In the first part of this Insurance Asset Risk/Invesco roundtable, insurers discuss the current environment for CRE investing and how the asset fits into their portfolios.
Randy Brown, Chief Investment Officer, Sun Life
Charlie Rose, Global Head of Credit, Invesco Commercial Real Estate Finance Trust
Robert O'Rourke, Head of Real Estate, Guardian Life
Bill Petak, CEO, Nassau CorAmerica
Jean-Roch Sibille, Chief Investment Officer, Allianz Life
Dan North, Senior Economist North America, Allianz Trade
Chaired by Sarfraz Thind, US Editor, Insurance Asset Risk
Sarfraz Thind: Could you tell us about your investments in commercial real estate (CRE), the benefits of it and how you've been allocating to CRE?
Randy Brown: We've been an active investor in both debt and equity for decades. The way I view the debt side is really an alternative to corporate bonds in the sense that I've got covenants and collateral and a different risk exposure than general corporate risk. In many cases, it's a secondary exposure to corporations. If I have office multifamily, different industrial corporations [and] different risk exposures than I'm going to get in investment grade public corporate bonds. So, I get a spread to corporates, I get covenants, and I get collateral, and the give is liquidity. So, as a life company, it fits very nicely into our asset allocation.
On the equity side, I view real estate equity as a long-term investment that we use to help offset some of our 30-year-plus liability risks. So, we are pretty well matched inside 30 years because we have fixed income assets that we can deploy to hedge the key rate duration exposures, across the curve. But outside of 30 years, we don't typically, and so we use equity like returns that over the long term should protect some of that long risk. Many of the asset classes have inflation protection, and so we are typically a long-term holder of the real estate equity that we invest in. Historically we have done it through owning individual buildings pretty much in their entirety. We are geographically diversifying now because of our partnership with BentallGreenOak, who have a global business. We've started to put funds into markets where historically the general account team doesn't invest.
Bill Petak: I certainly cannot add much to what has already been said with respect to why we would or would not use real estate strategies as a component of our overall investment strategy. Having said that, it is important to note that this last year, or just within the last 12 months, the new RBC [risk-based capital] rules that have been implemented have gone to favour commercial mortgage loans (CML) a little bit more.
We all understand that RBC categories are static as it relates to the CM-1, 2, 3 RBC charges, unlike the old Mortgage Experience Adjustment Factor (MEAF) approach to measuring portfolio risk, which was based on historic portfolio performance. Additionally, the grading levels that they now apply in the NAIC 1 and 2 categories are more aligned with CM1 and CM2 real estate to A- or BBB+ bond ratings, resulting in favourable RBC comparisons while providing for a superior return on capital due to the pickup and spread that you generally get on a CML for the less liquid nature of a CML in particular.
The new RBC rules also reflected a more favourable result for direct and indirect real estate equity investments. So, Randy, your wholly owned real estate equity portfolio or your wholly owned building portfolio should now benefit from a considerably lower RBC charge, even as low as 11% to 13%. Even if investing through limited partnerships into real estate asset classes. Another favourable result and benefit to holding this asset class is that it has the correlation relationship to corporates is far less than one-to-one ratio.
Jean-Roch Sibille: On the real estate side, there are mainly four asset classes that we invest in; CML, CMBS, some highly rated fixed income-based REITs, and RML. For residential mortgage loans, I understand that a couple of other companies in the insurance sector have also started to invest, in particular because of the favourable RBC treatment.
We have been very happy with that exposure. Given that our CMBS and REIT are so highly rated, we think there needs to be a stress from 30x to up to 100x worse before we see anything significant happening. We feel strongly about that and they are really built for going through cycles.
The CMLs is where there have been challenges and the consensus is that it is going to get worse before it gets better. On the other hand, from a liquidity standpoint, a capital standpoint, and the fact they have some favourable capital treatment, it's about weathering the storm.
We are mostly in prime locations and prime buildings. It is going to be about timing and eventually looking at some smaller opportunities. These are the type of environments where if you can safeguard a bit of your liquidity and capital capacity, it can be a positive. As an asset manager, you can choose to be picky these days, which is nice.
Bob O'Rourke: As we think about real estate investing at Guardian, it is a strategic asset class for us, so we're in the market all the time. That being said, we like to be tactical as well. We have what we believe to be a very prudently constructed portfolio. When market dislocations occur that often becomes opportunistic for us, that generally is the time we're more active.
We think about real estate equity as not being highly correlated to other asset classes. So, we like that. The current income return features of owning real estate is attractive for us as well. We haven't really talked about the inflation hedge, but I've been hearing about inflation hedge my entire career. Well, I've finally seen it.
In effect, it's worked out quite well for us, particularly in our multifamily positions. Real estate equity also provides the non-cash expense benefits of depreciation, which is a great thing from a real estate equity perspective. These are things we think about. Real estate equity is also a tax efficient vehicle. The 1031 exchange is a very tax efficient benefit for the ownership and sale of real estate.
Bill mentioned the RBC charges for equity LP interests on schedule B are 13%. I would like to note the RBC charge for wholly owned real estate equity on schedule A is 11%. So, also even more attractive. And the diversification of being in real estate equity is just a real benefit for us. As a percentage of our overall portfolio, it's not that large, but it's a diversifier and it provides good alpha.
With commercial mortgages, you've got a secured first lien positioned on a hard asset. That feels pretty good to us. We have historically earned enhanced returns over corporate bonds. The ALM duration match works really well, especially on our whole life insurance. The tail liability runs to be about somewhere around ten years for us and it's about 8.8 years on our ten-year mortgage business, so it works well. Commercial mortgages have superior call protection to corporate bonds, which in our business is really important, and we get diversification not just by asset class but by geography, property type, sponsors. So, that brings further diversification benefits. Commercial mortgage loans have historically low default rates, and when you have defaults, the recoveries are materially higher than many other asset classes.
These are the benefits and the opportunities of investing in real estate equity and commercial mortgage loans that we focus on in growing our portfolio.
Sarfraz Thind: How has the market performed or reacted to the economic environment where, in the last 12-18 months, you have had rising rates and inflation?
Dan North: There are a few things coming together at just the wrong time. One being rising interest rates and then the trend of work from home and lower occupancy in buildings and tightening lending standards. Let's focus on the big thing, which is rising interest rates, and that's caused by inflation. On the fiscal side, the federal government injected a lot of money to stimulate the economy and support the economy. Then, it became substantially too much. And so, you have the same old condition of too much money chasing too few goods. We get inflation. That's the fiscal side.
Where the real trouble lies, in my mind, was the monetary policy side. And that takes us back a little bit into history, so we can figure out where we are now. Okay, we shut down the national economy in 2020. The Fed Reserve does the right things, cuts rates to 0%, expands the balance sheet gigantically to make sure there's plenty of credit flowing. Then in the third quarter of 2020, the economy makes this roaring comeback. Well, if you're the Federal Reserve, you say, well, that's great, but let me wait one more quarter to make sure everything is okay, before I start normalising, before I start getting rates back up and reducing the balance sheet.
So, we did wait one more quarter, then another, then another, and another. And the Fed arguably kept these emergency conditions of too much easy money in place for too long. And that is the formula for inflation. If you wanted to create inflation, that's what you would do. So finally, they realised in December of 2021, they've been saying inflation is transitory, and it became obvious that it wasn't, and so started to raise rates. And they understand, as everybody else does, there's a lag in monetary policy of three to five quarters. So they start off when inflation is already starting to rage, and it's going to be three to five quarters before your first interest rate move has a real effect. So they were desperately behind the curve when they started, and that's why it's been the most aggressive path of interest rate hikes in the modern era. And obviously, when interest rates rise and rise that fast, asset values fall.
So, I lay it pretty much at the feet of the Federal Reserve. I think the pause recently was well-advised. Looks like we're going to get at least one more hike, maybe two more hikes. And I would suggest we've got a lot of ammunition that's already been shot at inflation that just hasn't gotten there yet – because of the three to five quarters lag. So my perspective would be, hey, let's hold off on any more interest rate increases because it is obviously degrading value of assets. And you saw it most clearly in residential where immediately the 30-year mortgage went from 3% to 7%, and all the metrics in the residential market were down sharply since then.
Charlie Rose: I would just chime in with how we've seen that filter through to the real estate markets. We are seeing a real bifurcation in commercial real estate right now. The impact of rising rates has affected all property subtypes from a valuation perspective, certainly. And on average, for high quality commercial real estate, including multifamily and industrial, we're seeing values down 15-20% in some instances, even a little bit more than that from peak, and that is 100% related to rates.
We have continued to see fundamentals for those asset classes hold up quite well. In the year-to-date, we have seen a moderation in rent growth and demand, but that is off of historically unsustainable levels of rent growth and demand. So, we're seeing at present, barring a future recession, fairly healthy, fundamental conditions for our favourite asset classes – multifamily industrial, single family for rent, some of the speciality product types like medical office, life sciences, self-storage and so on.
That bifurcation is coming into play with the commercial office sector, of course, which is getting all of the headlines. And we are seeing the combination of the rising rate environment with a wholesale secular change in how occupiers use commercial real estate, and that's resulting in some pretty severe impairments across the real estate lending space for class B office. Green Street Advisors is estimating that values are now down 55% from peak to trough. That's class B. So overall, for the high quality institutional-grade product, it's probably more in the 30% to 35% range. But there's a whole lot of class B real estate with a lot of loans against it.
So we've started to see a real increase in CMBS delinquency and defaults, especially for commercial office at a time. Overall, we're seeing credit performance be quite good for other property types, even after the Fed has hiked rates by five points.
Part two is accessable here.