Why Private Real Estate Debt Can Benefit Insurance Investors With Scott Carson From The Insurance AUM Podcast With Stewart Foley

Insurance companies need yield. That is not a news flash. Private real estate debt offers a good alternative to significant yield enhancement. Here to talk about both private and public real estate debt as Carolos Gergis, Managing Director, Portfolio Manager, Principal Real Estate Debt and Scott Carson, Director Portfolio Manager, Principal Real Estate Investors. Welcome guys. Thanks for being on the show.

Thanks for having us, Stuart.

Glad to be here.

It's a good topic, right? Lots to talk about in real estate. So if I'm an insurance cio, particularly if I'm in a mid sized company, right. How can I get exposure to real estate? What are my options?

Yeah, you know, I can start with that again. My name is Scott Carson. I'm a portfolio manager on our CMBS team. And you know, the reason I wanted to start with that is CMBS is a really efficient way to gain access to commercial mortgage debt. And so CMBS would be part of the public real estate debt quadrant principle. You know, we operate across all four quadrants, public private debt and equity. But being in the public debt space, it's a very efficient means for insurance companies to access diversified exposure to commercial real estate loans via bond structures. And so these, these bonds that we purchase, they're collateralized by pools of fixed rate commercial mortgages. And those pools are then tranched into different classes that are rated by the rating agencies. NAIC rates these as well from a capital efficiency perspective. And so that's a, I keep using the word diversification efficiency, but that's a really easy way for insurance company investors to access the market in a manner that's not very, it doesn't have to be granular, it's not rifle shot loan by loan, we can build an exposure pretty efficiently through these publicly traded bond markets.

And just for the sake of, there may be folks who aren't steeped in the bond tee as we are. CMBS stands for Commercial Mortgage Backed Security. Right. So this is a pool of loans, it's a diversified pool. And for the lack of a better term like a mutual fund, I am buying a diversified portfolio as opposed to buying individual private real estate loans. There is a difference there. And then the other thing you mentioned is the term tranche, which is know basically means slice. Right. So you've got a waterfall structure where some cash flows have priority over others and that's how you get the rating structure that's issued by all of the major NRSROs. I got to get the announcement. Right, Right.

So you got it.

I don't know who to address this to, but navigating the current environment and there's been a lot talk about real estate and all the different forces of the last change with COVID and so on and so forth. Can you talk to me a little bit about the current environment and what you see is coming?

So essentially we're long term believers in the debt space. We've been investing in debt for over 60 years, but today presents some interesting opportunities for private real estate debt and just kind of generally in terms of what's happening in the market. So the first time in a long time we're seeing interest rates rise and we're originating floating rate loans which should benefit from the continuing rise of rates. However, nothing comes without its challenges. So the rising rates will put pressure on the underlying equity. So in an environment where cap rates are still very tight, the focus on NOI growth and overall underwriting becomes increasingly more important. An investor has to be very confident in the business plans of the underlying assets and then stock selection will be key. So we're going to continue our strong underwriting culture, navigate the environment and utilize our risk rating models. And there's going to be a lot more scrutiny on rent growth assumptions today where cap rates are still very tight in that 3 to 4% range and debt is set to go to 5 and a half to 6%. You have to be very, very confident in that rental growth, the underlying asset. We're going to be disciplined in our debt struct to work with borrowers on acquiring things like caps in order to protect the assets from rising rates, ensure that cash flow is good enough to cover debt service. We'll likely start looking for a little more protection within our debt documents if value erosion comes to be. Our LTV levels provide a comfortable buffer to equity values. So if we start seeing that values are getting impacted, we've got a 25, 30% type of buffer and we don't expect that values are going to decrease that much. But we are expecting some pressure. There's going to be focus on inflation resistant assets where Scott was talking about how their pools of loans and you can't really control the underlying pools. Here in the private debt space we can take those kind of sector approaches. So there's a focus on residential. I mean homeownership right now is less affordable than it has been. And now you're watching a three year mortgage rates rise where everyone was super excited about locking in their 275 last year. You're at five and a half to six. So we're focused on the residential sectors which have been pretty resilient multifamily family leases roll every year can be a good inflation hedge if the market signals recession. Student housing has been pretty resilient in recessionary markets. We like trend stories such as self storage and data centers, life sciences, medical offices, even industrial to some extent. Even though pricing has been very tight. Industrial and then lease structures for the more traditional office and retail assets will need to be strong with the contractual rate month in order to combat the inflation. So in summary, you know, looking at underwriting, loan structuring, sector exposure and stock selection is what we're going to continue to do to help navigate the current environment. But it's going to be a very interesting market ahead.

You mentioned you threw out 275 as an example of rates. I am proud to say that I bottom ticked this market and that is exactly my rate. 275, 30 year fixed. I said to my mortgage guy, I go, listen, I'm a finance guy. How what's the maximum I can possibly borrow? Because I thought man, I mean this is like this is a magical environment. But you're right, rates have come up a lot. Inflation, everybody's talking about inflation. So when you look at, and you know you're an insurance company, right? You're at principal. Inflation is a double edged sword for insurance companies because it drives the price of the liability up and they own a bunch of long assets and as a bunch of fixed rates assets and it erodes the value. Right. This is the same math just upside down. So how have you seen or can you talk about real estate as an inflation hedge? Which it's difficult to find a good inflation hedge as you know, particularly one that produces income. Can you talk about how you think real estate does in an inflationary environment?

Sure, at the highest levels and I alluded to it a little bit here, you've got the ability to raise rents. In some instances it's stronger than others in terms of the sectors. And that's why the sector selection in my opinion becomes a little bit more important. You want to avoid sectors where you can't tie the inflation to it for whatever reason. I'm going to take an approach here that may not be that popular, but let's just talk about office for a second. I mean right now going into this market, there's still a lot of pressure about getting people back to the office and their office assets are struggling. So could office be considered an inflation hedge if you can't bump rents or you can't get people into the office or you can't rent those assets out? Generally so it's become more of a bifurcated market, in my opinion. So looking at things like residential, where you can increase those rents, where there has been strong occupancy and lease rolls every year, yeah, I think that becomes a pretty good inflation hedge when you can raise rents in this environment and combat some of that price adjustment, some of that inflation. Again, from a lender's perspective, the underlying assets do act as inflation hedge. But when you're in a rising rate environment, that may help an insurance company who could take on higher yields and could do a little bit more floating rate debt. From a yield perspective, when we're talking about ALM and trying to cover duration, trying to cover kind of the liabilities, from that perspective, you've got this structure where the rates are rising. We're trying to be as protective as possible at the underlying levels and the underlying assets are providing inflation hedges. So that's why I kind of use the term inflation resistant sectors is what we're really trying to focus on today. Scott, I don't know if you want to add anything there.

Yeah, no, I think all those points are key. And one thing we're looking at, given we're in the debt part of the capital stack, the average loan to values that we're seeing on CMBS issuances today are 55 inside of 60% loan to value. So really, not only is the loan to value important, but also the debt service coverage ratio. So these properties are generating enough income today to cover the debt service burden by over two times. So, well north of two times debt service coverage ratios. So clearly we like properties that have some sort of durability to inflation. They can do that by passing expenses onto the tenants. They can increase rents like Carlos mentioned. But overall we have a very healthy equity cushion based on our going in LTV position in these deals. Also, we have a very healthy NOI cushion in terms of the ability of these properties to be able to actually see nois come down and still be able to cover debt service. So those are some of the protections in the bond space and on the public debt side where we cannot obviously control the path of interest rates. But given where we are in the capital stack, we are well insulated from some of those potential impacts of inflation when it comes to the underlying value of the assets. The last thing I'd say is I feel a lot better about yields today than I did at the start of the year. Seeing the 10 year breach 3% today, we've seen another big sell off in the 10 year treasury rate that feels a lot better than when we were coming into the year at 1.5%. I think that's very notable. And as we see these absolute yield levels rise, we're certainly seeing more interest in the public real estate debt space as an alternative yield provider.

Yeah, I mean, it's interesting, you know, you talked about forecasting interest rates and I mean, it's clearly a fool's errand, right? I mean, 12 months ago if you said, hey, the tenure is going to breach 3%, you know, 12 months from today, I don't think you'd have gotten a lot of takers on that bet. And yet, you know, here we are. Right. And I think that it remains to be seen if the flow of two private assets slows any out of the insurance sector. You are from an insurance company and you work with a bunch of insurance companies. What conversations are you having? And I want to talk about servicing accounts as well, but what kind of conversations are you having with your insurance clients in particular on some of these issues?

Yeah, so for us, and Carlos mentioned this earlier, as the cycle has extended and we've gotten to this point where GDP was negative for the first quarter and we've had this tremendous run up in asset values post Covid because of all the monetary policy, the fiscal support, and now I think it's kind of gut check time where when we're sitting across the table from CIOs, they're asking us about values, they're asking us about potential cap rate pressures, they're asking us, you know, well, you know, we've seen this, this stress and we've seen this big recovery. But what happens next?

When you say cap rate pressure, can you just define what, unpack that and explain what exactly what you mean there, what that risk actually is?

Sure, sure. So if you think about a cap rate just simply as the discount rate used to value a commercial property, on the equity side of things, any discount rate is going to be a function of the risk free rate or the treasury yield plus some sort of spread. Right. And so as we've seen treasury rates, like I mentioned before, roughly rise from 1.5% to 3%. We haven't really seen cap rates move that much, if at all.

So the spread is compressing. That's right, correct.

Treasuries have come up. The spread between Treasuries and cap rates is pretty low, I think, on the back end, underwriting cap rates just generally now, in terms of cash flow modeling and things of that nature. On the back end, the cap rates I think you might see a little bit more expansion.

But what I think is really interesting about this is there is a pretty stark bifurcation between what we're seeing in the public markets versus what we're seeing in the private markets. And that's just the nature of how these markets operate. So living in the public world, we've seen our credit spreads widen quite substantially. So we've seen spreads from AAA down through single a widened 40 to 75 basis points this year you've seen that in addition to the yields going up. So it's different. And I think that's one thing that points to public and private being able to complement each other in the real estate debt space because we are able to, being in the public markets, take advantage of more of a leading view on what the market's pricing in in terms of risk. Whereas on the private side, you know, there's been a lot of capital raised and that large slug of dry powder out there is to this point really keeping cap rates low. And there are a lot of other factors in there in terms of capital that is very much looking for quality assets, looking for particular types of sectors that have better long term secular themes. But the public markets do offer the ability for insurance companies to take advantage of what we see as widening that may be in excess of what the private markets are pricing in. From a fundamental standpoint, you have a.

Very interesting vantage point in being in both markets, private and public, and being able to compare the relative value back and forth. And the other thing too is Scott, I mean a 45 to 75 basis point widening of spread or additional spread, right. When rates are 2% is a whole lot different than when rates are 10%. Right? That's a substantial increase. In percentage terms, it's substantially wider as well. Right now insurance companies obviously have a variety of liability structures. Some have very short tail lines. Property and casualty carriers and life carriers need duration. Carlos mentioned duration a moment ago. Can you talk about your respective markets in terms of a duration profile that you know, you go, hey yeah, this asset class offers yield great, but I got to be concerned about my duration exposure as well. So can you talk a little bit about that for each the public and the private side?

Sure, maybe I'll start Scott, and then you can jump in. But for insurance company investors, to your point, some insurance companies such as life cos they require longer duration instruments while some non life codes require shorter duration products. And the asset liability management is different for each one of these life insurance companies on the private real estate Debt side, we've got products that fit the entire gamut, as you may know. We've got short term notes that could be two to five years, that's with all extensions and that could be either done on a high yield basis, floaters, etc. And then you've got your core mortgages which are kind of longer duration and could do 7 to 10 year plus type notes. So our duration amount can fit any kind of bucket for the life companies, whether it's a Lifeco or a non Lifeco in terms of what they're looking for. So we can run the entire gamut. We can essentially structure this any way that life insurance companies or insurance companies in general want. And that's how we've been working with insurance companies just to understand what they need from an ALM perspective and how we can service that.

Yeah. And so on the public side it's similar in that we're very flexible. CMBS market has evolved and it does offer a lot more opportunities today than it has historically. From a duration management perspective, the sector that most life insurance companies are familiar with would be the conduit CMBS. These are comprised of 10 year loans in these conduit CMBS pools. And so those bonds have about an eight year duration when they're issued. So that's a new issue. But being in the public markets, we are able to buy bonds in the secondary market. So as bonds season down, the duration gets shorter. So that's one way for us to target different points on the duration curve within that space. In addition, there's a particular bond class called the interest only strip that we like a lot. We think it offers a lot of value. That class yields maybe 5 and a half to 6% today, carries a triple A rating. And at issuance those IO strips are carrying about a four year duration roughly. So that's a shorter duration point. And then finally, we haven't talked about it yet, but the single asset, single borrower space, sometimes you'll hear people refer to it just as sasb. That predominantly is a floating rate market, or at least it has been recently. Instead of being a diversified pool of loans securing these bonds in the SASB market, you'll either have one big trophy property, think of a large office building in New York for example, that would be the sole collateral securing the loan that the pool is comprised of. Or it could be, you could think of a large industrial portfolio of assets that are all owned by the same borrower. And so the borrower is able to finance that large portfolio through one Financing in the SASB market. But that's floating rate. And the point being there there's a lot of flexibility all the way from 8 year fixed rate duration with good ALM characteristics because these fixed rate loans do have very strong prepayment protection in that space. And then you flip, flip over to the single asset, single borrower, floating rate, more optionality. But you do have the benefit of the floating rate structure there for insurers that do have a need for that typ of asset stream.

So watch me get myself in trouble waiting neck deep into bond land. CMBs versus regular MBs, right? Residential MBs. So as interest rates move up and residential mortgages are infinitely refinanceable, right. As interest rates fall, people refi their home, but that pays off the mortgage securities which shortens that duration. And by the same token, when you've seen this amount of increase in rates, that is going to extend duration of single family residential mortgages. It has to. I mean I've got a low rate and there's no way I'm refi. Right. So they're going to. My last payment will be, you know, 29 years from now. So at the end of the day that's not the case for cmbs. You have a lot more. Watch this. There's a lot better convexity profile of cmbs, right? Convexity is measures refinance risk. The higher the number, the better the call protection or the refinance protection. The lower the number, the higher, the more likely it is to or it's going to get called. So the convexity profile on CMBS versus rmbs, I think it makes it, I think it matters right. When rates rise. I mean am I, have I gone from a 2 duration out to a, to an, you know, to a 6 duration because of interest rates that I can't control that. That's different in commercial mortgages, right?

It is, it is. So on the fixed rate side, like I mentioned, these loans all have very strong prepayment protection built in. You know, you can get into the weeds as much as you want. But there are a couple of ways that can happen. One is through defeasance. If a borrower wants to prepay a loan, they have to replace that cash flow stream with Treasuries. So if that happens, great. Because now my collateral isn't a mortgage. Now my collateral is US Treasuries. So my credit quality has gone up, but I still get the same stream of cash flows that I was expecting coming off of that loan. Or it could be done through yield Maintenance, which would just essentially be a prepayment calculation that makes the trust whole for the lost income relative to the current level of interest rates. So that is something that insurance companies, especially life companies, are drawn to. Having that a certainty or more stable profile around the expected duration going in and the realized duration of that investment over time.

I mean, that's a really important point because rates, rates have been pretty volatile and it's definitely impacting durations on refinanceable securities. I mean, there's no doubt about it. So insurance companies, if I don't have, if I'm a, I'm a CIO and I'm looking around and I don't have real estate exposure, why should I consider an allocation to commercial real estate and should I be looking at public private both? How should I get in to try and capture the yield advantage?

I think generally if you don't have real estate exposure, go get some unbiased opinion when we talk about things like correlation or diversification. Right. So real estate essentially is not correlated to other asset classes. Now it depends on where you're investing, right? Because if it depends on what you're comparing it to. But when you're looking at across the asset class space, for example, if you're looking at REITs, they might be more correlated to equities, but not directly correlated to equities versus something like private real estate where you get correlation benefits. We already talked about the inflation protection that you get from real estate. So those are some of the reasons why you would do it. I mean for real estate, private real estate debt, it is a good diversifier within insurance company portfolios and other portfolios. It's not that tightly correlated with other asset classes. It does provide the yield enhancement against other types of securities. So for example, historically the relative value over corporate bonds has been pretty strong in the real estate debt space. Private real estate has been able to provide those higher yields, specifically in instances when we are using moderate leverage. To our knowledge, it looks like more and more insurance companies are becoming into the private real estate debt arena. And to your point earlier about access, I think we've seen some of these insurance companies access to the open end real estate debt market, which I'm sure you've heard of and has been evolving over the last several years. But they could get access to a loan of private pools that helps them diversify their portfolio, gives them a pretty strong income stream, has been pretty resilient over time. So from my perspective, you get into real estate specifically for those diversification benefits. The non Correlation, the inflation protection, real estate, private debt, specifically for the yield enhancement and the strong income component that you get there. And then Scott, if you want to comment on the public debt piece.

Yeah, yeah. And it's interesting because it's a little bit different. So again, I like this idea of looking at the private and the public market and seeing how they complement each other because in the public space I would look at it more as an alternative asset class exposure versus corporate bonds. And, and not only do you have this alternative exposure, but there's a very nice spread pickup there. So we see 25 to 100 basis points of excess spread for CMBS versus similarly rated similar duration corporate bonds. And we know that the world is just chocked full of corporates and when we talk to other CIOs, they're looking for different types of credit exposure. And for the reasons that Carlos mentioned, CMBS is a good option there in terms of providing something different. And it's not only just the excess spread, but also it's very capital efficient. And I think that might be something that's underappreciated. The vast majority of CMBS conduit bonds rated aaa, AA, and even a good number of those that are rated single A get the best RBC treatment from the naic. And so when you look at the excess spread versus corporate bonds and then you take into account the superior capital treatment for some of these CMBS bonds, it really makes the, the net excess spread story pretty attractive. The last thing I'll say is when we're talking about an indexed or a benchmarked world. CMBS is a way to outperform a Benchmark. It's only 2% of the AG and the exposure within the AG is about 90% AAA. And 40% plus of that is an agency, CMBS securities that just, they don't carry as much yield or as much value. And so being able to take an approach where you're looking at CMBS as a value added sector can, you know, bring some benefit to a portfolio for an insurance company.

Real quick, we've just got a couple question or so here. How's liquidity?

Well, I'll start since I'm on the public side, but yeah, liquidity ebbs and flows and it depends on how you define it. So certainly there has been market volatility. You look at the interest rate volatility, the spread volatility that we've seen year to date throughout all of that, we can still trade bonds. You want to trade AAA bonds, that's fine. You want to trade some AA and single A bonds. We can make that happen. The benefit that our insurance company clients have is that we can take a longer term view, typically so we can hold bonds that we still see as fundamentally secure through market volatility. But when market spreads widen, like I mentioned before, that could present an attractive entry point when we look at again the market pricing versus our fundamental, if you think about it as our internal fair value. But yeah, you can trade, you can buy, you can sell very efficiently. We have a dedicated trader, that's what he does. They trade in the over the counter markets. All the major banks have dedicated cmbs trading desks.

Yeah, on the private side, it's a little bit more tricky. We're talking about inherently illiquid assets. You make the loan and you just wait for the maturity date and you get refinanced out or you get paid out by the borrower. But from that active, you know, liquidity has been strong and we haven't seen lots of instances where we couldn't get refinance out of our loan or we couldn't, you know, get the borrower to pay us a balloon payment or whatever the case may be. So we, we haven't really seen any issues from that perspective. But it is an inherently illiquid structure.

Absolutely. I mean that's just, that's the nature of the beast. Right. I mean you're getting paid, you're getting paid for that illiquidity, but that's right. And I mean, I'm glad to hear that there's been, you know, the markets have continued to trade, you know, throughout this volatility. So if I'm looking out today, right, where things are, there's been some volatility. We talked about that. Inflation where it is, rates going up. Should I be buying this asset class for the remainder of the year?

Yes. Short answer, it goes back to the two what we've been talking about. I mean, we're getting into really, really frothy values and I think it's a good time to start protecting portfolios. And that's what our debt programs do. Right. They're meant to be protective. And so when you're getting into the private debt space, given what we're seeing in the market today, you're buying into that equity buffer. Right. So if values do erode in the equity space, you're protected with structures in the capital stack, you're not the first loss position. You've protected yourself from that perspective. You've got a steady income stream. And again, we're not anticipating that values are going to drop to the extent where you're going to see a ridiculous number of defaults or anything like that. But we do want to be as protective as possible today and to provide that income stream. I mean the run up on the equity has just been so strong, I mean so strong. And there's still positives in the equity space and the pieces, the sectors that you decide to invest in will dictate your returns on a go forward basis. But again, when you start seeing values and pressures that we've mentioned already in terms of the cap rate pressure, the NOI growth pressure, all those pressures starting to come into play, it's always nice to be a little bit more protective within your portfolios and to layer in some of that into the private debt space. So that's why I say yes, you should absolutely think about it. And Scott from the public debt perspective likely has a similar answer.

Yeah, no, I think I mentioned this before but as we see spreads widen because of broader macro volatility because of contagion from the outflows that the, the IG and HY high yield corporate space has seen. When we see that impacting our spreads due to a weak macro and weak technical backdrop. But then when we look at the fundamental outlook for debt like Carlos mentioned, and we see that as still being supportive over the long term, I really like the entry point. There certainly will be mark to market volatility. I think there are broad expectations that there will be a lot of volatility throughout the summer as the Fed continues to pull back monetary easing from the market and really starts to tighten things from a monetary perspective. But it really points to the fact that you have to be a real estate expert to invest even in the public real estate debt space. You have to have a view on really what's ultimately securing your bonds with that equity cushion. With the strong debt service coverage ratios, we're very comfortable and we think the wider spreads could be an opportunity. On top of that, we haven't talked about it, but you know, from a structural perspective there's additional credit enhancement in these bond structures. So there are multiple layers of protection in these bonds that we're buying for our insurance company clients. So we pair that with the current market spread environment and we do think it makes sense, especially relative to equities.

That's good stuff. This is the ask me anything part of the program. Kirlos, I'm going to start with you.

Yes sir.

Do you remember your first day of work? I mean your real first day like you might have been in a suit even. Do you remember that day you meet Carlos today? What do you tell that guy in his first day of work?

Yeah, I tell him not to worry, everything's gonna be fine. I mean, look, I think when you walk in for the first time and you're nervous, you're nervous because of the unknown, right? You just really don't know. I can tell you every job after that first job, it got easier. It was still nerve wracking, but it got easier and easier. But that first day, kid, he was nervous and he was really scared about where his life was going to end up. And so if he met me today, first of all, I always tell people I'd love to meet my 20 year old self or my 21 year old self just to knock some sense into him. But I would tell him not to worry, everything's going to be fine. You'll find your way.

Scott, what about you?

Oh, yeah, no, I remember it. I had a great first day move. I went to meet my new mentor and immediately I said, oh, are you another intern?

No, I'm not an intern.

That's great.

Really started on the right foot with him. But yeah, nerve wracking. But if I had to look back, I would just say just, just learn how to learn. So long as you know how to learn, that's a continual exercise. If you come to the office every day thinking, yeah, I might not know how to do this, but I can learn, I can figure this out and we'll get through it. And you know, being in the industry for 18 years, living through the GFC and all the other volatility events, including Covid that we've been through, you gain that confidence, you gain that perspective and hopefully, you know, I can help pass that on to the younger generation as well. But can't underestimate the importance of being an active learner and having confidence in that ability.

That is good advice. I appreciate it very much. I really want to thank you for going over the asset class private and public real estate debt with principal real estate investors Kyrlos Girgis and Scott Carson. Thanks for being on.

Okay, thanks for having us, Stuart.

That was great.

Thanks for listening. If you have ideas for podcasts, please email us at podcast@insurance aum.com My name is Stuart Foley and this is the Insurance AUM Journal podcast.