want to take the first?
Stewart: There you go. Okay. So who's your lunch guest?
Justin: I'll take the more sentimental route. I'll say my lunch guest would be my stepfather. I would say that no single person has had a more profound impact on the trajectory of my life. I wouldn't say it was on a bad path before, but certainly coming from a small town allowed me to see that the world is smaller than you think from a very small city that I grew up in. So he gave me a lot of motivation. He pushed me in the right directions. He's inspired a work ethic in me that I don't think otherwise would've existed. He passed about a decade ago, so it would be great to catch up over dinner or over lunch, share a few laughs, introduced him to my kids who have come along since he passed, maybe even share a cocktail or two. So it'd be a lot of fun.
Stewart: That's fantastic. As a stepdad and a guy who has a daughter who has a stepdad who's been terrific to her, I can really relate to that. So thank you. And Dean, what's the best piece of advice you've ever gotten?
Dean: Yeah, I would say the best piece of advice I've ever gotten has been fairly simple. It's been, "Don't be afraid to say yes." As you think about life, whether it's from a career perspective or even a personal perspective, there are opportunities that you are confronted with on an almost daily basis. Sometimes they're big ones, sometimes they're small ones. But being afraid to take on risk by moving forward and trying something new, I think can really limit your growth.
So especially now when you think about where we are in this market, and if you happen to be a younger person in the industry, there's going to be a lot of opportunities that we will see. They will be different opportunities maybe from the job that you got hired into, because there will be needs that will come up for managing issues that arise as this economic environment moves forward. So I think being ready to say yes to those opportunities, even though it may completely change up what you're doing and maybe something that no one else is doing on the platform, really I think can help launch your career into something that could be a lot more fun maybe than the career you thought you were going to have in the first place.
Stewart: Yeah, that's great. I mean, those are two great answers and I want to thank you. You've educated our audience beautifully on CRE debt, the market, the opportunity set, and I want to thank you both for being on and taking the time.
Dean: It's been great to be here. Thank you for having us.
Justin: Thanks for hosting us, Stewart. A lot of fun.
Stewart: My pleasure. We have been joined by Dean Dulchinos, head of Debt Portfolio Management, and Justin Pinckney, head of private debt at AEW. If you like us, please rate us, review us on Apple Podcast, Spotify, or wherever you listen to your favorite shows. My name's Stewart Foley, and this is the Insurance AUM podcast.
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