CRE Debt: Insights, Trends & Capital Efficiency

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Stewart: Welcome to another edition of the InsuranceAUM podcast. My name's Stewart Foley, I'll be your host. Hey, welcome back. We've got a great podcast for you. Today I want to make mention of our upcoming A BF Real Estate and infrastructure event in Philadelphia. We have about two slots available for insurance investment LPs. We have right at 30, which is giving us about a two and a half to one ratio of LPs to GPs, which is really outstanding for both groups and allows the LP community to talk to each other, get to know each other, and solve problems together collaboratively. So if you're interested in attending that, please shoot us a note at events@insuranceaum.com and we'll be happy to get some information headed your way. The title of today's podcast is CRE Debt Insights, Trends, and Capital Efficiency, and we're joined by David Lehman, Managing Director, Head of Real Estate Strategies at HPS Investment Partners. David, welcome. Thanks for taking the time. We're thrilled to have you.

David: Hi Stewart. It's great to be here. Appreciate you having me on.

Stewart: Absolutely. We're thrilled. So let's get started. Just in case that somebody doesn't know, can you give us kind of the big picture of HPS investment partners?

David: Sure. So HPS is a global credit-focused alternative asset manager. It's been around for approximately 20 years at this point, 14 offices across the globe, roughly 800 employees and we manage $150 billion approximately of assets primarily in private credit, which is our background.

Stewart: Yeah, that's super helpful and a very, very hot asset class in the insurance investment space as you well know and has been for some time. Just to kick us off, I mean it's hopeful and we've kind of modified this question a little bit, can you give us a quick career journey for you from the first job, not the fancy one, to sitting in the chair you are today, and I mentioned to you before we started, we try to do this so that folks who are earlier in their careers can get an idea of how one achieves this level of success in this industry.

David: Absolutely. So, I'll try to give you the concise verbal CV here in terms of my job. So I grew up in central New Jersey just outside of Princeton and my first not-fancy job, I guess jobs plural, I was a summer camp counselor and also was a waiter at the local diner in New Jersey, which is a big thing for those on the east coast.

Stewart: Absolutely. That's a fairly thankless job as well, I would think.

David: It was amazing. I still think back on it today when I was in my teens there and arguably I learned more in that job than I did in many of my other ones. A lot of life lessons and interpersonal interaction and connections with folks. So yeah, waiting tables and summer camp was where my career started 30-odd years ago. But after college, I moved to New York City and started working in fixed income on the trading side in the securitization market and this is the late 1990s at this point, focused on asset-backed securities and then commercial mortgage-backed securities, where I've spent a lot of my career in and around trading businesses, managing trading businesses that banks ultimately managed real estate lending business, what a bank was doing on balance sheet as well as what we were doing with the intent to syndicate or securitize. And then roughly 6 years ago I did something entirely different store, actually not going back to the diner, but I worked in state government. Actually, my wife, family, and I live in the state of Connecticut now and I worked for the governor of Connecticut, oversaw economic and community development for a period of four years and served as senior economic advisor to the governor there from 2019 to 2023. And then I joined HPS in my current role in the middle of 2023. So a lot of different things over the past quarter century or so.

Stewart: Wow, that's interesting. The government stint is, I lived in Connecticut as well a little earlier than when you were there, but that's super interesting. I actually was in city government for a minute and that's a completely different world. Anyway, long story. So let's move to CRE market evolution. You have seen significant shifts over the past 25 years in commercial real estate. How would you describe the biggest changes you've witnessed particularly in sectors like office, retail, data centers, and senior housing?

David: I think the biggest change we've seen, and I think this is more important now than ever, given some of the obsolescence risk in real estate as the economy changes as how we work, how we shop changes. But when I started in the 1990s in the business, there were what folks called the four food groups of real estate. You had residential or multifamily, industrial or logistics, and then you had office in retail and you fast forward to today, office is a sector that has considerable challenges right now and we can spend a whole nother podcast on that. Retail there has been a slow transformation, but one that continues in terms of how people procure goods and get goods delivered to their door as opposed to going to the malls of the seventies or eighties. So in terms of the big food groups, then I'm happy to jump into senior housing and some of the other ones.

You've really seen a real shift where two of the sectors, multifamily, industrial, are still very much in vogue. There are arguably real tailwinds on those asset classes that we see over the next decade or even decades and there are challenges on some of the sectors. So just shows the dynamism in the market and that real estate, you can't chisel it in stone. You need to be open-minded and think about how the economy and the utilization of these assets is changing. Data centers is by far the fastest growing sector and we can debate if that's real estate or infrastructure or yes, both of them, and senior housing as the demographics of the country change and we get a little bit older here in age, senior housing is really an interesting asset class that we also think will grow in the US and beyond. So happy to go deeper in any of those, but lots of change and just really underscores the fact that you need to be dynamic when you're investing in real estate.

Stewart: This may be a dumb question and I'm confident it is, but when you're investing in data centers and you mentioned is it the real estate of the infrastructure, are there situations where you're actually, you own the computing hardware as well as the real estate or is that somebody else financing the computers and whatnot and their routers?

David: It's typically the latter. Typically the powered shell and the assets of the building and around the building are part of what the landlord owns. Typically the tenant in terms of the racks, the servers, what's in the data centers just given there is realest risk there that's replaced every handful of years if not more. That typically is the tenant and they've got the expertise as opposed to the landlord. So you're really focused on the longer-term infrastructure around the power in the shell of the building as opposed to what's in it.

Stewart: And a big part of that is cooling, right? The cooling infrastructure and whatnot. Alright, good stuff. So let me move on to the next decade in real estate. So looking ahead, how do you think about the next five to 10 years in real estate, how it'll differ from the time period since the GFC and will the market dynamics be similar or do you foresee significant changes? I'm basically asking you to dust off your crystal ball.

David: Let me get that out of my drawer here as we talk. Yeah, the GFC and now over 15 years ago at this point. So a generation effectively. So I think there are a number of, maybe we start with the similarities now and again the next 5 to 10 years, your guess is going to be as good as mine on this front end, all of the listeners here. But I think there are some notable similarities, at least in terms of how we think about it and how I think about it. And there are some really key differences. Maybe starting with the similarities again, first you've had a 20-plus percent decline in real estate values, peaked a trough that's actually only happened three times in almost the past 50 years. The SNL crisis around 1990, then the GFC in 2008, 2009, and then the 2022 to present period. So it's a very rare occurrence and that's happened again in terms of commercial real estate prices. 

Secondly, bank lending really contracted after the GFC. You saw de-leveraging sales of loans, sales of assets off banks given the pressure not just in commercial real estate but residential real estate. And actually that is a difference I can get into, but you have not seen the pressure around residential prices this time around. And then thirdly, you have seen an increase in risk premium for whether it's commercial real estate as an owner in terms of the spread over risk-free rates or as a lender, which typically is indicative of a good time to enter the market. And we feel like it is a good time to be a new entrant in terms of real estate debt in particular. So a couple key similarities: prices declining bank activity and the increased risk premium, which typically is a sign of a good time to enter the market.

Shifting maybe to key differences, and I think there are really some significant ones. First post the GFC, you had a period of near 15 years of quantitative easing, artificially low, arguably no, interest rates and that really supported real estate prices and provided a lot of stability to the market. It feels like that certainly currently we can debate if their high interest rates are normal, I would argue they're more normal interest rates, both real interest rates around 2% and then what inflation expectations are in terms of nominal interest rates. So very different versus the QE period. Secondly, another key difference, the other two real estate downturns I mentioned around 1990 and the GFC that was driven in large part by changes in demand and much less demand at the property level and the top line level at the asset. You actually haven't seen that this downturn and this price decline has really been driven by multiple or by cap rates.

Expanding property NOIs or net operating income is actually up 8% to 10% over the last three years as a whole. So that's very uncommon in real estate to see prices down, but cashflow at the property level up and broadly indicative of the economic strength that we have had in the United States in particular. And then lastly I'd mention inflation. Inflation in some of the uncertainty around what inflation looks like going forward, coming out of the GFC, there was still globalization. You had a younger China for example, the world was in a different place in terms of the macro that was happening. It feels like you're seeing more onshoring, the world's in a different place demographically, and there's clearly more discussion around economic nationalism or protectionism that could impact both the property level demand as well as how those properties are valued from a cashflow perspective.

Stewart: Yeah, that's super helpful. I've got some questions that expand on a couple of things that you touched on just now. And one is the interest rate environment. As you mentioned that interest rate environment was exceptionally low for an extended period of time and you sort of indicated that you viewed that period as an aberration, but I want to get clarity on that. It seems like we are now entering a sustained environment of higher rates and a lot of folks have said that the exceptionally low rates for long periods of time was not particularly helpful. I don't think anybody wants to go back there. Talk about what you think the rate environment was, the GFC in aberration and how do you see the rate market from here?

David: And again, clearly predicting interest rates is not my specialty, but...

Stewart: Nobody, we've had 280 some odd podcasts and we've had a grand total of zero folks wanting to forecast interest rates. So you're in good company.

David: That's right, that's right. I'll take a swing with the best of them here. I think in interest rates, if you look over a very long period of time, 50 or even 100 years, and certainly let's go with the 50 year period, you saw gradually declining inflation and declining real interest rates. I think the period of 2009/2010 to 2021 was really unique because coming out of the GFC, you had QE to varying degrees with the Fed purchasing treasuries and you had real interest rates that weren't zero and at times negative, but when you went in period, that is not normal to state the obvious there. And I think we're now reentering a more normal environment with different demographics in terms of the rate of growth in the country, how the country's aging, what is globalization these days or de-globalization. So I think there's a lot of factors here at play, but in our minds where we are now call it 2% real interest rates and two to 2.5% inflation expectations seems normal.

I think that should be the base case. There's obviously a lot of variability around what the outcomes could look like, but in our minds, stability is going to be important and providing confidence to investors both on the debt and equity side in terms of real estate. So, we would argue we're in a normal for longer period and the distribution around what could happen is significant. But at the same time, I think this is the environment investors should expect going forward, certainly for the next handful of years and arguably the next five to 10 years. Maybe that's a very long-winded way of me saying, Stewart, the playbook that folks utilized during the post GFC period, we think that should be thrown out in many ways. I'm not sure we're going back to that environment. I think you're going to have higher rates, maybe a little bit less stability or more volatility around those rates and we'll need to live with that uncertainty. But I still think it's a great time to invest. I just think we're not going back to that QE period.

Stewart: Yeah, and I mean I think part of the challenge was the speed at which we went from one environment to the other with a 550 basis point essentially vertical wall, which created a lot of challenges for a lot of assets that are tied to rates in that way that can adjust higher. So you touched on bank versus non-bank CRE lending. There's been a notable shift in real estate financing away from traditional banks toward non-bank lenders. How do you see this trend evolving and will insurers and private credit continue to gain market share from banks? I think the answer to that one's pretty clearly yes. But the kicker question here is you've been in both periods, do you see a difference in underwriting standards, for example, between the two?

David: Yeah, so there's a lot to unpack there. Let me start on the first part of the question if that's all right. So banks round numbers are roughly 50% of a $6 trillion market. So they have, and this is small to mid-size banks, to the global players in the us roughly $3 trillion of commercial mortgage loans. I also think it's important to note here during that QE period that we just talked about, banks doubled their portfolios approximately from 2012 to 2022 going from roughly $1.4 trillion to $2.8 or $2.9 trillion. So banks have been and are a significant part of the market and they've been a bigger part of that market growth during the QE period when the cost of capital was arguably artificially low. So what does that mean? Where are we now? We do think given how banks, and again I mentioned before Stewart, when there is a real estate price decline of 20% or more, and there's only been three of them historically, banks have behaved by contracting their real estate lending anywhere from 13% to 20%.

And it typically is taken, if history is any guide here upwards of a decade for banks to regain their peak portfolios prior to that decline. I think we likely are in a similar period. There certainly could be, there could be upwards of 600 billion if you use those numbers, 20% of the $3 trillion of a market share shift over the next decade or thereabouts. And then we can debate now to the second part of your question, and I'll get into underwriting. Is it insurance? Is it private credit, broadly retail entering the alternative space is a discussion that's certainly out there. The CMBS market where I grew up and spent a lot of time is likely a beneficiary as well. So I think you're going to see changes in terms of how the capital is deployed and where the growth is. I think certainly insurance companies are a significant beneficiary and I think there's a lot to, in terms of the profile of real estate debt and if it makes sense for insurers.

And I think the answer is unquestionably yes. And I think what you're starting to see is can private credit be complimentary in many ways to what insurance companies traditionally have done? And we could talk more about that perhaps. But in terms of the underwriting, the way we think about this is there's a fairly consistent underwriting in the market for real estate, whether you're a bank or an insurance company. Banks do think about their customers at times differently given other activities they're doing with whether it's a developer or an investor for that matter. So there may be slightly different framework, but insurance companies traditionally, it's always dangerous to generalize here, have focused on what I call the core part of the market, lower risk, lower award lending on stabilized assets at low LTVs generally, banks traditionally have done some of that, but they've also done a bit more development in construction finance, especially the regional banks. And they've done stuff slightly higher up the risk curve, more what I would call core plus where there is some level of business plan execution at the asset and improvement at the asset away from the full-scale construction. So can talk more about that, but I think the market underwriting right now is actually in a good spot and I think this is a really good entry point for real estate credit in particular given some of what we talked about on the interest rate and risk premium front.

Stewart: So the next topic is the role of investment managers, right? So insurance companies often partner with third-party investment managers for their real estate portfolios. What role do these managers play and how does that enhance the insurer's real estate investment strategy?

David: Yeah, you're seeing, and this, I think this gives back a little bit to the post Q, what's different or what's the same post the GFC, but you're seeing a bit of consolidation now in the investment manager industry where you're seeing the importance of scale, geographic scope, being able to look across asset classes across the capital structure. And that trend is out there and certainly I believe it will continue and that's important to insurance companies where you want a manager generally that can be complimentary to what you do. So a lot of insurers have the scale and the size to do direct commercial mortgage lending for example. It's been a core piece of what insurers have done for as long as I've been in the market and a lot longer. So then I think the question is, well, what's complimentary to that? Are you talking to different borrowers?

Are you in different markets? Are you in different asset classes? Is there a level of expertise that we don't have in house that we're able to efficiently outsource that is truly complimentary to our portfolio from a mitigating risk mitigating diversification perspective? And do you have that ability to scale? And then lastly, but I think importantly, maybe this should be the first point is: Is there the right risk management if you're going to work with what's viewed as a complimentary manager? So I don't think it's about duplication. I think it's about where could there be a compliment to what we do and does outsourcing make sense? And then if that judgment has been made, then you figure out what's the right place to do with who should go with.

Stewart: That's super helpful. So let's move over to capital efficiency and insurance portfolios because capital treatment with the insurance companies is always a consideration. Can you explain the capital treatment differences between holding commercial mortgage loans directly versus through a fund and how does that compare to holding investment grade corporates as an example? And I believe that the NAIC has just made it easier for insurers to own this asset class, so this is particularly timely I think.

David: Yeah, so having some visibility from my seat in terms of how insurers allocate capital and how they think about risk-based capital charges. Commercial mortgage loans, CM1, CM2 in particular, so the highest quality end of the commercial mortgage loan spectrum are very capital-efficient. So if we take CM two for a second, the risk-based capital charge there is roughly just under 2%. It's 1.75%, I believe, at the loan level. And you referenced how does that compare to corporates and corporate bonds? If you're comparing that to on the lower end of the spectrum, a BBB or BBB- investment grade corporate, you're in that 1.5% to I think roughly 2.25% range. So CM two commercial mortgages are on par with BBB or BBB- investment grade corporates. The flexibility I think you alluded to before is if you're an insurance company that's doing direct CM two loans, you have that 1.75% capital charge that's assigned.

If you are an insurance company that's contemplating a fund, a complimentary fund versus what's done on balance sheet is. So again, different segment of the market, different borrowers, different geography. The way that the capital treatment works there is insurers have the ability to look through to the underlying mortgages in that fund. So if it's a fund that's predominantly doing CM2 mortgages, that fund will be treated like a CM2 from a capital charge perspective. So there is what we call a look-through treatment and it is a very simple judgment as I just mentioned, is the fund predominantly mortgages of a certain type, CM1, CM2? If so, the fund benefits from that treatment. So it makes it very simple as opposed to treating funds differently than the mortgage itself. You treat the funds like the mortgages that they own and invest in.

Stewart: You have certainly delivered on the title of the podcast, which is CRE Debt Insights, Trends, and Capital Efficiency. I've got a couple of more for you on the way out the door that are more general. One's fun one's instructive for others.

David: You start with the fun one or do you start with the instructive one?

Stewart: No, I start with the instructive one. So I want to end with fun, but this one's fun too. When you're adding new members to the HPS team, what characteristics do you look for? Not necessarily major or skillset or school, but what characteristics do you look for when you're interviewing somebody to be on your team?

David: Yeah, there's two that really have been critical in many of the jobs that I've had, including importantly HPS. But there's two things that we really look at. One is broadly what I'd call emotional quotient and ability to anticipate. So does him or her have the ability to read the room, read the situation beyond maybe what's exactly written or what's exactly said and understand what's the next step in a project or a decision for that matter, whatever we're trying to achieve. So having a high emotional quotient, being able to anticipate and perceive basically where we're going and what's appropriate is really critical. And that's the leadership quality that I think is underappreciated, especially in a world where things have gotten more digital and done over text done online, but making sure there is that high EQ really, really critical. The other thing that I think is really necessary, and it's somewhat related, but being able to work very, very strongly in small teams is critical for us as an investment manager. So someone that has the ability to work across, whether it's regions, across product types or within a two or three person investment team, again, often I think can be overlooked in the environment we are where more stuff is done on Zoom these days, but being in the office, being able to work on that team and work efficiently in that small team is the second thing I'd really call out.

Stewart: Wow, that's super helpful. And the last one is purely fun. So lunch or dinner you get to invite three people alive or dead. Who would you most like to have lunch or dinner with? Alive or dead? You don't have to be all three. You can go one, two, or three. I just want to give you all the rules here just so you've got some optionality.

David: I've got two and I was listening to a bunch of your podcasts before. What I like about this question is you go lunch or dinner, I'm not sure if my dinner guest, it could be different than the lunch guest. 

Stewart: Yeah, I think that's right because if you're going to have a bottle of wine or whatever, maybe that's dinner, although maybe it's lunch, who knows?

David: I'm going to go dinner. My lunches tend to be short and often at my desk for whatever reason. So I've been a fan of kind of the Civil War era and I wouldn't call myself a buff, but to me it would be remarkable to have dinner with US Grant and Lincoln at the same time.

Stewart: Wow.

David: And I mentioned that just because we're in an area, people think the country is divided today. Could you imagine what was happening in the 1860s? And Lincoln obviously went through a lot of generals before him and Grant really established a rapport and a working relationship. And again, certainly, there were shortcomings there, arguably in both of them, but just understanding what that relationship was like and it was very effective to me, that would be a fascinating dinner to have.

Stewart: Wow, that's a very interesting pick. Very cool. I've really enjoyed having you on. It's been extremely informative. Thanks so much for taking the time and sharing your knowledge and experience in this asset class.

David: Stewart, thanks so much. Really appreciate having you on. Hope to see you again soon.

Stewart: Good deal. That sounds great. We've been joined by David Lehman, Managing Director, Head of Real Estate Strategies at HPS Investment Partners. Thank you so much for listening. We appreciate  it, we've got a really solid community of podcast listeners and want to say thank you so much for that. Please rate us, like us, and review us on Apple, Spotify, Amazon, or wherever you listen to your favorite shows. We are the home of the world's Smartest Money and this has been the insuranceAUM.com podcast.

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