Stewart: Insurance companies need yield. That is not a news flash. Private real estate debt offers a good alternative to significant yield enhancement. Here to talk about both private and public real estate debt is Kirloes Gerges, Managing Director, Portfolio Manager, Principal Real Estate Debt and Scott Carson, Director, Portfolio Manager, Principal Real Estate Investors. Welcome guys. Thanks for being on the show.
Kirloes: Thanks for having us, Stewart.
Scott: Glad to be here.
Stewart: It's a good topic. Lots to talk about in real estate. So, if I'm an insurance CIO, particularly if I'm in a mid-size company, how can I get exposure to real estate? What are my options?
Scott: I'm a portfolio manager on our Commercial Mortgage Backed Securities (CMBS) team and the reason I wanted to jump in here is CMBS is a really efficient way to gain access to commercial mortgage debt since CMBS represents the public real estate debt quadrant within commercial real estate. At Principal Real Estate Investors, we operate across all four quadrants, public, private, debt, and equity, but being in the public debt space, it's a very efficient means for insurance companies to access diversified exposure to commercial real estate loans, via bond structures. These bonds that we purchase, they're collateralized by pools of fixed rate commercial mortgages and those pools are then tranched into different classes that are rated by the rating agencies, and the National Association of Insurance Commissioners (NAIC) rates these as well from a capital efficiency perspective. I keep using the words diversification, efficiency; CMBS is a really easy way for insurance company investors to access the market in a manner that doesn't have to be built loan by loan. We can build an exposure efficiently through these publicly traded bond markets.
Stewart: And just for the sake of, there may be folks who aren't steeped in the bond tea as we are, CMBS stands for commercial mortgage backed security. This is a pool of loans. It's a diversified pool. And for the lack of a better term, like a mutual fund, I am buying a diversified portfolio, as opposed to buying individual private real estate loans. There is a difference there. The other thing you mention is the term tranche, which basically means slice. You've got a waterfall structure where some cash flows have priority over others and that's how you get the rating structure that's issued by all the major National Recognized Statistical Ratings Organizations (NRSROs).
Scott: That's right. You got it.
Stewart: I don't know who to address this to but: navigating the current environment and there's been a lot of talk about real estate and all the different forces of the last change with COVID-19 and so on and so forth. Can you talk to me a little bit about the current environment and what you see coming?
Kirloes: Essentially, we're long-term believers in the debt space. We've been investing in debt for over 60 years1, but today represents some interesting opportunities for private real estate debt, and just generally in terms of what's happening in the market. The first time in a long time, we're seeing interest rates rise. We're originating floating rate loans, which should benefit from the continuing rise of rates. However, nothing comes without its challenges. The rising rates will put pressure on the underlying equity. In an environment where cap rates are still very tight, the focus on net operating income (NOI) growth and overall underwriting becomes increasingly more important. An investor has to be very confident in the business plans of the underlying assets and then stock selection will be key.
We're going to continue our strong underwriting culture, navigate the environment and utilize our risk rating models. And there's going to be a lot more scrutiny on rent growth assumptions today where cap rates are still very tight in that 3% to 4% range and debt is set to go to 5.5% to 6%. You have to be very, very confident in the rental growth of the underlying asset. We're going to be disciplined in our debt structuring. We're going to work with borrowers on acquiring things like caps in order to protect the assets from rising rates, ensure that cash flow is good enough to cover debt service. We'll likely start looking for a little more protection within our debt documents.
If value erosion comes to be, our loan to value (LTV) levels provide a comfortable buffer to equity values. If we start seeing that values are getting impacted, we've got a 25%, 30% type of buffer and we don't expect that values are going to decrease that much but we are expecting some pressure. There's going to be a focus on inflation resistant assets. Where Scott was talking about how there are pools of loans and you can't really control the underlying pools here in the private debt space, we can take those kind of sector approaches. There's a focus on residential. Home ownership right now is less affordable than it has been and now you're watching your 30-year mortgage rates rise, where everyone was super excited about locking in their 2.75% last year, you're at 5.5% to 6%.
We're focused on the residential sectors, which have been pretty resilient. Multifamily leases roll every year, can be a good inflation hedge. If the market signals recession, student housing has been pretty resilient in recessionary markets. We like the trend stories. Self-storage and data centers, life sciences, medical offices, even industrial, even though pricing has been very tight in industrial. And then lease structures for the more traditional office and retail assets will need to be strong with the contractual rate bumps in order to combat the inflation. In summary, looking at underwriting, loan structuring, sector exposure, and stock selection is what we're going to continue to do to help navigate the current environment, but it's going to be a very interesting market ahead.
Stewart: You mentioned you threw out 2.75% as an example of rates. I am proud to say that I bottom ticked this market and that is exactly my rate, 2.75%, 30-year fixed. I said to my mortgage guy, I go, "Listen, I'm a finance guy. What's the maximum I can possibly borrow?" Because I thought, man, this is a magical environment. But you're right, rates have come up a lot. Inflation, everybody's talking about inflation. When you look at, and you know, you're an insurance company, you're at Principal. Inflation is a double-edged sword for insurance companies because it drives the price of the liability up and they own a bunch of long assets and a bunch of fixed rates assets and it erodes the value. This is the same math just upside down.
How have you seen, or can you talk about real estate as an inflation hedge? Which it's difficult to find a good inflation hedge as you know, particularly one that produces income. Can you talk about how you think real estate does in an inflationary environment?
Kirloes: Sure. At the highest levels, and I alluded to it a little bit here, you've got the ability to raise rents. In some instances it's stronger than others in terms of the sectors. That's why the sector selection, in my opinion, becomes a little bit more important. You want to avoid sectors where you can't tie the inflation to it for whatever reason. I'm going to take an approach here that may not be that popular but let's just talk about office for a second. Right now, going into this market, there's still a lot of pressure about getting people back to the office and their office assets are struggling. Could office be considered an inflation hedge if you can't bump rents, or you can't get people into the office, or you can't rent those assets out generally? It's become more of a bifurcated market in my opinion.
Looking at things like residential, where you can increase those rents, where there has been strong occupancy and lease roles every year, I think that becomes a pretty good inflation hedge when you can raise rents in this environment and combat some of that price adjustment, some of that inflation. Again, from a lender's perspective, the underlying assets do act as an inflation hedge but when you're in a rising rate environment, that may help an insurance company who could take on higher yields and could do a little bit more floating rate debt. When we're talking about asset liability management (ALM) and trying to cover duration, trying to cover the liabilities from that perspective, you've got this structure where the rates are rising, we're trying to be as protective as possible at the underlying levels and the underlying assets are providing inflation hedges. That's why I use the term ‘inflation resistant sectors,’ is what we're really trying to focus on today. Scott, I don't know if you want to add anything there.
Scott: Yeah. No, I think all those points are key. And one thing we're looking at, given we're in the debt part of the capital stack, the average loan to value that we're seeing on CMBS issuances today are 55%, inside of 60% loan to value. Really, not only is the loan to value important but also the debt service coverage ratio. These properties are generating enough income today to cover the debt service burden by over two times so well north of two times debt service coverage ratios. Clearly, we like properties that have some sort of durability to inflation. They can do that by passing expenses onto the tenants. They can increase rents like Kirloes mentioned.
But, overall we have a very healthy equity cushion based on our going in loan to value position in these deals. Also, we have a very healthy NOI cushion in terms of the ability of these properties to be able to actually see NOIs come down and still be able to cover debt service. Those are some of the protections in the bond space, on the public debt side. We obviously cannot control the path of interest rates, but given where we are in the capital stack, we are well insulated from some of those potential impacts of inflation when it comes to the underlying value of the assets.
The last thing I'd say is I feel a lot better about yields today than I did at the start of the year. Seeing the 10-year breach 3%. Today, we've seen another big selloff in the 10-year Treasury rate. That feels a lot better than when we were coming into the year at 1.5%, I think that's very notable, and as we see these absolute yield levels rise, we're certainly seeing more interest in the public real estate debt space as an alternative yield provider.
Stewart: Yeah. It's interesting, you talked about forecasting interest rates and it's clearly a fool's errand. Twelve months ago, if you said, "Hey, the 10-year's going to breach 3% twelve months from today," I don't think you'd have gotten a lot of takers on that bet. And yet, here we are. And, I think that it remains to be seen if the flow to private assets slows any out of the insurance sector. You are from an insurance company, and you work with a bunch of insurance companies, what conversations are you having? And, I want to talk about servicing accounts as well but what kind of conversations are you having with your insurance clients in particular on some of these issues?
Scott: Yeah, so for us, and Kirloes mentioned this earlier, as the cycle has extended and we've gotten to this point where GDP was negative for the first quarter and we've had this tremendous run up in asset values post COVID-19 because of all the monetary policy, the fiscal support. Now I think it's kind of gut check time where when we're sitting across the table from CIOs, they're asking us about values, they're asking us about potential cap rate pressures, they're asking us, well, we've seen this stress and we've seen this big recovery, but what happens next?
Stewart: When you say cap rate pressure, can you just define that and explain what exactly what you mean there, what that risk actually is?
Scott: Sure, sure. If you think about a cap rate just simply as the discount rate used to value a commercial property on the equity side of things, any discount rate is going to be a function of the risk-free rate or the Treasury yield plus some sort of spread. And so, as we've seen Treasury rates, like I mentioned before, roughly rise from 1.5% to 3%, we haven't really seen cap rates move that much, if at all.
Stewart: So, the spread is compressing.
Scott: Correct.
Kirloes: The treasuries have come up. The spread between treasuries and cap rates is pretty low. I think on the back end, underwriting cap rates just kind of generally now in terms of cash flow modeling and things of that nature, I think you might see a little bit more expansion. We’re sitting here waiting for cap rate adjustment, we’re just not seeing it.
Scott: But, what I think is really interesting about this is there is a pretty stark bifurcation between what we're seeing in the public markets versus what we're seeing in the private markets. That's just the nature of how these markets operate. Living in the public world, we've seen our credit spreads widen quite substantially. We've seen spreads from AAA, down through single A, widen around 50 to 100 basis points this year. You've seen that in addition to Treasury yields going up. It's different, and I think that's one thing that points to public and private being able to complement each other in the real estate debt space because in the public markets we are able to take advantage of more of a leading view on what the market is pricing in, in terms of forward looking risk.
Whereas on the private side, there's been a lot of capital raised, and that large slug of dry powder out there is, to this point, has really kept cap rates low. And, there are a lot of other factors at playing terms of capital that is looking for very high quality assets, looking for particular sectors that have better long-term secular themes. But, the public markets do offer the ability for insurance companies to take advantage of what we see as widening, that may be in excess of what the private markets are pricing in from a fundamental standpoint.
Stewart: You have a very interesting vantage point of being in both markets, private and public, and being able to compare the relative value back and forth. And, the other thing, too, is Scott, a 50 to 100 basis point widening of spread or additional spread, when rates are 2% is a whole lot different than when rates are 10%. That's a substantial increase in percentage terms. It's substantially wider as well. Now, insurance companies obviously have a variety of liability structures. Some have very short tail lines, property and casualty carriers, and life carriers need duration. Kirloes has mentioned duration a moment ago. Can you talk about your respective markets in terms of a duration profile that you go, “Hey, this asset class offers yield, great; but I got to be concerned about my duration exposure as well.” Can you talk a little bit about that for each the public and the private side?
Kirloes: Sure. Maybe I'll start, Scott, and then you can jump in. But for insurance company investors, to your point, some insurance companies such as life companies, they require longer duration instruments while some non-life companies will require shorter duration products. The asset liability management is different for each one of these insurance companies. On the private real estate debt side, we've got products that fit the entire gamut. As you may know, we've got short term notes that could be 2 to 5 years, that's with all extensions and that could be either done on a high yield basis, floaters, et cetera. And then you've got your core mortgages, which are kind of longer duration and could do 7- to 10-year plus type notes.
Our duration amount could fit any kind of bucket whether it's a life company or a non-life company in terms of what they're looking for. We can run the entire gamut. We can essentially structure this any way that life insurance companies or insurance companies in general want. And that's how we've been working with insurance companies, just to understand what they need from an ALM perspective and how we can service that need.
Scott: On the public side, it's similar in that we're very flexible. The CMBS market has evolved, and it does offer a lot more opportunities today than it has historically, from a duration management perspective. The sector that most life insurance companies are familiar with would be conduit CMBS. These pools are comprised of 10-year loans and so, those bonds have about an eight-year duration when they're issued. That's at new issue, but being in the public markets, we are able to buy bonds in the secondary market. As bonds season down, the duration gets shorter. That's one way for us to target different points on the duration curve within that space. In addition, there's a particular bond class called the “interest only” strip that we like a lot. We think it offers a lot of value, that class. Yields may be 5.5% to 6% today, they carry a AAA rating and at issuance, and IO strips have about a four-year duration roughly.
And then finally, we haven't talked about it yet, but the single asset, single borrower (SASB) space, sometimes you'll hear people refer to it just as SASB. That predominantly is a floating rate market, or at least it has been recently. Instead of being a diversified pool of loans securing these bonds, in the SASB market, you'll either have one big trophy property, think a large office building in New York, for example. That would be the sole collateral securing the loan that the pool is comprised of. Or it could be, you could think of a large industrial portfolio of assets that are all owned by the same borrower. And so, the borrower is able to finance that large portfolio through one financing in the SASB market, but that's floating rate.
Point being there, there's a lot of flexibility in CMBS. Conduit bonds have an eight-year fixed rate duration with good ALM characteristics, because these fixed rate loans do have very strong prepayment protection, in that space. And then you flip over to the single asset single borrower floating rate, more optionality, but you do have the benefit of the floating rate structure there for insurers that do have a need for that type of asset stream.
Stewart: CMBS versus regular MBS, residential MBS. As interest rates move up and residential mortgages are infinitely refinanceable. As interest rates fall, people refi their home but that pays off the mortgage securities, which shortens that duration. And by the same token, when you've seen this amount of increase in rates, that is going to extend duration of single family residential mortgages, it has to. I've got a low rate and there's no way I'm refi-ing. My last payment will be 29 years from now.
At the end of the day, that's not the case for CMBS. There's a lot better convexity profile of CMBS. Convexity measures refinance risk. The higher the number, the better the call protection or the refinance protection. The lower the number, the higher the more it's going to get called. The convexity profile on CMBS versus RMBS, I think it matters. When rates rise, have I gone from a two duration out to a six duration because of interest rates that I can't control? That's different in commercial mortgages, right?
Scott: It is. It is. On the fixed rate side, like I mentioned, these loans all have very strong prepayment protection built in. One pre-payment mechanism is through defeasance; if a borrower wants to prepay a loan, they have to replace that cash flow stream with treasuries. If that happens, great, because now my collateral isn't a mortgage, now, my collateral is U.S. treasuries. My credit quality has gone up, but I still get the same stream of cash flows that I was expecting coming off of that loan. Or it could be done through yield maintenance, which would just essentially be a prepayment calculation that makes the trust whole for the lost income relative to the current level of interest rates. That is something that insurance companies are drawn to, having that certainty or more stable profile around the expected duration going in and then the realized duration of that investment over time.
Stewart: That's a really important point because rates have been pretty volatile and it's definitely impacting durations on refinanceable securities. There's no doubt about it. Insurance companies, if I'm a CIO and I'm looking around and I don't have real estate exposure, why should I consider an allocation to commercial real estate? And should I be looking at public, private, both? How should I get in to try and capture the yield advantage?
Kirloes: I think generally if you don't have real estate exposure, go get some. Unbiased opinion. When we talk about things like correlation or diversification, real estate essentially is not correlated to other asset classes. Now, it depends on where you're investing and it depends on what you're comparing it to, but when you're looking at across the asset class space, for example, if you're looking at REITs, they might be more correlated to equities but not directly correlated to equities versus something like private real estate, where you get better correlation benefits. We already talked about the inflation protection that you get from real estate. Those are some of the reasons why you would do it. For private real estate debt, it is a good diversifier within insurance company portfolios and other portfolios. It's not that tightly correlated with other asset classes. It does provide the yield enhancement against other types of securities.
For example, historically the relative value over corporate bonds has been pretty strong in the real estate debt space. Private real estate has been able to provide those higher yields. Specifically in instances when we are using moderate leverage. To our knowledge, it looks like more and more insurance companies are coming into the private real estate debt arena. And to your point earlier about access, I think we've seen some of these insurance companies access to the open-end real estate debt market, which I'm sure you've heard of, and has been evolving over the last several years but they could get access to a loan of private pools that helps them diversify their portfolio, gives them a pretty strong income stream, has been pretty resilient over time. From my perspective, you get into real estate specifically for those diversification benefits, the non-correlation, the inflation protection. Real estate private debt specifically for the yield enhancement and the strong income component that you get there. And then Scott, if you want to comment on the public debt piece.
Scott: Yeah, yeah. And it's interesting because it's a little bit different. Again, I like this idea of looking at the private and public market and seeing how they complement each other because in the public space, I would look at it more as an alternative asset class exposure versus corporate bonds. And, not only do you have this alternative exposure but there's a very nice spread pickup there. In the upper investment grade space we see 25 to 100 basis points of excess spread for CMBS versus similarly rated, similar duration corporate bonds. And, we know that the world is just kind of chocked full of corporates. When we talk to other CIOs, they're looking for different types of credit exposure. For the reasons that Kirloes mentioned, CMBS is a good option there in terms of providing something different.
And, it's not only just the excess spread but also it's very capital efficient. And I think that might be something that's underappreciated. The vast majority of CMBS conduit bonds rated AAA, AA and even a good number of those that are rated single A, get the best RBC treatment from the NAIC. So, when you look at the excess spread versus corporate bonds and then you take into account the superior capital treatment for some of these CMBS bonds, it really makes the net excess spread story pretty attractive.
The last thing I'll say is when we're talking about an index or a benchmarked world, CMBS is a way to outperform a benchmark. It's only 2% of the ag and the exposure within the ag is about 90% AAA and 40% plus of that is in agency CMBS securities that don't carry as much yield or as much value. And so, being able to take an approach where you're looking at CMBS as a value added sector, can really bring some benefit to a portfolio for an insurance company.
Stewart: Real quick, we've just got a couple questions or so here. How's liquidity?
Scott: Well, I'll start since I'm on the public side. Liquidity ebbs and flows, and it depends on how you define it. Certainly there has been market volatility. You look at the interest rate volatility, the spread volatility that we've seen year-to-date. Throughout all of that, we can still trade bonds. You want to trade AAA bonds, that's no problem. You want to trade some AA and A bonds, we can make that happen. The benefit that our insurance company clients have is that we can take a longer term view typically. We can hold bonds that we still see as fundamentally secure through market volatility, but when market spreads widen, like I mentioned before, that could present an attractive entry point. You can trade, you can buy, you can sell efficiently, especially relative to private markets. We have a dedicated CMBS trader, that's what he does. CMBS trades in the over the counter markets. All the major banks have dedicated CMBS trading desks.
Kirloes: Yeah. On the private side, it's a little bit more tricky. We're talking about inherently illiquid assets. You make the loan and you just wait for the maturity date and you get refinanced out or you get paid out by the borrower. But from that perspective, liquidity has been strong, and we haven't seen lots of instances where we couldn't get refinanced out of our loan or we couldn't get the borrower to pay us a balloon payment or whatever the case may be. We haven't really seen any issues from that perspective, but it is an inherently illiquid structure.
Stewart: You're getting paid for that illiquidity. I'm glad to hear that markets have continued to trade throughout this volatility. If I'm looking out today, where things are, there's been some volatility, we talked about inflation, where it is, rates going up. Should I be buying this asset class for the remainder of the year?
Kirloes: Yes. Short answer. It goes back to what we've been talking about: I think it's a good time to start protecting portfolios. That's what our debt programs do. They're meant to be protective. And so when you're getting into the private debt space, given what we're seeing in the market today, you're buying into that equity buffer. If values do erode in the equity space, you're protected. You're not the first loss position. You've got a steady income stream. And again, we're not anticipating that values are going to drop to the extent where you're going to see a ridiculous number of defaults or anything like that, but, we do want to be as protective as possible today and to provide that income stream.
The run up on the equity has just been so strong. And, there are still positives in the equity space and the pieces, the sectors that you decide to invest in, will dictate your returns on a go forward basis. But again, when you start seeing values and pressures that we've mentioned already, in terms of the cap rate pressure, the NOI growth pressure, all those pressures starting to come into play, it's always nice to be a little bit more protective within your portfolios and to layer in some of that, into the private debt space. That's why I say yes, you should absolutely think about it. Scott, from the public debt perspective, likely has a similar answer.
Scott: Yes, I agree. Like I mentioned before, we’re seeing spreads widen because of broader macro volatility, because of contagion from the outflows that the investment grade and high yield corporate space has seen, we see that impacting our spreads due to a weak macro and weak technical backdrop. But then when we look at the fundamental outlook for debt, like Kirloes mentioned, and we see that as still being supportive over the long term, I really like the entry point. There certainly will be mark-to-market volatility. I think there are broad expectations that there will be a lot of volatility throughout the summer as the Fed continues to pull back monetary accommodation from the market and really starts to tighten things from a monetary perspective. But, it really points to the fact that you have to be a real estate expert to invest even in the public real estate debt space.
You have to have a view on really what's ultimately securing your bonds. With that equity cushion, with the strong debt service coverage ratios, we're very comfortable and we think the wider spreads could be an opportunity. On top of that, we haven't talked about it, but from a structural perspective, there's additional credit enhancement in these bond structures. There are multiple layers of protection in these bonds that we're buying for our insurance company clients. We pair that with the current market spread environment and we do think it makes sense, especially relative to equities.
Stewart: That's good stuff. This is the ask me anything part of the program. Kirloes, I'm going to start with you.
Kirloes: Yes, sir.
Stewart: Do you remember your first day of work? Your real first day. You might have been in a suit even, do you remember that day? You meet Kirloes today. What do you tell that guy in his first day of work?
Kirloes: Yeah. I tell him not to worry. Everything's going to be fine. Look, I think when you walk in for the first time and you're nervous, you're nervous because of the unknown. You just really don't know. I could tell you every job after that first job, it got easier. It was still nerve wracking, but it got easier and easier. But, that first day kid, he was nervous, and he was really scared about where his life was going to end up. And so, if he met me today, I would tell him not to worry. Everything's going to be fine and you'll find your way.
Stewart: Scott, what about you?
Scott: Oh yeah, no, I remember it. I had a great first day move. I went to meet my new mentor and immediately I said, "Oh, are you another intern?" "No, I'm not an intern."
Stewart: That's great.
Scott: Just really started on the right foot with him. But nerve wracking. But, if I had to look back, I would say, just learn how to learn. So long as you know how to learn, that's a continual exercise. If you come to the office every day, thinking, I might not know how to do this but I can learn. I can figure this out and we'll get through it. Being in the industry for 18 years, living through the Global Financial Crisis and all the other volatility events, including COVID-19 that we've been through, you gain that confidence, you gain that perspective, and hopefully I can help pass that on to the younger generation as well. But I can't underestimate the importance of being an active learner and having confidence in that ability.
Stewart: That is good advice. I appreciate it very much. I really want to thank you for going over the asset class, private and public real estate debt with Principal Real Estate Investors, Kirloes Gerges, and Scott Carson. Thanks for being on.
Kirloes: Okay. Thanks for having us, Stewart.
Scott: It was great.
Stewart: Thanks for listening. If you have any ideas for podcasts, please email us at podcast@insuranceaum.com. My name is Stewart Foley and this is Insurance AUM Journal podcast.
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