Talk Your Book: Opportunities in Commercial Real Estate Debt

0:00Today's Animal Spirits Talk Your Book is brought to you by Benefit Street Partners. Go to benefitstreet benefitstreetpartners.com to learn more about their private debt offerings, CLOs, real estate, specialist situations, high yield structure credit. On today's show, we're going to be talking mostly about real estate debt. We also talk about private credit. Remember, that's benefitstreetpartners.com to learn more.

0:19Welcome 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. Clients of Ritholtz Wealth Management may maintain positions in the securities discussed in this podcast.

0:48Welcome to Animal Spirits with Michael and Ben. Michael, for a couple of years now, it feels like we've been talking about this coming train or whatever you want to call it. Maybe it's more like a slow moving, what's the thing on Austin Powers? Steamroller? Yes. There was a lot of Forest Camp movie analogies. That's exactly what it is. And I guess we're talking specifically that slow motion steamroller crash. Get out of the way! Get out of the way! By the way, on the show, I was stuttering and stumbling and bumbling for and I used the word isolated. My brain, I couldn't retrieve it. I was looking for the word contained.

1:26This happens to me too. I was looking for contained. This is harder than it looks. But anyway, the isolation or the containment, I should say that, we were referring to, we're talking about the office real estate train wreck. And he made such a great point. I'm so happy he said this because I have been saying this, but when I say it, it doesn't matter because I don't know what I'm talking about. You got really excited. When an expert says, I'm like, yes, I was right. We had the crisis in our office real estate. It's not coming. It came. Right, and now is the aftermath and dealing with it. And so we talked to Rich Byrne today from Benefit Street Partners.

1:58And yes, he talked about - Via, via, via. You know, I like the Via Via. Benefit Street Partners is owned by Franklin Templeton. Yes. And they're huge alternative asset management firms focusing mainly on debt. And he talked about, he was really excited about the opportunity. And sometimes you can get the difference between someone who is just pushing an opportunity versus actually like excited about the opportunity. We saw it in his face. Yes, you could see it in his face. And he thinks that there's a lot of opportunity there for fresh capital in this space. If you've already, we're in this space and your legacy, it might be hard to clean up the mess.

2:29But he's saying coming in with fresh capital, he's seeing opportunities unlike he's seen in a long time. Yeah. All right. This was a fun conversation. Hope you enjoy it. Thank you, Rich. And thank you, Franklin and Benefit Street Partners for coming on.

2:44Rich, thank you very much for joining us today. Great to be here. Before we talk about all things private debt, real estate, all that good stuff, mind giving our audience just a sense of who Benefit Street Partners are? Absolutely. Hey, guys. Benefit Street Partners is a$76 billion alternative asset manager. Everything we do is credit. So it's corporate credit in the form of direct lending or liquid credit in the form of high yield bonds or broadly syndicated loans slash CLOs, or it's distressed lending. Or last flavor for us is real estate lending, which is a really cool relative value right now.

3:24We're owned by Franklin Templeton. They bought us about six years ago. Franklin's a little bigger than us. They're about a trillion six. And we've enjoyed that relationship. So that's the background. Rich, you've got a bunch of pieces that you've written for Franklin Templeton about commercial real estate and the debt there. and I'm a sucker for a good movie analogy and I've used this one before. You wrote about Forrest Gump taking out the shrimp boat and coming back and all the other boats are taken down, right? I've used that one before, so you're good in my book. Maybe you could just give a, Michael and I have talked about the commercial real estate market.

3:58It seems like it's a place people have been talking about for the last 18 to 24 months as like this coming crisis. Something's going to happen. Commercial real estate is going to take down the market. This is the next thing. Maybe you could give us an update about where things stand in that marketplace Because I think the fact that there hasn't been anything, it hasn't really caused any macro waves yet is probably surprising to some people. I think you're right. And the only thing I would say a little different than the way you phrased that is I think the crisis has occurred already. I think the consequences of that crisis are the part maybe that haven't.

4:33That's the semantical difference, I would say. What happened in commercial real estate? Well, two things. rates went up and that affected valuations of properties real estate's very highly correlated very easy to understand cap rates go up when rates go up hence property values go down i think that's generally true for most asset classes but it's most easy to understand and highly correlated for real estate but the thing that i think people don't appreciate as much is if maybe we use a boxing analogy, that's like a left jab. That's a jab that gets your attention. It stuns you a little bit. It's certainly not life-threatening.

5:14The punch that knocks you out is the cross, and that's the office sector. So while everybody's focused on rates, office sector really has nothing to do with rates. Office sector, as you all know, and the rest of the world knows, is we have more office space now post-COVID. Then we have people that need to work in offices. And that's got to settle itself out. We think that's going to take three to five years to resolve. While that's getting resolved, there isn't a good outcome for an office property, at least in this country. Some will be way better than others. And on the bad side, there'll be zeros.

5:59So what hasn't happened yet is the sort of price discovery of what everything is really, truly worth. Maybe you need some more time for some of that to play out so you really kind of know. But there's a lot of reasons why that hasn't happened. and the fact that it hasn't all happened at once is actually a good thing because if it all happened at once then I'm not sure all the people that own real estate loans or real estate have enough equity capital to get through this. So that's why this is playing out so slowly and we can talk more about that if you like. Rich, I'm so glad to hear you say that the crisis, I don't want to put words in your mouth, I forget exactly what you said, but we had a crisis, is that what you said?

6:40The crisis has already occurred. Okay, okay. So to that point, And I was saying something similar. Listen, I don't know where all the bodies are buried and what might happen in the future. This is what I was saying a year ago or so. But my point was, guys, everybody knows these things are in deep doo-doo. SL Green, which is based in New York, the equity was down 76%. It's not a secret. I'm sure the bonds were at least as bad. It already happened. And in fact, SL Green, the equity at least, is acting really well lately. But it's no secret. This is not going to come out of nowhere. And you're seeing all sorts of headlines in the newspaper.

7:16This San Francisco skyscraper, this New York skyscraper got sold. And OK, yeah, the office sector real estate is in deep trouble. And to your point, that's a post-COVID work-from-home type of environment. That's not a rate story. So we're already digesting that the rabbit is working its way through the Python. The equity will be written down. The debt will get restructured and pain will be felt. But maybe it's not more of a macroeconomic story. it seems to at least to date have been relatively isolated or maybe that's a bad phrase, but you know what I mean. So what sort of real estate do you all focus on?

7:50Okay. So I think of the world in two ways. There's legacy loans and there's new loans. So when I say legacy loans, so back in 2021, it was about a two-year period of post-COVID. It was the end of 20, it was all of 21 and the beginning of 22. It was basically, we'll call it the free money era. Money was cheap or almost free. And there was a lot of construction. There were a lot of loans. There was a lot of parties and happy times. All of those loans, even the best properties, the best multifamily, new vintage, Sunbelt, great stuff, is worth less purely because interest rates went up. So if you were lending at a 65, let's say, loan to value, 65, 70 LTV as a lender in 2021, that loan today, that property is probably worth 20, 25 % less just because of rates, not because of any reason else.

8:48The property is perfectly fine, just rates are higher. That loan to value now, if you're a lender, is like 90. Does 90 mean you're losing money? In theory, no, but you don't have a lot of margin for error at 90. So all of the lenders out there, the banks, the public mortgage rates, the private funds need to work through all of that 2021 vintage origination. And that's what has to get through the Python. That has nothing to do with office, but that problem exists all by itself. So getting back to the Forrest Gump analogy, where are you seeing value these days? And this is the kind of thing where you think value is going to be there for a long time because it's going to take a while for this to play out?

9:32Or like, where are you finding opportunities? Yeah. So the Forrest Gump analogy for everybody, funny, just as a side note, I wrote this white paper and we have an editor and this editor said, you should take out the Forrest Gump thing because not everybody has seen the movie. So I just did a test of like the 10 people near my office. I think we were 10 for 10 that they all saw the movie. So anyway, we'll assume that your viewers have seen the movie. But Forrest decided to get in the shrimping business, and he couldn't catch a shrimp. He was catching license plates and things until Hurricane Katrina came, and he was irresponsibly out at sea.

10:10But in a Forrest Gump way, his boat was saved. All the other boats crashed into the shore and were wiped out. And for a period of time, he was literally the only boat in the Gulf of Mexico shrimping, in this fictional story, and caught all the shrimp. and then he ended up creating Bubba Gump Shrimp and investing in Apple Computer and live happily ever after. It feels like that because all of the traditional lenders, all these big boys that when we show up to give a term sheet for a loan to an attractive property, we're competing against the biggest names on the street plus banks. Banks are unlike corporate debt, direct lending, where banks have largely been disintermediated by this private capital.

10:58In real estate lending, the market is still about 50 % bank and it's small regional banks. So they're all on their butts right now. They're not making a single loan. Most of the traditional lenders, the big guys, they're not making a single loan. Why? Because they're hoarding cash. Because if somebody injected them tomorrow with sodium pentothal. That's from old spy movies. That's the truth serum. And said, you know what? Let's mark everything what it's worth and we'll wash our hands of it and we'll just go forward. And that'll all be yesterday's news and we'll go make money in the future. Everybody wants to do that trade.

11:39Well, you can't. You can't do it because nobody has enough equity now to absorb those losses when they have to buy loans off of their warehouse lines or out of CLOs or get new appraisals. Nobody has, and certainly the banks don't. So especially the small regional banks, because they just don't have a big enough business model to bail out of this stuff. Because the average corporate lender, lender to, excuse me, commercial real estate has 25 % office. That's the problem. So this is why it's going to take a while. So back to your question, what's the opportunity? While all that's going on and all those boats are crashed in the shore and they can't go fishing.

12:21Fresh capital to deploy into just a regular way market right now, just making regular loans, you're getting your pick of the litter. You're underwriting properties. You're probably excluding office. You're not even looking at office. But high quality class A multi, you're making loans against them at valuations that are 20, 25 % lower than they were in 2021 at like 60 LTVs with great terms and you're getting looks at great properties because you're not getting outbid by anybody. There's nobody else. I wouldn't say nobody, but the amount of competition is a fraction of what it used to be. So the play is new loans.

13:02Fresh money is the opportunity right now in commercial real estate lending. Talk about the vehicles through which the investors can access some of these great new loans? Okay. So that's going to be a little trickier. So Michael, let me say it this way. You'd be a fool to think that any attractive market opportunity, the markets aren't efficient. Of course, there's going to be new capital to take advantage of it. But most of the vehicles that investors would see have legacy exposure. That's tricky. So it's owning any bank that makes commercial real estate loans or commercial mortgage rates. We have a publicly traded commercial mortgagery.

13:43We have under 5 % office exposure. The average exposure of our peers is 25%. They're also trading at 70 % of book value. So the market kind of gets it. So there might be some value if you think one is better than the other or whatever. But to us, the opportunity is in a newly created vehicle. So you'd make loans. You know, anything with new capital to deploy, because I would call that the 2.0 vintage. You're making loans against, as I said, properties that are marked down 20, 25%. You can skip office as an asset class and, you know, until it comes back and you can be super selective because it's so, so little competition.

14:24Is this an interval fund? Is that the structure? A perpetual REIT. So how does that, how does that work? I'm not familiar with that. Okay. So a perpetual REIT is – think of it as a closed-end fund that has quarterly redemptions. Okay. Just like an interval fund. Yeah, just like an interval fund. So the way that this works, practically speaking, is you raise a pool of capital, issue shares, and then take that money. Is there some leverage there? There can be. That sort of has to do more with the flavor of how the manager wants to run the strategy. But with 60 % LTVs, which is real, 60, 65, let's say LTVs, which is really like sub 50 LTVs off of 2021 valuations, we think it's perfectly appropriate to put a turn or two turns at most of leverage on that.

15:12So on an unlevered basis, you're generating SOFR plus three, 400. SOFR is 5 % plus some upfront fees, some back end fees. I mean, that's like 9 % or higher unlevered. So I don't sure equity real estate investing has that kind of return potential right now. And this is cash return. So, you know, just in the scheme of value, you know, we look at, we look over a giant purview of different investments. I mean, we run all these other strategies. It's not like, you know, we have one strategy and we're just pushing it. Compared to corporate lending, this is just more yield, better, better value, you know, less crowded.

15:55Dumb question. Dumb question. So the loans are being paid back by what? Is this just rent? Yeah. So think of in real estate lending, think of there being like three types of loans. There's construction lending, which we generally don't do, but we'll dabble in. That's riskier, right? Well, yeah. You're doing something ground up. It's a different type of expertise. Then there's once your property is completed, there's sort of like a bridge financing, taking it from start to stabilized. You know, think of a multifamily. Once you get it all occupied and people paying rent, then it's stabilized. And then the third type of financing is like a permanent financing.

16:35Think of that as Freddie or Fannie or CMBS eligible financing where you're getting like 10 year fixed rate financing. Where we typically, we'll play in all three, but where our balance sheet is more often than not is in that middle one. These are generally three-year floating rate loans. So a sponsor will buy a property or take out a construction financing, and then they'll look for this financing to be temporary until the property is stabilized, and then they'll take it out with a fixed rate, longer term piece. Does that make sense? That yield, especially with leverage, sounds pretty juicy. What's the risk here?

17:14Is there default risk for some of these loans? What is the possible downside? Well, from our perspective in this new vintage, I mean, everybody's thinking about the risk of real estate. They're thinking about stuff that got underwritten in 2021. For this new vintage, I mean, I'm not going to say it's without risk. You obviously need to be careful. There's different asset categories. We favor multifamily. We can talk about why, but one of the risks in multifamily people talk about is that rent growth has really slowed. It's actually been negative in some of the Sunbelt markets because there's been an influx of new capacity that's been added to all these markets because when money was free, people were just building buildings.

17:55So that's certainly a risk that rent slows. You're not hitting projections. What about prepayment risk? So you're making the loans sort of to stabilize it. And what if the company says, hey, you know what? We're actually okay. We don't need this money anymore here. It's yours. Yeah, we'll take a small prepayment penalty and then move on and make a new loan. I mean, if that's your worst risk in the world, think of it this way. The three-year loans, we're on a treadmill set at like 10. So if everything goes according to plan, you have to replace a third of your book every year anyway. So if you add a few prepays in there, then it's not – and remember, they're floating rate.

18:31So the only reason that they're prepaying is if credit spreads tighten, not rates, because they're – and they usually have rate hedges too. So they kind of take right out of the equation. So that's another risk, albeit not like the real risk that you're thinking about, but just in terms of the stated income that you could expect today, if and when rates go down and they are heading down, you're going to get a low return because the rates are floating. Correct. You're right. Right. That's the – it's not a default-oriented risk. It's just a lower income risk. It's a lower down the totem pole risk.

19:05But actually, I think that that's like a good risk because are 11 % loans like really sustainable? Like, yeah, that's great. But it's great until they can't pay it because it's like punitive. Exactly. So there's – it's a double-edged sword. People were – all the legacy books were freaking out because rates were going up. and they were worried about how are these loans going to exit. But at the same time, they're generating record net interest margins. So funny enough, all these mortgage rates that are trading at 70 % of book value, they're all over covering their dividends because they got this windfall of extra income.

19:44So it's a double-edged sword. The lower rates go, the higher the credit quality is, the easier the exit path is going to be for all the loans when they hit maturity. But the less income you're going to generate. or get greedy, generate more income and hope for the best on the back end. For the multifamily, is there also some thinking there that, yes, there was a huge building boom when rates were really low and the pandemic stuff took off, but I assume most of that stuff has kind of been stopped dead in its tracks with rates getting higher. Are we going to see rent growth increase again in the coming years because of this period?

20:14Yeah, Ben, you nailed it. It's cheesy, but we're talking about Forrest Gump, that Wayne Gretzky quote of go where the puck is going. Yeah, rent growth has slowed because of all the properties that have been delivered into the market. There's only another quarter or two before any new construction is finalized. But how many shovels have gone in the ground since second quarter of 2022? Like zero. So now come 2024, 2025, there's not going to be any new capacity delivered. Unless something starts today, it's probably not in 26 either. So yeah, you're going to see a lot of that pressure relieved and probably lead to some pretty healthy rent spikes in the good markets where people want to live.

21:01Richard, I don't know if this is a fair question to ask. It's like asking a barber if you need a haircut. And actually, I was going to say that you and I share the same barber. So just from that alone, you're good in my book. But in terms of investors doing diligence on benefit and Franklin versus some competitors, what sort of questions should they ask? I mean, this is, you know, we, I speak for our listeners or are not experts in the real estate loan space. We don't, you know what I mean? Like, how do we say, okay, I like what they're doing. I don't like what they're doing. Like, what should we even, what are the questions that we should be asking?

21:35So this is a good question, and this applies to commercial real estate lending, to corporate lending, to anything. But I mentioned that a lot of the traditional lenders are on the sidelines, and it would be crazy to not expect the market for their new capital not to be formed. So when you think about new capital that's being formed to address this opportunity, there's a different way of asking your question. What should you look for? Well, you want somebody that's done it before. Let's at least start with that. Because a lot of the new capital is coming from the equity guys, the property REIT guys that are like, oh, it's not so great to buy properties now.

22:14I should be lending. And they'll figure it out. Well, they're smart real estate investors for sure. But lending is a different discipline entirely. clearly, writing loan documents. We've been doing this for a billion years. So I think it's expertise, not just in real estate, but in lending. There's, of course, track record. For example, a lot of the commercial mortgage rates that trade at 70 % or less percent of book value, they're licking their wounds. So their credibility in going out and raising new capital would be like, well, what did you do with the capital they used to run? Where's that trading?

22:49So I think you look at track record. I think you look at length of time in the business. I think you look at what you've done. Is it the same as what the opportunity is? Because in some cases, Michael, that new capital is being formed not in the form of traditional first mortgage loans like we're talking about, but in MEZ or in like gap capital, which does look more like equity. So it depends on what flavor you're looking to invest. You might have a different expertise. But I think you're trying to match the track record and expertise and experience of a manager with what is the opportunity. I think it's the basic ABCs of doing your due diligence on investing.

23:29And if you're buying into a legacy book, I only have one answer for you there. And that's you better due diligence on the assets that they own or that they've lent to. So we're talking mainly about real estate debt here. Your firm manages all these different strategies. Do you talk with clients about being more opportunistic in this kind of space? Do you think it makes sense to have just a target allocation to stick with it? How do you think about that? Because it seems like you're pretty excited about this opportunity. When this sort of thing happens, are you pounding the table for people? Hey, this is a better opportunity than that.

23:59How do you think about that? Yeah. So you have to, you know, as a president of a big lending firm, an asset management firm, you kind of think of this as like a mother would think of choosing amongst her children. So, you know, don't really have any favorite favorites. But, you know, from time to time, certain strategies have a better relative value. They just do. And this this is that time for commercial real estate lending as compared to commercial real estate equity investing. for sure. But in our world, we do, as I mentioned upfront, corporate lending. You don't have an office sector in corporate lending.

24:37So people think it's way better. Of course it is. You don't have 25 % of your market that got kicked in the behind. But you also don't have the dislocation that occurred with that that creates the opportunity. So I think there's apples and oranges. I want to talk about private credit. But before we move off the real estate stuff, how does this work in terms of, okay, we've got a real estate company, they need to raise money, they need a loan, they hire an investment banker, there's an auction. Am I making that up? How does it work? Yeah, no. That would more describe a corporate loan opportunity.