Stewart: Thank you for listening to the Insurance AUM Journal podcast. My name is Stewart Foley. I'm your host and today's topic is private real estate debt. And fortunately for us, we're joined by an expert in the field, Charlie Rose, managing director and portfolio manager of real estate at Invesco. Charlie, thanks for being on.
Charlie: Thank you, Stewart. It's a sincere pleasure.
Stewart: It is great to meet you. This is the interesting asset class that has become a bigger deal for insurance companies. Everybody's looking for sources of investment income. This particular asset class is certainly front and center as where funds are flowing. And I get to ask the question that hopefully is a good starting point. I want to be a private real estate debt investor, how does a private real estate debt transaction come to be? What makes it private? And what is it that I'm financing?
Charlie: Sure. Thanks, Stewart. I'll start with what makes it private? We are talking about non-securitized real estate loans and we are talking specifically today about commercial real estate loans. We're not talking about pools of loans made on single family residential homes made to owners. So how does one of these loans come to be? The loans are quite simply a secured loan, secured by a commercial real asset, as well as certain appurtenances. The loans are made to commercial real estate owners. They're the borrowers. The borrowers are typically SPEs and the commercial real estate industry remains a relationship business with a great deal of information asymmetry.
You generally have relationship lender who has a direct connection, perhaps through a broker with a borrower originating these loans. In our experience about half of our business, a broker is paid and in about half of the business we are making direct originations to existing relationships of ours. The loans can be fixed rate loans. Those are loans that are going to look more generally like traditional CMLs with longer durations, five to 10 plus years in certain instances or they can be floating rate instruments, which are generally shorter term loans that are viewed as more transitional with greater prepayment flexibility. Our focus at Invesco Real Estate as with the majority of debt funds is primarily on the floating rate, more transitional space, which is less heavily trafficked historically by insurance investors.
Stewart: That's really helpful. Financing real estate projects has been kind of straight down the middle of the fairway for the insurance industry for a long time. How has private real estate debt evolved as an asset class?
Charlie: Yeah. First I would take a step back broadly speaking over the past 15 years and it is relevant again, as we're in an environment of very tight yields across the investible universe and inflation broadly in the economy. But we have seen a permanent shift in underwriting standards and leverage levels after the GFC that has been very sticky. In the run up to the global financial crisis and even going back into the 1980s and before, leverage levels were substantially higher in the commercial real estate industry. And we did see going into that 2007, 2008 period, a material weakening of underwriting standards. The reforms coming out of the GFC have successfully resulted in greater discipline among commercial real estate lenders in the intervening years. And we are not seeing wholesale loosening of credit standards.
The second evolution that we have observed is the emergence of private real estate debt funds. These are funds that are typically managed by investment managers, whether they're large global investment managers, like an Invesco or a Blackstone or more specialized investors who may be managing a single fund. And that has been driven by a couple of factors. First is investor demand. Investors historically have accessed real estate in one of a couple of fashions. We hit on CMLs already, of course also accessing real estate through equity investments but real estate debt has now become a staple in institutional portfolios that is recognized as being attractive for its stable income profile, downside protection and diversification benefits in a portfolio with relatively low correlations to other asset classes.
So, investor demand has driven the emergence of real estate debt funds as has an increased demand from borrowers who have widely recognized real estate debt funds as being more nimble, more responsive and more flexible. And the result of that has been: as the private real estate debt market has grown, real estate debt funds have also gained incremental market share, going from about 10% of the market pre-COVID to circa for 15% today.
Stewart: And where is that market share coming from? Who's losing that share?
Charlie: Most notably the banks and most recently the agencies have been losing market share. Prior to that, coming out of the GFC, the debt funds were able to gain significant market share from securitized lenders or CMBS lenders.
Stewart: And so insurance companies, as we mentioned a minute ago, are users of this, there's property and casually carriers who have a very different looking portfolio than life carriers. How are you seeing insurance general accounts using real estate debt in their portfolios today as this market has shifted?
Charlie: Yeah. Most notably in today's low interest rate environment, insurers find it as challenging as ever to find opportunities to enhance portfolio yield. So real estate debt represents one compelling opportunity to do just that. Considering US investment grade corporate bonds spreads versus swaps are (you know probably better than I do), circa 110 basis points. Private real estate debt can offer as high as 500 to 600+ basis points with the moderate use of leverage, which the majority of real estate debt funds will use some leverage. So even a small allocation to this asset class can materially improve an insurer's portfolio yield.
Stewart: So, real estate pricing is getting a lot of attention as cap rates have tightened. One thing I'd like to talk about is relating cap rates to real estate pricing. I think it's a discounted cash flow mechanism but nevertheless for our audience, an important thing to note. Prices have gone up as cap rates have tightened and real estate remains attractive versus other asset classes. We know that spreads are considerably higher than investment grade fixed income. What are you seeing broadly in terms of investor demand and opportunities for real estate in the US? And then what about other regions?
Charlie: The United States remains the most investible commercial real estate market globally and, by a decent margin, the most liquid commercial real estate market globally. In the aggregate, we have seen a very strong rebound in transaction volumes within the commercial real estate industry. And I'm speaking about equity transactions at this time coming out of the lockdowns. Now that has been driven, not surprisingly, largely by industrial residential broadly writ, including traditional multifamily, as well as more specialized commercial residential sectors, such as the single family for rent sector, seniors housing and student housing. And then some of the specialty sectors. We are seeing still very muted transaction volumes in the office sector, most notably.
But generally speaking, in an environment where investors have seen equity portfolios see very significant gains, we are noting that a denominator effect is playing to the benefit of the commercial real estate industry. Investors are increasing allocations to commercial real estate, just in order to balance their portfolios. And that fundamentally creates a substantial opportunity for private real estate debt investors. Our largest single source of new loan opportunities are acquisitions of properties. We finance buyers who are our borrowers when they acquire a property. So the greater the transaction volume we're seeing in the equity markets, the more opportunity we will see as a private real estate debt investor. Now in a inflationary environment, a high velocity investing environment and a low cap rate environment, one must be very attuned to risk. And so we are focused on asset classes where our borrowers have the ability to reset rents with inflation more quickly. These are generally shorter dated leases, such as you see in residential, that we think will offset those low cap rates on a going in basis throughout the whole period of our loans.
Stewart: You referenced risks and that's kind of the next set of questions I wanted to pose to you. Insurers are always looking at the risk side of the portfolio. They get paid to take risk on both sides of the balance sheet. In your mind, what is the biggest risk in the private real estate debt market? And how are you managing it?
Charlie: The biggest risks in the private real estate debt market are largely consistent throughout any point in the cycle. We're looking at counterparty risk with our borrowers. We're looking at term default risk to the extent that we are unable to be refinanced out of our loans. And we're looking at interim default risk as a result of volatile cash flows at the assets. So those are the largest risks in any real estate debt transaction. In this environment, we are perhaps most focused on more aggressive underwriting that is necessary to justify some of the low cap rates being paid. That is specifically underwriting by our borrowers of fairly substantial rent growth over the next couple of years. And then that gets paired with the potential for a rising rate environment, which could squeeze coverage levels and impair the financiability or mortgagability upon a maturity of the loan. So, we are focused on mitigating that by underwriting asset classes that we think will be material beneficiaries of an inflationary environment.
Stewart: No way can you do a podcast without bringing up COVID, particularly in real estate. The COVID situation is fluid and it is impacting real estate differently depending upon the segment. What is your view of the various real estate segments? And is there anything – what sets you apart from the industry's consensus view?
Charlie: Certainly. We are seeing a reordering of our economy in certain sectors that is creating substantial opportunity in the commercial real estate market. The logistics story, the warehouse industrial story is well understood I think by the broad public. It is our belief that we are going to continue to see very strong rent growth demand and appreciation in the industrial sector for the foreseeable future, with residential being shortly behind that as a sector that has performed very well coming out of the COVID environment and should continue to perform very well. Perhaps what is bit contrarian in our view, we are seeing industrial being priced to perfection. So as a private real estate debt investor with substantial equity subordination beneath our loans, we're seeing a more attractive risk/return opportunity generally speaking in other asset classes.
So while we make industrial loans, our primary focus has been the residential sectors, broadly speaking. Default rates historically on residential multifamily residential loans have been lower than other real estate asset classes. We anticipate that that should continue to be true. And then perhaps the other contrarian view that we are taking is the office sector has clearly been the sector that has been most negatively impacted by COVID for the moderate to long term. And our view is: that is a real issue for the broad middle of the office sector but there are office assets which will outperform going forward. These are office assets that provide a particularly compelling place for people to come in and collaborate and so we are lending against those assets selectively.
Stewart: Right now there's a lot of speculation in the press around the current monetary environment, the current fiscal environment and all of it sort of culminates into inflationary pressures, potential Fed responses. How do you see this? And you touched on it with regard to residential rent rates but how do you see that impacting the US real estate market?
Charlie: First and foremost as a real estate debt investor, our first objective is to never lose money, to minimize defaults to effectively zero or as close as we can get to that and not lose money. So we must underwrite our loans agnostic to future interest rate and inflationary environments in order to achieve those goals. We simply are not interest rate or economic prognosticators and we do don't think that is what our investors are hiring us to do, to make speculative bets around rates. So, it is clear to all of us that we're an inflationary environment.
The forward curve and the dot plot would indicate that we are going to a higher rate environment. We structure our loans as floating rate loans with floors. So we're insulating our returns in an event where rates do not move. We're offering our investors upside to the extent that rates do move on a real time basis. And we are underwriting the underlying collateral for a variety of different rent growth and expense growth scenarios, such that we believe our portfolio should perform well. What we are very keenly focused on avoiding is long dated leases with very little ability to mark rents to market in the moderate term.
Stewart: And last question on risk, do you see the current real estate troubles in China spilling over to the US and elsewhere? What do you think there?
Charlie: Yeah. In short, I'm not the best person to ask about the Chinese real estate market. Our understanding is that the Chinese market is fairly... the broader global economy and the broader global real estate market are fairly well insulated from the problems in the Chinese real estate market. Our borrowers are typically global investment managers who are very well capitalized. We're not lending to the major Chinese developers who have been in the press or in fact, any of the major Chinese developers. And so we don't see substantial ripple effects in our portfolio. And I would anticipate the effects in the US would be fairly isolated to a handful of projects that those investors specifically have invested in and they may have some liquidity issues supporting those assets going forward.
Stewart: Let's just shift over to sectors. If we're talking about logistics and residential, you mentioned interest in those two sectors, are we still seeing robust investor interest there? While you have disavowed yourself of being a prognosticator, I'll ask how you see the future in those two as well.
Charlie: We talk about this constantly. The industrial market has been so good for now a fairly long period of time. You have to constantly ask yourself how long can things be as good as they are in that sector? And we do believe that the secular changes in the ways that people produce and buy products will provide a substantial tailwind to the industrial sector for a fairly significant period of time. On the residential sector, our country has been under producing housing for an extended period, now, so the supply demand picture for residential was good going into the pandemic. With supply chain disruptions, wage inflation and materials inflation all driving higher construction costs, we currently see an acceleration to that balance between demand and supply with demand outstripping supply in the residential sector broadly writ.
Outside of those two sectors, we are very focused on the specialty sectors, which have benefited from this period. Most notably, life science is a very specialized product type and one that we have some fairly substantial experience and internal expertise on. We think that the demand tailwinds for life science are very similar to those for the industrial sector, albeit it is a much smaller sector, so more prone to overdevelopment going forward.
Stewart: So, within certain sectors, we've talked about logistics and residential industrial cap rates tightening but retail has gone the other way. When you look at malls, you look at retail, you look at all the reasons the logistics areas are doing so well is why retail is having such a tough go. How do you see that progressing from here? Do you see anything that's over corrected? Is there value there? Can you talk a little bit about retail?
Charlie: Yes. Retail is actually a fairly interesting asset class at this moment in time. We have seen, I believe, more clarity in the future of retail over the last 12 months than we had for several years or even a decade prior to that period. So we are largely very negative on enclosed malls but we have seen certain retailers be able to effectively pivot their strategies to the modern environment of online shopping. We're always focused on avoiding binary risk as a private debt investor and we actually have no retail in our portfolio today but we think retail and when we talk about retail, we're talking about specific types of retail, but we think that better retail has become more underwriteable today than it was 24 months ago. So I wouldn't be surprised if we actually wrote our first retail loan in many years at some point over the next 12 months.
Stewart: Charlie, I'm convinced. I'm a CIO and I'm looking at this asset class, a CIO of an insurance company and I look out and I say, "I want to make an initial allocation." What should I be looking for in a private real estate debt manager? And while you're at it, can you talk a little bit about how that's going to change my risk profile, particularly from an RBC perspective?
Charlie: Sure. First and foremost, real estate debt, as we've mentioned, should be a bedrock, sleep-well-at-night portion of a portfolio. Every conversation has to focus on the risk profile of the opportunity set. So you should be looking at the underlying risk profile of the portfolio but you should also be looking very keenly at how real estate debt fund managers manage their balance sheet. The majority of debt funds use some form of leverage, whether that is by originating mezzanine loans or retaining mezzanine loans, which have inherent leverage to them or by originating whole loans and applying some form of leverage to those loans. You should be looking at risk management of that balance sheet, what exposure to margin call risk, duration risk of their underlying liabilities, interest rate risk is on the balance sheet.
Second, focusing in on the risk profile of the underlying portfolio, we would typically see the majority of the underlying loans in a debt fund portfolio qualify for CM2 or CM3 treatment. Accordingly, this RBC treatment should result in an attractive premium on a risk adjusted basis for real estate debt fund investments as part of an insurer's portfolio.
Lastly, I would focus on the way in which the manager accesses opportunity and how they are approaching underwriting each individual asset. Our view is taking a real-estate-first approach and lending to relationship borrowers who are well known to us and who have long track records of doing the right thing during difficult periods of time. And so our belief is that through our broader exposure to the commercial real estate markets, we're better able to access the best risk adjusted opportunities and underwrite the inherent risks associated with each of the investments.
Stewart: Okay. That's very helpful. My follow up to that is: I've got liabilities on the other side of my balance sheet. I'm certainly not buying this asset class for liquidity, but it is a concern of mine. Can you talk a little bit about the liquidity profile of a private real estate debt portfolio?
Charlie: There are three primary ways in which an insurer could access private real estate debt. 1) would be directly investing in or acquiring commercial mortgage loans, CMLs. 2) would be investing in an open ended fund, a perpetual life vehicle. And the third would be investing in a closed end fund. The best liquidity profile for an insurer is offered by investing in a well capitalized, well performing, risk averse open ended fund, which offers quarterly liquidity. These open ended funds are designed and structured similar to equity open end funds, which have been around for several decades now but we actually believe offer better liquidity than equity open ended funds as a result of the constant churn in these portfolios, given the shorter duration of the underlying investments, as well as the strong income profile of those underlying investments.
Stewart: Thank you. And my last question, well, I've got one more. I got a surprise question for you at the end, but my last private real estate question is what are you excited about? In this space, this is what you live and you breathe every day, what are you most excited about looking forward?
Charlie: Honestly, I am most excited about my team and the growth of our business. I mentioned it before, real estate is a relationship business at the end of the day and we have a great team. That's what gets me coming into the office on a daily basis. In terms of broader trends in the industry, I think there are really interesting things happening in Europe and now spilling over to the US in terms of ESG investing and we have been pushing hard to incorporate new approaches to understanding climate resiliency and risk in our portfolios and helping our investors green their portfolios. That's something that personally is important for me as the father of young children and I think an exciting opportunity for this industry to evolve in the coming years.
Stewart: Thank you. I really appreciate, I always tell people, I learn the most on every podcast because I get to listen to experts talk about what's in their wheelhouse and it is always terrific. So I really thank you for that. And I want to leave you with one question. I want to take you back to a day that I know you remember, which is your graduation from your undergraduate institution. Now, regardless of what may have taken place the evening before, you are bright eyed and bushy tailed in your cap and gown, your last name starts with R so it's been a little bit of a wait, but there you are on the steps. They read your name. The crowd goes crazy. You walk across the stage, get a quick handshake, a photo op, they hand your diploma and down the stairs you go. At the bottom of the stairs you run in to Charlie Rose today. What do you tell your 21 year old self?
Charlie: Slow down in your twenties and just enjoy life.
Stewart: I love it.
Charlie: There's plenty of time to grow up, take on responsibilities, make money. Just be present and enjoy every single moment.
Stewart: That's great advice. I really appreciate you being on. Thanks for taking the time, Charlie.
Charlie: Thank you, Stewart. The pleasure was mine.
Stewart: And thank you. Thank you for listening. If you have ideas for a podcast, please email us at podcast@insuranceaum.com. My name is Stewart Foley and this is the Insurance AUM Journal podcast.
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