Lara Castleton: Hello, and thank you for joining this episode of Global Perspectives, a podcast created to share insights from our investment professionals and insights they have for investors. I’m your host for the day, Laura Castleton. Today, I’m thrilled to be joined by Jason Brooks, Securitized Products Analyst and Portfolio Manager at Janus Henderson, and Pat Brophy, Portfolio Manager at Forum Capital Advisors.

Together, you two manage a real estate income fund across the public and private landscape. And so I’m really thrilled to speak to both of you to talk about something we really haven’t in granular detail in this podcast before, which is private credit.

So, we all know private credit has grown rapidly over the past couple of years. It’s now nearing $2 trillion in size, but it definitely has a lot of complexities. While you two manage a very specific portion of the private credit landscape, I do think it would be helpful to just take a high-level overview of the space.

So, if I can start with you, Jason, just what is private credit? What are the different types? What should investors and listeners think about when they hear private credit?

Jason Brooks: I mean, private credit can be a lot of things. I know it’s a hot topic right now. I’d say predominantly, when private credit is mentioned in mass media outlets, it tends to be synonymous with private lending to middle-market companies.

Now, while that is a big portion of the landscape, of the market itself, there are other pockets of private lending that just don’t happen to be lending to companies. So, there’s senior loans, there’s specialty finance, there’s asset-based finance, and there’s commercial real estate finance. And within commercial real estate, there’s plenty of public lending that goes on. But there’s plenty of private lending where a borrower, an owner of a commercial building, needs a loan and goes to a bank or goes to a private entity, private equity firm, a specialty finance private-debt firm. And that’s sort of where where these guys come in, in the space on the Forum side. It’s a big market holistically, but there are niche pockets of it, and that’s where we tend to operate.

Castleton: Yeah, I think that’s what I tend to hear when we talk about private alternatives within the wealth channel or for end investors. I tend to hear private credit is associated with that lending to corporations. But then on the other hand, you hear private real estate, which tends to be talked about as from the equity side.

So, Pat may be getting into, again, that portion of what you specialize in, private real estate debt. Can you just talk about that means in the broad landscape there?

Pat Brophy: Yeah, sure. And I think, commercial real estate is also a hot topic these days, unfortunately not always for the right reason, but yeah, in the commercial real estate debt side, if you just sort of look at the addressable universe, sort of $5.5 trillion, $6 trillion of commercial real estate debt out there. And if you get a little more granular on that and sort of look back in history, so you can go back 30 years, early ‘90s, it was less than a trillion. So you’ve got this pretty good organic growth story in commercial real estate.

And then if you sort of break it down a little further, really for that 30-year history, 50% of that market has been commercial banks, and that’s still true today. Now, we expect that to start changing here over the next decade. And then maybe if you take another slice at that and say, OK,  how does that break down in commercial real estate in the four basic food groups we always talk about, which is office, industrial, retail, and multifamily apartments, so really the big growth sector, the big sort of market-share gainer has been no surprise, multifamily over the last 30 years.

So, if you look back to sort of early ‘90s, multifamily accounted for about 25% of the commercial real estate debt. Now it’s pushing 40%. And then, no surprise with that, we’ve seen the increasing importance of the agencies. So Fannie [Mae] and Freddie [Mac], who are the big lenders to that space. So if you go back early ‘90s, again, Fannie and Freddie probably accounted for about 15% of the commercial real estate debt, or excuse me, of the multifamily debt, and now they’re almost 50%. So, the market share has come up huge there. So, that’s sort of our sandbox, our big addressable market, sort of a five-and-a-half, six trillion market that has a pretty good growth story to it.

Castleton: Both of you are on the debt side of real estate, private and public, and narrowing in on commercial real estate. So, I’m glad you gave us the backdrop of commercial real estate as it stands. I think we should dig into it a little bit more. Over the past five years, it has no doubt dominated the headlines. Starting in COVID, commercial real estate has been kind of something people have shied away from, I will just say in the most generous terms. So what has just been the recent history, if you don’t mind, of the commercial real estate market?

Brophy: Yeah, it’s sort of been like five cycles in five years. And I’ll let Jason chime in here, but if you go back to, seems like a lifetime ago, 2019 pre-pandemic…let’s just move into COVID, obviously. Commercial real estate, a good starting point going up to 30-thousand feet is what we always like to tell our investors and people who are day-to-day in the sectors, commercial real estate, you are the landlord to the global economy. So, you’re not going to escape a macro meltdown or something; it’s going to filter through commercial real estate. It’s just which sectors get hit hardest and and where you maybe want to hide out and where you want to be opportunistic. And so those are things we’re thinking about every day.

But so, just in a nutshell here, you obviously, you got the COVID meltdown, the big drawdown, commercial real estate wasn’t immune. You got sort of the V-shaped recovery, which was I think somewhat unexpected, particularly for those of us who were around back in GFC [Global Financial Crisis] days where things took forever, but that massive infusion of liquidity sort of stabilized things quickly. And then it became sort of, OK, what happens here? And I think this is where we were sitting up late at night trying to figure out, you know, where do we want to be? What’s going to work? Where do you want to hide out?

You know, hindsight’s 2020. So if you look back, obviously you didn’t want to be in hospitality, you didn’t want to be in retail. And I don’t think any of us saw the complete office meltdown coming, but you didn’t want to be in office, and fortunately for us, we were already, our bias was to multifamily. So apartments held up extremely well. In fact, you had sort of a robust demand story in apartments as people spread out, got out of the city centers, so particularly suburban apartments. And then industrial, right, e-commerce became that much more important. People started really focusing in on global supply chains and onshoring.

So, those were the two best sectors. Medical, office, some of these other places, life sciences were good. Then you started to see, not to sound overly alarmist, but this office Armageddon where it’s like, OK, is this work from home, the Zoom thing going to be permanent? And then sort of the hollowing out of city centers. So, San Francisco being the poster child. And that’s where things really start to look bleak on the office front and where you start to see some real pain.

So, transition quickly though, all that liquidity got pumped into market, all that COVID relief, no big surprise that a lot of that found its way into commercial real estate, capital-intensive business. And we got into this, and Mr. Brooks can talk about this, in ’21, ’22, where, you know, crazy low rates, cap rates, which which we use to price real estate, at all-time lows. So that means all-time high prices. So we got this sort of, I call it the brain mush period, where people were just underwriting real estate on crazy terms. You know, they were getting debt with three and four handles on it and paying historically low cap rates, and some of them weren’t even locking up that debt, they were leaving it sort of floating, which is a problem. And that gets us to the phase we’re in now, which is to me sort of the clean-up phase and what we’ve called this sort of slow-swinging wrecking ball of a higher cost of capital.

So, commercial real estate is a slow-moving cycle. And that’s what we’re playing out now. We’re sort of stuck in this protracted period of price discovery as sellers try to hold on for yesterday’s prices and buyers are trying to underwrite to higher cost of capital. And with the Fed (Federal Reserve) rate cut and people starting to feel pretty good, even if they don’t understand the trajectory and cadence, you know, we’re starting to see a little bit of momentum here. But we’ve talked about this a lot, we think it’s still about an 18-month slog to clean up all these bad balance sheets and and get commercial real estate back to stabilization. And again, it’s going to be sectors that work, sectors that don’t. We’ve got huge demand in data centers. Office still looks really rough, but that’s sort of a five-year. That’s way too much, I know, but it’s been sort of like five cycles in five years. We feel like we’ve lived through this condensed period of history that’s just been crazy volatile. Jason, you could probably put some…

Castleton: So, you mentioned 2021, cap rates super low, and then 2022 happened and that obviously had a lot of pain for your industry. But maybe you can also, when you answer and add on to that, address how did that affect the private and the public landscape over that time
period from an end investor perspective?

Brooks: At the end of the day, like Pat said, real estate is an interest-rate sensitive sector. So, when rates got extremely low, there was a lot of demand for real assets and commercial property is obviously a real asset. So, how that was split into private and public is you had this liquidity premium, which always exists for privates. You’re always going to get paid more for privates. But that was exacerbated by the fact that public markets were so tight because there was effectively so much liquidity that was being pumped into the system by the Federal Reserve. So, that disconnect created a lot of demand for capture of that illiquidity premium by going into or trying at least to get into private markets. Now, granted, that’s not as easy. I mean, similar skill set in terms of how to underwrite, but in terms of access to it, it’s a lot different. And so, there was that disconnect between especially in 2021 and early 2022 before the the Fed started raising rates of valuations between public and and private. Then you fast forward a little bit into the Fed hiking cycle, where rates go up, valuations effectively on real estate decline, and then you have a repricing of debt across everything too.

And so that made that private-public relative value proposition much more attractive on the public side of things, because effectively you could go out and, for what I’m looking at every day in the CMBS market, you could go out and generate low double-digit returns on a public debt investment that you could trade in and out of, and the private market was still kind of in the same return profile; it doesn’t really move all that much. So, if you can get the same returns and something that’s tradable versus something that’s not, then you would obviously take the liquidity, because your illiquidity premium that I just mentioned has collapsed to almost nothing.

Castleton: Very interesting. So you’ve lived through a lot of cycles over the last five years. It created a lot of bifurcations within the public and private sectors. But as we stand today, let’s look forward. So real estate is real estate. And Pat, as you just mentioned, a Fed first cut in September. The economy is still resilient there. We had a growth scare within the equity markets, but we’re still broadly looking at all-time record highs this year in 2024. So, with that backdrop in general, what do you see as the prime opportunities for commercial real estate going forward?

Brophy: Yeah, and maybe I’ll take that to debt, since that’s our window. I mean, we’ve sort of talked about which sectors are going to look interesting here, and I think, in terms of the opportunities for debt, the Census is projecting 15 million more Americans over the next decade. So, couple that with the standard obsolescence you get in our space, and you’ve got this sort of organic growth story. We’re going to need more bricks and mortar. How those filter out between sectors is going to be part of the story.

But if I was going to get more granular, if I sort of siloed three areas I think will be interesting for the next 18 to 24 months and beyond, I’d start with those broken balance sheets that I mentioned earlier. So, we just have a lot of guys who had a lot of sponsors, a lot of owners who were 60% loan to value. Now they’re 75%. They’re coming up on a refinance. They’ve still got equity. It’s a decent property, it’s cash flowing. They’re making their debt service, but they’ve got a gap, right? So, the lender’s only going to give them 60 and the commercial banks are on their heels. So they’re maybe only going to give them 50. So most of these sponsors don’t want to go out and get new equity and dilute themselves. They want to hold onto the asset, get back to ‘22 prices and grow those cash flows.

So you have that big gap, and this is where Jason and I spend a lot of time, this is the private credit piece. Private credit is set up for that, and our team inside of Forum who underwrites that stuff. So that’s sort of this gap funding, and that’s going to be available for the next 18 to 24 months at least, where all these broken balance sheets need to be fixed. And that’s where maybe mezzanine loans, preferred equity, even some JV (joint venture)-type equity. And if you’re a good underwriter, like we hope we are, you have a really good opportunity in front of you. So that’d be one, that that’s the big private credit piece.

Number two would be more the world Jason’s the expert in. So I’ll let him speak to it. But I do think consolidation remains that, this is what was going on pre-pandemic and now it’s sort of coming back. So commercial real estate, like everything else, is getting less and less mom-and-pop and more and more institutional. And so, the big guys are, you know, taking huge swaths of the market in sectors they want to be in, whether that’s Blackstone and KKR coming in and taking REITs private or Brookfield taking huge portfolios out. But what happens there is you end up with these billion-dollar deals, billion-plus deals, $5 billion, $10 billion deals. Those are going to get financed in the CMBS market, where Jason’s looking at stuff every day.

And then lastly, I think the third bucket I just threw out there is, we already talked about a little bit, is multifamily. Housing’s non-discretionary. And it’s hard to make a case that we’re not going to become more of a renter nation. Everybody knows the headwinds against for-sale housing, the pricing, you know, the high barriers now and and just what a home builder can get something out there for. So, you think those housing tender patterns are going to continue to shift towards multi family. Like I say, housing is non-discretionary. We’ve got growth. Somebody’s going to have to solve for that. And so multifamily looks to be in a pretty great spot. And that sort of brings the agencies into play. Another area where Jason’s an expert. But so those would be the three I would identify as the most obvious short-term opportunities.

Castleton: Before we turn to you, Jason, can I double-click on the first one that you just mentioned? Because I mentioned commercial real estate’s in the headlines all the time and the big scare that you hear is the extend and pretend argument out there. So, the first bucket you mentioned, is that technically what that is? Or is that a risk that you see broadly in the space?

Brophy: You know, you’re dead on. It’s absolutely right. And pretend and extend is sort of coming to wind down. You’re going to, as lenders get a little more comfortable, you will see capitulation. We’ve been talking about this for a while and you’re going to see some more ugly headlines. There’s some stuff that’s just not going to work.

You know, there’s the office guy who’s got a B office building in downtown San Francisco, looking at 50% vacancy. He’s not covering his debt. The keys are coming back. So there’s going to be more of that kind of stuff. There’s even some multifamily guys, sort of what you’re talking about, ’21, ‘22, who put floating-rate debt, paid peak prices… they’re going to be in a little trouble. Their equity’s probably gone, but that’s what we like to do. We can go in and underwrite there. I think the vast majority of these assets are OK, there’s still equity left. And so we can fill that gap. And for them, if you’re going to pay, on your capital stack, we’re not taking a very big piece of it. You’ve got your senior lender down here for a bulk, and you’ve got your equity. If it’s 15% of the capital stack and you’re having to pay us 14% to get through another day, and you can cover that easily on your debt service and start growing your your NOI again. That’s a pretty good story.

At some point you can only kick the can so much. So the, some of those broken assets that are completely done need to get into stronger hands and go away or be repurposed. But there’s a lot of assets. The vast majority will muddle through and muddle through is a really good environment for the private credit space because the other piece of that is regional banks are under increasing regulatory pressure. They just don’t do this creative stuff anyway, and they’re way on their heels. So, if they were giving 60% loan to values on construction loans or something, they’re down to 50% now. And so, it’s getting harder and harder and there’s a big capital gap there. So yeah, that’s the vacuum that private credit is going to.

Brooks: At the end of the day, extend and pretend only works when you have a viable asset that you can extend and pretend on, right? So, to his point, if you have an office building that just will not lease because it’s in a bad area of a downtown that people are no longer going to, you don’t have a viable asset. It’s like a corporate analysis, how corporations can sometimes grow into their multiple. Well, that only happens if you actually have top line revenue growth, right? And so, in a lot of cases, extend and pretend will work simply because you have a current repricing of asset values that the revenue and effectively the rent growth has to catch up, which it most likely will in a lot of the cases we just mentioned – multifamily, industrial data centers, things like that. In areas where you’re seeing rent declines – offices obviously a predominant example – you’re probably not going to see that. So, it really doesn’t make as much sense to extend and pretend for a later day when your value may be even further degraded from current.

Castleton: Yep, that totally makes sense. Thank you. And then maybe to you, Jason, that second bucket was really interesting, like what we’ve already been seeing from Blackstone, KKR. Let’s
talk more about the opportunity you see in your public CMBS world going forward.

Brooks: To Pat’s point, any time that there is a leveraged buyout by private equity in the real estate sector, for the most part, it gets to some degree shown to the CMBS market and the CMBS market finances it just because a lot of times banks, while they will provide temporary or bridge financing for those types of things, they’re really not going to have those things, those debt packages, sit on their balance sheets. They’d rather syndicate them out, so they can free up more capacity to lend. So how does that work within the real estate space? For the most part, those deals come through the CMBS market and they get syndicated out to asset managers like Janus who look at various areas within the risk spectrum, AAA, AA, single A, all the way down, and put capital to work in those structures that otherwise, the debt on which would have maybe gone to the unsecured corporate market, or it just may not have gotten done. So, the securitization effectively frees up lending capacity as a whole and allows for transaction volume as well as transaction frequency to occur.

Castleton: So, both of you across this universe of real estate, commercial, you mentioned, and I’d love to just dig into a little bit more, if possible, multifamily specifically for a reason because it’s one of those sectors that you see as being strong for years to come. Is there anything else you want to add in terms of what you’re seeing within the broad multifamily landscape today?

Brophy: We have a lot of in-house expertise. We have the ability to really… you know, the shop where I sit, Forum, has boots on the ground, owns apartments all the way across the Sunbelt. So, it’s a great resource for us. So, when we’re doing our underwriting, we could move much more quickly. And so you do, like I say, sort of had that built in. You know, housing is non-discretionary. And I do sort of stick to that thesis that we’re going to become more and more a renter nation. But truthfully, multifamily does not look great right now. You know, everybody jumped into the the development game when they start to see we had these years of double-digit rent growth. That’s just not normal for commercial real estate, and other than really short cycles in sectors. So, people piled in, and we’ve got way too many units delivering here over the next nine to 12 months. But the demand drivers are there, so you can see it. If you’re sitting in Phoenix and you’re delivering, you’re going to have a slower lease-up, but you can still see the job growth.

Now, obviously you need the macro economy to hold in. You know, apartments will get hurt if we dip into recession, but the long-term sort of secular demand story is there to bail out those assets, unlike in office where we’re seeing people come back to the office, but with the hybrid model, whether work from home is actually going to play out.

We’re sort of agnostic. We spend a lot of time…Jason and I were talking the other day that one space we really like is retail, and we’re not talking B malls or something, we’re talking grocery anchored. So there are ways we can play that stuff, there’s just good real estate that’s well underwritten, pretty conservative. We’re not adding any new supply in retail. So you can see the opportunity. And then obviously, if you were just looking, if you’re sitting in our place where you’re looking commercial real estate every day, the one sector that really shines right now is data centers. And so that’s this whole AI power grab that where supply is way behind demand, and that looks to have a really long runway here, maybe. I mean, you don’t want me talking about tech, right?

Brooks: I mean, to add to the multifamily point, I’d say, in the end, the demand drivers for multifamily are population growth, right? So if we’re Japan, then multifamily probably doesn’t work as well as the United States where we’ve had consistent population growth. It’s slowing, but it’s still growing, right? And you know, a growth even at 1% or or less on a 300 to 400 million population is three-plus million people that effectively need housing to some degree. And to Pat’s prior point, with where mortgage rates are, cost of debt, as well as where home values are, we are kind of leading towards being a more renter-focused nation just because the price of, the pay to play of buying your own home has just become so expensive. So that either leaves you to rent or, I guess, people could kind of move back in with mom and dad and things like that. For the most part, that’s a secular tailwind for growth in multifamily.

Castleton: Thank you both for walking us through that. For investors, there’s a lot of unique ideas and opportunities. It sounds like within the real estate space, it’s been very dislocated over this five cycles in five years environment.

Jason, maybe just talk through the liquidity, like how do investors think about liquidity in terms of… because you have private, you have public – what should they be considering?

Brooks: In a public vehicle, whether that’s an ETF or mutual fund, right? Realistically, and in any vehicle, your liabilities always dictate your assets. So, if you offer daily liquidity, and for the most part your assets should be in much more liquid, you know, whatever it is, CMBS, corporate loans, stocks, whatever it is. And so, the vehicles that you can generate income from on the public side, they are lower yielding. There’s still plenty of income there, but they’re lower yielding than vehicles that are much less liquid but offer you hundreds of basis points of potential upside in income.

And on that side of the world, you’ve got your fully locked up kind of five-, seven-, 10-year vehicles where you’ve got zero liquidity for that timeframe. And you’re really expecting kind of a 15-plus percent-type equity return profile because you’re giving up pretty much all your liquidity for close to a decade, right? Then there are these hybrid vehicles, where you can kind of marry the public and the private together, so you can offer a liquidity lever, right? You know, in some cases quarterly, where people can get their money out, but you also have the private component where you’ve got that hybrid liquidity where you’re not, it’s not daily, it is quarterly, and you can put those private assets in that vehicle, and you can blend to a return that looks more like a private type of income strategy while not being completely private.

Castleton: Thank you both for being here today to walk us through this. At Janus Henderson, we are definitely investing in private alternatives and private credit specifically because we’re hearing our clients are wanting more access to the space. So this was really helpful to walk through all things in terms of the private debt real estate side and the exciting opportunities that lie ahead.

So, thank you both for being in here and we hope that you found the conversation insightful and came away with some takeaways on how to think about private and public real estate debt going forward.

For more insights, you can download other episodes of Global Perspectives wherever you get your podcasts, or visit janushenderson.com. I’ve been for your host for the day, Laura Castleton. Thank you. See you next time.

Agency securitizations – Investment security made up of a pool of mortgage loans backed by multifamily properties purchased and securitized by a government-sponsored enterprise that pay investors coupons similar to bond.

A leveraged buyout (LBO) is a type of acquisition where a company buys another company using a large amount of borrowed money, rather than its own capital.

Capitalization rate (“cap rate”) is a metric used to evaluate the potential profitability and risk of a real estate investment. It is expressed as a percentage and is generally calculated by dividing the expected income of a property, after operational costs, by its market value.

Credit quality ratings are measured on a scale that generally ranges from Aaa (highest) to C (lowest).

Fannie Mae (“Fannie”) and Freddie Mac (“Freddie”) are U.S.-government-sponsored enterprises established to provide liquidity and stability to the residential mortgage market in the United States by purchasing and guaranteeing mortgages from lenders.

Liquidity is a measure of how easily an asset can be bought or sold in the market. Assets that can be easily traded in the market in high volumes (without causing a major price move) are referred to as ‘liquid’.

Mezzanine loans – Functions as a bridge or gap financing between the construction loan and comment equity. Rather than being secured by the underlying property, the sponsor typically puts the common equity position up as collateral.

Preferred equity – Similar to mezzanine debt, however, is entitled to force a sale of property in the event of non-payment and may include an “equity kicker” or additional entitlement to profits in the event the project performs well.

Senior loans – A loan secured by real estate and then repackaged and sold to investors. The repackaged debt obligation may consist of multiple classes. Senior bank loans typically hold legal claims to the borrower’s assets above all other debt obligations.