Commercial Real Estate: Opportunities for Insurers in Multifamily, Industrials and the Suburbs

September 13, 2024


Samantha Andreoli, a Director in Conning’s Business Development unit, spoke with Stephen Quazzo, CEO of Pearlmark Real Estate, L.L.C., a Conning affiliate, about current market conditions in commercial real estate and considerations for insurers.

 

 

  1. Samantha: Global geopolitical tensions have risen, yet risk markets through July generally had performed well. Has the real estate asset class followed suit? 

    Stephen:     I would say “not exactly” and let’s put the whole office sector to the side for a moment given its challenges. Real estate is a notoriously interest-rate sensitive investment and from 2022 to 2023 it experienced a rapid upward change as interest rates doubled. Couple that with excess supply in a lot of markets, where we’ve now seen rent growth flatten out and go down. At the same time, costs, like insurance, particularly in coastal markets, have gone way up; property taxes have done the same; and other inflationary costs at the property level have also gone up. On top of that, financing is in short supply. Put all that together in the soup and you’ve seen a big value drop in real estate. So, no, being in the stock market would have been a better trade over the last few years. 




  2. Real estate has long been a part of insurance portfolios, although generally more among larger firms. Are exposures growing overall?

    Yes, overall exposure to real estate continues to grow for insurers, who invest through securitizations, direct loans and equity participation. As of year-end 2023, mortgages crossed the $700 billion mark and grew to 14.4% of the life insurance industry’s invested assets. That’s up from $520 billion and 13.1% at year-end 2018.1

    Mezzanine loan exposure, which is part of the mortgage portfolio, has held steady at 2% of life insurers’ mortgages over the past five years.2 So if real estate in total is about 13-14% of all insurer invested assets and mezzanine accounts for about 20 basis points of life insurers’ real estate investment strategy, then on a dollar basis that equates to about $11 billion. 


  3. Pearlmark has de-emphasized the office sector for a long time. What is your current office sector outlook?

    Office has pretty much been a disaster and, while I think it’s a sector that’s been dying for some time, Covid was really the last nail in the coffin. Well before 2020, companies were getting way more efficient about their space and people were realizing that they didn’t want to spend all their time commuting, so there’s just a lot of obsolescence and excess space in the office market. Just think of the downtown gateway cities’ older buildings: vacancy rates in some markets are 30%-plus, which is certainly the case in San Francisco and Chicago, particularly when you factor in sublet space.

    There’s sort of a bloodletting going on. We think the top 20% of the office stock will be fine but for the rest of it, we feel it will be like what happened to the mall business over the last 15 years: we just need a lot less of it.


  4. There have been high-profile property devaluations in some urban centers and delinquencies are reportedly on the rise. Does this create opportunities for risk-sensitive investors like insurers? 
    I do not feel currently there are many opportunities in office, especially not yet in a lot of downtown gateway cities that are wrestling with issues like public safety and school systems that aren’t performing at anything close to an acceptable level. However, I do think there are select office opportunities in the suburbs. 

    In the apartment and industrial segments, the underlying fundamentals are good. And because of the shortage of debt capital in the financing markets and some oversupply, there are opportunities for risk-averse investors on both the equity and debt side of real estate.


  5. What are other areas where are you seeing opportunities in the market today?

    We believe there’s intrinsic value in buying great, well-located, well-constructed properties. Generally, we’re a value-add-type buyer. We’re looking to go in at cap rates of ~5.5% to 6% and grow those cash flows over the ensuing two to three years through either reinvesting in the asset, pushing rents as markets tighten, etc. So, we tend to look for opportunities at a spread between our stabilized return on cost and where cap rates are currently set. If we think cap rates and multifamily and industrial are in the 5% range and our yield on cost is at the 6.5% level, then that’s a very healthy spread. We don’t feel that there’s a big leap of faith to get to those levels. 

    For example, apartments and industrial are two of the favored asset classes. A few years ago, they were trading at cap rates of 4% and even below. Today, we see cap rates 100-150 basis points higher for those same assets. 


  6. Multifamily is an active area for Pearlmark and one with potential opportunities given the nation’s housing shortage, but 
    higher interest rates may be a challenge. What’s your view? 

    Whenever you’ve had a massive price dislocation coupled with a rapid rise in rates you will experience issues and, as I said previously, in some markets there is some oversupply. We’re in a bit of a digestive phase in terms of absorbing those excess apartments, but underneath that the fundamentals are solid. 

    The U.S. has become a nation of renters. People are delaying home purchases due to high prices, they’re getting married later in life, and the cost of a mortgage is significantly higher than a comparable for-rent equation. As a result, I see these units getting absorbed, particularly in the markets where we’re seeing both job and demographic growth - the Southeast, Florida, Texas, the Carolinas, etc. We like the multifamily space and will continue to invest in apartments both on the credit side, as well as the equity side.


  7. Banks are being more conservative in their commercial real estate financing due to a more challenging regulatory environment. What’s been the impact?

    I think the short answer is that it’s creating a huge gap and therefore there’s an opportunity for private debt funds and, more subtly, equity investors to fill that gap. As construction loans are coming due and banks are no longer willing to “pretend and extend” like they did last year, borrowers and owners are forced to confront reality: they must capitulate and accept the required loan paydowns. Either that or they’re tired of funding the shortfalls out of their own pocket and willing to let the asset go.


  8. Inflation has been stubborn but the inflationary period of the 1970s was a good one for real estate. Do you expect similar results today? What do you anticipate happening should the Fed ease?

    Our view is that short-term rates are going to come down. But we don’t really see the long end of the curve coming down much. I think the 10-year treasury is at a very reasonable rate today and we believe it will stay within that band. We’re not counting on cap rates compressing.

    So going forward we think it’s going to be a terrific time to acquire real estate because, to the extent that inflation bumps along, the underlying value of the real estate will increase. We’ll have the ability to grow rents, particularly in apartments where almost half of your rent roll matures and moves out every year. We think owning hard assets in an environment rife with inflationary trends (i.e.. rising labor costs, fiscal deficits, global conflict, etc.) is a great investment.


  9. In Q4 2023 there was an uptick in foreclosures on real estate mezzanine loans, another area of focus for Pearlmark. How would you differentiate your specific strategy? 

    When values drop that precipitously, no one is immune. But having been through a number of cycles, including the early 80s when I came out of college during a highly inflationary environment, at Pearlmark we’ve developed a number of risk mitigation policies.

    One is, on the mezz side, we’re almost all multifamily residential with some industrial exposure. We don’t employ any leverage to our positions. We have a balanced portfolio mix: stabilized assets; bridge transition loans; and then opportunistic/development. Our last-dollar exposure generally doesn’t exceed 75% of loan-to-value or loan-to-cost and we’re generally attaching at 55% so it’s a very clean, simple structure. Also I might add our borrowers are highly qualified, well capitalized sponsors, and the assets that we’re lending against are institutional quality, so that tends to help withstand some of the cyclical downward pressures.




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    Conning (www.conning.com) is a leading investment management firm with a long history of serving the insurance industry. Conning supports institutional investors, including insurers and pension plans, with investment solutions, risk modeling software, and industry research. Founded in 1912, Conning has investment centers in Asia, Europe and North America.


    Commercial Real Estate Risk Factors
    Systemic and /or Idiosyncratic Risk:     significant deterioration in economic conditions can fuel diminished liquidity and increase overall default and downside risk.

    CMBS/CRE may experience a higher beta/spread volatility during periods of heightened volatility which may impact demand for these assets.

    Interest rate risk and inflation can have adverse impacts on commercial real estate valuations.|

    Regulatory and Political Risks:     specific regulatory or political initiatives may have an adverse impact on commercial real estate development, the supply/demand balance and availability of financing opportunities.



    Disclosures
    Past performance is not a guarantee of future results.

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