Talk Your Book: Investing in Real Estate Credit

0:00Today'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 Batnick 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 Ritholtz Wealth Management. This podcast is for informational purposes only and should not be relied upon for any investment decisions.

0:38Clients of Ritholtz Wealth Management may maintain positions in the securities discussed in this podcast.

0:47Welcome 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, right? I'm a shareholder and I'm an owner of the equity of the Empire State Building, the Bellagio, whatever. but this underinvested asset class, at least on the individual level, institutional investors have been investing here for years. And frankly, there really hasn't 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.

1:30And this asset class makes a lot of sense to me. Just because what, it's simple, 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. It's short duration, floating rate. I think that's a thing that probably a lot of people would be drawn to.

2:08I'm guessing not a lot of defaults outside of the office space. It seems like an appropriate use of capital. Obviously, caveats galore, but - 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's investing in parts of equity and parts 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.

2:47Yeah, 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 Invesco 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 with Charlie Rose.

3:13Charlie, welcome to the show. Thank you so much for having me. All right, I have to be honest. Invesco Real Estate. Obviously, everybody listening is very familiar with Invesco. Huge global asset manager, huge, incredible brand. Invesco 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 investment manager. We've been around for 41 years. But historically, we've managed money on behalf of institutional clients.

4:00And our brand has not been as well known. increasingly 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 of different areas. What are you guys focused on? Invesco 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.

4:43So you will see us investing in large-scale multifamily properties, distribution and warehouse facilities, retail, not so much office 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? 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. But there is more clarity today on demand for office.

5:37And 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 democracy.

6:35graphic changes. I'm curious about your strategy in residential because if you look at the numbers, it's kind of surprising the number of investors in, especially in the residential market in the US, 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?

7:07So 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 multifamily property, a senior housing, community or student housing community. Second, since the global financial crisis, we have been under-manufacturing housing in the United States. And there is a fundamental undersupply of housing in this country that is broad and seen across most major markets today. Now, there are many different strategies within residential.

8:03And 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 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 supply-demand picture.

9:10Institutional 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 Investco and others are going to be in our neighborhoods? My focus is primarily on the real estate credit business here at Invesco. 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 I've mentioned.

10:07Our 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.

11:07Historically, 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 % of their portfolios are allocated to private markets on average. The largest and most sophisticated endowments, of course, today may have 50 % or more of their portfolios allocated to private markets, well documented by the David Swenson Yale model, whereby they have, to date, outperformed public markets 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.

12:02Real estate equity has performed an important role in those portfolios as an income generator and a diversifier over time. 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 no exposure to previously. Real estate credit is a$6 trillion asset class in the U.S. So that's 50 percent larger than the municipal bond market.

12:55That'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 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.

13:42To 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, 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, 5 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.

14:33All right. So what exactly is real estate credit? We are a lender to institutional 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 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.

15:34These 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? 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.

16:34So you'll see us generally on the lower end of that LTV range in the 60 to 65 % LTV range, which means loan to value, that our borrowers have 30 to 35, even 40 % equity fully subordinate to our loans. So if property values drop by 30%, 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? 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.

17:34And that gives a much more clear path to resolution 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 have to go through the judicial process, that timeline can extend out.

18:37But 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.

19:29The 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 can you unpack that a little bit? Am I completely off the mark? 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.

20:22We 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 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.

21:19Is that standard or is that something that's 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 questions about what can go wrong in real estate credit, that we have two great case studies in modern history.

22:06One 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 SOFR environment, all of a sudden, these floating rate instruments based on term SOFR saw the all-in interest rate go from, call it 3 % when term SOFR was five basis points to north of 8 % with a 5.5 % term SOFR. 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 percent between the peak of the market in early 2022 and late 2023, with office in particular correcting even farther than that.

23:06So 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 strain. So what are you seeing for yields these days? And maybe it changes across the spectrum where you're getting the investments, but what What are yields look like for investors today?

24:01Yeah. So clearly, when term SOFR 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 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.

25:06So 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 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.

26:01Historically 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. 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 has created an opening in the space. And where the banks are participating is typically in providing back leverage to alternative lenders.

26:49They 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 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 than 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.

27:58But there has been significant 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 that are working very well for our institutional clients to the wealth channel.

28:50Now, I would say that there is still a lot of fundamental education in the wealth channel about what these different private markets products are, 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 some of the same benefits that private credit have delivered.

29:51But 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 its 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? Is it going to be private placements or do you think it's going to be evergreen funds or maybe something even publicly listed?

30:33What 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 mortgagary 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 REIT 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.

31:31So the liquidity structure will look pretty similar to what investors have become familiar with, with non-traded equity REITs and BDCs, monthly or 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 on an investment like this? We talk about this as a strategic allocation, which should be a long-term allocation within a portfolio.

32:17Historically, 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. 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.

33:11Perfect. 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, Invesco.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. Email us at animalspirits at compoundnews.com.