Bernard Ryan: In private markets, and really private credit, growth has been prevalent over the last 10-15 years. The primary driver of this growth was the large-scale bank disintermediation that took place following the GFC.
What’s been interesting is the degree to which insurance - and all sectors within - has participated in this growth within their portfolios. Within private markets, insurance allocations have been particularly focused on private credit, including: real estate credit, corporate direct lending – where we’ve seen the most growth – asset-backed receivables, as well as other real asset-related debt.
"Recent market indicators suggest that corporate direct lending may be at a later stage in its cycle."
CIM’s private credit capabilities are primarily focused on real estate credit, which has a long history with insurance companies. Within our platform, we have multiple approaches. The first would be what we refer to as ‘bridge lending’, which we qualify as first lien senior mortgages on well-maintained properties where sponsor business plans are focused on lease-up to stabilisation strategies – similar to what many life insurance companies have played in for decades. We also employ a value-add strategy – also first lien senior mortgage-orientated, but where the sponsor’s business plan is more transitional in nature, including heavy repositioning and even ground-up construction.
Recent market indicators suggest that corporate direct lending may be at a later stage in its cycle, whereas commercial real estate lending appears to be coming out of a downturn into a more normalised market with lower, reset valuations.
Daniel Ottensoser: What Bernie alluded to with respect to the disintermediation of banks is directly tied to the post-GFC regulatory regime, whereby Basel III (and talk of Basel III's endgame) rules now require significantly higher capital charges on balance sheet lending. What’s interesting in today’s post-interest-rate-hike environment is that this disintermediation is even more pronounced. In fact, as risk-weighted capital charges increase, private lenders’ share of commercial real estate lending increases almost dollar for dollar.
When you think about the current market environment, we are coming out of a major period of dislocation for commercial real estate. Valuations are down. A lot of assets continue to be overleveraged and essentially have broken capital structures. Importantly, there is not a lot of clarity around who is in control of these assets – whether it's the borrower, the lender, or the lender to the lender.
As a result, many of these assets are on the sidelines with borrowers reluctant to invest additional equity or take action to right-size the capital structures. Rather, loans are being extended or modified with the “hope” of things working out. However, because certain lenders don't want to take back assets because they lack the want or capability, what you see is a market where private lenders and private capital are chasing fewer deals. As a result, while capital markets activity has picked up recently, what’s winning the day for lenders is being one basis point tighter than their competition or one dollar more of leverage – which is not ideal from our perspective.
Daniel: We believe that if you are a lender in this market without in-house, on-the-ground development or property management/leasing capabilities, then you are likely confined to lending opportunities on vanilla assets, which are typically multifamily or industrial in nature. What you're seeing increasingly is that many lenders are so focused on this now-commoditised space that spreads are contracting to very tight, sub-250 basis point (over SOFR) levels for these types of assets.
"Said more directly, such lenders are getting paid less to provide more leverage."
Meanwhile, the leverage required to earn return thresholds is increasing, debt yield (defined as NOI divided by loan amount, measuring the return a lender may expect if the borrower defaults and foreclosure is required) is falling, and lenders are chasing loans that underwrite to stabilised debt yields of 7% in an environment where interest rates are still above 4%. That doesn't seem like a safe loan in our opinion.
Said more directly, such lenders are getting paid less to provide more leverage.
The last leg of the stool to assess are covenants. When there is a lot of competition for loans, the first thing that goes is pricing, followed by proceeds, and lastly and most importantly, covenants. As a result, these competitive loans are being structured with almost no covenants. And, if we have learned anything during the last cycle, it’s that having strong covenants matters. Covenants allow lenders to approach borrowers early when issues arise, but also provide a tremendous amount of leverage in seeking to preserve capital when loans really go sideways.
We have experience identifying attractive risk-adjusted return potential within less-travelled, value add lending opportunities, through various market environments. As mentioned, these are senior mortgage loans where the sponsor’s business plan is more transitional in nature, including heavy repositioning and construction projects.
We believe these more off-market and off-the-run loans may offer higher spreads with more conservative structures (e.g., lower LTVs and higher equity cushions) and stronger covenants, including cash flow sweeps, completion guarantees, and carry guarantees, amongst others. Importantly, within these deals, borrower business plans are not driven by financial engineering – which in our opinion reduces risk.
"The other area of the market where we're seeing attractive risk-adjusted return potential – on a historic basis – is in the office space."
We can source these opportunities given the depth and breadth of our relationships. Importantly, we are confident in our ability to underwrite and asset manage these more complex loans, given we fully leverage our in-house vertically integrated platform of 500+ professionals across development, property management, leasing and capital markets teams.
Interestingly, the other area of the market where we're seeing attractive risk-adjusted return potential – on a historic basis – is in the office space. This is a function of most traditional lenders stepping back from the space after the sector was extremely challenged in the last cycle, and a lot of capital was lost. The resulting dearth of capital providers we see today has left a void where willing lenders can command very attractive spreads, along with very conservative structures and covenants.
With the help of our in-house property management team, we are seeing a bifurcation in the office asset landscape. Our platform is structured to evaluate and identify opportunities and risks in the office market, including which buildings are well-capitalised and have the right amenities and bones to attract tenants.
Bernard: Insurers have indeed grown their corporate direct lending exposure, seeking to capitalise on both liquidity and complexity premia. Many insurers are buy-and-hold investors, so they don't need the liquidity. Why shouldn’t they seek the potential for higher spreads and yields?
When looking at corporate direct lending as a complement to real estate credit, there are some key differences to consider.
First, is that real estate credit is cycle-tested, where multiple downturns have allowed lenders to learn what works and what doesn't in terms of approach. However, in the corporate direct lending space, there is a belief amongst some that the asset class has yet to go through a downturn. Further, there is some acknowledgement that the percentage of corporate loans where cash-paying coupons have converted to payment-in-kind (PIK) has increased – certainly a potential cause for consideration.
"It is well recognised that commercial real estate valuations fell considerably during the latest Fed hiking cycle."
A second consideration is current valuations. It is well recognised that commercial real estate valuations fell considerably during the latest Fed hiking cycle. Office valuations declined 30 to 40%, while multifamily and industrial each fell 10 to 20%. Broadly speaking, corporate valuations remain close to their peaks, when observing public valuations as a proxy. As a result, new corporate direct loans are being made at high valuations relative to real estate credit, where valuations have meaningfully reset.
Third, is the real asset nature of real estate lending, where loans are collateralised by physical properties. As most are aware, insurance companies, more so than most other institutional investors, have an investment objective to protect against the downside. In our view, loans backed by real assets may help address this objective.
Importantly, we’re not advocating that insurers avoid corporate direct lending exposure. Rather, we believe having balanced allocations across private assets that are complementary and provide levels of diversification may be the most prudent approach.
Bernard: We believe insurers are really drawn to real estate credit’s cycle-tested nature, risk mitigation features ( structures, covenants, and hard collateral), and attractive valuations. Importantly, their confidence is further supported knowing that loans are being made at lower, reset valuations – a stark difference relative to today’s corporate direct lending environment. To that point, we believe life insurers have significant experience in real estate credit, having invested in the asset class over many years.
Another noteworthy development we're observing is that insurance companies have become interested in partnering with external investment managers beyond their internal team to gain exposure to more complex, higher-yielding deals.
Bernard: The traditional means is through an investment mandate within a commingled open-ended or closed-end fund, where an insurer receives immediate diversification and spread/yield of an overall portfolio. Life insurers can utilise look-through treatment, capital-efficient treatment. In the P&C insurer space, we have seen the development of rated notes, given look through treatment is not available.
"The third form we're seeing is via a formalised partnership arrangement where the insurance company could be an investor in a life insurer."
Over recent years, we have begun observing the evolution of partnerships; whereby life insurers are willing to partner with investment managers to develop more of a core plus portfolio – above and beyond their traditional fixed rate stabilised portfolio. These mandates can also take the form of a customised separately managed account.
The third form we're seeing is via a formalised partnership arrangement where the insurance company could be an investor or an equity provider in a life insurer. This provides equity to life insurers, the ability to go out and buy additional blocks of business.
Daniel: We take a disciplined approach – mitigating risk, partnering with institutional borrowers, and managing assets proactively. Our priority is to identify opportunities where we can deliver meaningful value for insurance companies and other clients.
For information about CIM’s credit capabilities, please visit: https://www.cimgroup.com/our-platforms/credit
Disclaimer: The views and opinions expressed in this commentary are those of the contributors as of the date of publication and are subject to change. The forward-looking statements in this paper are based on CIM’s current expectations, estimates, forecasts and projections, and are not guarantees of future performance. Actual results may differ materially from those expressed in these forward-looking statements, and you should not place undue reliance on any such statements.
