Animal Spirits Podcast - Talk Your Book: How Higher Rates Are Re-Shaping Commercial Real Estate

Starting point is 00:00:00 Today's Animal Spirits Talk Your Book is brought to you by Benefit Street Partners, a Franklin Templeton company. Go to FtPrivatemarkets.com to learn more. Welcome to Animal Spirits, a show about markets, life, and investing. Join Michael Batnik and Ben Carlson as they talk about what they're reading, writing, and watching. All opinions expressed by Michael and Ben are solely their own opinion and do not reflect the opinion of Ridholt's wealth management. This podcast is for informational purposes only and should not be relied upon for any investment decisions. clients of Britholz wealth management may maintain positions in the securities discussed in this podcast. Welcome to Animal Spirits with Michael and Ben.

Starting point is 00:00:41 Michael, one of the most fun things about changing times is that people love to predict what's going to happen. And most of the time, people are wrong. But think about coming out of the pandemic, there was a ton of this is how the world is going to change. Remember there was like no one's ever going to give handshakes anymore? People are going to wear more masks on planes, colleges done, all of these predictions. Travel is dead. business travel is dead. Business travel is booming. Yeah, there's all these things that people predicted. And one of them was, all right, that's it. Commercial real estate is just dead. Deter than dead.

Starting point is 00:01:11 No one's ever going to go to an office again. Well, it is pretty dead. I think you could say it's mostly dead. More of a death by a thousand cuts as opposed to like people, remember people thought like, okay, the commercial real estate crashed. That was a story that you and Josh and I talked about for probably a month. It was like a thing. People were discussing. And then it kind of moved on and you realized, oh, that's not how real estate works actually. No, but commercial real estate really did crash. It's office space. Explain yourself.

Starting point is 00:01:36 How did office space crash? Well, it went down a lot in value. Okay. But it really did. I mean, the Class A buildings in New York City, for example, are doing just fine. But my God, you do not want to be where people don't want to be. Right, an older building, right. It is dead.

Starting point is 00:01:54 Never coming back. When we go to look for new space, whenever our lease runs up in a few years in New York City, We're not going to go to some 1970s building. We're going to go to a brand new spot that looks nice, right? Anyway, fascinating time to be in real estate because rates are shooting up and the economy's boom. It's like a weird thing to think about. The economy is still kind of booming, but rates are going up, making it more difficult.

Starting point is 00:02:13 So in today's show, we had Jerry Bagley. Jerry is the head of real estate at Benefit Street Partners, a Franklin Templin Company. To talk about everything that's going on in commercial real estate, the spots that are attractive, the spots that are unattractive. I love talking to people in the space like this when, like big things are happening. Like, if real estate was booming right now, it wouldn't be as interesting of a conversation as,

Starting point is 00:02:36 oh my gosh, rates keep going up and up and up. They're going up really fast. What does this mean? And Jerry is a straight shooter with upper management written all over him. He told it like it is, right? You set office space earlier. So here's our talk with Jerry Bagley.

Starting point is 00:02:56 Jerry, welcome to the show. Thanks for having me, guys. All right, we're going to start out big picture and then we'll zoom in on some different areas of the real estate debt market. How would you describe where we are right here. We're recording on September 28th, the 10-year-Ire screaming higher that is a base rate for which all other rates are determined, certainly in the real estate market. Save us, help us.

Starting point is 00:03:16 What's going on with interest rates screaming higher? Your time is impeccable. I think I've done seven calls today, and that's been the first question in every single call. If AI doesn't kill us, the 10-year will. Exactly. No, it's beyond the topic du jour at this point. I think it's scaring everyone clearly because it's ripped so fast in such a short period of time. It's putting a bit of appall. I think over a lot of different things, it's going to slow down transaction volume for sure. It's going to make refis trickier than they were and it's going to put pressure on valuation. So all wonderful things if you're in the real estate business. It's exactly what you want, multiple headwinds all at once. But also opportunity, right? I I think people are terrified by it, but it also means you're going to have to solve a lot of problems. So I don't think fear is the right response. I think you should be cautious, but also very opportunistic. It's going to make agency much more challenging. It's going to depress valuations. So even refis get trickier.

Starting point is 00:04:19 And I think it could force some capitulation in the market. Those aren't all terrible in my mind, right? I think those are all things you can attack if you're well capitalized or if you're willing to be inventive. So, you know, I think everyone's hoping that I'll just be all doom and gloom, but that's always easy. And maybe it's more popular. But I don't believe it's the only response just because things got a little bit negative. Jerry, you know at the end of like a sporting event, doesn't matter with a sport, where a team gets killed. But they want to at least like do one thing well so that they can take something good into the next game. I feel like that happens a lot in the NFL. Like they say like, all right, just put something on tape that we could take it to the next

Starting point is 00:04:57 game. It sounds like even though we might, even though the real estate market has been challenged for a while and it doesn't look like it's going to get any easier today, there might be, there might be something that investors can look forward to once the next game happens. Yeah, I think that's right. I mean, in terms of where I'm spending a lot of my time, and that's on the credit side, this is just more conviction in that part of the real estate trade than I had six months ago, right? I think I've been very comfortable investing on the credit side of the real estate space because I've been saying for two years, I love having that cushion for uncertainty. You just got a big dose of uncertainty, right? Having a 30% 40% cushion

Starting point is 00:05:46 in front of you before you take losses feels a lot better, right? We had a big correction in value a couple years ago, but it didn't feel like everything got started out in terms of all the stuff that had to be resolved, the refied or grown out of from an NLI perspective, I could never tell you with certainty that rates were going to go all the way back down or they were going to stay as high as they were. Sometimes it's just nice to sit in a spot and take a pretty good return instead of swinging for the fences. That's kind of how I see this. You've mentioned the refite piece a couple times. Can you just tell us how the loans typically work in this space? Because it's not like you're taking out a 30-year fixed-rate mortgage like a house as far as I'm, as far as I know.

Starting point is 00:06:27 So how does that work and how quickly do some of these loans have to be changed to the market rates? It's a mix. When I say refies, I mean, the entire spectrum of real estate, if you go, you know, you had people taking five-year loans in 2021 from an agency side. You certainly had it from a traditional value add balance sheet side, which would be a floating structure with one-year extensions out to five years. So you've got a few different types of loans maturing. You also have some bank stuff that could have been seven years from kind of the 19, 20, 2021 range that was done at much richer valuations than where we stand today.

Starting point is 00:07:08 All that stuff is rolling and it's been rolling, but a lot of it's been kicked down the road because no one's in a rush to foreclose on stuff in a messy market like this. You're just taking on someone else's problem. But eventually those things have to get resolved. So when I say a little capitulation isn't bad, I think getting some of that stuff out into the market and sort it out is not a terrible result. The real estate market is not one thing. There are, of course, many different sectors and industries. So what are some things that you all find attractive and one or some things that even at the press valuations are not necessarily for you.

Starting point is 00:07:50 Still staying away from office almost categorically. It's an asset class that has some clear winners, but a lot of, you know, I don't know if they're losers, but they're sure hard to predict pieces to it. I saw a headline last week about Pimpco, one of their realest, one of the, I think it was an office property, but I'm not 100% sure. I didn't see that particular one, but I've seen plenty of negative ones. over the past couple years, and I just don't think there's an easy solution. I mean, it's much different than, you know, a sector which I've liked for a long time, which is multifamily,

Starting point is 00:08:21 where, look, valuations are tough, but cash flows haven't disappeared. Now, your returns have gotten much, much lower with, you know, whether it's occupancy issues or concessions, there's a number of things that have been headwinds in a way, but you're not losing, say, half the building like you do an office where, you know, you're forced to do something as a lender, right? You can't just sit there and watch it go to zero. It actually becomes a negative carry, right? I think in multi, you've seen your, you know, your debt yield or the yield to the lender go down, certainly in some cases, but you can take a little bit more time. I also think you've sorted through at least a decent amount of, you know, everyone's heard about the oversupply in that space. I think it's being chipped

Starting point is 00:09:05 through. There's still a long-term need for that product. For me, the uncertainty is what's the timing on it? You know, how quickly does some of that come back before we actually see income growth? What is the rate environment for some of the valuation questions? But the long-term need and fundamentals there, I think you've got a little more safety than anywhere else in the commercial real estate space. Jerry, what's the overall sentiment in your industry? Because we've gone from generationally low rates in five years to, you know, average historically. But if you just take it on a relative basis, the speed of the change has been so great that I think so many people were caught off guard. And then you had this period where it's like, just wait, wait till 2024, wait until 2025,

Starting point is 00:09:50 no, wait till 2026 and things will get better. In rates, you know, we've been, mortgage rates have been above 6% since 2022, essentially, the fall. So it's been a long time now. I'm just curious what the general sentiment is and how people are feeling in the space. I think hope is getting pretty stomped on at this point. I've seen the same thing and heard all the fun sayings, you know, survived to 25, exists to 26. Someone can coin 27 and win the same prize, which is that just because rates were low doesn't mean they're going to go back to being low. There's not a rule that says that has to happen. You've got higher rates for not terrible reasons. We've had awesome economic growth. Like the economy is humming along. You don't see things crashing. You have massive. AI investment, you have efficiencies and productivity gains all over the general economic sphere. Those are good things, right? And they're going to cause pressure on rates. I would say the sentiment is maybe a little bit of disappointment because people sort of got

Starting point is 00:10:51 addicted to that low rate environment. But there's absolutely no reason to assume that that was the norm. And if you're trying to run a business focused on a paradigm that might not. exist anymore, I think it's going to be difficult to do that. What do the opportunities look like in terms of somebody allocating their portfolio to this? Because right now, treasuries are looking certainly more attractive than they have, but in the past just based on simple arithmetic. What do spreads look like and what are some of the potential risks associated with the reward? Yeah, I think comparing treasuries and real estate is

Starting point is 00:11:33 So a little bit apples and oranges because treasuries don't appreciate it in value and you don't get rent growth on treasuries. And just because treasuries are 5% doesn't mean cap rate should be 5.5%. I don't think that's a perfect one to want to think it's an oversimplification of the reality of the situation. Right. A good asset, even if you buy it at the same yield as a treasury and you run it really, really well, there is an expertise in real estate that over a decade, you're going to compound some of those returns because you can do it right and you've got a hard asset at the end of the day that's worth more than when it started. So I still think there's a very good fundamental argument for real estate, especially if you get, you know, it's a better investment now for inflation than it

Starting point is 00:12:16 was before because rents should inflate with everything else, all things being equal. Now we went through some exceptions to that rule for sure. But on the longer term trend, I think it does end up in the right space. Where I playing credit is a little bit different than that. This is sort of a different spin on how to attack the market. Here, you know, my viewpoint is not an equity viewpoint, which I would say is kind of a seven to 10 year hold. I look at a shorter window. I'm looking at a three to five year investment horizon. So the question is, you know, what can I do in the debt world today relative to that 5% return? In the markets today, for let's just use multi, because that's where we've done a lot of invest in. And that's the ability of taking the mortgage

Starting point is 00:12:58 we make, you lever that mortgage and you get a total return in that range. it's a shorter duration, right, than your typical real estate hole, but the return is still quite high. And that takes advantage of, one, you've got a base rate that just moved up, which is helpful to us. But two, you still have very competitive capital markets. And that means the cost of debt that you're using on the back end there has compressed as well. You put those two things together. It's a very interesting return and you get a nice cushion in the market. That's still pretty tough to be. Now, the, The long term holds a different viewpoint, but short term, I think I'm still heavily in favor of the credit approach here. That credit, that makes sense to me because you're acting as the lender, essentially, right? And yields are higher. That increases your return. How much competition is there to be the lender today? Because maybe there's not as much activity.

Starting point is 00:13:50 Like, how hard is that for you? Like, how much does scale matter in that space? I think scale just generally matters more and more in the asset management business. And you continue to see consolidation there across the board. and large and more diverse platforms will continue to win out. I mean, you've seen smaller players disappear over the last few years, and you've seen the bigger guys get bigger.

Starting point is 00:14:14 You know all the same big-named asset managers. They're not shrinking. They're growing at pretty good clips. There's a trend in that regard, but it doesn't mean there's no competition. There's always some. And some of that isn't just other debt funds. You still compete against banks and insurers and things like that.

Starting point is 00:14:30 But I can tell you this, this run up and rates will pull things back. You know, this will cause some fear. Panic might be too strong a word, but extreme caution by other lenders. Like, you know, I think having consistency and staying within your guardrails, but it's still being active in the market, this is, this is like differentiation time as far as I'm concerned. So on multifamily, how does that work? Are you making loans to the lenders to build?

Starting point is 00:14:57 And if so, is that appreciation down the road or is it cash flow? from the tenant. What does that look like? We do everything. So we do construction lending for sure. We'll do what I call lease up. You pay off a construction loan to fill up a new asset, value add where someone buys an asset to improve it. Some of it's stabilized. So the business plans that we lend on are all across the board. And you see the needs for all types of different capital today. I would say less on construction. You know, there's been so much supply delivered in multifamily. I think construction's fairly depressed right now. It'll snap back in a few years and we'll be in another cycle,

Starting point is 00:15:34 but we're in the lull right now. I would say that the biggest need right now is less transactional, and I think that'll massively slow down with the spike in rates. It's more natural maturities that have to be addressed. I mean, we had record origination numbers from a real estate credit perspective in the early 20s, and that all has to be reckoned with in the next couple years. That doesn't sound good. It's not good if you're on the equity side. It sounds done right scary. If you, if you were trying to be patient and hope that finally low rates are coming back to save me, they didn't come back. This kind of ties in with the capitulation thing I said before. You're either going to have to re-up and recapitalize some of these things, bring in some sort

Starting point is 00:16:19 of subordinate partner to sustain it, or you're going to see more foreclosures hit the market here over the next year or so. I feel like in the 20s, early 20s, as you mentioned, like it felt like a lot of people in real estate were like, all right, we don't like office. Makes sense. But we really like multifamily in the sunbelt. How did that thesis play out? Was it overbuilt?

Starting point is 00:16:41 Was there too much money chasing that story or did it generally work out okay? Still a lot of money chasing that story, to be clear, the focus on multi is only increased since then. In traditional real estate, probably still seen as the safest part of the market. You can see it bifurcated a little bit in the nicest stuff, you've seen a nice preservation of value. So there's not a simple answer on this, right? It's not just yes across the board. What you've seen is on the nicer, newer assets, you didn't see the same depression and value on those that you saw on the stuff that's 30 years old in the sunbelt.

Starting point is 00:17:15 So not all areas, not all assets are created equal. What you saw is a bifurcation of results through a downturn, right? the best money or the more institutional, better capitalized investors trended to the nicest stuff, which isn't shocking. The nicest assets preserved more value. But the other bucket had more severity in terms of outcome. And so that's what's really showed. It's not just as simple as, oh, everyone moved to Dallas. Dallas is fine. Or Austin's a great growing city. If you're there, you're in a good spot. No, it didn't play out like that. It's much more micro in terms of winners and losers. And we continue to see that on assets today. I'm glad that you mentioned before

Starting point is 00:17:57 about how rates are rising for the right reason, right? Economic growth has remained strong. Yes, inflation is higher, but part of the reason inflation is higher is because of that growth. And there's a ton of spending going on. Consumers are still doing well. Consumers are still spending money. So I'm just curious. I feel like a lot of people have, in recent weeks and months, have tried to predict like the, this is the end of like the housing activity recession or whatever. And I'm just curious if you're seeing that where some companies and so, Some developers are saying, you know what? Yes, rates are high. The hurdle rate is high, but we can't wait forever. And things are going pretty well for our business. So why don't we continue to spend? Is there any of that that's happening that people are going to go, you know what? We just have to deal with the environment as it is instead of trying to wait forever for these lower rates to happen. That's a rational answer. But no, I'm not sure. I'm not sure that's the response we're seeing. It's harder than not there. Because if you're building something in real estate, I'm joking, but only half. You're looking out multiple years.

Starting point is 00:18:52 And pulling the trigger on construction, it is a lot harder when your cost of debt is 8% to 10% maybe higher, depending on how risky your project is. Everyone built everything in the world when you could borrow construction debt at 5% or 6%, but now it doubled. And that's going to depress construction. So what's going to happen is you're going to be oversupplied. No one's going to build. and then you'll be undersupplied again and everyone will build again. That's why it goes so cyclically like this. It's actually hard to be a little bit contrary in this environment

Starting point is 00:19:29 and look through where you are today out into the future because you're delivering into a supply that you can somewhat guess that, but you can't be perfectly right. What about things like industrial warehouse? Is that in your bag? It is. Yeah, we do a decent amount of industrial. I think it's been our second largest asset allocation.

Starting point is 00:19:50 the last couple years. And probably the biggest growth part of our portfolio, mostly because the capital providers there step back quite a bit. I mean, we lost the banks there for years. And I'd say it's one of the more acute spots in the market where we've seen capital pullback and an ability to step in as a, you know, alternative credit provider and take a little bit of market share. I guess it was coming out of the 2020 pandemic.

Starting point is 00:20:19 people are trying to ferret what it means for the future. And everyone said, oh, this is bearish for offices, right? People aren't going in as much. There's remote work. You said you're still kind of avoiding office as an investment segment. A lot of people are also saying this is a systemic risk and it's going to be a crash. You can talk about why that crash, I guess, never happened, even if the returns maybe weren't so great and how incentivized the lenders are to sort of not have these huge losses hit their books. Well, there's definitely a large incentive not to do that. There's plenty of skepticism if you look at the public markets in terms of how people look through to those effective valuations. So whether you want to take the mark or not, people are assuming the mark

Starting point is 00:20:59 exists on that stuff. In terms of it being, you know, an under the radar opportunity, it probably is, but I would say in very select areas. You know, I think if you bought right in San Francisco, you might have caught the upswing on some of the AI trade and played that correctly. But if you made the same bed and I'll go back to Dallas in downtown Dallas. That's probably not looking so hot right now. I think you have to be much more selective on office today because people always think of the downtown office, right? The tower that I sit in right now, right? It's class A. It's brand new. It's got giant companies in it and they all need that for a long time. But office is so much wider ranging than that, right? There's office suburban office, right? There's offices in small towns. A lot of that stuff, like the long

Starting point is 00:21:46 term use case is so much harder to argue for. It's not just, you know, the ones you picture in your head, the shiny glass towers, it goes well beyond that. That asset class is much more diverse. And it's all that stuff that you're not thinking of day to day. That's not as, you know, not as sexy when you drive by, but you drive by a lot of those. That's where the pain is. Hospitality. The consumer has held up remarkably well. They continue to spend that experiences. Is there anything there that's attractive? I think hospitality still generally looks good. I don't know the entirety of the space, but if you just go back to the the economy part of this, you know, with a well-running economy, which interest rates would suggest we have, like we've,

Starting point is 00:22:27 like we've said, I think you can feel pretty good about that. There's still, there's still a high amount of disposable income. The consumer seems pressured, but it's remarkably resilient. You know, just despite all the negativity out there, you still see strong spending by consumers. And I think that's flowed through to the hospitality industry as well. So, you know, I wouldn't say I'm super bullish on it, but I feel like it's been fairly consistent. And you don't see any, you know, near-term storm clouds on the horizon. I still like that part of the market.

Starting point is 00:23:00 Jerry, this morning I took a plane from JFK to Austin. Both airports were mobbed. And I was at JFK at 5.30 in the morning. What about like airports? Is that outside you? Is that like public, private? What does that look like? No, we don't do.

Starting point is 00:23:14 we don't do that kind of stuff. That probably falls closer to infrastructure. No, we're more traditional asset classes. But again, that's like more evidence. I think, again, there's so much pessimism and negativity with the rate move. And look, maybe it is a precursor for a larger change. But I think it's so easy to get caught up and be worried about everything on the horizon when I think you can look through to some of this too. It also means that if you've got a little more inflation, that should be growing your rents across assets and growing your ADR and your hotels. Things don't end in a vacuum. You have to widen the lens sometimes to take in some of these other data points and all those things kind of touch upon them. Jerry, who are the investors that you

Starting point is 00:23:58 typically work with at Benefits Street Partners? It runs the whole gamut. We do everything from wealth channel sort of investors to the largest institutions in the world. So I talked to it extraordinarily a wide range of investors. Some of them are doing it for themselves. You know, your could be, you know, local family offices investing money for, you know, your doctors and lawyers to people investing for entire countries. Pretty broad array of feedback and, and interactions across everyone I speak to. Maybe too general a question, but as we wrap up here, what is the pitch? Because I think just for real estate done in general, on the one hand, you have higher base rates, which is great. On the other hand, there's not a ton maybe to be optimistic about

Starting point is 00:24:46 in real estate debt. How should investors think about including this in their, certainly, income-oriented investors? How should they think about including this in their portfolio? I'd say I'm less optimistic on equity from just a mathematical perspective today until you get some cap rate adjustments and you don't have negative leverage. It makes me like credit all the more because, one, I think there's plenty of opportunities for transactions that need financing. I can't perfectly predict what's going to happen with valuations or rates. And I think it's, it's a bit of a fool's errand to try sometimes. You can, you can make reasoned guess off the curve and off the economic activity you can see. But all things being equal here, I'll take the

Starting point is 00:25:27 investment with, with the cushion on the equity. I'm investing in front of me. Because I do think we've got more twists and turns to come before you sort out a lot of the issues that exist within our space. And now we're, you know, one correction in values in. Maybe we have a slight leg down here again. That's a pretty good time to be in our seat, right? And earn what we're earning. I have more conviction, not less today because of everything that's happened. Jerry, if people want a little more, where do we send them? You can check us out at our website. You can contact our investor relations on that site. Appreciate it. Thanks for the time. Thank you, guys. All right, thanks to Jerry. Remember check out Ftprivatemarkets.com to learn more.

Starting point is 00:26:14 Email us, Animal Spirits at the Compoundews.com. And we will see you next time.

Animal Spirits Podcast - Talk Your Book: How Higher Rates Are Re-Shaping Commercial Real Estate

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