In part three of the Insurance Asset Risk/Invesco roundtable, insurers look at the outlook for CRE in the next 18 months—and the economic realities of the world we find ourselves in.
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
Randy Brown: If you think 18 months forward, do you expect your real estate, in terms of new money investments—so not mark-to-market on the existing book but the new money where you're allocating—do you expect your allocation relative to your historical stuff to increase, be the same or decrease? And then the second would be, how do you express that? Because we've seen a disconnect between the public markets and the private markets, where the public markets have repriced more quickly than the private markets in some cases. So how do you express it?
Bob O'Rourke: I don't have a crystal ball, but it feels to me that we should be equal to up in investment from a tactical perspective. If in fact, we do believe there's good opportunity. Many will have to reallocate resources to manage issues. But if your book is strong, you should be able to deploy capital at probably the highest rate of return in the last 10 to 15 years and it should be an attractive opportunity. And I think that if you have room in your portfolio that you haven't already filled your targeted allocation to the asset class and you have room to grow it, this would be a good opportunity to do that.
Jean-Roch Sibille: I would agree. We would be positioning ourselves slightly up in rating quality these days. We don't want to create problems and there are some other allocations in terms of the private structure and direct lending, which we are increasing maybe even a little bit more. It is also about the subcategory, we mentioned multifamily a few times, looking a bit more at the geographies.
If I consider the real estate in cities like Washington, Chicago or San Francisco, there are still some challenges. However, if I travel to New York, the dynamic is much stronger; it feels like we are really getting back to before the COVID crisis. Looking at the asset characteristics is critical and overall, I would invest slightly more conservative today.
Now, the last thing I would say is you need to look whether there's any impact on the dynamic of your portfolio liquidity and keep an eye on potential scenarios to stabilize your key accounting variables. Compared to previous years, there are currently strong sales number coming in from life insurance products, but it does not necessarily all translate in higher cash, there are also a lot of replacement and disintermediation going on that you have to consider.
Bill Petak: I think the opportunities are there. Obviously, a dislocated market is indeed a market where everybody would like to think they're the grave-dancer and or a contrarian looking to generate outsized returns. It's not that easy when you're an insurance company, an institution that is regulated and managing capital and all these things that you have to address. At the same time, the opportunity is clear, with the lack of lenders in the market, the characteristics we just discussed, opportunities to write smart loans is there.
If you really looked at the relative value pickup across the capital stack, the biggest beneficiary is the senior mortgage or those senior CMBS bonds. It isn't necessarily equity. At this point in time, equity has been the hardest to really price and underwrite. We're active on the buy side, so we see and understand how difficult it is. We also see the bifurcated market between private/public. Very interestingly, what we're seeing is the larger transactions have stopped. We've seen a considerable amount of smaller to mid-sized transactions and they're being driven by high-net-worth family offices on an all-cash basis. Debt is less of an issue, and they're buying aggressively and keeping cap rates at a very, very tight level on certain asset classes. Of course, you see that in the multifamily space as we've talked about, as well as industrial, and we're seeing activity in medical office as well.
So, we're struggling on the buy-side because we still see competition where we're always seem to be the bridesmaid or a cover bid. It's just that the deals are getting done and they're getting done rather aggressively, and you are kind of stunned that something like that is actually happening today. But it is. The best deals in the market are getting done. You're seeing a heavy amount of industrial assets trade as well as multifamily and the like.
Will there be opportunities office? Yes, sure. Self-storage also has been a solid performer as well, both from a CML perspective and we do see it as a target acquisition type notwithstanding the significant supply that has been delivered to the market. We like the asset class as part of our strategy. So, we're bullish and will be, as Bob said, neutral to up, in terms of an allocation to the space. But the best benefit right now is just that up in quality trade, whether you're in the CMBS space or in the CML space, recognising you're not going to get a CM1 due to the current coupon environment as well as the desire for amortisation. But you can still write a good solid loan with good covenants, characteristics, and structure.
So, we will be allocating more to the space over the course of the next 12 months.
Randy Brown: On the loan side, it is up in both public and private markets, because we are seeing opportunities from the disintermediation of regional banks. On the real estate equity side, I would say we're going to have a denominator effect which will take values down relative to other assets. That being said on the purchases, I'm seeing better opportunities outside North America in many cases. So, we are geographically diversifying and frankly, selling into a very strong bid in some of the asset classes mentioned to redeploy that capital into other asset classes.
Charlie Rose: A lot of sponsors in real estate equity have made a lot of money over the last four decades by simply riding a trend of lower interest rates and lower cap rates over time. And so it's a credit pickers market for sure. And it is a time to be highly discerning in the equity business. Owners of real estate equity truly need to create fundamental value in this environment and it's incumbent upon lenders to be highly selective with who their sponsors are and underwrite business plans very carefully in a world where you're likely not going to be bailed out by materially lower rates.
Dan North: I'm hearing what basically seems to me a really optimistic panel. Being the economist, I'll throw in a bit of pessimism here. Our business saw the not so great side. We were in an office park with a number of buildings. Our lease came up. Because of work-from-home where people are working two to three days a week, we had two floors and suddenly we didn't have a need for one. So, we tried to renegotiate the lease and they wouldn't do it. So, we moved to another building and just took one floor. That office park is now a ghost town. They're not renegotiating the leases that need to be done because the business' needs have changed dramatically. So, that's the bifurcation that we've been seeing.
There's also some more pressure on the occupancy side. We had a strong employment report last month and we've had employment reports that have been strong for four months. But employment is the last pillar of the economy to fall because businesses don't really want to let employees go unless they have to. Historically, you can go back in every recession and see that the economy is growing 300,000 non-farm payrolls, six months ahead, two months ahead 200,000 non-farm payrolls. You don't lose jobs until the day the recession starts. So, the fact that we got a strong report again last month tells you nothing about what's going to happen in the future.
There are some other things under that shiny hood that do say this labour market isn't quite as great as it looks like. One of which is the actual year-to-year job hiring rate is shrinking rapidly. That's a pretty bad sign, that's what often happens leading up into recession. I believe the job hirings window is closing rapidly and we're also getting the layoff window opening up. There are other leading indicators, such as a consumer confidence survey where they're asking are jobs plentiful or are they harder to get? Well, it's peaked in the sense that now people are saying jobs are getting harder to get. That's a very strong leading indicator and consumers know this as well. Consumers are also saying, 'things are fine now' but the future 'looks really grim'. And when you get that big divergence, it's a perfect indicator of an oncoming slowdown.
The yield curve going negative is also always a perfect indicator. Yield curve goes negative, it takes three to five quarters for the slowdown to get here. It went negative last October, so the slowdown is not going to start until the fourth quarter of this year. We believe we're going to get at least one negative quarter of growth, followed by 0% skating right around the edge of the recession. It's coming. But everybody called it early because it seemed like the signs were very strong.
Bob O'Rourke: Are you calling for a job recession? We are at a very low unemployment rate, that trend has changed, it's clear there are less open positions. Some predict the recession being pushed off to second half of next year. This is the recession that's been coming for years but just keeps getting pushed out.
Commercial real estate historically has been a lagging indicator, we're not going to be on the front end of the bellwether informing the beginning of a recession. First, there will be jobs elimination and then the slack in demand. The question is, in your view, is the pending recession going to be deep, moderate, or shallow? And that opinion likely informs this panel's thinking or psychology about looking forward, whether optimistically about opportunity versus having a more sanguine view of we're heading into some real trouble here.
Dan North: That's the hardest question to answer. The indicators strongly suggest that we're going to have at least one negative quarter, and technically skating around a recession. To answer how deep it's going to be or how long is more difficult, because you have to take a qualitative look at it.
Every one of the previous recessions have had a Federal Reserve raising rates, so that's what we have now too. But previous recessions had an extra imbalance that we really don't seem to have right this moment, like the meltdown in the subprime market during the global financial crisis.
We don't quite see that imbalance now. The average recession since the end of World War II is 11 months. We think it's going to be a bit shorter than that and a bit less severe than we see. Certainly, less severe than the previous. No question about that.
Sarfraz Thind: But it needs something concrete to have the panic beginning—something real for people. What would be your top pick in terms of concern, asset classes or events?
Dan North: The first victim of the Fed's interest rate hikes was residential real estate. As I mentioned, as soon as the Fed finally gave up their narrative saying inflation is transitory, and finally they gave that idea up in December of 2021, the 30-year mortgage rate goes from 3% to 7%. All the other interest rates go up sharply. And that hit the residential housing market very sharply.
The other one is manufacturing, which is interest rate sensitive. If you look at data in manufacturing such as industrial production or core durable goods orders, industrial production is now, I believe, around zero and maybe even negative year-over-year. Durable goods orders are still positive, but they're way below average, and the ISM survey is deeply into contractionary territory. So, I would suggest that manufacturing is already in recession.
The next shoe to fall might be the one thing that's really held up the economy is the services sector, which has been doing very well. And we could well see some erosion there because we are going to see a slowdown, negative job hiring, and consumers who are already losing that excess savings are going to start drawing back.
Sarfraz Thind: What are your thoughts for the next six to 12 months?
Bob O'Rourke: The challenges in our sector will be office. The wave of refinances coming, it's particularly serious in the office sector. How they are going to be managed, will be curious. It's going to be challenging and with the recession potentially being pushed into next year, I feel like it's going to be more of the same in the near term.
Randy Brown: We all agree there will be opportunities. You have to be very cautious to read the tea leaves about what's coming. Everybody knows something is coming and the question is how long and how deep? So, we're just biding time to dive in and increase allocations when we see opportunity.
Jean-Roch Sibille: I keep an extra eye on my liquidity buffers and run more stress scenarios than usual. I try to be a little bit up because the problem is that when there is going to be the next thing, there is always this panic period that you are going to witness. The probability we get a panic period during the next 6 or 12 months is, I believe, high. If we are disciplined and looking well at the right economics and the right opportunities, we can get out of it very strong as a sector. So, I want to remain positive.
Charlie Rose: We expect to not be particularly active as equity investors. We're so big, we're buying and selling in any market, but I would anticipate us to be net sellers on the equity side for the foreseeable future with relatively low transaction volume. We are quite actively growing our credit book of business, both in the US. And we didn't really talk about it, but we're actually seeing particularly interesting opportunities in Europe right now as well as a result of even lower liquidity and less competition for commercial real estate loans. So, the opportunity for us, feels like today already for debt and not quite yet for equity.
Bill Petak: Insurers have strong balance sheets, currently their loan originations over the last several years have been driven by lower LTVs and careful underwriting. They're in a great position to be able to sustain any kind of headwinds in the real estate market and then look for the opportunity where they should be really getting that value spread pickup.
Insurance companies have a strong history of positive experience across multiple cycles in real estate, and benefit from the diversification that these portfolios have. Loan origination professionals are well-positioned to take advantage of those healthy balance sheets. Those insurance companies that have stronger RBC ratios can even be more aggressive or active, but I expect it to be muted in terms of the transaction velocity and volume for the coming quarters. Ultimately, we'll have an active late 2024 and into 2025.