Show V/O:
This is Alternative Allocations by Franklin Templeton, a monthly podcast where we share practical, relatable advice and discuss new investment ideas with leaders in the field. Please subscribe on Apple, Spotify, or wherever you get your podcast to make sure you don't miss an episode. Here is your host, Tony Davidow.
Tony:
Welcome to the latest episode. of the Alternative Allocations Podcast. I'm thrilled to be joined today by Rich Byrne, President of Benefit Street Partners. Welcome Rich.
Richard:
Welcome, Tony. Thanks for having me again.
Tony:
And you're in fact our first repeat guest of the podcast series and part of it is you and I have been talking for the last several months about the incredible opportunity in real estate debt. Frame the opportunity for our audience just a little bit here.
Richard:
Sure. Well, what's I think so compelling, Tony, and I think you have become a believer in the story, and maybe that's why we're here now, is that across the whole panoply of everything we look at. So at Benefit Street Partners, we're a credit manager.
Everything we do is credit, corporate credit, real estate credit. But if you think about Franklin Templeton and Franklin Templeton Alts, I mean, that's all these products. I think across all that stuff, we have become convinced that this is the best relative value, and the reason that it is, is because there was just a storm, and that storm is continuing.
If you want to go through that metaphor a little more, maybe it's a Category 4 or Category 5 hurricane. That hurricane has caused some tremendous disruption. What was the hurricane? It was higher rates. Higher rates having moved so quickly and so dramatically upward have created a dislocation across many asset classes, but in real estate, there's a very clear correlation between higher rates equals lower property values. Two, the office sector. Talk about a real Disaster. I mean, COVID accelerated it, but we're just an oversupply of office space, which is leading to, and that story hasn't played out yet and probably won't for several more years, a real terrible outcomes for many folks that own office space.
Add to that the high leverage that most real estate lenders and most real estate buyers operate with. That'll just magnify the problems. And then add to that all the debt maturities that are coming due. That's a hell of a storm. And in the wake of that storm creates the opportunity for new money.
Tony:
What's interesting is I think most folks who listen to the podcasters are very familiar with real estate broadly. It's something that they've probably been investing in. And of course, the headlines are offices. And it was interesting as you and I were doing some individual research on this. What I found interesting is there's a lot of real estate funds. There's very few real estate debt dedicated funds because I think people think broadly about real estate and then often the funds are allocated between equity, Mez, and then debt.
Talk specifically about the opportunities for real estate debt for those who maybe haven't been exposed to it. You know, obviously we've looked at the data, really strong risk adjusted returns and all that, but talk about the individual case for real estate debt.
Richard:
Sure. So if you think about real estate, you're right, Tony, everybody thinks about real estate. They’ve got a brother-in-law or somebody that owns commercial buildings on residential buildings. You want to own a building, right? Because it's and it's the long-term investment and it's great for retirement accounts. And they appreciate over time. Absolutely agree. We've been a lender to those properties. Right now, the lending opportunity is just so much more compelling. Why? Well, let's start with, if you were in the lending business, you have probably have had over the years, you have some experience. You probably have a portfolio that has comprised of multifamily, as you said, office and other sectors, hospitality, industrial, retail, etc.
It was almost like office was unavoidable. The average office exposure across real estate lenders, including banks, is probably about 25%. Well, when 25 percent of your portfolio goes down by somewhere between 25 and 100%, that creates a dislocation. On the equity side, obviously there's folks with office exposure too, but I would summarize the lending opportunity in maybe even a different way.
I would say that by the stats that we've run, about 50 percent of all the capital, the debt capital provided to real estate developers has been from banks, banks. 70 percent of that 50 percent has been from regional banks, small banks that don't have a business model that can diversify them away from these losses in the 25 percent of their books that are office loans.
What does that mean? Well, when a market dislocates like that, people always say, well, the markets are efficient. Of course, if there's this great opportunity in real estate because all of these legacy funds are sitting on the sidelines right now, they don't want to add any exposure. They're licking their wounds. They're trying to fix their problems. You say, Oh, there's going to be new capital will replace that capital. That opportunity will dry up. Perhaps. But try drying up 50 percent of your market that was banks, because the banks aren't putting out new capital to office or even any kind of commercial real estate anytime soon.
And we can do a deeper dive into why, but banks just don't currently have the equity base, the depositor base, to support the losses that these holdings are likely to cause them. Or say it differently, I said it in front of an audience the other day, I got a couple of chuckles, so maybe some of your audience will laugh.
If you injected sodium pentothal to every bank CFO, or every bank portfolio manager, and just said, you have to mark all of your assets to exactly what they're worth. If they did that, they would be very relieved. I think they would get a lot of catharsis out of having, you know, the ability to just rip the band aid off and then, you know, move forward and let the markets do what they would do.
The problem is that nobody has enough equity to do that now. So what all the banks are doing, what the private funds are doing, they're just trying to stretch this out. If they don't make new loans, then when other loans come due, they're just using that cash to build their equity base to the extent they can raise additional equity.
When these loans eventually get marked or sold, they want to have this happen over a multi-year period so that they can remain solvent. That's the game everybody's playing, Tony. And to summarize it all while they're playing the game, who's lending? Nobody. You wouldn't believe all the calls we're getting. We're getting invited into rooms right now that we've never been invited to, you know, some super high quality loans that usually, I'm not saying we wouldn't do high quality loans, but just the spreads aren't ever high enough. Now we're getting spread. We're getting high quality. In the form of construction loans, mezzanine loans, CMBS loans – we typically favor just regular old first lien floating rate construction lending.
But the fact that we're getting invited to these other rooms, whether we do them or not, is just emblematic of what the opportunity is. There's nobody home right now.
Tony:
And that's exactly where I wanted to take the discussion. So you're exactly right. I think banks won't be lending. It's an opportunity for you. And I think as you and I were doing our research, we both came up with this ginormous number of $2 trillion of a wall of debt. That debt is going to need to be financed in the next four years, which again, seems to me provides opportunities for those who have capital, those who have the wherewithal and those who can be more selective in allocating capital. So you're one of those folks sitting at the table. Where are you seeing the best opportunities?
Richard:
The opportunity is across the board right now. And I think it depends on what flavor you're most comfortable than what you have the best experience. And cause I think all of them are good. Let's talk about each.
I think opportunity number one is buying troubled assets from banks or from whomever was going to need to sell things over time and inheriting somebody else's problems, but hopefully at the right price. That's an interesting business. We have some opportunity funds and some other ways to do that, but for the most part, that's a little bit of a sideshow and a lot of money has been raised around that opportunity.
Another opportunity is looking at existing portfolios like publicly traded mortgage REITs. And maybe buying them. The average publicly traded mortgage REITs, which is another barometer of how bad this problem is, is trading below 70 cents a book value. So these companies mark their books. Their book value of their loans is a hundred and the public equity markets are saying, no, no, no, no, it's more like 65 to 70.
So maybe getting deep inside those companies, some will be winners. Some will be losers. It's very treacherous. That's another opportunity. But where we think the best opportunity is, is just simply doing what we've been doing all these years, the same way we've been doing it. But do you know how much easier it is? Let's use a fishing analogy, to fish when you're the only boat out in the water. All those big commercial fishing boats, the banks that used to be, you have with the radar and the sonar and they knew exactly where the fish were and they had the giant nets and you have rods. Well, they're not out there. And therein lies the opportunity.
Tony:
So let's kind of drill down a little bit on offices, office clearly getting the headlines. And I think there's concerns about, could there in fact be a contagion? What are your views specifically on office? And as you're looking at those opportunities, is that an area that you find attractive? Or is that an area that you're staying away from?
Richard:
As a general rule, it's an area we're staying away from. I think office will be a very attractive investment in a few years.
Tony:
It needs to come down more.
Richard:
It needs to come down more and things need to rationalize. You know the story. Your viewers know the story. The world changed. You know, there's work from home. I'm sure everybody who's listening to this has their own story of whether it's three days a week, some no days a week. There are even some firms at five days a week, but still, realistically, we're way over capacitized. You look at any stats around how much office space there is available and how many tenants that there are.
The other problem with office is that it's just very expensive to keep buildings full. It always was, even before these problems occurred. And tenant improvement packages, free rent, things like that, you wouldn't believe what tenants are demanding now. Either existing tenants to keep them in the building once their leases run out, or God forbid, if they left to find a new tenant. Those TI packages are more expensive than multiple years of the rent they're going to pay you.
So these are almost uneconomic decisions that landlords have to make to keep their buildings full. But what if they don't? Or what if they don't have the money, which in many cases, even if they wanted to, they probably can't afford it. Then the buildings are going to gradually shrink their occupancy and then eventually going to have to shut and then they're worth land value.
So I feel like you probably have to play ball with this expensive proposition of keeping your buildings full, just so you can play for another day. And that's hard. And then lenders are going to have to make tough decisions. Do they take the keys? Because once you take the keys of an office building, that's not great for your leasing program.
You know, when people say, oh, this is now owned by the blank and blank bank. So, nobody's lending to office right now. As you know, real estate developers, I always say have an allergy to using all their own money. So, if you're contrarian and you want to bet on the office sector and you're an equity investor, you're probably doing with all equity capital because I don't know, the risk reward just isn't there for a lender.
You'd want an equity type return. So for a lot of these reasons, it's going to take a while for this to play out. Just to conclude that thought, how does it play out? Why are we ultimately optimistic? Of course, because markets are efficient, class B and C buildings and suburban and less interesting markets are going to eventually go away.
Or a lot of that capacity will go away. Nobody has put a single shovel in the ground since COVID or really at very least since rates started going back up. So new capacity coming online is non existent. So between buildings going offline, converted maybe in some cases to residential, or maybe there's some alternative use or shutting. Between all that, eventually supply will meet demand. It's just that we have a long way to go for that supply to come down enough to meet the demand. So we'll be attractive. We just think it's too early.
Tony:
So it's early on office. Clearly there's more disruption to come there. But I think you mentioned earlier, and I know you're kind of excited about multifamily.
Multifamily seems interesting where I think we're probably under housed in America. Having two millennial daughters, thinking about getting their first home, I realized how expensive it is, especially with the rates up. What's so attractive about multifamily here?
Richard:
Okay. So if you're constructing a portfolio, we'd like to think we're agnostic around all asset classes, but multi just always ends up being the most interesting.
It's where you just find the most opportunities. And you nailed it, Tony. It's exactly what you said. There's a, and not enough. single family housing stock out there, and then you add to that, the cost of a mortgage, like a mortgage. Let's say you had saved the next egg to put down the deposit and, you know, on the place.
Well, your monthly payment just went, probably tripled, say if you were looking at it in early ‘21 or mid- ‘21 and to today. So that dream has eluded a lot of people and what's their alternatives other than living at home or being homeless is it's multifamily. What are the other reasons? It's just a very liquid market.
The government agencies, specifically Freddie Mac and Fannie Mae, were mandated to provide liquidity into the housing sector. And this has facilitated just lots of folks that, despite all we said about real estate and how long it's going to take to recover, there's a multifamily property on the market.
They'll be 5, 10, 15, 20 bidders and that thing will sell relatively quickly because there's liquidity in that market. And then the last thing is, we talked about it for office, shovels in the ground, since rates started going up. So one of the negatives that people say about multifamily is that there's too much capacity now.
There's been limited rent growth in certain submarkets, maybe even negative growth in rents because there's a lot of supply coming online. Well, like I said, no shovels have been put in the ground since rates started going up in 2022. So come about a year from now, all that overcapacity problem is just about to go the other way.
And you're going to see the market. It's going to take a while for people to start rebuilding and make the math work with the cost of capital today. And while we're waiting for that to happen, that's just sort of the next surge in demand for multifamily. So, for all those reasons, I mean, it's a pretty compelling story.
Tony:
Yeah, I would say, Rich, your enthusiasm is contagious. Thank you for that. I want to go back. So I wrote a white paper on real estate debt. I know you're working on a series of white papers and blogs and just getting some of this information out there. And what was interesting when I was doing my research, why real estate debt: superior risk adjusted returns, low to negative correlation to traditional investments, higher income, and the added advantage of being favorable on the cap stack, which sometimes I think we forget about a little bit.
So for our listeners who are thinking about how to allocate in the portfolio, how do you think about it? Is it a replacement for real estate, a complement to real estate? Do you think about it as filling a fixed income sort of role in a portfolio? It can obviously provide multiple roles, but how should advisors think about it?
Richard:
Tony, it's a great question, and I would summarize the answer this way. Why do people buy real estate? Because they want long term capital appreciation. If your investment horizon, however, isn't 10, 15, 20 plus years, over a five-year period, there's very little return in real estate. And the counter argument I always hear lately is because interest rates went up so much, just correlating to my earlier remark, there's a very clear correlation between when properties are down 20 to 30 percent just because of interest rates, because their cost of capital went up. So real estate investors look at that and say, Oh my gosh, there's a 20 to 30 percent off sale. This must be a great time to buy. But that's implying that that correction was mispriced. If the correction was priced correctly, all it did is just reprice the asset for the current cost of capital. If you have a belief, the rates are going to go down, that's different. But in the current environment, those assets are no less expensive or cheap than they were before. Alternatively, remember we're lenders. We're lending at now the higher rates.
Spreads are higher, but more importantly, the base rates are higher. Our loans are floating rate. So those loans are typically two to three times more interest. So we're generating a similar, if not superior return, to the equity investor at a double digit rate, you know, unlevered, let's say 10, 11%. The equity investor is theoretically earning that, but here's the crux.
The answer to your question, I saved it, buried the lead to the end here, is we're investing at a 65 to 70 percent loan to value. The equity investor is, by definition is buying in at a hundred percent loan to value. They're the first loss. So in other words, in order for us to protect our double digit return as a lender, we just need the property to go down less than 30, 35%.
Every percent that property goes down, you know, above one, is going to dig into your equity return. That's the difference. So I guess that's my reader's digest way of saying the best relative value is in debt because those are our contractual returns and you'd have to eat through all the equity before you impaired your.
Tony:
So thank you, Rich. We covered a lot of ground. Clearly real estate debt looks very attractive here. A lot of compelling reasons. There's probably been a underutilized asset class as advisors think about building portfolios. Fortunately, real estate debt plays multiple roles in client portfolios – better risk adjusted returns, higher income than you're going to get elsewhere, low to negative correlation. And again, when we look at the market environment today, I think it feeds off of this market disruption that we're seeing all around us. So thank you for painting such an attractive pictures for us today, Rich. Thank you for being our first repeat guest on the Alternative Allocations Podcast.
And I invite everyone to follow our collective research on this topic, because this topic I think is going to be front and center for the foreseeable future and some time to come. Thank you.
Richard:
Absolutely. Thanks, Tony.
Show V/O:
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