Although commercial real estate markets remain healthy, slower price appreciation and year-end volatility have made certain investors more cautious. Portfolio managers Devin Chen and Jeffrey Thompson discuss the latest market developments and how they are positioning portfolios to be more defensive.
Q: HOW WOULD YOU DESCRIBE THE CURRENT STATE OF THE U.S. COMMERCIAL REAL ESTATE MARKET?
Chen: Overall, the commercial real estate market is stable, and conditions appear relatively benign, but we are seeing deceleration in fundamentals and price appreciation, the latter reflecting investors’ increasing caution lately.
The market was a more mixed picture in 2018 than in recent years, suggesting that commercial real estate, like the broader economy, may have entered the late-cycle phase. Prices for U.S. commercial real estate (CRE) rose 6.2% in 2018,1 but with a gradual deceleration throughout the year. The story varied significantly by sector. In retail, liquidity continued to be poor, with transaction volume down 20% in 2018. On the other hand, deal volumes for hotels and industrials were up by about 60% and 20%, respectively.2 We’re at a point in the cycle when construction activity is increasing but job creation is slowing, which will likely translate into declining rent growth. And as interest rates stabilize, we think prices are unlikely to benefit from further capitalization (cap) rate compression.
That said, we don’t expect a meaningful downward correction. North American closed-end CRE funds are holding a record amount of “dry powder” – funds awaiting investment – totaling $169 billion, which represents significant potential demand for U.S. CRE assets.3 In addition, leverage in the system is still at manageable levels, with prudent debt structures and covenants for the most part, especially compared with pre-financial-crisis levels. And the macro economy is stable.
Taking all of this into account, our view of the CRE market is more cautious now than in the last several years, and as such, we have a general bias toward more defensive investments.
Thompson: Against that backdrop, three things stand out in relation to the real estate debt markets. First, with transaction volume still well above historical averages, there is more than enough demand for credit – which means it’s still a lender’s market, especially in the bridge, stretch-senior segment. Second, the robust capital market environment allows us to originate loans at attractive levels with structures that include strong covenants. Third, at this late stage in the cycle, as defense becomes more important, we generally find better relative value taking senior rather than junior positions in the capital structure, so debt is a natural fit right now.
Q: THE LAST TWO MONTHS OF 2018 WERE VOLATILE ACROSS THE PUBLIC MARKETS. DID YOU SEE ANY IMPACT IN THE PRIVATE REAL ESTATE MARKETS? WHAT ABOUT YEAR-TO-DATE 2019?
Thompson: In November and December, we saw commercial mortgage-backed security (CMBS) spreads widen by as much as 50 basis points (bps). It took a bit longer to play out in the private market, but by the end of the year, some deals repriced – not plain-vanilla CRE deals, but more complex, structured deals. We took advantage of the volatility, signing a number of deals at wider spreads. Although CMBS spreads have retraced a significant portion of the fourth quarter widening since the start of the year, we expect bouts of volatility will continue, and we aim to be well positioned to react to opportunities.
Chen: Periods of volatility like the fourth quarter present great opportunities for us to provide liquidity when others seek it, whether in our equity business or our lending platform. We expect global political uncertainty and central banks taking a less active role in suppressing volatility will result in greater bouts of market uncertainty over the next few years. Our debt investments are structured to mitigate downside risk, and we are prudent in our use of financial leverage, which allows us to be defensively positioned and, at the same time, able to go on offense amid volatility.
Q: SHIFTING GEARS, PRIVATE CRE DEBT MANAGERS HAVE REPORTEDLY RAISED A SIGNIFICANT AMOUNT OF CAPITAL OVER THE LAST COUPLE OF YEARS. WHAT IS THE CURRENT COMPETITOR LANDSCAPE?
Thompson: New competitors have entered the CRE debt space since the financial crisis, but the capital in the bridge, stretch-senior segment, which is one of our primary focus areas, still benefits from strong demand for financing relative to supply.
Many of the funds that have recently come into CRE debt are specialized, focusing on construction lending or sectors like senior living and multifamily. Transaction size also limits the number of our competitors: We typically target loans greater than $100 million, and according to Preqin, out of 63 North American CRE closed-end debt funds actively seeking capital as of March, only 10 target $1 billion or more in capital – and that includes a broad array of mandates, such as nonperforming loan funds. Another consideration is concentration limits – geography, asset type, and sponsor – which can also reduce the number of lenders on a particular deal. This is one of the advantages of being a player of scale in this space.
Q: EVEN AMONG FEWER COMPETITORS, HOW DOES PIMCO DIFFERENTIATE ITSELF?
Chen: Our borrowers value certainty of execution and speed. By leveraging PIMCO’s overall resources we are able to evaluate complex lending opportunities efficiently and can offer creative solutions. We view ourselves not just as a lender, but a solutions provider and long-term partner to the borrower.
We have an active CRE equity business that creates synergies from an underwriting and asset management perspective. We’re also one of the largest investors in the CMBS market, which provides insight into the pricing of CRE risk and collateral performance nationwide.
Beyond commercial real estate, we have access to PIMCO’s credit research analysts, who help us assess potential tenant risk. We work with our analytics group to analyze the intricacies of loan structures, including embedded optionality. Finally, we rely on PIMCO’s macro views, particularly on the direction of the economy. These capabilities within our organization help make us a very reliable provider of financing to our borrowers.
Q: HOW DO YOU MANAGE DOWNSIDE RISK?
Thompson: We mitigate downside risk by adhering to three pillars in building a resilient debt platform: sponsorship, underwriting, and covenants.
First, in terms of sponsorship, we lend to well capitalized, smart investors with strong track records. Second, we perform our own bottom-up underwriting. An appraisal is a part of the process, but it’s only one data point, and we do not rely on it. We project cash flows based on our own assumptions on rental-rate growth, leasing velocity, cap rates, occupancy, and many other inputs. The underwriting is vetted extensively, and all assumptions and inputs are debated, resulting in our collective view of value. The loan itself is then reviewed and analyzed to determine an appropriate risk-adjusted return. As part of that, we prioritize loan covenants and structure, the third pillar in building a defensive portfolio of loans.
Debt in general has one big downside risk – namely, loss from default – and covenants are designed to protect against loss. They provide for loan surveillance and cash flow controls that help us meet our primary objective in lending: the return of principal.
Q: LOOKING AT LOAN STRUCTURES, HOW DO YOU EVALUATE THE TRADE-OFF BETWEEN FIRST MORTGAGE LENDING AND MEZZANINE LENDING?
Chen: This is a common question we get from clients and to put it simply, a first mortgage is a secured first lien on the underlying real estate and offers an investor all the controls, or protections, that go with that, while a mezzanine loan involves a pledge of the borrower’s ownership interest. Under a foreclosure, a first mortgage can take longer to enforce than the mezzanine interest, but the mezzanine lender inherits the borrower’s and the asset’s total liabilities. While each can make sense in the capital structure depending on the circumstances, it’s important to understand the structural differences between the two.
At this point in the economic cycle, we generally prefer a more senior claim on a high quality asset with reasonable financial leverage versus lending further down the capital structure, taking on more risk. We often focus on originating the entire loan stack. It allows us to do business with our borrower without having to involve other parties and makes for a more efficient and predictable closing process. We can also structure the whole loan based on our priorities while also meeting the needs of our borrower. And finally, a whole loan allows us various funding options, and we can choose the most attractive terms available to PIMCO.
Q: WHAT TYPE OF INVESTMENT PROFILES ARE YOU TARGETING, AND ARE THERE CERTAIN SECTORS OR DEAL TYPES THAT YOU ARE AVOIDING?
Thompson: In assessing any potential investment, the quality/reputation/history of the borrower is central. We look at the sponsor’s track record with the type of asset involved, their ability to add value to that asset type, and the amount of cash equity they are willing to put into the deal. We also look for deals in markets with good liquidity and visibility for projecting cash flow.
There isn’t a sector that we would avoid entirely, but in certain areas, we are highly cautious and unlikely to lend. For example, we hesitate to lend against assets that are specialized or operate in highly regulated environments, like skilled nursing facilities. Also, we tend to shy away from sectors that are facing macro headwinds, such as retail. Even the grocery-anchored segment is vulnerable, in our view, as some very large, well-capitalized companies are disrupting that space, which could lead to volatility.
We also seek to avoid structures where the borrower has all the optionality: for example, deals in which the cash flow is distributed to the borrower despite the asset clearly deteriorating, or where lenders have limited call protection while the borrower has multiple extension options. We want to make sure that we have the ability to protect our investment in a downside scenario.
Ultimately, we’re trying to find the gems: investments that are somewhat complicated, but give us the ability to underwrite, get comfortable with our basis, and price accordingly.
1 RCA CPPI – U.S. National All-Property Index
2 Eastdil Secured
3 Preqin as of March 2019