Real Estate Debt: Why Now?

Greg Campion: Real estate debt has continued to grow in prominence for institutional investors, who've been attracted to the healthy yields on offer, as well as the senior position in the capital stack. But as we all know, commercial real estate remains rife with risks and uncertainty, including the future path of interest rates, current valuations and transaction volumes, and broader macro and geopolitical risks. What are you going to be keeping an eye on as we move forward here?

Nasir Alamgir: I think I'd say that despite all the risks and uncertainties that are out there, this is still probably one of the best times to be deploying capital in real estate debt that I've seen in my entire career, and that's spanning over 25 years. And you can probably go back another decade or so before you saw something as attractive as today.

Greg Campion: That was Nasir Alamgir, head of US Real Estate Debt Investments at Barings. And this is Streaming Income, a podcast from Barings. I'm your host, Greg Campion. Coming up on today's show, US Real Estate Debt, why now? Before we get into the conversation, if you are not already following us and you are interested in hearing our views on asset classes ranging from high yield to private credit to real estate debt and equity, you can follow us by searching Streaming income on Apple Podcasts, Spotify, YouTube, or wherever you get your podcast. With that, here is my conversation with Nasir Alamgir. All right, Nasir, welcome back to the podcast.

Nasir Alamgir: Greg. Thanks for having me. It's great to be here.

Greg Campion: Excited to have you back. So it's been almost a year, I want to say, since you were last on the podcast and a lot's changed over that timeframe. So obviously we're in a little bit of a different interest rate environment. We've got another year under our belt in terms of developments in the real estate market and everything that commercial real estate is working through. But maybe let's start there. If you just look high level at the real estate debt landscape, in particular over the last year, what are some of the biggest developments that you've seen?

Nasir Alamgir: Well, I think it was interesting. I was going back and going through some of my notes from our last conversation and I recalled mentioning that one of the things that we're keeping an eye on was bank exposure to commercial mortgage loans. Their balance sheets had grown by about 500 billion in 2022 alone, increasing by about 20%. And we thought that there was going to be a really significant pullback in terms of their origination in 2023. I think the one thing that we didn't anticipate is a month later there was going to be a liquidity crunch, a run on banks, and you had a number of banks fail.

Greg Campion: Yeah. Happened a lot quicker than maybe expected.

Nasir Alamgir: So Silicon Valley Bank, Signature, et cetera. And I think those events took us a little bit by surprise, but again, we did think it was going to be consistent thematically with what was going to be happening in 2023, which is a retrenchment from most lenders in the marketplace, mostly dealing with existing problems on their books, dealing with maturity walls, and trying to really find opportunities to put money to work. Which was hard to do because transaction volume continued to be a challenge in 2023. We thought we found some really interesting opportunities, but overall it was an interesting year, let's just say.

Greg Campion: Yeah, yeah. All right, well, a lot of the stuff you mentioned there I want to follow up on, including the retrenchment of the banks and transaction volumes. But maybe before we get into those, let's hit interest rates. I mean, I feel like every podcast we do these days, there's a big question around, okay, we've kind of gotten to this point where it seems like maybe we're at peak rate. Maybe the Fed is sending us a message that the next move is lower. But there's a lot of question marks around what does the pace of that look like, et cetera. So broadly speaking, you look at where we are in the interest rate environment today. Tell me a little bit about the implications for investors in real estate debt today.

Nasir Alamgir: Well, and I'm going to juxtapose it a little bit to last year too. Last year we expected rates to continue to go up. It was interesting, I was at a conference in January of last year. There was a lot of optimism. There was another conference January of this year. Now that's more cautious optimism. I'm not sure either of those are going to, didn't play out last year, I'm not sure it's going to play out this year.

Greg Campion: Okay.

Nasir Alamgir: So I think the expectation for us is maybe we don't see rate hikes anymore, but we certainly see higher for longer. At least that's our view in real estate debt. And I think what that means is for those dealing with asset management concerns or issues with existing loans, you're going to be faced with certain outcomes. Those outcomes could be trying to extend your loans. We had about 500 billion of loans maturing last year in the commercial real estate space. A lot of those probably got kicked down, that can, the proverbial can, got kicked down the road. We have 2.2 trillion maturing between now and the year end of 2027. So higher rates means it's going to be really difficult for borrowers to find alternative sources of capital to refi out those existing lenders, and it's going to continue to put pressure on valuations. So with that backdrop, asset managing your portfolio is going to be a very hands- on endeavor and it's going to take a considerable amount of people's time. But again, as a new lender or originator with fresh capital, I think 2024 is going to present as many opportunities as 2023 did and probably a little bit more.

Greg Campion: Yeah, okay. So a lot to work through there, but yeah, to your point, if you're putting fresh capital to work, it could be a really interesting time to do so at this point. Now, a lot of these loans that you reference are historically, for historical reasons, I guess, on bank balance sheets. So banks have historically been the biggest lender to this space. And as you kind of mentioned up front, you were talking this time last year about bank retrenchment. We're seeing that now. So we're seeing much more stringent lending standards. We're seeing banks pull back for a variety of reasons. So tell me a little bit about that. It's almost, parts of it are almost reminiscent to me of this kind of major structural tailwind that we've seen in the direct lending space for a decade plus where you've just seen this long- term trend of bank retrenchment and that's kind of driven a lot of opportunities for institutional asset managers, AKA lenders like Barings. But tell me just how you're thinking broadly about that bank retrenchment trend, how far you think that's going to go, and what you think some of the impacts will be?

Nasir Alamgir: Yeah, look, I think that like private credit, I think it's a permanent retrenchment. So the US commercial real estate market's roughly 5 trillion. Banks make up about half of that. Last year, their origination volume was down 70%. The market overall was down 50%. Interestingly enough, the size of their balance sheets didn't shrink. It actually went up last year, despite that. So again, that's the proverbial can being kicked down the road.

Greg Campion: Sure, yeah.

Nasir Alamgir: Those loans weren't maturing and being repaid or refinanced. So I think what's interesting is if you think that there's a permanent shift in the way banks will approach the market, that means that there will be a broader opportunity for that private lending base. So again, like we've seen in private credit, the private markets substituted that bank capital. We're seeing that not just in banks alone, we're seeing that in the securitization markets, we're seeing it in life insurance company production. So in general, private debt is going to have to step in to fill that void.

Greg Campion: Now, thinking ahead to what this year may offer, I was speaking with our head of US Real Estate Research, Dags Chen. He was telling me in his view, he thinks this could be the year of a couple things. One, it could be the year where we really start to see distress hitting the market, so to speak. So you reference this idea of kicking the can down the road and pushing out loans, but ultimately the bill comes due and that isn't possible or banks don't want to do that, et cetera, and so you start to see more distressed assets kind of hitting the market. So I'm kind of interested what the implication of that could be. His other thought was though, while this could be the year of distress really hitting, it could also be the year where we start to see stabilization and even a bit of recovery in the commercial real estate market. So if he's right and those things are true and hopefully not mutually exclusive, curious around what you think that means for things like transaction volumes and just broader ability to deploy debt capital.

Nasir Alamgir: And you would think those two ideas are almost counterintuitive, but I think what Dags is saying is distressed activity will allow us to truly figure out where the bottom of valuations are. And without those data points, which we really haven't had in any substantive way up to this point, it's hard to pick where the bottom is.

Greg Campion: Yeah, yeah.

Nasir Alamgir: So once we are able to establish that, we can establish that baseline, and then figure out where we go from there. I agree with him. I think distress is coming this year, and some of that fact is attributable to lenders having taken write downs or impairments on their existing book, which will allow them to move that paper this year.

Greg Campion: Okay, yep.

Nasir Alamgir: Which where they weren't really able to do last year. I think that's across the board. I think you've seen tighter underwriting standards. I think banks alone have reported six quarters of credit tightening in terms of their lending parameters and their provisions have gone up each and every quarter since that time. So all of those things mean that there's more capacity to absorb the pain that may be felt in some of those loans. So, yes, I agree. I think there's going to be more activity in that, in the distressed loan space.

Greg Campion: Okay. And do you think that will be exclusively centered in the office sector or do you think it's more broad based than that?

Nasir Alamgir: It's more broad based than that, but that'll be the focal point, the center, of transaction activity. I think one of the things that may be difficult to move with respect to moving office, distressed office paper, this year, or even in the foreseeable future is we don't really know what the true future of office ultimately is going to look like.

Greg Campion: Yeah.

Nasir Alamgir: We can see what some of the existing trends are, but does return to office or office utilization continue to improve down the road? Do the properties that we consider commodity and obsolete today actually find some home? Are there conversion opportunities. There are a lot of different questions that we need to have answered? There's so many that it's really hard to see all of that figuring itself out this year.

Greg Campion: Yeah.

Nasir Alamgir: So I might disagree with Dags in terms of truly finding that opportunity in terms of setting that value for equity in 2024, but we're getting there.

Greg Campion: Yeah, yeah, that makes sense. Yeah, and when I had Joe Gorin our Head of US Real Estate Equity on the podcast a couple months ago, I mean, I think his sentiment was similar, but he was also saying, " Look, that doesn't mean there's no opportunities in office. They're just very highly select, very idiosyncratic specific situations." And he talked about a deal that Barings did recently, I think it was near Newton Massachusetts, that was kind of a refurbish. But it's a lot of these types of properties that are hitting very specific trends in a highly educated area in a sector that needs to be in the office, like a life sciences, et cetera. So it seems like there are these opportunities emerging, at least on the equity side that he was talking about, but it's very idiosyncratic. Would you agree with that?

Nasir Alamgir: I do. I agree with that. So I think you're probably strategizing more today in terms of what you want to do with equity and debt. You're trying to figure out how to put fresh capital to work.

Greg Campion: Yeah. Tell me a little bit more about that. I'm interested in this kind of relative value because I think, obviously US real estate equity and real estate equity, I guess more broadly as well, is a much more developed institutional asset class. People have been used to investing in this for a long time. Less so, debt. And so how are you thinking just broadly about what that relative value picture and how do you and the team, I guess, think about relative value between the two?

Nasir Alamgir: Yeah, we talk about relative value pretty frequently, and we have to do it across the risk spectrum and we have to do it across debt and equity and we have to do it across geographies. And I think what's really interesting is that probably geography plays a much more important part than I think people realize because you can have very different macroeconomic factors that are going to influence the outcome of your investments, whether those are dead investments or equity investments. So I think one of the examples I like to use today is, well, if you look at an economy like China's, they're worrying about deflation. Right here in the US we're worrying about inflation. And so those have very different impacts on the type of investment you want to make, the duration of that investment, and the risk profile you want to consider.

Greg Campion: Yeah,.

Nasir Alamgir: So for us today, again, I think with fresh capital, regardless of the bucket, we want to put it to work in debt. With future capital, we want to figure out where that opportunity might be in equity.

Greg Campion: Yep, yep. Yeah, that makes sense. Before we started recording, I was mentioning a conversation I had with Dags Chen, again, our Head of US Real Estate Research where he was sort of comparing the two and saying, " US real estate equity is almost in its off season right now, and it's your time where you're kind of dusting off your playbooks and doing your draft picks and things like that because you know there's a real opportunity coming. It's just when is that specific time?" And whereas in debt, it seems like that is much more apparent opportunity today as we sit here.

Nasir Alamgir: Agreed.

Greg Campion: Yeah. Okay, so let's talk about, within the real estate debt universe, we've kind of been high level so far. We touched on office a little bit, but tell me, as you look across that kind of broad universe, where are you seeing particular opportunities today? Any sectors that really jump out at you that are particularly attractive today?

Nasir Alamgir: Much like last year, we still think bridge lending on transitional properties is still some of the best risk adjusted returns that we see in the market today. I think interestingly enough, last year we probably talked about construction lending as well.

Greg Campion: Yep.

Nasir Alamgir: I like to think about the market in three ways. There are parts of the market that are moving fairly smoothly, but slowly. Then there are parts of the market, and I'm talking about the real estate debt market, that are pretty dysfunctional. And then there are parts of the market that are actually look almost completely broken. And one of those spaces really is in construction lending. So we said banks have been retrenching on lending for six quarters, but they've been retrenching on construction loans for seven. The alternative sources for capital in construction lending are almost non- existent. So to the extent that you're a private source of capital and you can make a construction loan today, relative value is really, really amazing. Now, there are certainly things that we want to be cognizant of in delivering new supply in certain economic conditions. But that trade, if you want to call it one, that investment, looks really attractive. From a property type perspective, it's really hard to pick outside of the safest asset classes, whether it's multifamily, whether it's industrial. Self- storage is attractive. Data centers continue to have their moment in the sun. But like Joe said, you got to kind of find that needle in the haystack when it comes to the office deal or you might have to find that needle in the haystack when it comes to maybe a retail loan.

Greg Campion: Yeah, yeah.

Nasir Alamgir: Or investment.

Greg Campion: And on the construction lending, is there specific sectors on construction lending that look more or less attractive? Is that a multifamily or anything else that jumps out at you as being particularly attractive there?

Nasir Alamgir: I certainly think that multifamily and industrial lending, I feel like it's just such an obvious answer. Great. Go make a multifamily loan, whether it's construction or bridge. Go make a industrial loan, whether it's construction or bridge. But I think you can actually still find really interesting opportunities outside of those asset classes. I think hospitality is one that's really attractive.

Greg Campion: Okay. So building hotels?

Nasir Alamgir: Building hotels.

Greg Campion: Okay.

Nasir Alamgir: And I think that we also see mixed use being attractive. And that can include office as a use.

Greg Campion: Yeah.

Nasir Alamgir: Because that new building that's highly amenitized, near a transportation hub, that has surrounding amenities, either within or out immediately surrounding the property, is still an attractive asset class. So there are some unique opportunities outside of just your traditional ones.

Greg Campion: Yeah, that's interesting. I mean, we're sitting here recording this in Charlotte, North Carolina today, and we've got a surprising, to me, a surprising amount of skyscrapers still going up all over the place, even in spite of the fact that some of the older, more out- of- date buildings have pretty darn high vacancy rates. But also to your point, out in the suburbs, there's a lot of development going on with reinvention of 1990s industrial parks into much more modern, amenitized, multi- use properties with retail and restaurants and residential, et cetera. So it's interesting to see that. I feel like Charlotte's a pretty good case study of some of that actually on the ground today.

Nasir Alamgir: Yeah. It's evidence of the experiential economy or state of mind today where people want to be able to do lots of different things within the convenience radius of where they live, where they work, where they play.

Greg Campion: Yep. Yep. Any particular geographies or cities in the US where you're like, " We are really trying to put capital work here today?" Or is it more on a kind of idiosyncratic basis?

Nasir Alamgir: I don't know if I want to give away all of our secret sauce here, so I'm going to try to be a little bit-

Greg Campion: Yeah.

Nasir Alamgir: Look, I think there are a lot of unobvious places that you can put money to work. And what I mean by that is there are overlooked parts of the country, simply because it doesn't have international cache or whatever it is, but that are resilient because people work, people live, people play in those areas and they're growing. And I think when we apply that research lens that Dags puts on our investments and we're looking at educational attainment, population growth, job growth, wage growth, resilient industries, it isn't just markets in the Southeast that reflect those statistics.

Greg Campion: Right, right.

Nasir Alamgir: And so we're looking a little bit beyond some of those obvious choices.

Greg Campion: All right, folks, you heard it. You have to have a one- on- one conversation with Nasir to get the real secret sauce there. But, yeah, clearly the work of the research team in all the structural trends factors heavily into sourcing and evaluating different opportunities that your team comes across so I'm glad you gave Dags a shout out there. Okay, so one of the interesting trends that we've seen in recent years is institutional investors really increasing their allocation to real estate debt. And I mentioned earlier it's kind of been maybe a little bit less developed-

Nasir Alamgir: Music to my ears, by the way.

Greg Campion: Maybe a little bit less developed. Some of them probably have been doing it a while, some of them newer to the asset class. Curious, where are you seeing capital come into the asset class from today?

Nasir Alamgir: So historically it was, like you've mentioned, it's a pretty niche investment type. Somebody had to have true understanding of the real estate industry, and probably real estate debt specifically to make an allocation to real estate debt. Today we're seeing that interest come from your traditional real estate equity investors and we're also seeing it from the private debt, private credit, landscape. And for two different reasons. Real estate equity is looking at some of the returns that they can achieve in the debt space and they're saying, " Whoa, this looks really interesting and we're struggling putting our equity dollars to work. There are opportunities for us in real estate debt that can achieve similar returns."

Greg Campion: Right.

Nasir Alamgir: Maybe that's moving a little bit-

Greg Campion: And you're an attractive place in the capital structure.

Nasir Alamgir: Right. You might be a little bit higher in the capital stack than some of the areas that I was pointing out earlier. But you can find really nice risk adjusted returns from that equity perspective. With respect to private credit investors looking at the real estate debt space, they look at it as a diversifier. It's backed by a real asset. There's a long track record. And I think you were pointing this out earlier too, private credit went through some of these shifts where it was dominated by banks or insurance companies. Real estate lending has been dominated by banks and insurance companies. And that slowly started to unwind post the financial crisis and now even more so today.

Greg Campion: Yeah.

Nasir Alamgir: So I think that shift will continue and we'll see investors across the investment world start to consider real estate debt.

Greg Campion: Yeah, it's really interesting to see the development of the private credit asset class, broadly speaking, in the biggest umbrella terms you can use. A few years ago we were talking about private credit, we'd be talking about corporate middle market direct lending, like pretty very specific area of the market. Now, that market, obviously due to some of the factors that we've talked about already, has taken off and I don't know how the magnitude exactly of the growth, but it's something like a 1. 5 or 1. 6 trillion market today. So grown massively. But you have this scenario that I think you're kind of alluding to that a lot of investors have gotten very comfortable with investing in private credit and now we are seeing many different flavors of that. You can include everything from infrastructure debt to different asset backed, private asset- backed, securitizations and such. So much more broad than just traditional corporate middle market lending. But I think to your point, increasingly investors are seeing real estate debt as part of that investment universe and what's really interesting to me is that you are starting from a point where this is already a massive market, it's just one that's not traditionally been financed by institutional lenders. It's something like a$ 5 trillion market. But a lot of that obviously has been financed by banks. I mean, what do you see, I mean I'm sure you and the leadership team here at Barings are looking at that and expecting or trying to predict what the growth of the asset class could be over time. What do you broadly think could happen here?

Nasir Alamgir: Well, I certainly think that private lenders can increase their market share exponentially over the next few years. And again, I do think that that's a permanent shift in terms of supply demand for real estate loans. I think a lot of that permanency is going to be dependent on a lot of the factors that we're looking at today with respect to asset performance, regulation, et cetera, which will impact the traditional lenders in that landscape. It's hard to imagine a scenario where they don't curb some of that historical appetite. So there's only truly one source to fill that, and that is private capital. Public markets have always had some share of the market landscape, but private sources of capital will fill that void.

Greg Campion: Yeah. Awesome. Okay, well as we wrap up here, I wanted to just ask you, thinking ahead for the remainder of the year here, I'm curious just to hear a little bit about what you're going to be watching, what you think some of the big trends are. What are you going to be keeping an eye on as we move forward here?

Nasir Alamgir: Well, an obvious one is the election, which here in the United States, presidential election, which I think everybody-

Greg Campion: I haven't heard about that one yet.

Nasir Alamgir: Which everybody will be focused on.

Greg Campion: Okay, yeah.

Nasir Alamgir: But I think to throw out one last statistic, so not to be an encyclopedia here. There are about 1 million units, multifamily units, that will be delivered in 2024. Now housing is almost a global crisis in terms of availability of housing in many, many markets, but that is going to be a very interesting amount of inventory for us to absorb. And if it was spread out evenly nationally, it's probably like okay, but there are pockets of concentration of that development. So it'll be interesting to see what impact that has on valuations asset performance, specifically in that asset class. So as much as I like multifamily as an asset class, again, we have to be very disciplined in our deployment approach, taking that macro level research lens and then the bottom- up approach of boots on the ground and understanding where that supply is coming in and how it's going to impact existing assets or new assets that we might want to lend on.

Greg Campion: Yep. Okay. That's a great one to watch. All right, Nasir, I am going to give you the last word on this podcast. I want you just to think about addressing any investors out there in real estate debt. Maybe they have allocations to the asset class today. Maybe they're thinking about allocating to the asset class. Any kind of core messages you'd want to leave them with?

Nasir Alamgir: I think I'd say that despite all the risks and uncertainties that are out there, this is still probably one of the best times to be deploying capital in real estate debt that I've seen in my entire career. And that's spanning over 25 years. And you can probably go back another decade or so before you saw something as attractive as today.

Greg Campion: Wow. Okay. Yeah, that's a great one to leave it on. So you heard it folks. Nasir's been operating in the asset class for a long time, and so I think that really holds some weight in terms of the opportunities that you're seeing today. So thank you for doing this. Always appreciate getting your insights into this market. It's a fascinating space to watch. I think it's going to be really, really interesting to see its growth in the years to come, and I think you and the team are right at the forefront of that. So really appreciate your time and hope to do it again soon.

Nasir Alamgir: Thanks for having me. It's always a pleasure.

Greg Campion: Thanks for listening or watching 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 debt and equity, make sure to follow us and leave a review on your favorite podcast platform. We're on Apple Podcasts, Spotify, YouTube, and more. And if you have specific feedback, you can email us at podcast @ barings. com. that's podcast @ barings. com. Thanks again for listening and see you next time.