Borrowers may be feeling the pinch from higher interest rates, but investors such as MetLife Investment Management (MIM) continue to see attractive investment opportunities in the estimated $5.2 trillion U.S. commercial mortgage market.

MIM recently published a report on Investment Opportunities in Private Commercial Mortgage Investments that highlighted key benefits mortgages can offer multi-asset class portfolios that include diversification, the potential for favorable risk-adjusted returns and characteristics that make them attractive for liability-driven investing. MIM also sees new commercial mortgage investment vehicles emerging every year, which is making the asset class more accessible to a broader range of investors.

WMRE spoke with William Pattison, MIM’s Head of Real Estate Research & Strategy, to hear more about the firm’s current commercial real estate debt and equity investing strategies.

This interview has been edited for style, length and clarity.

WMRE: Can you briefly describe MIM’s real estate investment portfolio in terms of overall AUM and your different strategies?

William Pattison: Overall, MIM manages a little over $110 billion in private real estate, about two-thirds of which is in debt and one-third in equity investments. Our investor capital includes MetLife Insurance Company, and also over 100 institutional investors that we partner with, either on direct investments or through funds that MetLife Investment Management offers.

WMRE: Has your allocation to real estate changed due to the denominator effect?

William Pattison: We’ve certainly had equity investors who have wanted to grow their holdings at a slower pace than they were planning at the start of the year. And in some cases, they have wanted to decrease their allocations, which have grown faster than they were expecting at the start of the year. That has been partially offset by investors who recognize the potential opportunity in today’s market and have been making new allocations. On the debt side, the denominator effect has had less of an impact, and demand for debt products has remained relatively high across our investor base.

WMRE: What’s it like navigating the current market as a lender? Are you still active or are you more selective?

William Pattison: Today is much more lender favored than at the start of the year. The largest banks in the U.S. began pulling back or even stopping lending in June of this year. That is a result of capital requirements and comments from the Federal Reserve. That also has trickled down into medium and small size banks that are seeing increased regulatory pressure, which is creating opportunities for non-bank investors in the mortgage space. In terms of borrowers seeking fixed versus floating rate investments, there has been increased borrower demand for floating rate debt, but not as much as I was expecting given how the interest rate environment has moved.

Over the last several years, about half of our debt investments have been fixed rate and half floating rate. We have a mix of clients, some of which are seeking senior, low risk mortgages, and others who are investing through debt fund vehicles that either have warehouse lines to boost the return or are investing in mezzanine or preferred equity investments.

WMRE: On the fixed rate side, are you being more selective given some of the potential risks and headwinds ahead?

William Pattison: It’s a little difficult to answer that because it varies so much depending on the investor and the risk-profile investors are seeking. Certainly, in the office sector we’re more selective and the wide bid-ask spread that exists in offices gives us less confidence in the loan-to-value ratios we’re calculating. In terms of fixed versus floating, I don’t think we’re being more or less selective based on whether a mortgage has a fixed or floating component. On the floating rate side, we’re almost always requiring interest rate caps that the borrower has to purchase so there is not a significantly different risk profile between fixed and floating rate debt investments.

WMRE: What type of loans are you offering on the floating rate side?

William Pattison: We are active across all the major property types, typically as a five-year or three-one-one, which is a three-year loan with two one-year extension options. We’ve found strong relative value for three-one-one loans in cases where there is a high vacancy property that only needs moderate capital improvements. That’s an area where we have felt the market is somewhat underserved and we have liked the pricing we are able to achieve on those investments. We’re active in some types of bridge lending, including providing financing to borrowers who are trying to season a newly constructed asset.

WMRE: So, what’s your overarching view on debt investments in the current environment?

William Pattison: The pullback from the banks has created an opportunity both in being willing to invest in higher risk assets at higher spreads and for safer assets at unchanged spreads. It’s been a material reduction in who we’re competing against when we make loans. Conversely, on the equity side when we’re borrowing, we’re struggling much more than we were six months ago, which is why we’re sometimes recommending our investors consider lower leverage positions.

WMRE: What’s your strategy on equity investments?

William Pattison: Over the last decade, we have taken a barbell approach, with a focus both on core investing and opportunistic spec ground-up development. Academic literature has suggested value-add investing has not offered as attractive of risk-adjusted returns in our opinion, and that’s why we’ve taken the barbell approach. We’re active in the office, industrial, apartment, single-family rental, life science and data center sectors. We have almost no exposure to retail.

WMRE: A lot of investors have pushed paused on new investment over the last several months given the volatility with rates. What has been your position?

William Pattison: We slowed down our acquisition pipeline in June as a result of the rising interest rate environment and pressured relative value. Preferred equity has increasingly seemed more attractive on a relative basis. That includes helping distressed owners out when they can no longer refinance at attractive rates, or in some cases refinance at all. On the disposition side, we were somewhat active earlier in the summer. But as of today, the bid-ask spread is so wide that we’re not very active right now either buying or selling—at least not at scale. We’re still buying and selling a small number of assets, but not as much as we typically would be in a given quarter.

WMRE: What do you like right now or what opportunities are you finding in this market?

William Pattison: Industrial assets look attractive at today’s rates. The average cap rate in that sector has increased 50 to 100 basis points. That is a sector that has strong fundamentals, and we think the structural shift towards faster e-commerce delivery speeds is going to continue to produce demand that will be less impacted by a potential economic downturn.

WMRE: What do you see ahead for other sectors, such as multifamily and office?

William Pattison: Multifamily has strong fundamentals, but the pricing has not moved as much as the other sectors. We’re probably not going to be buying much core multifamily unless pricing changes. The office sector has struggled as a result of remote working, and we expect the vacancy rate to remain high for several years, but that is the sector where pricing has moved the most. From a tactical perspective, we may find opportunities in the office sector, but that also is where the bid-ask gap is the widest today.

WMRE: The Fed raised rates again in November and another increase is expected in December. What does that mean for your investment strategy looking ahead to 2023?

William Pattison: We have been targeting lower leverage levels on many of our investments. I think leverage level is something that the industry as a whole doesn’t put enough consideration on. One metric that we’ve been looking at is the difference between our underwritten yield with no leverage and our underwritten yield with leverage, and that has compressed significantly over the last six months. There are some cases where adding leverage may only boost the return by 100 or 200 basis points. In other words, an unlevered investment may be underwritten at a 7 percent return and a levered investment may be underwritten at a 9 percent return, but that 9 percent investment may be triple the risk. That’s where we’re questioning whether this leverage is adding any value at all on a risk-adjusted basis.

WMRE: What do you typically go into acquisitions with on leverage?

William Pattison: It varies by client. We have some clients who have already been investing on an unlevered basis and other clients that have typically been in the 65 percent loan-to-value range.

WMRE: From a big picture perspective, where do you think the market is headed and how is MIM positioning its strategy or portfolio to prepare for that?

William Pattison: An open question is what are the core real estate property types going to be over the next decade? In the past, there was a strong consensus that this was office, retail, apartments, and industrial. Going forward, sectors like self-storage, life science and manufactured housing may be looked at in a similar manner as they the same or even more stable track records as measured by things like same-store net operating income, returns, and loan defaults. We’ve been modestly increasing our exposure to those alternative property types, and for institutional investors, I would guess a decade from now the office and retail sectors will comprise a smaller portion of their portfolios.

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