U.S. Real Estate Equity Today… & Tomorrow

Greg Campion: Commercial real estate markets have come under a tremendous amount of pressure this year hit by the historically rapid rise in interest rates alongside massive changes in tenant behavior, most notably the shift to hybrid and remote work. What does all of this mean for investors, and is it possible that today's crisis may be sowing the seeds of tomorrow's opportunity?

Joe Gorin: I'm not going to sugarcoat it. It's very, very tough out there and things at least from a valuation perspective are going to get worse before they get better, but with the right time horizon and risk tolerance, I think there's some very, very interesting opportunities in both real estate equity and debt.

Greg Campion: That was Joe Gorin, Head of U. S. Real Estate Equity at Barings, and this is Streaming Income- A Podcast from Barings. I'm your host, Greg Campion. Coming up on the show, the outlook for US real estate equity and why the real estate equity portfolios of tomorrow might look substantially different from those of today. All right, Joe Gorin, welcome to Streaming Income.

Joe Gorin: It's great to be here.

Greg Campion: I'm psyched to have you, psyched to talk about commercial real estate. It's a segment of the market that is just really in focus at the moment. Everybody's got an opinion, everybody wants to talk about it, clearly quite a few headwinds. You've got structural headwinds, you've got cyclical headwinds. I don't think we're breaking any news by talking about that, but what I'd like to get a sense from you maybe right upfront is are things as dire as the average media headline would lead you to believe today?

Joe Gorin: Well, if folks are going to listen into this podcast and think that I'm going to go glass half full-

Greg Campion: Yeah.

Joe Gorin: ...I think we all have to be pretty sober about the environment for real estate investing right now, so I'm not going to sugarcoat it. Some of the headlines are right, some are overblown, but as you said, cyclical and structural, you really have to dig into those two questions. The biggest cyclical issue we have in real estate right now, which I could argue is a structural issue down the road, is interest rates. Real estate is a highly interest rate- sensitive asset class, and we've got, in my investing career, one of the most challenging interest rate moves of many cycles, and so what that means is there's a massive value question, what is equity worth today? No one pro forma'd the 10- year going from 2.5% to 3.5% to 5%.

Greg Campion: Right.

Joe Gorin: That wasn't in anybody's playbook-

Greg Campion: Yep.

Joe Gorin: ...so now we're trying to manage the valuation question. There's not all negative out there. There's the structural issues, some are negative, some are positive. Let's hit the first negative one-

Greg Campion: Okay.

Joe Gorin: ...office.

Greg Campion: Of course.

Joe Gorin: That's a structural issue. I'm not telling anybody anything they don't know, but that's something that we're going to have to navigate, because we're not going to ever go back to the way people used to use office. As an example, our office utilization number is 60% of what it was pre- pandemic. By now people thought we'd be getting back into the office, we're probably never going to use office buildings the way we used to. That's a major structural issue that we're going to have to work with, and we've got the interest rate problem for the value. So, other structural issues that we have that are positive, look at the residential sector. You've got some great tailwinds for apartments and rental real estate. The bad news is home affordability is so difficult today, but those structural issues are having a positive impact on what we can invest in from a real estate perspective.

Greg Campion: Yeah, okay, so let's dive into that a little bit more. I also want to give a little context to people, a little historical context. If you think about how real estate equity portfolios have traditionally been constructed, what I'd like to do is understand where we've kind of been, where we're at now and then where we're going, right? Because a number of the trends that you mentioned, especially the structural trends, I would imagine are going to change the way institutional investors and others want to actually construct their real estate equity allocations over time. So, I think it'd be great to walk through that and leave people actually at the end of this conversation with some real ideas there in terms of where they may want to go with their real estate equity allocations. But maybe to start, where are we coming from? What does that traditional mix look like? You mentioned some of the sectors. What does that traditional mix look like in your traditional real estate equity portfolio?

Joe Gorin: Yeah, well, let's go back to the early 2000s. I mean, even before that, if you look at the construct of institutional ownership in real estate, it was pretty basic for a long time,'80s,'90s, 2000s. If you look at the NCREIF index, which is basically the major index that tracks institutional ownership in real estate, it was kind of broken up across the categories of office, resi, retail and industrial. Office was by far the highest holding of institutional investors, and surprisingly, it was the highest holding basically up until the start of the pandemic. Then you look at the other categories, apartments and retail were a little bit lower in the range of 15% to 20%, so if office was 35% to 40%. Then you've got the lowest, which people today are probably going to be surprised to hear, for a very long time, 20 + years, industrial was the lowest holding. Today you've had a flip, and it didn't start today, it started really back in 2015, 2017. I would argue that a lot of the shift in institutional ownership in real estate has been driven by technology, innovation, convergences of technology, and that's really sprouted obviously the industrial category, it's hurt the retail category. When you look at the makeup of institutional ownership today, you've got office which is trending down below, it's right around 25%. It was as high as 35% to 40%, and now you've got apartments that's moving into the 30 + category. You've got industrial that's very close to the apartment ownership and retail's a bit of a laggard, but that's been pretty steady. So today is a very different outcome in terms of institutional ownership, but a lot of people may think today has been going on for a long time, it hasn't. It's really interesting to see this shift, and I would argue that this is going to be a shift that goes forward. We don't think office is coming back the way it used to within institutional ownership, but it's a much different paradigm. On top of that, you've also had a number of subcategories within each of these four categories that have gotten really interesting. You've got data centers obviously with increase in data storage, that's a new sector that you could kind of put in that industrial category. You've got life sciences that's exploded in the 2015, 2017 category, that's a whole new category of office. You've got student housing and senior housing that have always been there, but you've also got so much transparency and information that institutional investors and managers are now comfortable going into those categories, and they're working their way into the index as well as a component of some of these larger product sectors.

Greg Campion: So I'm sure there's just so much nuance in terms of every single one of those sectors, so let's talk about that, because I'd like to understand the risks in some of these and probably some of the opportunities as well. So, let's talk about the office sector first. This sector has obviously been in the headlines more than any other. We've talked about it ourselves quite a bit in podcasts and papers, everywhere else. Everybody's got a view. Obviously hit hard by the double whammy of hybrid work as you were referencing, and higher rates, so dramatically, dramatically changed landscape. You already mentioned that it's fallen quite substantially in terms of allocations in institutional portfolios. I'm curious kind of where this goes. I guess I have kind of a double- barreled question for you here. One is, is office still core? Is it still a core allocation for real estate equity investors? Question one, and then question two, you mentioned life sciences, but where in this space are there still attractive opportunities, if there are?

Joe Gorin: Yeah, quick answer, no, office is not core today. Simply because of this structural shift, I don't think there's any core investor out there that's really excited about buying office. You've got kind of that double whammy of the highest interest rates you're going to pay for real estate today are going to be to fund office, and that would even be in the stabilized income category, all the way to the more opportunistic redevelopment and development category. I'll be a little provocative and I'll say that office probably shouldn't have been as much of an allocation within the core category over the past 20 years. I grew up at equity office many, many eons ago and we understood how lumpy the cash flows of office are. There's certainly a subset of office that should have always been in the core, but we're talking the highest quality assets with the longest lease terms, and what happened over time is there was such an affinity for office within institutional real estate is I think people overvalued the outcomes. They underwrote renewal probabilities of tenants that were probably too high in multi- tenant buildings, they bought weighted average lease terms that were too short. If you have that vacancy within an office building, the capital expenditures can really hurt your bottom line. If you're a core investor looking at stability of cash flows, having a multi- tenant office building that doesn't fit that profile is the wrong decision, and I think a lot of people have paid that price over a number of years. There is the subset obviously, the best of the best. I will say today we're not scared of office, we're not scared of a very small subset of office,'cause I think that's one of the more interesting value- add to opportunistic opportunities out there, because, and a lot of people talk about the have and the have- nots coming out of the pandemic, there's certain assets that will outperform and there'll be certain assets that underperform. We're starting to see the data that's proving this out, but I will say from a capital markets perspective, the babies are getting thrown out with the bathwater, and so there are opportunities to go out there and find the haves that are absolutely mispriced, and I'll give you some of the have data that really stands behind this. If you take a building that was built from 2015 or more recently, the net absorption of those buildings since the start of the pandemic is about 120 million square feet nationally. That's positive net absorption. If I cobbled together all of the buildings that are older than 2015, the net absorption numbers are negative 350 million square feet, and that's a drastic difference. If I look at rents, rents for the better quality 2015 and beyond, call it class A to trophy rent growth is about 13% to 15% since the pandemic. People are going to be really surprised when they hear that rents are actually up in that category. They're down about 5% in the category of the B's and the C's and even the lower quality A's. One of the challenges we have even at the highest level is cost, right? Capital costs are really expensive, tenant improvements are through the roof, so your net effective rents. When I say face rates are up 13% to 15%, your net effectives are a little bit lower in terms of what you're bringing home. But if I can buy one of those assets that's post- 2015, that's in the right location, it's the right amenities, and the HR department looks at that office building and says, " That's where I'm going to recruit and retain great talent," 'cause in the US we're in a fight for the skilled workforce that sits within the office buildings. If they're going to say that, and I can buy that building, as I said, baby out with the bathwater, I can buy that building at cap rates that I haven't seen in my lifetime because of interest rates are high, I'm going to buy that building.

Greg Campion: Yeah.

Joe Gorin: I worked for Sam Zell many years ago, God rest his soul, and it was all about the fundamentals, discount to replacement costs. Today you can actually buy on fundamentals. Believe it or not, people are going to be shocked to hear me say you can buy on fundamentals.

Greg Campion: Yeah.

Joe Gorin: For those buildings, I think those fundamentals are going to prove out.

Greg Campion: I'm curious if this is actually happening on the ground, if you're seeing transactions come across your desk today that you're ready to pull the trigger on, or is it more a type of thing of waiting for valuations to come to you?

Joe Gorin: Yeah, so we have had deals come across the transom that we like few and far between. When you have a skilled team that are experts in their product sector, it makes it a lot easier to be efficient, so we throw out 99.9% of the opportunities that come across. Actually call me crazy, we bought an office building not too long ago during the summer in Boston. It was owned by a public REIT and now's the opportunity to help fix problems. If there's a seller who needs money by a certain date and they need to transact, and they need a credible buyer on the other side who could basically go all cash,'cause leverage isn't giving you the bang for your buck that you used to get-

Greg Campion: Sure, sure.

Joe Gorin: ...there can be really interesting opportunities. These guys called us up, we like to do off- market deals with friends too. They called us up, big public REIT, deal was outside of Boston right at the last stop on the Green Line for the MBTA, so you got a direct shot into Boston. It's at the nexus of two major highways, 128 and the Mass Pike. We bought it, financial metrics are 68% leased at a seven and a half cap rate. If we can lease it back up to call it the high 80s to low 90s, and this project has basically never had any vacancy in it, we're close to a 10.5% to an 11% return on cost, which is a very attractive yield for us. It's one of those assets that are timeless. The HR department likes it. It's got higher floor to ceiling heights, a lot of light and air, great access to decision- maker housing, and so we bought it. We offered on an all cash basis and we promised that we would close by a certain date, and we ended up actually financing that asset on our base case underwriting, so we were really happy.

Greg Campion: Yeah, yeah.

Joe Gorin: I'll just add, the seller's total basis in the asset was call it$ 255 million and we paid 117. So, those are the types of deals we'll pursue.

Greg Campion: Yeah, yeah, yeah. Wow. Okay, so very much opportunistic in terms of the types of deals that are coming across your desk. Seeing not a ton of attractive things, but there are kind of diamonds in the rough, I guess, so to speak.

Joe Gorin: Yep, yep. By the way, when you say opportunistic, I will add what you can do today in office is you can generate value- add to opportunistic returns by buying Core to Core Plus profiles, and so that is real unique and that window may not be open for too long.

Greg Campion: Okay, okay. Well, that's encouraging to hear. I mean, we started this conversation talking about just all of the very negative dire headlines out there, and I think you very realistically painted a picture of there is a lot of bad stuff going on out there. There are a lot of challenges, but it's encouraging to hear that the team is still able to find attractive assets like this one and that tick a lot of the boxes. I mean, you mentioned the location of that. I mean, first thing I think about is that is a lot of technology talent right in that area, a lot of biotech talent in that area, so that makes a ton of sense.

Joe Gorin: Yep.

Greg Campion: Well, the segment of the market that is perhaps most closely related to office or maybe has become more closely related since the pandemic is residential, right? So you talked a little bit about how worker behavior has changed, how the way offices are being utilized has changed. That's having sort of knock on impacts in the residential space as well, right? If you are working in an office now two or three days a week, you very likely need some kind of a workspace at home, maybe you don't have that, et cetera. So, let's talk a little bit about residential. The other obviously big factor that's going on you kind of mentioned upfront is we've got massive pressure from rates on this sector, it's frozen portions of the market and you've got a shortage of housing. It's no secret there we've got basically a housing crisis some could say in the US. So, how are you thinking about that from an investment standpoint? It would be interesting to hear both the structural and kind of cyclical side of where you see residential today.

Joe Gorin: Yeah, I would say of all the product categories we're talking about, the strongest tailwinds are behind residential. That's positive from an investor standpoint. If you're buying into rental real estate, I do sympathize with the fact that there's a real housing affordability issue. We had an issue before, now we got a real issue with interest rates. Up to 2021 the average mortgage for someone looking for a$ 400,000 mortgage was about 3%, today that mortgage is about 8%.

Greg Campion: That's amazing.

Joe Gorin: That has basically taken 28 million households out of the realm of homeownership. That's a major tailwind obviously for demand generation within rental real estate, but we are obviously bullish on residential, we like basically all categories of it. Aside from, and I will say there have been challenges in the urban high- rise category, you've seen a lot of development. One of the challenges is that because residential's become such a sought after product sector, you had very low cap rates driving investments over the past three to five years. I would say that people probably overpaid for some of that residential, what it also did is it spurred new development. Most of that urban development has been in the urban core. We tend to like more suburban residential where you've got more amenities closer to grade schools, stronger worker nodes outside of the urban core and more space. So, what you've actually seen since 2017 is the value of suburban real estate is up about 59%. When you look at the urban core and you look at the high rise category of residential, comparatively that's up 3%, so there's a drastic shift in the evaluation. It just shows you the long- term fundamentals of yeah, people are moving to cities, there are new interesting areas, but as taking a broad brush across the residential sector, we've seen over many, many years, if not decades, that suburban real estate tends to outperform. We also want to be careful, again, with the cap rate environment for residential. So I would say right now, similar to office, we're scared about some of the structural challenges in residential. Not all managers and owners of residential I think have woken up to what the real valuation is, and you're still seeing some of those trades that are in the high 4% cap rate range to low 5% cap rate range primarily from longer term holders, more private buyers, you're not seeing as much of the institutional owner in residential. So, we are kind of patient right now. We believe in these tailwinds, we think there's going to be a great buy- in opportunity over the next call it 12, 18, 24 months, but we're going to wait for it, because some of these cap rates have to back up. When you're looking at residential, you have some of the same financing issues you have for office. Not nearly as dire, but the average interest rate you're going to pay when you buy residential is call it 7% to 8%. If you're talking about cap rates over the past few years that range between 3. 5% and 4.5%, well, that dog doesn't hunt right now. So you could argue that you need cap rates that are in excess of a six handle, and that's even for more of the Core, Core Plus. Then we get into more development opportunistic residential investing and you're talking about sevens, and the market's just not there yet. It's coming, it's going to go there we strongly believe, but it's not there yet.

Greg Campion: Okay. Now you mentioned that you're more bullish on the rental market, and so tell me about that. I saw recently Barings announced a transaction that the team did in North Carolina, a build- to- rent transaction. So similar to what we were talking about in office, it's good to see transactions happening, but tell me what you saw there that was so attractive to you.

Joe Gorin: Yeah, and what we're drawn to in residential is really that kind of shift right now if you've got more space, and so we gravitate towards, we like single family rental where people are actually renting single family homes and BTR, build- to- rent, so building some of these single family homes in master planned areas or even a scattered site. We found an opportunity recently outside of Raleigh. So when we're buying single family rental or we're developing BTR, typically we want to find those homes that are within a 20 to 30 minute drive of a major urban center or a major employment node, and we want to find the right size houses for the users. But a lot of these young families, the millennials, finally they're getting married, they're having kids later in life and they're moving out of those smaller units and they're looking for houses, but again, they can't afford the down payment, they can't afford the mortgage. So this deal was outside of Raleigh, it's about a 20 to 30 minute drive into the urban center. We're buying it from a developer, they're delivering portions of the units over time. It's about 150 houses. There's a clubhouse, a pool, so there's great amenities. That's a deal where we looked at it on an un- trended basis, on a cap rate basis, and it was about a six cap when we originally looked at it. One of our number one metrics in all multifamily, and this should be everybody's number one metric when you're investing in multifamily is what is the rent divided by the median income level?

Greg Campion: Okay.

Joe Gorin: Because when we buy something, we don't want to upcharge people, right? I'm sympathetic to the affordability issue. We want to be at the right rent level, but we also want to be able to see our way to higher rents, we want growth. As an investor, that's what our clients expect from us. So when we originally looked at this deal, the rent to median income level was in the 35% to 40% range, which is a little bit high. We typically want to be under 30% in any type of multifamily we do. But as we dug into it, we had our eyes on the future, not the past, and we started to see a real demographic shift in Raleigh and the skilled workers who were moving in with higher median incomes. By the time we closed on the deal, we realized that the real rent to median income level of those people who are now moving into this area of Raleigh was below 25%, which is a good rent level, it's an appropriate rent level. It also provides us the opportunity to mark rents up over time at the right level that people can afford, and so everybody wins. So, this was one of our entry points into BTR and we'll continue to do that. Not just in Raleigh, we're looking all over the country,'cause there's so many micro markets like this and we look at SFR.

Greg Campion: Mm-hmm. Yeah, that's awesome. I'd love to hear that. Raleigh is definitely more of a booming market these days. You've obviously got all the universities in the area, a ton of academic institutions, science, technology, so much talent. But that's really cool to hear just how you guys are analyzing that from the bottom up, and that denominator of that income going up. I mean, what a tailwind that is for an asset like that over time.

Joe Gorin: Yeah, and we also find some of these deals off- market from home builders who they need the money, and so if they find a credible buyer who they can do multiple deals with, they come to us. We don't want to be one and done-

Greg Campion: Yeah, yeah.

Joe Gorin: ...so we're building lots of relationships with home builders around the country so that we can execute on this strategy.

Greg Campion: Yeah, I mean, that build- to- rent segment of the market, that seems like it's going to be in demand for some time to come. Just given the housing crisis that we mentioned, it seems like there's going to be no shortage of demand there. Okay, well, let's switch gears. I know we're sort of bouncing from one sector to another, but I think it's interesting to hear your views on these, and even some of these anecdotes I think help people understand what's going on on the ground, which I think is hugely valuable. So, you mentioned retail and industrial upfront. Obviously, these two segments have become much more closely intertwined I would say over the last 10 to 15 years given the rise of Amazon, online shopping, everything that's meant in terms of bricks and mortar effects and the rise in demand for well- located warehouses and all that sort of stuff. So, let's talk a little bit about that. Those trends I would say have been big structural trends for what, a decade + now? So, what I'd be interested in is where does this all go next?

Joe Gorin: Well, I'll break them up, and there's some inverse relationship here. Obviously industrial has cannibalized the footprint of retail, they both have their cyclical and structural issues. I would say that the benefit for retail, and I think this is going to be the long- term benefit for retail, is that since... and you said a decade, and actually it's really closer to 2015, 2016 when we saw this cannibalization, this increase with eCommerce and this shift that was only accelerated obviously during the pandemic, but retail really is benefiting from a lack of new supply. I would actually give retail, using my basketball analogy, the sixth man award. It's just chugging along and it's doing its job, and it still has some stigma attached to it because malls are still in the retail category. Well, you know what? Don't buy the regional malls, they're obsolete. If you can find open air centers, that's interesting. But when you look at retail in general, you've got most of retail's performing pretty well. The overall vacancy rate nationally across the entire retail sector is just around 4%. That's not so bad. When you start to look at grocery anchored and strip centers, you're talking about anywhere between 2. 5% to 3% vacancy, which in real estate we almost call structural obsolescence, you can't get better than that.

Greg Campion: Mm-hmm. Mm-hmm. Right.

Joe Gorin: But there's still some issues with the retail that caters more to the discretionary consumer where you can buy those products online, the nail salons, the pizza joints and the grocery stores where it's a must- have, you got to go there to get it.

Greg Campion: Mm- hmm. Yep.

Joe Gorin: There is some cannibalization there, but if you find it in the right location, even with omnichannel now, people want to go into the store, they want to see the product. So we like retail, I think we'll be doing more of it. Again, there's still a valuation issue across all product types, so I'm waiting for cap rates to come up even for retail, but you're getting a little bit more premium I believe for the strong fundamentals, just because of the stigma that's still attached to retail. So, it's kind of interesting.

Greg Campion: Mm- hmm. How about on the industrial side? Obviously big tailwinds there from the likes of Amazon. What's looking really interesting there in the years to come?

Joe Gorin: Yeah, so the inversion with retail is we've got the opposite problem of supply, and so everybody loves industrial right now. We're a little bit cautious, we're going to continue to do industrial. Right now as of today, there's 520 million square feet being built in the United States of America in industrial.

Greg Campion: Wow.

Joe Gorin: So, there are going to be pockets that are overbuilt. There are plenty of areas where there's still opportunity. The tailwinds are so strong, right? You've got supply chain reshoring, you've got onshoring, you have a great need for more industrial space, but you're going to find pockets because you've had so much delivered. Just over the past three years since the start of the pandemic, you've had about 8% added to the inventory of industrial across the US.

Greg Campion: Okay.

Joe Gorin: As an example, for retail over the past three years, the same three- year period, you've had about 1% added for retail.

Greg Campion: Okay, yeah.

Joe Gorin: So I look at the $520 million, I say, we got to be really careful about where we're going to invest in industrial, we got to pick the right places. There's still an opportunity to do it. Then I'll also go back to the valuation question that is going to encompass everything I'm saying, which is cap rates for most of this stuff is still too tight. It means managers, we all have to get real and tell our investors what is the right cap rate to mark this asset at? What's been great about industrial over the past five, seven years has been these mark- to- markets. Everyone thought that, well, I'll have 3% to 5% rent growth, and some buildings get 20% to 40% to 50% rent growth, if not greater. Then what that did is now people go into the sector and they say, " Oh, great, I can buy it at razor- thin cap rate,'cause I'm just going to bet on that mark- to- market." They keep betting on that mark- to- market, but they're pushing out that lease expiration. So, I'll buy the three cap knowing that in year five or six that three cap is going to go to a six cap. Well, what happens if there's oversupply and maybe you don't? So, you need to buy at the right cap rate based on your vision for when does the rollover happen. Too many folks I think got lulled into buying at tighter cap rates based on the mark- to- market argument that may not be there.

Greg Campion: Okay.

Joe Gorin: So that's a challenge for just valuation purposes, we just have to be able to buy at the right cap rate. Financing, it's an easier time to finance residential and industrial right now, but it's still a lot more expensive. So we'll be focused on the port areas, we'll be focused on some of the port areas that are growing faster than others. There's a whole inland port system that's growing within the United States because the ports are tapped out, so I think there's a great opportunity to invest around these new emerging inland ports that are going to need more industrial. Looking across the border, onshoring just over the border of Mexico into Texas and some of the southwest states I think are going to be really interesting opportunities for expanding your industrial footprint. But some areas you got to not just understand what's in the ground now, but what's being planned, so you just have to be smart about what you're buying and where.

Greg Campion: Yeah. Yeah, those supply demand dynamics are really fascinating, really interesting to hear how it's so different from industrial to retail. Especially when you think about supply, obviously a big part of that is new development, right? So you've kind of mentioned a few things about development, we talked a little bit about the build- to- rent transaction in North Carolina, but a lot of what you hear today about new development is that things are really challenged, right? It's no surprise cost of money has gotten much more expensive, so the economics in many cases may not make sense to develop new properties. When you look at development, I know this is kind of a broad question, but what actually does work in development today?

Joe Gorin: Nothing. Well, few and far between. I would say that, again, I go back to the whole valuation question and where's the debt? You're going to finance any development. Unless you're going to do it all cash and not a lot of people want to go all cash on development today, you're looking at a SOFR rate, which is kind of the base index rate that replaced IBOR that we're all utilizing primarily as a base rate, and SOFR's well over 5% now. To develop, the banks are concerned, and so they're putting spreads on top of SOFR. Depending on if it's office, they're going to probably put 1, 000 basis points over SOFR. If it's residential or industrial, you could be looking at anywhere from 350 basis points to 400 to 500 basis points over. So, there's no available loan for development today that's going to be low of a constant of let's call it 8% to 10%, and so then you have to look at what do you think the rents are going to be if I develop this building to get me outside of negative leverage? There's very few areas where you can get that. I will say there's some distressed land deals for industrial where we can come in and buy land at cents in the dollar, and we can start to look at the importance of the location and start to make sense, and we don't have to develop it tomorrow, so that's an opportunity. Residential, I would say we'd prefer not to do ground up. We can find development in residential that's probably in the seventh inning, 70% done. Well, seventh inning, my fractions are off on a baseball game currently.

Greg Campion: Close enough, close enough.

Joe Gorin: But we don't have to take the full ground up risk.

Greg Campion: Yep.

Joe Gorin: If we're touching office development and people say I'm crazy, but we have had some interesting opportunities, where if you can build something unique in a location that doesn't exist, and you can bring pre- leasing to the table and you can get to that 9% to 11% cap rate, and let's say you're 50% to 60% leased with a credible high credit well- known tenant that's going to really brand the asset, I think that could be an opportunity down the road, and we have entertained a few of those.

Greg Campion: Yeah, I was going to ask you, has anything come across your desk recently that kind of ticks those boxes?

Joe Gorin: There's one deal in particular. I'm not going to tell you the market it's in. It's a very interesting node that is surrounded by residential, cool restaurants. There's an emerging tech element of the market, there's a great demographic shift from other markets. This is a more affordable area, maybe a more favorable tax environment, both for companies and employees. It's-

Greg Campion: You're narrowing it down a lot.

Joe Gorin: Yeah, yeah, yeah, yeah, yeah, yeah, yeah, yeah. Ask me about the weather and I might give it away, but that's a deal that we're trying to land, call it a 50% to 60% pre- lease with a tenant who could be a game changer for the market, and-

Greg Campion: That's an office property?

Joe Gorin: It's an office property, and there's a couple term sheets from lenders on it, so there is a lending world that would entertain a term sheet for a deal like that. When you look at what can be developed that is so unique, again, the haves, if you can create either repositioning, redeveloping something that is existing into the best building in its competitive set, or you can build it better than anything that's around it. So I always look at the competitive set in everything we do, we're not going to shy away from those opportunities. We may look back five, 10, 15 years from now and say, " Wow, that was the opportunity of a lifetime."

Greg Campion: Mm- hmm. Yeah, for sure. All right, I feel like we've kind of been talking about risks this whole conversation, but I do still want to ask you about risks.

Joe Gorin: Oh, there's none.

Greg Campion: If there's anything else out there. I mean, gosh, we've talked about rates, we've talked about some of the structures-

Joe Gorin: Wars, recessions, what do you want?

Greg Campion: Yeah, I mean, there's no shortage, but is there anything else? If you're looking at a real estate equity allocation over the next whatever timeframe you want to look at, let's say five years, is there anything that jumps out to you as a risk that we haven't talked about yet that you really need to consider?

Joe Gorin: Folks have to focus on expenses. I mean, we always talk about rents and how high rents are going to grow, but we're in an inflationary environment, we have to look at environmental concerns and how that's impacting expenses. I'll give you an example. Insurance costs are through the roof-

Greg Campion: Yeah.

Joe Gorin: ...and that can really eat into your net operating income. We did a study, I think since 2017 insurance expenses on an annual basis are up 7. 6% annually. I'll tell you, just over the past one to two years, we're talking about double- digit increases in insurance expenses. If you have a gross lease product and multifamily is gross lease where you have net, where the tenant pays you not just their base rent, but they pay their proportionate shares of expenses, in multifamily you're getting a gross rent, the tenant pays the gross rent. Insurance is a big component of multifamily. So I would tell people, be careful about expenses overall, labor, admin obviously with the labor situation and insurance and really understand how that can eat in to your bottom line. Also-

Greg Campion: Is that market- specific on the insurance side? I mean, is it much more expensive in certain states or certain locations?

Joe Gorin: Absolutely. Yeah, I mean, Cat 1 properties, I think there's a real risk there, that not just the insurance is too expensive, but you may not be able to get it at some point in time. So we do a lot of studies on everything we own and everything we buy, and we rate all of our assets based on a risk level of where it sits in terms of flood, storm, wind, fire, because you got to be careful not just in what... and we're underwriting the appropriate insurance number. We do stay away from Cat 1 as much as possible. If we're going to step into any of those areas, we want to make sure that the physical product is in a unique location, it's protected in terms of how it's built, but I'm also concerned on not just what the cost is, but you have to think about if you're an owner of real estate, you're always thinking about someday I'm going to sell this thing, and what's my buyer going to pay me for it? Because if you have an IRR, it has to end with a sale. So I just want to make sure that there's liquidity, and not just liquidity because people like the location of the product long- term, but because they can get insurance for it. You take the environmental risk today and you have to really weigh that risk in everything you're underwriting.

Greg Campion: Yeah. Yeah, that's definitely very important and increasingly important risk to consider. Joe, to finish out this conversation, I wanted to take a step back and ask you to put yourself in the shoes of an LP for a minute, a limited partner. One of our clients, institutional investor who's got an allocation that they're managing to real estate equity, and so maybe they're managing it or looking to construct a new allocation. Given everything we've talked about, all the themes and trends, all the risks, all the opportunities, if you're in that person's shoes today, what changes are you making or how are you thinking about constructing that allocation let's say over the next five years?

Joe Gorin: Yeah, well, I think you really have to break that down and say, okay, there's this year and then there's the longer term perspective. I talked about the spreads in debt. I call debt the new equity disguised as debt, and so I think you really got to focus on looking at some allocations within equity perhaps into debt,'cause you can get some really strong returns there. Then as you look over the longer term, you're still going to want that equity upside, so all institutional investors. I put myself in the shoes of an institutional LP every day, and as I look out to the future, I say, " I want the upside in equity. How do I get it?" Well, I got to be patient, but I got to find those managers who have real expertise to navigate a lot of these structural issues, both on the risk side, but also where's the opportunity? Structure provides opportunities. We talked about in residential, we talked about in industrial. So don't shy away from those opportunities, but really understand what's the pricing proposition over the next year to two years, and where are managers looking at their attack point? Where are they going to buy and how do they talk about valuations? Then as you look up the Core to Core Plus spectrum, I think there's going to be the tailwinds in residential I talked about. Industrial, don't be scared of industrial, but again, watch out for those structural issues and where there might be oversupply. Then as you go up the risk curve, and again, some people may think I'm crazy, but I do think office. When we look back 10 or 15 years from now, the opportunity to invest in the haves at such distressed pricing for the right buildings, you can think about dabbling into the office sector for value- add to opportunistic returns by buying Core to Core Plus risk. So, that could be a value segment that you want to look at. Life science within the office category, that's really interesting. That can't be cannibalized if I work from home, you've got to create the research and the pharmaceuticals and the tests inside the buildings. So long- term, we think life science is going to be really interesting as well. As scary and risky as the product is-

Greg Campion: Yeah.

Joe Gorin: ...I'd be negligent if I didn't put that plug out there for folks.

Greg Campion: Okay, okay. All right, you heard it here first, folks. We've got our head of equity promoting debt and also diamonds in the rough. So I think that's a great place to leave it, and like I said, I think that's a very realistic view of what's happening out in the market today. To me, it's encouraging to hear that there is opportunity out there still, despite all the negative headlines, and that you obviously have to do the work to really find those really attractive transactions today.

Joe Gorin: Yeah.

Greg Campion: So Joe, this has been awesome. Thank you so much for joining me today, and I hope to do it again soon.

Joe Gorin: Thanks for your time.

Greg Campion: Thanks for listening to this episode of Streaming Income. If you'd like to stay up- to- date on our latest thoughts on asset classes ranging from high yield and private credit to real estate and emerging markets, make sure to follow us and leave a review on your favorite podcast platform. We're on Apple Podcasts, Spotify, YouTube, and more. We publish a new episode every other week. If you have specific feedback, you can email us at podcast @ barings. com. That's podcast @ B- A- R- I- N- G- S. com. Thanks again for listening and see you next time.