Real Estate Debt: Headwinds and Tailwinds

Greg Campion: Commercial real estate markets have been at the center of the storm in the wake of the pandemic, with structural changes in tenant demand, putting the office sector in particular under pressure, but it's not all doom and gloom in the world of real estate, particularly in the fast- growing area of private real estate debt.

Nasir Alamgir: We're seeing interest from domestic and international pension funds. We're seeing your traditional sovereign wealth funds invest in the space. And we're having a lot more conversations with consultants who are representing a slew of different types of investors looking to invest in real estate debt. So it's been a very active conversation. I think a lot of people are hearing about real estate debt. They're seeing some of that relative value and attractiveness in the space. And so word's getting out.

Greg Campion: That was Nasir Alamgir, head of real estate debt portfolio management at Barings. And this is Streaming Income, a podcast from Barings. I'm your host, Greg Campion. Coming up on today's show, sizing up the opportunity in commercial real estate debt, why the asset class is garnering increased attention today, and how factors like rising rates, persistent inflation, and shifting tenant demands are shaping the opportunity. Nasir, welcome to the podcast

Nasir Alamgir: Greg, thanks for having me. I'm excited to be here.

Greg Campion: I'm excited to have you here. There is no shortage of things to talk about when it comes to real estate debt, so I think we got you at a very good time. And I'm hoping that we can start by zooming out and looking at the current landscape for real estate debt. There's obviously been a lot going on that everybody's been dealing with for the past year or so. Rising rates, pretty persistent inflation. So help set the scene for us and just tell me what you're seeing out there in terms of the current landscape.

Nasir Alamgir: Well, for investors thinking about real estate debt or already invested in real estate debt, I've got some good news and I have some bad news. I'll start with the bad news first. That's usually the way people want it. From an asset management viewpoint, I certainly think that there are going to be some challenges in 2023, and probably in 2024 as well. While historically CRE is a good, commercial real estate is a good inflation hedge, particularly in an asset class like multi- family where you can reset the rents fairly frequently, we still have issues with rising rates that are going along with inflation, which is creating refinance risk from any of the loans that might already be on your books, as well as pressure on cap rates, which are going to influence your valuations. So as you have this pressure on valuations and difficulty refinancing your assets, it's going to create problems for existing lenders with large books. And depending on what your exposure is, some folks are going to have more asset management work than others. I think it's also going to be really difficult for smaller managers that don't have the staff or the experience or the history in dealing with problem assets. I think they're going to struggle a little bit more in 2023 and 2024 than others. On the positive side, the good news side of the equation, in terms of if you have dry powder, you're looking to put money into the space, the originations and the opportunity set is probably some of the best that I've seen in my 25 year career in real estate debt. And a lot of that has to do with the fact that over the last six to nine months we've seen an incredible rise in both base rates and spreads. And that's really, again, been unparalleled in my experience. The degree to which both of those things have moved have, and I'll give you an example, have doubled coupon levels almost across the board.

Greg Campion: Wow, okay.

Nasir Alamgir: And when you think about the risk profile of the underlying loans that you're originating as well, you're generally originating them at lower loan to value rates. You're originating them with a little bit more structure, around on the floating rate side, for example, more protection around interest rate caps, and you're generally seeing the most liquid borrowers being able to tap what's a challenging capital markets environment.

Greg Campion: Okay, well that's a really interesting picture that you paint, I guess both on the positive and the negative side. So encouraging to hear, I guess, with regards to the base rates and the spreads. The potential returns on offer could be pretty attractive at the current kind of vintage. So I want to talk about that. I want to talk about some of the specific opportunities that you and the team are seeing. But maybe before we get into that, it might be interesting to hear just a little bit more detail in terms of what you're seeing out there today. So how about on the transaction side? What are transaction levels looking like currently?

Nasir Alamgir: Well, if you think of our real estate debt pipeline composed of really two types of deals, refinancings of existing mortgages or acquisition financing for new acquisitions, what we're seeing is that investment sales activity, the new acquisitions, has almost all but disappeared. And that started probably about six months ago and it's probably going to be the case for the next six months. So when half of your pipeline or somewhere, it's usually historically for us it's been between 40 and 60%, when that portion of your pipeline disappears, it means inevitably you have fewer opportunities to pick from. I think the one thing that has increased our opportunity set is given the backdrop of what's happening at a macro level and financial level, we're seeing other competitors, primarily banks or institutional lenders, pull back from the space, and loans that we might not historically view as debt fund product or client product is now coming through our pipeline and hitting our return profiles. So that has actually increased it from that perspective, and that's been a positive. But I would say for the most part we think that the next six months will continue to be quiet again on the investment sales side, which means we'll have some muted activity level. The other thing that's been a little challenging for our production is the borrowers that are out there aren't necessarily executing on their searches at the same clip that they were historically. And essentially, that means that we issue a term sheet, they look at our spread and our proceeds levels, and they say, " Yeah, I think we're going to try to kick the can down the road with our existing lender for 12 months and see what happens there."

Greg Campion: Got it. Got it. And then I guess the other thing that there's been headlines around some big outflows from some big name REITs, you're seeing more and more noise about that. Does that impact the landscape that you're seeing currently at all?

Nasir Alamgir: It does. That to me, and I'm thinking about equity REITs in the space, both public and private, I think that's what's impacting some of that transactional activity that we're talking about and the opportunity set there. One of the challenges that we're going to face that might last longer than six months is especially on the private side of equity ownership, the reset in values has dramatically lagged what's been happening in the public equity rate market. Just this past quarter, inaudible published their property index, and I think for the first time in quite some time we've actually seen it gone down. It went down about three and a half percent. To put that into context, if you look at the trailing 12 month return for inaudible, which measures the Odyssey funds, which are the core property funds that you see in the-

Greg Campion: Odyssey is open- end, diversified core equity funds, right?

Nasir Alamgir: Exactly, that's right. So if you look at the one year return for the Odyssey index, it's plus five percent. If you look at the one year return for public equity REITs, it's down 25%.

Greg Campion: Wow, okay.

Nasir Alamgir: Big difference, right? So there's still a lot of gap that the private side needs to catch up on with the public side. Now, comparing that to the REITs isn't perfectly apples to apples because the composition, property composition within Odyssey generally is different from what you're seeing on the public side. There's more industrial and multi- family in Odyssey, but if we isolate to the performance of just those two asset classes, multi- family over the last year is down 30%, industrial is down 18%. So still, you have a big delta between them.

Greg Campion: There's a reckoning coming in terms of private asset valuations, I guess.

Nasir Alamgir: That's right.

Greg Campion: Okay. And then just back to the concept of rising rates, we've been living in this rising rate environment for a year plus, 2022. The Fed obviously very aggressive, most recently just raised rates another 25 bps, so slowing pace but still directionally heading higher, at least for now. I guess my question for you would be in terms of your outlook for the space, does it change at all if we actually see a pause or even a turn in monetary policy at some point?

Nasir Alamgir: Absolutely. I mean, that's the biggest question and answer that we're looking for. What's interesting is I think the Fed has repeatedly said that they're not going to lower rates.

Greg Campion: Yeah. The market tries to keep pricing in-

Nasir Alamgir: The market keeps saying that we don't believe you. We think that there's going to be quantitative easing. And I would say many in the real estate space I think are thinking along the same lines, which is, again, why you're not seeing that transaction activity happen where it hasn't happened recently and probably won't happen for this first half of the year, because people are waiting, for some reason June's the magic date where the Fed's going to stop and they're going to start easing again. And I think that if they do, that changes the landscape. But if they stick to what they've been saying, I think it's going to have a pretty meaningful impact. I think it's going to force people to transact. One of the things that we're trying to figure out is we do think that there's going to be distressed opportunity in the markets. That probably doesn't happen until the fourth quarter of this year, but some of that has to do with, well, what does the Fed do? I mean, they could slow the pace of their increases, they could pause it at a level below what they've indicated in the past, based on some of the economic indicators out there, or they could ease it and that'll change the amount of distress. But regardless, there will be some distress and particularly in office, which we can talk more about, but that'll be one of the asset classes that we'll focus in on.

Greg Campion: Yeah, a lot of focus on office obviously. So yeah, let's talk about some of these sectors. So maybe let's start with what looks attractive to you today from a sector perspective when it comes to debt?

Nasir Alamgir: Well, I'll break that into two categories. One, in terms of what property types we think are attractive to investing in, and two, what parts of the capital stack look interesting. In terms of the capital stack, or risk profile I should say, for deals this year and likely into next, we really like that core plus, so light transitional business plan investment, and we like the opportunistic. For us, mostly that means construction, but again, I think there'll be some interesting distressed opportunities later this year and probably throughout 24. So those two areas seem like some of the best risk- adjusted returns. And it's also probably the safest way for us to truly measure risk- adjusted returns because when you're looking at core, you like to think that you're in almost a risk- free environment, but I don't really feel like that's the case. And when you're looking at value add, you're probably taking a little bit more business plan risk, and it's hard to measure the right return for taking that additional incremental business plan risk. So that paints the picture of where I see value in terms of risk profile. In terms of asset classes, I think that, look, there's this traditional multi- family industrial and it's just because the fundamentals are still really good in those two categories. And there's some strains on supply, there's some strains on demand, but not nearly as much as in almost every other property class. And ultimately, particularly for multi- family, when you look at the alternative, which for most people means owning a home, it's much more affordable to rent. Our research team covers a hundred markets. 85% of those markets, it's cheaper to rent than it is to own. Some of that has to do with the fact that mortgage rates have gone significantly up and we are seeing a little bit of relief in housing pricing, meaning it's coming down a little bit, but at the same time, the gap between the two in some markets is very, very large and it's hard to make up. And those are usually the fastest growing markets, too. The other asset class, which seems really interesting, ties to multi- family, that built to rent space where your single family home for rent space, where again it's the same dynamics as the multi- family, we think is pretty attractive. We've seen home builders pull back, which is probably an opportunity for institutional capital go in and build homes, and inventory is really important to communities. So we're happy to take a look at that as well.

Greg Campion: Okay, interesting. So going back to your comment on construction, I remember you mentioning that as a potentially attractive place to be looking for opportunities back in our 2023 outlook, back in December. And I also remember that sort of seeming a little bit contrarian. I guess potentially if the Fed is trying to engineer a recession or a slowdown, is it a contrarian time to be looking at construction lending?

Nasir Alamgir: I think it sounds more contrarian than it actually is. So when we review our own loan performance in history, and we've been lending in the construction space for more than two decades now, we find that some of the best vintage construction loans we've made have actually happened during a recession. And most of that has to do with the fact that when you're delivering your final product, you're usually doing it when you're coming out of a recession. And so you're that newest product, generally what people are looking for. Money's coming back into the system. It's actually a really great time to be making construction loans. So we continue to like the space. It's not as contrarian as it sounds. And sometimes, too, you'll end up seeing some relief and expenses on construction costs because if, again, labor market gets softer, less demand for some of those goods and services, you can create some cost savings too on that side, as well.

Greg Campion: Okay. So that's a good window into some of the areas where you're seeing some attraction in terms of value today. What sectors are you shying away from?

Nasir Alamgir: So I was at a conference earlier this year, the beginning of January, and needless to say, when you're talking shop, people always want to tell you what they like and what they don't like. And plenty of people telling us not to like office, and I'll talk about that. But I think one of the things that people did like, and I'm going to take the contrarian view and say I don't like, there was a lot of fanfare around retail. So it was, well, retail debt yields on loans look really attractive and their cash flows are strong. And if you look at the supply demand fundamentals, they look really good. But there's a reason that that's the case because simply no one's been building any retail, and we aren't building any retail because we continue to be over retailed as a population here in the United States. So there is still less need for the amount of retail we have. So fine, those supply demand fundamentals look good from the perspective of the next 12 months. But long term, retail is still going to struggle as an asset class. There's a lot of talk, and I'll talk a little bit about the hotel space too, because I think it falls into this category somewhat of asset classes, maybe you aren't shying away from, but you're being mindful of. In a recessionary environment, things that get impacted are your ability to spend money. So if we look at consumer savings, and I want to give a shout out to Christopher Smart from the Barings Investment Institute, he put together a paper that had the top 10 stats to look out for 2023, and one of those was consumer savings. And consumer savings peaked at 2. 3 trillion in August of 2021. They ended the year down to 1. 2 trillion. So as that discretionary capital is moving out of the system, and I think what we saw is probably, I'm going to talk about revenge travel, which people were doing-

Greg Campion: Revenge travel. inaudible

Nasir Alamgir: I think there's some revenge shopping that took place. So if, again, that demand was there because people had been cooped up, shopping online, and they finally said, " Hey, I want to go out to eat. I want to go out to get something to drink. I want to go see a show."

Greg Campion: We're going to spend some money.

Nasir Alamgir: We're going to spend some money and we're going to get out there. As that stuff normalizes again, I'm not sure that retail really is the place that you want to be. Again, maybe if you could do a six month loan, but then you worry about what's your takeout, and no one's really doing that. It's a lot of work. I'll talk about office because it's on everybody's mind. It's clearly an asset class that's going to be challenged, and what's probably the most eye- opening about office is how quickly that sector has deteriorated during this pandemic. So most other asset classes you've seen a rebound. It's gotten better as we've gotten through the pandemic. Office has gotten worse. Now, it doesn't mean that there isn't return to office, return to office has gotten better, but the demand for office space has gotten worse.

Greg Campion: Is that more of a timing issue, I wonder, because we're three years since the beginning of the pandemic and I would imagine that it's like sort of turning a barge, trying to reassess your corporate footprint, real estate footprint. So is that what it is? Is that part of it, that there's just a lagged timing effect that companies probably realized a year ago that they're going to need less space, but it takes a while for it to work its way through the system?

Nasir Alamgir: It does. It takes a while for it to work its way through the system because most of these office leases are five to 10 years long, and so you're waiting for them to expire or you're waiting for options within your lease to reduce your footprint and those things are happening. Remote working is here to stay. I think we've changed the culture due to the pandemic. We've proven as a society that we can work remotely. There's still some industries that feel that it's really important to be in the office and those will continue to exist, but they're in the minority and we're seeing it across the board, and that pressure is going to exist, particularly for assets that are featuring structural obsolescence. So the older vintage product that might not be as energy efficient, that might not be as clean from a pandemic perspective, those are going to be challenged assets. There are going to be markets that are more challenged than others. Again, growth marks are going to be really important in terms of if you're going to pick your spots to invest in, in office, and there are some. There are bright spots in the office space, but the clouds are over much more of that office sector than there are spots of sunshine. So it's certainly something that we want to pay attention to. Our head of research in real estate wrote a quick piece on sort of beware the appraisal valuation of office because just like we were talking about with the Odyssey index versus publicly traded REITs, there's always that lag. Trusting an appraisal right now on an office basis is almost an impossibility because those data points are just starting to come in and it's really hard to gauge where those valuations are. The valuation reset in office is probably going to be the most significant reset that we can see in the next 12 to 24 months. It reminds me a little bit of retail, where if you thought, look what happened to the regional malls, in cities that might have had five regional malls that only needed three, number four, number five slowly went away, and that's happened over a couple of decades. We're seeing that reset happen a lot faster in office. And again, because of the pandemic, you're seeing that reset happen much quickly.

Greg Campion: Yeah, yeah. Wow. Yeah, that's a really fascinating parallel to draw, and obviously both going through major structural changes and that changing the demand profile, the client, or sorry, the tenant demand profile for the space. But it's also interesting for me to hear about that you think there's going to be opportunities, and I know that you and the team have done lots of work in places like life sciences and content creation, some of these more specialized type of office types that are in very high demand and you can achieve high rents, et cetera. So it's interesting to watch the almost divergence in that space. Now, I guess the other question along those lines, you mentioned that you think that come Q4 of this year you may start seeing some distressed opportunities. Would office be one of those areas where you could see distressed?

Nasir Alamgir: It is. Generally speaking, I think office loans from a lending perspective made up somewhere between 20 to 30% of your portfolio. In terms of maturities that we're seeing in 23 and 24, we're approximating there's about 70 billion of office loans maturing this year, another 60 billion of office loans maturing next year. And if you think the world of office is much more filled with the have- nots than the haves, that's a lot of office space coming due that may not have a refinancing exit or an investment sales exit. And I think many lenders aren't, generally speaking, lenders aren't necessarily prepared to own real estate. Some shops have equity arms, especially in the private sector. Banks generally don't. So they don't want to own real estate. It's going to likely push banks to kick the can down the road. And from what I'm hearing anecdotally, I think people are trying to get to that, again, that magical June timeframe when the Fed is going to start quantitative easing.

Greg Campion: Oh no, it seems to keep getting kicked back further, though.

Nasir Alamgir: Well, they're looking to try to get to that state, and I think both borrowers and lenders are inclined to do that. What's going to happen is we're going to get to that state and if we don't see real positive signs from the economy, avoiding a recession or it being a very mild recession, and if we don't see that quantitative easing to the degree that people are expecting that quantitative easing, then I think it's going to force people to act. And that means that loans are going to have to be sold, properties are probably going to go back to lenders, things like that. So you're going to see that distress, and it'll start to creep up in that fourth quarter.

Greg Campion: Got it. Okay. Now, I think most of your comments thus far in this conversation have been with the US markets in mind, or the US market in mind, I should say. As you think geographically, obviously Barings has a large presence in Europe, increasing presence in Asia. As you think about the dynamics and how they differ between the US and Europe, do you have a sense for if some of the conclusions you're drawing are applicable for Europe as well, or is it completely different there today?

Nasir Alamgir: No, I think there are a lot of similarities between the US and Europe. I think that the same sort of competitive dynamics in those markets, meaning banks pulling back, some of the traditional lenders pulling back and creating opportunities for debt funds and private lenders, is real. And it's real over there, just like it's real over here. I think some of the same pressures exist from an economic perspective at the macro level and at the asset level. I think they still have some similar challenges in the office market. But what's positive for the EU specifically is in 2022, they grew at a faster rate than the US economy did or many Asian economies did. So I think that that's a telling sign for them. So maybe that's a silver lining for them. There's still some issues also around resetting private valuations to public valuations, so they'll have some of those headwinds as well. But again, the opportunity set looks very similar, particularly in real estate debt.

Greg Campion: Got it. And so when you're having conversations with investors today, clients at Barings, I'm curious how you're explaining to them some of the attributes that you're seeing in real estate debt right now, both positive and negative.

Nasir Alamgir: So I sit on a relative value committee here within Barings that sits across all of our private asset classes, and we talk a lot about relative value or what we're seeing in our individual markets. And generally speaking, you can make an argument for each asset class, their strengths and weaknesses or reasons to invest in a number of those private asset classes. So we aren't necessarily comparing each asset class to one another. We're looking at things, though, like illiquidity premium to certain corporate indices. We're looking at correlation, volatility. At the end of the day, what real estate debt provides most investors is diversification. It provides lower volatility, it provides little correlation to many other asset classes. So it's what a CIO is often looking for as a diversifier. And because you can invest in different parts of that risk spectrum, if you need to match long- term fixed rate liabilities, you can do a lot of core, very plain vanilla lending. If you're looking for high yield, you can do floating rate, core plus, construction, value add lending. So we think that it's an asset class that belongs in everybody's allocation, and there are ways to make it work in various investors' portfolios, based on their risk return profile.

Greg Campion: And it's my understanding, correct me if I'm wrong, that the kind of universe of real estate debt has really evolved quite a bit over the past decade in that it was maybe a decade ago seen as more appropriate for distressed opportunities. But today, as you're describing, you can kind of cover the full gamut in terms of the potential opportunities that are out there. Is that right?

Nasir Alamgir: No, that is fair. And I think part of the reason for that, or much of the reason for that is since the GFC, a lot of the regulation that was put in place to protect banks from themselves has created the private market opportunity set. And so that allows those private lenders to participate in all parts of the capital stack. There are still plenty of traditional lenders out there, whether they're insurance companies, again, regional, super- regional banks, money center banks, international banks coming in. They're all there, but there's a much bigger opportunity set today than there was 10, 15 years ago for the private sector.

Greg Campion: How about in terms of the types of investors that you're seeing investing in real estate debt today? We hear a lot about insurance companies, but tell me what you're actually seeing day to day.

Nasir Alamgir: Insurers definitely top the list. We're seeing interest from domestic and international pension funds. We're seeing sort of your traditional sovereign wealth funds invest in the space, and we're having a lot more conversations with consultants who are representing a slew of different types of investors looking to invest in real estate debt. So it's been very active conversation. I think a lot of people are hearing about real estate debt. They're seeing some of that relative value and attractiveness in the space. And so word's getting out. We're having a lot more conversations these days.

Greg Campion: With regards to insurance companies specifically, are there any particular things that are attracting them to this asset class?

Nasir Alamgir: Historically, I would say insurance companies were more attracted to the core part of the risk profile. They had maybe long- term liabilities that they're trying to match with investment grade risk. What we're seeing is insurers look a lot more at our high yield products from core plus to opportunistic. And so that's been a welcome change and it certainly, again, ties into where I see the best relative value in the market today.

Greg Campion: Got it. This has been very educational for me, Nasir, hopefully for our listeners as well. I think you painted a really great picture not only of the challenges that the real estate space is facing today, I think you give a really realistic picture of that, but also some of the opportunities out there. And I think it's a good reminder that some of the vintages that come out of recessionary periods or times of increased macro volatility often end up being the most attractive vintages over the long term. So I appreciate you giving this insight to us today, and hope I can have you back on the podcast soon.

Nasir Alamgir: Well, I'm looking forward to that, and thanks for having me today.

Greg Campion: Thanks for listening to episode number two of season eight 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 in 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. 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.