31 August 2023

Finding opportunities in the negative headlines

In the second part of this Insurance Asset Risk/Invesco roundtable, insurers talk through the distresses currently seen in real estate markets. And how bank repositioning offers opportunities for insurers to invest.


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: Are there going to be more CRE impairments or is it still too early to say?

Charlie Rose: Very much early days. I want to emphasise that we think that the bulk of the pain is going to continue to be in office. And some of the broad-brush analysis around commercial real estate really is an office story and is not the story that we're seeing in other property types.

Bob O'Rourke: I agree with Charlie on that and I further state that there's a lot of headlines in the paper clearly about office, major REITs defaulting on loans—names that you would never think would default relative to the future impact of their ability to borrow money. So, there seems to be a shift in thinking of ownership in terms of working through challenged assets. You're also seeing a lot of print about rent growth or lack of rent growth or declining rent growth in multifamily. Rent growth had unsustainable high levels the previous few years, however in our portfolio, we're still getting rent growth, it's just not at the pace that we were getting over the last several years.

I would say that the headline is, if it bleeds, it leads. And I would suggest that multifamily is being challenged. Multifamily is being overbuilt in some markets, some southeast, southwest markets. But from what industry experts are forecasting, we think the absorption will be strong in those markets over the next several years and it will work its way through. And so, if you look at what is really being challenged in the market, it clearly is office. Office is impacted by a secular shift in demand, pandemic, post pandemic, which is very different than other asset classes. Some asset classes benefitted from the pandemic, i.e. self-storage and multifamily. Certain geographies had an influx of migration of people moving to lower cost of living as they no longer had to be located in central business districts of major cities. So, there's been winners and losers in this trade. But clearly office is the standout problem in our asset class of commercial real estate, and that is something that's going to have to be worked out for many years to come.

Charlie Rose: We compare it to the mall sector in that it will be at least a ten-year story with distress throughout that next ten years in that sector. But I would agree with Bob, overall that we did not have a supply-side problem during this past cycle. Supply has been much more constrained. We're under-housed as a nation, we don't have enough housing supply, and within industrial we've seen a pretty sharp drop off in new starts ever since rates started to rise.

Randy Brown: Going back a little bit to what Jean-Roch said, in all of this there's opportunity. So, the headlines make it sound like the entire real estate market is highly distressed and is going to be forever, which frankly, we love, on one hand and hate on the other. I can't tell you how many questions we get every day about 'is your real estate portfolio on fire?' and then you try and reassure people that it isn't. But the opportunity, which is where I really focus, is exactly in all these headlines. If you have the right office building in the right location with the right amenities and the right environmentals, we're actually getting rent increases, not decreases.

So, if you have the right multifamily, we are getting significant rent increases. If you have the right industrial, in particular logistics, we are still getting very good rent increases with very strong inflation riders built in. That being said, for this past quarter, this Q2 mark session, to me feels like the external appraisals are now coming to the realisation where they've lagged in terms of marks on office. So, the office write down is coming stronger—but it's already down a lot. It's going to get marked down more, and we're seeing for the first time in a while the cap rate and yield decompression overtaking the rent growth and therefore prices coming down in other asset classes. But in our experience, modestly.

Bob O'RourkeBob O'Rourke: An industry report that recently came out commented that investment sales transactions are off 70%, some number like that. Let's say we're off 50% to 70%. Say about 50%, I mean that's just a dramatic number. So, we're not getting really good marks in terms of trades happening to really look at valuations and a lot of what's trading is distressed. So, then you get back into that whole discussion of what is clearing the market, distressed versus not distressed. There's just not a lot of activity to discern between the two in terms of where you really think values are in a high-quality portfolio that we all would probably own. That being said, the safe rate up is up dramatically, and if you put any kind of reasonable credit spread on top of that, cap rates are up 150 basis points and there's your value change.

Jean-Roch Sibille: Something markets probably do not capture fully, is that there's a difference between the fact there's a problem and the fact that people just want to stick with what they hear is happening and that they can observe. We are seeing in other sectors some assets not getting the same volume as they used to.

This is especially true on the public lending side; there are for example discussions about possible impact on CLOs down the road. We nearly had a stop of the loans market during 2008, which did not bring the markets under but led to distressed pricing. In addition, private lending is growing significantly, which means there are some backdoor ways to push the cash and people just do not want to realize it. This can sometimes be mistaken for panic just because the volume is not there, but it is not the same thing. I think understanding this difference is especially important in the life insurance business because you want to have a comfortable balance sheet, and you should be able to focus on the facts and not the daily market disruptions. Hopefully, you did a good job on your ALM. For example, you do not have any disintermediation tail risk, which is something we check quite often. We also talk constantly with our specialized asset managers, we want to be sure they monitor the facts.

The last thing I would say is some trends are reversing. There was recently an article about the big resignation. If I talk to my HR area, it's been six months that the trend has been reversing, which is probably also emboldening some of the managers to ask people to go back, particularly in areas such as operations. So far, people have been a little bit concerned, but if the risk for resignation is out, I am expecting that there is going to be some increased return to office. The problem with reduction in the workforce in some sectors is on the other hand not helping. I am slightly more positive on the bigger movement of going back to the office. As I said before, it's probably going to get a bit worse before it gets better. We should be through the challenges by mid-year next year.

Bob O'Rourke: And the insurance industry's balance sheets were built to manage the vagaries of cycles and high-quality underwriting and ALM management should carry the day for the portfolios in our industry.

Charlie Rose: I would just highlight from our perspective as direct real estate investors how attractive the opportunity is today. A couple of people have made reference to that and that's really being driven by the significant pullback from the banks in the commercial real estate debt markets. We actually saw the money centre banks start to pull back really since 2020, and then the regional banks rushed in. In 2022, regional banks originated 27% of all commercial real estate loans in the US. That's up from on average, historically around 17%.

So, now that the regionals are largely on the sidelines and expected to be much more restricted in their lending capability for some period of time, we're seeing really, really attractive spreads in the market. And I'll just give you a quick example. We use leverage, so we originate CM3 loans and then we apply prudent leverage to that. Our insurance investors get look-through treatment from our fund vehicles. We were generating a 7-8% return from those commingled vehicles before the Fed started raising rates. As a result of having floating rates, we're now distributing 10-11% current income. And on new loans that we originate at CM3 loans, institutional sponsors, limited business plan risk, we can generate a levered 13% IRR at 65% LTV. And that's because the banks are so limited in their lending capacity right now. So that opportunity set is here today and we're seeing it real-time. There will likely be another opportunity set that plays out starting later this year, where some of the banks are selling loans. And that could even be a higher yielding opportunity, but we haven't really seen that pick-up momentum quite yet.

Dan NorthDan North: You mentioned the banking system and that's really something pretty interesting to look at because what's happened obviously, is you have several failures and the Federal Reserve once again jumped in with lots of credit, which is the classic mistake, the moral hazard that creates a lot of these problems. The Fed said well, I'll give you more money. Banks took advantage of that emergency lending and they haven't really stopped. I mean, it peaked and it's come down a shade to something around $250bn. But it says to me that there's still an issue there. Banks took those loans and they're not giving them back. That loan from the Federal Reserve is not going back yet, they're still holding on to it.

Now, as a result, you do see as you mentioned in the regionals, the small- and medium-sized banks who may indeed be the ones holding on to these loans are restricting credit. In fact, they were restricting credit even before the banking crisis. Pretty sharply, in Q1 of 2023 the net percentage of banks that were increasing lending, or I should say decreasing standards for commercial real estate was -10% and now it's +74%--that's the net percentage of bankers that are tightening standards. That 74% is the highest ever outside of COVID, and that's before the banking crisis. I believe credit from banks is only going to get tighter. And if you look at the size of the loans and the size of the banks, I see figures of between 50% or more that the small- and medium-sized banks are responsible for commercial real estate.'

So, I'm still concerned that those banks are kicking the can down the road for another year, and we could see what happens after that. But to me the problem, although it seems to be ringfenced at the moment, I think there's risk issues going forward.

Sarfraz Thind: Is anybody else looking at the move from banks as an opportunity?

Bill Petak: Definitely, we see it as an opportunity. It is going to be further enhanced with the sheer fact that we have an avalanche of CML refinancings that are going to be coming to the market over the course of the next several years. The combination of the two are going to provide what should be good opportunities, for CMLs, and to a great degree, of course, strategic real estate equity investments.

We primarily direct our real estate equity focus on "beds, sheds and meds." That is our kind of rhyme. Housing, industrial, storage and medical office. Medical office is something that we have found to have great legs, sticky tenants, consistent demographic benefits in terms of the population, age and needs, and, of course, well located, properly constructed, logistics-oriented industrial and warehouse assets. Also, as we look at "sheds", we recognize that some consider certain industrial assets as a new retail class, given that e-commerce continues to grow and the demand for a strategically located logistics related asset is highly sought after along with well located, older infill industrial "last mile" assets which are becoming more and more critical. This provides opportunities to create value with older real estate assets, in and around markets that are demanding last-mile distribution.

So, there are always good opportunities in bad markets. Our office experience in our CML portfolio, for instance, has certainly gone against the headlines that you read in terms of the idiosyncratic risk associated with certain markets and certain regions of the country where you have large users, less diverse rent rolls and lots of corporate decision-making that is reflecting both the economic environment as well as the demands and needs of their employees.

We chose to participate in the middle market around the country mainly in the secondary and smaller secondary markets, where we see market characteristics that have affordable housing, population growth, good income to cost of occupancy ratios and job growth. These opportunities are in secondary and larger tertiary markets and where smaller companies and regional businesses around the country continue to expand and are still in need of and demand office space.

The idiosyncratic risk associated with office use and demand can be managed to a great degree in terms of where and how you underwrite and structure new real estate investment opportunities. From a CML perspective, we can also create an asset to suit specific investor risk appetite as well structuring CML's and CMBS investments to match liability, duration, ALM, target, etc... This flexibility is further enhanced with call protection and/or flexible prepayment structures to meet whatever your ALM goal might be. Given the historic environment conservative life insurance company underwriting and, lower LTVs over the last couple of years, along with the reasonably high debt service coverage ratios, seasoned CMLs on life company balance sheets will likely demonstrate that they can withstand a great deal capital markets shock and user demand shock.

As an example, our office portfolio represents approximately 18% of our CML portfolio, and we have had modest if any real issues. In some cases, we seen tenants move around, but it's predominantly been a pretty steady rent roll experience across our portfolio. Also, in today's lending environment, you can write stronger covenants into your loan documents. Real estate, just like any other competitive market, like broadly syndicated loans, middle market CLO paper and others lending strategies, competition can really take the edge off loan structures. And structure really does work when you combine a good asset with a good sponsor. So, we stick to our knitting with the way we manage cash, lockboxes, and controls, and have various triggers and covenants that allow us to make sure that we're in the right position and that the property is well supported.

Charlie are you saying that you are originating CM3 loans or are you buying strips or mezzanine pieces that are, by their nature, CM3 loans because they're subordinated?

Charlie Rose: Our business model is derived from our real estate business, which is a $90bn AUM business. So, we have always talked about being property first commercial real estate lenders. So, we originate whole loans at 65% loan to value. We then turn around and obtain leverage against those loans up to the 50% loan to value level on average. And I'm not the insurance expert but, generally speaking, I think our loans would be considered CM2 if it weren't for that use of leverage.

Bill Petak: I was just trying to understand that very few loans are originated on a whole loan basis at a CM3 level. Mostly, today it's CM2. And of course, with the interest rates and adding amortisation that should be in place in these deals, it's nearly impossible to find a CM1 opportunity today.

Charlie Rose: We're seeing high-grade loans, CM2 loans on industrial or multifamily today, institutional sponsors, good Metrics, high quality real estate. We, on a floating rate basis, will price it SOFR plus low-300 on average. So, that's a low 8% interest rate today. We'll put a floor on that. So you're protected in a falling rate environment. And then after the use of leverage, we get to roughly a 13% on those loans.

Part one is accessable here.