Animal Spirits Podcast - Talk Your Book: Investing in Real Estate Credit

Starting point is 00:00:00 Today's Animal Spirits Talk, Your Book, is brought to you by Invesco. Go to Invesco.com to learn more about how they help manage institutional real estate portfolios for institutional investors and the wealth management channel and advisors. That's Invesco.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.

Starting point is 00:00:33 This podcast is for informational purposes only and should not be relied upon for any investment decisions. Clients of Ridholt's wealth management may maintain positions in the securities discussed in this podcast. Welcome to Animal Spirits with Michael and Ben. One of the things that we spent a lot of time discussing today was real estate credit. I think when most investors think about investing in real estate, you think about the equity stack.

Starting point is 00:01:00 right? I'm a shareholder and I'm an owner of the equity of the Empire State Building, the Bellagia, whatever. But this underinvested asset class, at least on the individual level, institutional investors I've been investing here for years. And frankly, there really has been an opportunity for individuals to invest. So this is part of the broader theme of the, I don't know what other word to use, but the democratization of investments. And, And this asset class makes a lot of sense to me. Just because what? It's simple.

Starting point is 00:01:34 It's well known. I guess it's another portion that used to be done by banks and now is being done by asset managers and wealth managers. So asset managers are loaning money to sponsors, said differently, the alternative asset managers, the behemoths of the world, you know who they are. They're lending them money to finance projects, buy, turn around, rent, flip, whatever it is. LTVs are reasonable. Spreads are reasonable.

Starting point is 00:02:03 It's short duration, floating rate. I think that's a thing that probably a lot of people would be drawn to. I'm guessing not a lot of defaults outside of the office space. It's just, it seems like an appropriate use of capital. Obviously, caveats galore, but. Yeah, I get, yeah, it's illiquid. Obviously, you need a long time horizon to invest in, which we talked about. And I guess you'd say that it kind of, it's investing in kind of parts of equity and parts

Starting point is 00:02:27 of debt. It feels that way, right? It's a debt instrument. It's a debt instrument, but with some equity like risk characteristics, I would think. But with a shorter duration. So, yeah, it is kind of this different asset class altogether. Yeah, you know what? Now that we say that, I don't think we spoke about the risk side enough on this call. Yeah, we try. We talk a little at the end. So we talked to Charlie Rose, who is a managing director of global head of real estate credit and CEO of the Investco Commercial Real Estate Finance Trust at Invesco. Michael and I didn't know this. Invesco manages nearly $90 billion in real estate assets worldwide. So it's a big player in the space. So Charlie gave us a lot to think about and learn about. So here's our talk

Starting point is 00:03:08 with Charlie Rose. Charlie, welcome to the show. Thank you so much for having me. All right. I have to be honest. Investco real estate. Obviously, everybody listening is very familiar with Invesco, huge global asset manager, huge, incredible brand. Investco real estate, less familiar to me, $87 billion in assets. How have I not been familiar with your work? Michael, we hear that all of the time. We are probably the largest real estate investment manager that most in the retail channels have never heard of. We're a top 15 global real estate real estate investment manager. We've been around for 41 years. But historically, we've managed money on behalf of institutional clients. And our brand has not been as well known. Increasingly,

Starting point is 00:04:05 the path of travel for groups like us in the private market space is increasing adoption in the private wealth channel. And I expect you'll be hearing more about us in the future. Okay. So what kind of real estate are we talking here? Residential, commercial, like, there's a lot different areas. What are you guys focused on? Investco is a broad global investment manager. We manage roughly $87 billion of capital across our three major regions, North America, Asia PAC, and Europe. And we're a commercial real estate investor at an institutional scale. So you will see us investing in large-scale multi-family properties, distribution and warehouse, facilities, retail, not so much office

Starting point is 00:04:57 these days, and specialty product types like senior housing, medical office, self-storage and others. So every time real estate comes up, people are like, we don't do office. So who does do office? Is everybody just underwater forever? Like, I know you said you don't. I'm just curious if you have a take there. So office has gone through a significant change in fundamental demand that resulted in a seizing up of the capital markets for that sector specifically.

Starting point is 00:05:31 But there is more clarity today on demand for office. And there is much more understanding of which buildings are the winners and which are the losers and how to value those. buildings. So we have seen the capital markets open back up for higher quality office in the markets that are the best performing today. Those markets include New York City, Dallas, and select submarkets in most major cities. That being said, our focus areas really are on demographically driven trends. And we are seeing the most attractive relative value, largely in residential property types, some of the specialty property types, and logistics and warehousing, which are all seeing fundamental long-term increase in demand as a result of demographic changes. I'm curious about your strategy in residential, because if

Starting point is 00:06:40 you look at the numbers, it's kind of surprising. The number of investors in, especially in the residential market in the U.S., it's mostly small-time people who own a handful of rentals, right? It's not people think that all these big institutions are buying up all the houses, but it's really not the case. Institutional investors are a relatively small portion of the residential real estate market. You can correct me if I'm wrong, but why do you think it's taken so long for residential become a bigger piece of this investor landscape? So first, residential is a very fundamentally attractive asset class because everyone needs a roof over their head. Not everyone necessarily needs an office space to work in, but everyone needs to live in a home, whether that is a single family home, a multi-family property, a senior housing community or student housing community.

Starting point is 00:07:37 Second, since the global financial crisis, we have been under-manufacturing housing in the United States. And there is a fundamental under supply of housing in this country that is broad and seen across most major markets today. Now, there are many different strategies within residential, And historically, you would have seen an institutional investor such as ourselves investing primarily in apartment buildings, large-scale apartment buildings, typically, as well as some larger-scale specialty product types like student housing, senior living, and manufactured housing. So there has been an increase in institutional ownership in single family homes for rent since the global financial crisis, but that is still just one piece of the broader residential story. And today we're seeing a particular strength in apartments, manufactured housing and senior housing as a result of weakness in the for sale home market. fundamental trends that are delaying the age of the average first-time home buyer, and today, much less new construction in those spaces, setting up a particularly attractive

Starting point is 00:09:08 supply demand picture. Institutional ownership of individual homes, not for rent, did pick up after the GFC, after the housing price collapse. But today, they play a much bigger role in homes for rent than they do for the average person listening. It's not like they can't buy a home because Blackstone is buying a home in their neighborhood. Do you think that, though, that is going to happen where institutional money, such as Invesco and others, are going to be in our neighborhoods? My focus is primarily on the real estate credit business here at And we have not been lending on single-family homes for rent. Rather, our focus really has been on institutional quality apartment blocks and some of those specialty product types that

Starting point is 00:10:06 I've mentioned. Our expectation is that that is going to be the majority of our focus going forward. And these are products which are designed specifically for renters and intended to provide more options for residential situations in an environment where buying a single family home has become a less attractive option for many individuals. Okay. So you're on the credit side, I think. Explain to us what that means. What exactly are you doing? So let's just set the stage. I think most people listening to this podcast are very familiar with real estate equity, at a minimum familiar with buying and owning a home as a primary residence or owning a few small rental properties.

Starting point is 00:11:07 Historically, institutional investors have been increasing their allocations to private markets, broadly speaking. If you look at institutional investors in the aggregate, roughly 10 to 15 percent of their portfolios are allocated to private markets on average. The largest and most sophisticated endowments, of course, today may have 50 percent or more of their portfolios allocated to private markets, well documented by the David Swenson Yale model, whereby they have to date outperform public market. through their private equity allocations and achieved broader diversification and reduced volatility by allocating to other private markets asset classes, including real estate equity as a hard asset. Real estate equity has performed an important role in those portfolios as an income generator and a diversifier over time.

Starting point is 00:12:14 And starting after the global financial crisis, we started to see institutional investors take some of their allocation to private markets, either from private credit allocations or private real estate allocations and move that into real estate credit allocations. And they did that for a couple of reasons. First, real estate credit is the largest asset class that most of them had been. exposure to previously. Real estate credit is a $6 trillion asset class in the U.S., so that's 50% larger than the municipal bond market. That's bigger than Bitcoin, even. It's a vast market. And historically, it's primarily been the domain of the banks and the government-sponsored

Starting point is 00:13:07 enterprises. But the banks start to pull back after the GFC as a result of regulation, Dodd-Frank, And that created an opening for institutional investors to come in and get access to real estate credit. And they did so because the diversification benefits were strong for them. The correlation between real estate credit and other alternatives is actually quite low. So by adding real estate credit into an existing private markets allocation, they realized diversification benefits. to put some specific numbers on that. Over the past 13 years, real estate credit has had a 0.1 correlation to private equity, 0.2 to VC, effectively no correlation to private credit,

Starting point is 00:13:57 and roughly a 0.25 correlation to real estate equity. So it was a good diversifier in their portfolio. And over that time period, the volatility was remarkably low, a standard deviation of around 1.6 compared to, say, five for private credit or private real estate equity. So they got that diversification benefit plus lower volatility and a strong current income stream. And today, we're starting to see increased interest from retail investors in this asset class for the very same reasons. All right. So what exactly is real estate credit? We are a lender to institute investors who own commercial real estate. We directly originate loans to sponsors who you are familiar with. Big names were a sponsor-driven lender when they are acquiring

Starting point is 00:14:57 multifamily properties, industrial buildings, or specialty asset classes for their institutional funds businesses. Generally, these investors have a buy-fix-sell business. plan. So they're buying a property, leasing it up, optimizing the cash flow stream, and then they're selling to a core investor. And accordingly, our loans are on average five-year terms to allow for the execution of that business plan and then repayment through either a sale or a refinance. These are relatively large loans, $50 million and larger on average. and are sourced on an off market, direct, bilateral basis. What are the LTVs usually like, and are the interest rates floating or fixed?

Starting point is 00:15:51 We are generally a floating rate lender, and that is the market standard within this space. And LTVs can range anywhere from 60% loan to value up to as high as 75% loan to value or higher. Our approach to the business is characterized by two fundamental pillars. We have a property first approach, meaning we're only lending on the type of real estate that we own in the equity side of our business and a credit over yield approach, meaning we define outperformance for us as hitting our stated return objectives and outperforming on credit metrics. So you'll see us generally on the lower end of that LTV range in the 60 to 65.

Starting point is 00:16:41 percent LTV range, which means loan to value that our borrowers have 30 to 35, even 40 percent equity fully subordinate to our loans. So if property values drop by 30 percent, our loan would still be insulated in that scenario. So what does it look like if and when a loan goes bad or something goes wrong? Like, how does the workout look on that? Are there defaults? Is it typically usually a period of time that just the loan gets extended? Like, what happens when something goes wrong? Yeah. So one of the reasons why there has been less volatility in real estate credit over the past 13 years than traditional private credit is because real estate credit is an asset backed asset class. And that gives a much more clear path to resolution.

Starting point is 00:17:39 in default situations, it's also a deterrent to a default in the first place. So just as a homeowner obtains a mortgage on their home, when one of our institutional borrowers, borrows from us, we are providing a mortgage to them. So our loan is secured by the hard asset. And in the event of a default, a real estate lender can commence a mortgage foreclosure as the remedy process. In many jurisdictions, a mortgage foreclosure can be completed in as short of a period of time of 60 to 90 days. In those jurisdictions where mortgage foreclosures

Starting point is 00:18:31 have to go through the judicial process, that timeline. can extend out. But there are ways that sophisticated institutional lenders structure loans to ensure that they can avoid the judicial foreclosure process and execute on a foreclosure, again, typically within that 90, maybe 120-day process. And then ultimately, own the real estate and have the ability to write the listing ship and maximize value on behalf of their, investors post foreclosure. Tell me if I'm thinking about this right in terms of the interest rate environment. So when interest rates were rising in 2022, anything with duration got destroyed, right? Like fixed income, treasuries, investment grade, anything like that was in a world of pain.

Starting point is 00:19:29 The floating rate side did quite well because there was very little stress in credit markets. and the income was there. There is a tipping point where in some alternate universe, the rates got too high, and the borrowers of this private capital were going to suffocate with the debt burden. I would imagine that it's a little bit different in real estate because the cash flows are there and the rising costs are a little bit less punitive. So could you unpack that a little bit? am I completely off the mark?

Starting point is 00:20:06 Yeah, it's a really good question. So first, we believe that real estate credit is a strategic asset class and should sit in portfolios on a through cycle basis. We do not view real estate credit as a tactical allocation. So that means that real estate credit managers should operate on an interest rate agnostic. basis. Now, as a floating rate lender, you're absolutely right in a rising rate environment. There's a direct benefit to the lender. The lender is going to see a significant increase in income in that environment. But we've maintained discipline to structure around various rate

Starting point is 00:20:57 environments. So we require 100% of our borrowers to buy interest rate caps. So, they're buying a hedge against interest rates. So to the extent that rates rise, their derivative contract will pay out to help support the debt service under our loan. Is that standard or is that something that's like a little bit unique to how you operate? I would say it depends on the segment of the market. In the most institutional space, it has become quite standard. In less institutional segments or higher yielding segments, you would see less of that. And then on the flip side, we structure floors on all of our loans such that interest rates floor out in a declining rate environment. So what did we see in 2023 in this space? I generally tell people if they have

Starting point is 00:21:58 questions about what can go wrong in real estate credit. We have two great case studies in modern history. One was the global financial crisis, but a lot has changed since then. There's a lot more discipline throughout the system than there was then. And then we have a much more recent case study in which floating rate lenders had been originating loans in a five basis point term sofer environment. all of a sudden, these floating rate instruments based on term sofer saw the all-end interest rate go from, call it 3% when term sofer was 5-faces points to north of 8% with a 5.5% term sofer. So that did, by definition, put stress on debt service coverage ratios. And then you had real estate values overall correct by on average 22 to 25%. between the peak of the market in early 2022 and late 2023, with office in particular,

Starting point is 00:23:04 correcting even farther than that. So there was a great strain in the real estate markets in 2023. And within the data that we look at for real estate credit, there was never a single quarter of negative performance, total return in the GL2 index, which is probably the best index tracking institutional floating rate real estate credit. The total return was just north of 5% in 2023. So there was an increase in default rates, albeit from a very low level. And as such, the asset class continued to deliver positive performance even under that significant period of strength. So what are you seeing for yields these days?

Starting point is 00:23:54 And maybe it changes across the spectrum where you're getting the investments, but what do you look like for investors today? Yeah. So clearly when Term Sofer was north of 5%, both real estate credit and the direct lending space in private credit, the BDCs were seeing extremely elevated current income, oftentimes double-digit distribution rates. There's been some moderation as short-term rates have started to moderate. So generally speaking, we talk about real estate credit as being a through cycle,

Starting point is 00:24:35 7 to 9% net distribution rate product over the last 12 months within the top 50% of that range has been where we've seen net distribution rates for real estate credit. And one interesting thing about real estate credit from the wealth perspective is most real estate loans are held within REIT structures, real estate investment trust structures. So for most retail investors who are accessing real estate credit today, they will be investing through a REIT. And under the one big beautiful Bill Act, the OBBA earlier this year, a 20% deduction to headline tax rates was made permanent for REIT distributions. So on a tax equivalent basis, REIT distributions or real estate credit distributions as a result have a unique tax benefit

Starting point is 00:25:42 benefit that you wouldn't see in private credit or the BDCs. On top of those yields, are you also applying leverage yourself? So typically real estate credit is a levered strategy. And there's been a wholesale shift in the market. Historically, in the U.S., over 50% of real estate loans were held and originated by banks. In some of the other markets that we lend in, such as some European and Asia PAC markets, over 80% of the market has historically been the banks. Now, post Dodd-Frank, you started to see the banks pull back.

Starting point is 00:26:25 And today, there's been an even sharper pullback from the banks, such that we're seeing only roughly a third of new loan originations today come from the bank sector. That is created an opening in the space, and where the banks are. participating is typically in providing back leverage to alternative lenders. They do so because the capital treatment is much better for them if they are providing an alternative lender or a debt fund leverage versus originating a direct real estate loan. So you'll typically see up to about 50% look through loan to value ratios in leverage coming from banks or insurance companies

Starting point is 00:27:14 applied to these real estate credit portfolios. Charlie, can we talk about the transition from institutional investors to the wealth channel? What are you seeing there? We know broadly that institutional investors have adopted private markets much more quickly then wealth investors. If we point to the most sophisticated endowments, in some instances, having north of 50% of their portfolios allocated to private markets, most of the data has illustrated today that on average, wealth or retail investors have 5% or even less of their portfolios allocated to private markets. But there has been significant

Starting point is 00:28:01 increase in participation in the wealth channel and a clear interest in additional participation in private markets generally through the wealth channel for all of the reasons that institutional investors have already increased their allocations to private markets, diversification benefits, lower reported volatility, and potentially in some strategies, higher returns than you see in the public markets. So that is a broad-based trend and has led leading managers such as us to bring our best ideas

Starting point is 00:28:44 that are working very well for our institutional clients to the wealth channel. Now, I would say that there is still a lot of fundamental education in the wealth channel about what these different private markets products are

Starting point is 00:29:01 how they perform and how they can be suitable or not suitable for individual clients. And real estate credit is a great example of that. Most retail investors have no exposure to this $6 trillion asset class. And so we have a lot of early conversations about how does the asset class perform, how does it compare to traditional private credit, how does it compare to real estate equity, and what are the appropriate use cases for the asset class. But we've seen a real increase in interest, particularly over the last 12 months, as there have been more questions about what is the next solution that will deliver

Starting point is 00:29:47 some of the same benefits that private credit have delivered. But if I have questions about where we stand in the private credit cycle, what is maybe an asset class with similar benefits that is in a much earlier stage of the credit cycle? And real estate has just gone through. It's correction. So whereas if you think that we may be in later innings in the corporate private credit space, real estate is probably in the first or second inning of its cycle today. What sort of investment vehicle do you think this comes to the retail slash wealth channel?

Starting point is 00:30:26 Is it going to be private placements or do you think it's going to be evergreen funds or maybe something even publicly listed? What do you think it looks like? We're seeing the majority of new offerings come out in a pretty familiar modern wrapper, which is a non-traded mortgatory product. This is a product that is distributed through financial advisors, has either monthly or quarterly liquidity, much more transparency than you would have seen historically in the non-traded reed space. Typically, these vehicles will be public filers and will select to be governed, consistent with public company standards, with independent boards and independent valuations. From a liquidity perspective, private markets are fundamentally illiquid investments or semi-liquid investments.

Starting point is 00:31:31 So the liquidity structure will look pretty similar to what investors have become familiar with, with non-traded equity rates and BECs, monthly or quarterly. quarterly liquidity, subject to caps on that liquidity of, on average, 2% monthly or 5% quarterly. So one of the biggest questions when figuring out the risk of an asset class for me is, what is the time horizon? And when you're talking to investors, because this is a relatively illiquid asset class, what do you tell them that the time horizon should be an investment like this? We talk about this as a strategic allocation, which should be a long-term allocation. within a portfolio.

Starting point is 00:32:17 Historically, we've seen our institutional investors in similar strategies have, on average, a seven-year time horizon for their investments. So for short-term liquidity needs, you do not want to be allocating that portion of your portfolio to private markets. You should be thinking about this as a multi-year allocation with semi-liquid functions.

Starting point is 00:32:48 There are drawdown structures that are being offered in the market, which are truly a liquid with no repurchase feature. So the structures that I've talked about offer better liquidity, clearly, than those drawdown structures, but this should not be viewed as a liquid product. Perfect. Okay. So people who want to learn more about Invesco's real estate credit investments, where do we send them? Take a look at our website, investco.com. We have a lot of information about our capabilities broadly. Perfect. Thanks, Charlie. Thanks so much. It's been a pleasure. Okay, thanks to Charlie. Remember to check out Invesco.com to learn more.

Starting point is 00:33:33 Email us at Animal Spirits at Accomponews.com. Thank you.

Animal Spirits Podcast - Talk Your Book: Investing in Real Estate Credit

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