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Spencer Levy
Assessing risk is a big consideration, a fear factor for some that affects all investors, from individuals to the largest institutions in the world. On this episode, the leaders of two major real estate strategies offer insights into the dynamics of risk, taking us inside their own approaches to portfolio strategy and management. They'll help us consider the interesting role of alternatives and understand key benchmarks.
John Lippmann
The real important thing is to tease out where are you outperforming by understanding the risk better and taking less actual intrinsic risk by seeing opportunities where others aren’t.
Spencer Levy
That's John Lippmann, head of capital markets at Barings Real Estate, a U.S. and global platform that is part of the larger third-party asset management group owned by MassMutual. Barings has more than $450 billion of total assets under management, around $60 billion of which is invested in debt and equities across the real estate spectrum.
Liz Troni
There is sometimes a tendency to look over your shoulder at your peer group and be cautious about extending yourself beyond the peer group's activity for fear of career risk or performance risk, but for those that use it more as a performance benchmark and market indicator, it is really useful.
Spencer Levy
And that's Liz Troni, portfolio manager of CBRE Investment Management's U.S. Direct Core Strategy. Overall, CBREIM has assets totaling around $150 billion under management. The flagship strategy Liz oversees has about 33% invested in alternatives, but primarily tracks the so-called ODCE Index – O-D-C-E, that is, not Odyssey like Homer's epic. We'll define that benchmark along with more expansive details in the conversation that follows. Coming up: An informative ode to portfolio strategy, featuring two investment leaders who routinely make billion-dollar decisions. I'm Spencer Levy and that's right now on The Weekly Take.
Spencer Levy
Welcome to The Weekly Take and we're here at 200 Park Avenue, New York talking about portfolio and fund strategy with John Lippman, Managing Director, Head of U.S. Real Estate Capital Markets, Barings. John, thanks for coming out.
John Lippmann
Pleasure to be here. Thanks so much for having me.
Spencer Levy
And our old friend Liz Troni, Fund Manager, Managing Director, CBRE Investment Management. Liz, thanks for coming out today.
Liz Troni
Thanks for having me, Spencer.
Spencer Levy
Well, let's dig a little bit more since this is about portfolio and fund strategy. Tell us what a ODCE fund does as distinct from what other funds do.
Liz Troni
Sure, so an ODCE fund sits in the core bucket of risk. It serves as typically the first allocation for investors looking for the more conservative style of real estate investing. Most of the assets are stabilized. They're in proven locations. And the funds have been in existence, some from the 80s, some launched more recently in the last decade or so. So an array of vintage coming to the market. But they often form the initial entry point for institutional investors to core, secure, proven real estate.
Spencer Levy
John, turning to you now, let's start with your core vehicles and then we'll branch out.
John Lippmann
We have a variety of core vehicles, value add and opportunistic vehicles across the spectrum. One of the advantages of our platform is that we can invest in all kinds of different environments through different vehicles that are focused on the appropriate time horizon and risk reward scenario in that environment. I think in terms of the growing amount of alternatives that's in different funds today, that reflects really the amount of transaction volume that are focused on alternatives. So when you look at different sectors that are not part of the four major food groups, those have been growing as a percentage of overall transaction volume over the years. And so it's no surprise that as the portfolios of core vehicles evolve, they follow that trajectory of transaction volume in the market.
Spencer Levy
So, it's not just proactive, let's go buy data centers or senior housing or student housing, some kind of a niche sector. It's also reactive. The market's changed and as the market changes, you change. Is that a good way to put it?
John Lippmann
I think that every investor has to change with the market. And so you have to make the best investments that are available and that offer the best risk adjusted returns in that market. And I think what you're seeing is investors expand to accept different classes of alternative investments as offering those attractive returns.
Spencer Levy
Liz focuses on core, but you have a variety of vehicles. Tell us how they work together.
John Lippmann
Well, we have an allocation queue that's a normal part of our just investor compliance and making sure that all of our investors get a fair shake at the investments that are sourced through our platform, which spans the globe. And so we have different features that would allow different investment parameters that would make different investments appropriate for different vehicles. But on that spectrum of core to core plus to value add to opportunistic, clearly there's just a focus on the higher returns for taking more risk. And when we evaluate that, we look at a combination of both the redevelopment or development attributes of an asset and the combination of what percentage of the current value is coming from foreseeable cash flows and what is really on the back end on the sale of the asset at termination or at the end of our investment horizon as it's planned. And I think one thing where all of those strategies end up is to say what's our exit back to a core vehicle at the end of the investment horizon, just like a lender would say, what is the debt capacity at maturity for this asset to be refinanced? What is the exit for our equity investments that would marry up to a core vehicle? That is part of any analysis. It's not unique to us. I think that that's an appropriate way to view an investment.
Spencer Levy
And some people use the terminology in our business “build to core”. And I think what you can also say is “invest to core” –meaning that you don't necessarily have to go ground up to build a core. You can buy a value add asset and turn it into a core asset.
John Lippmann
And I think we saw a lot of that in terms of what was going on with what I was called like scratch-and-dent multifamily, where people redo the kitchens and the bathrooms.
Spencer Levy
Time out! Scratch and dent multifamily, this is good. Keep going.
Liz Troni [00:06:33] I was thinking about a car park.
John Lippmann
Look, when we think about scratching down multi. We think about, you know, just things that you can see. You know, redo the kitchens and the baths. Right. And what's the upside there? Now, clearly multifamily hasn't been unscathed when you look at the different headwinds in terms of expense growth, in terms of cost of capital. But that build to core or renovate to core is a pretty block-and-tackle approach – the first day football season, block-and-tackle approach to achieving a business plan.
Spencer Levy
Liz, ODCE funds or core funds – let's just be straight up: It wasn't the best run the last four years. It was tough. And it was tough as interest rates went up and core vehicles are much more interest rate sensitive because they have less margin there. You also had redemption cues, people wanting their money back. But things have gotten better recently. Why don't you tell us just the last four years to the present, not the whole story, just a summary of where we are today.
Liz Troni
There was certainly a pullback in allocations or money earmarked for these funds, these ODCE core funds over the last couple of years. And that's one of the features of open-end funds is that you offer investors their right to liquidity in your funds, and then you have to match that liquidity by often selling assets, which are hard assets and may not meet the timetable of the investors to receive their money back. So the funds received redemptions as interest rates moved up and the expected return for real estate was not as competitive with other asset classes, but the funds struggled in then a declining market to sell as many assets as they needed to, to meet the investors requirements for their funds back. And so we had a bit of a mismatch between investors' expectations for liquidity in the market and the fund manager's ability to meet that by selling. So redemption cues, this cycle versus the GFC, which was the last time we saw this spike in. Redemption cues in ODCE were larger and they were longer. So the duration and the depth of what we call the cues to manage was greater. We're now coming out of that. There is an unfreezing of the majority of funds with at least less pressure. A number of funds have, now, zero cues. So we have a kind of lead table with funds moving towards very limited to single digit percentage of NAV cues. So less pressure on those funds. Some of the larger ones still have a lot. To handle, but overall the pressure has certainly reduced. New allocations are a few and far between, but we are starting to see them come back and the more dominant funds, typically with the alternative bias are seeing an outsize share of that new capital for core funds.
Spencer Levy
John?
John Lippmann
Yeah, I think, I think that that makes a lot of sense. And it speaks to the way that all kinds of real estate investments fit within an investor's portfolio construction. So having that liquidity in an open-ended fund might be appropriate for some investors having a closed ended vehicle where there's a target date, which they're trying to sell the assets in the fund by different strategies. They speak to different oppportunities in the market and they fit in different ways in institutional investors, overall asset allocations. And when we look at investors in different parts of the market, we can see how that plays in and how different investment vehicles can be suitable for different investors. And at Barings, that's one of our strengths to have those different vehicles be available for different investor goals.
Spencer Levy
Let me dive into alternatives because they keep coming up here, which is unusual in a core discussion. And I say why it's unusual. So unusual because alternatives are considered alternatives because they are more operationally intensive than the big four: office, industrial, multifamily and retail. But yet we're going into them. Yet we're going into data centers, senior housing, student housing, SFR, BTR – single family rental, build to rent – stuff. How'd you get comfortable with that, Liz? How do you get comfortable with that shift?
Liz Troni
Quick response is most, if not all, real estate has become more operational. So there's been a broader acceptance of that, largely driven by a shorter lease lengths, even in the more traditional areas. So we've had to accept real estate as a service and operational real estate being a much larger component of the driver of value versus the traditional rent collection, irrespective of the sector label. But more directly in response, it is challenging to overcome the history, the data, the lack of familiarity over market cycles with those areas. And so we lean heavily into specialism and we lean heavily into edge of the specialist and particularly the operational capability and niche of the entity, the company, the partner that we have that we're working with. So typically there is an intermediary between us and the real estate that has a particular niche serving that tenant base or serving that real estate product type.
Spencer Levy
I agree with you, by the way, most real estate has gotten more operationally intensive, but there's also been another change in our business. And the other change in our business is that large, traditional real estate investors are not just buying an individual asset. They are sometimes buying the operating companies themselves. So John, what's your point of view of going direct to the real estate, buying a piece of Op-co or both?
John Lippmann
I think in any investment, you have to understand both the real estate and how the business plan is going to be achieved and how the real estate’s going to be operated. So any investor would be wise to focus on not only what looks good on paper, but also the operating partner's ability to achieve what's set forth in front of them. And their track record – and even an investment manager who has a track record of working with different operators in a space – is better suited to make investment decisions into non-core assets than a core operator that maybe has less of a familiarity with non-core investments and non- core operators. You know, the old adage, right? Character first of investing, right? Who are you investing with? What's their experience? Can they actually achieve the business plan and can they operate the property efficiently is more and more and more important. And it was very important to begin with. So I think as we get into alternatives more, as we expand the universe of investments, the people involved in the business and real estate is always a people business. The people involved become super super important.
Spencer Levy
Well, not as catchy as scratch-and-dent multi, which by the way, I wrote down, I'm going to use that this entire episode. I think it's fair to say that the operator matters more than the real estate, good operators matters more in the good real estate.
John Lippmann
I don't know if they matter – maybe I oversimplified it. They don't matter more, but it matters as much. If you have an operation intensive real estate investment, just think of a hotel and sort of the four plus one of alternatives, right? Of that hospitality asset, you have to have an operator who knows how to run a hotel, whether it's a limited service hotel or a top-notch five-star property. That experience? Super important and will contribute to the success or failure of that investment beyond if it's just a well-located asset. And I think Liz really got to where you see operations matter more is where leases are shorter and shorter. So the shorter the leases, the more touch points with the cashflow, with the sales, whether it's a room night, whether it a one-year lease, whether it's semester, whatever. It just starts to feel more powerful.
Spencer Levy
Is it fair to say – maybe this is unfair to say – that core vehicles need to take more operational risk to achieve the same return goals? Is that a fair statement?
Liz Troni
I think that is fair. And what John was aptly summarizing in some sense is operational alpha becoming a requirement for core funds to outperform that index. And the operational alpha can come from the partner. It could come from intrinsic understanding of that sector and the actual on-the-ground operations in terms of revenue optimization, et cetera. But certainly operational alpha and that reaching for additional sources of excess return to outperform the index or maintain a competitive position has become critical.
Spencer Levy
John, will you jump in there?
John Lippmann
100% agree with that.
Spencer Levy
All right, we'll go with that, too. I think one of the beauties of the ODCE Index is that it is as transparent as any vehicle there is in our entire industry, with the exception of publicly traded vehicles. And I know in the debt side, people are trying to now do their version of an ODCE Index to try to gain transparency. So, Liz, how would you describe that transparency of ODCE funds versus other types of real estate vehicles?
Liz Troni
We think of it like the S&P 500 for institutional real estate. Data goes back, as I mentioned, late 70s, early 80s. It's quarterly. It's transparent. It's structured for a common purpose. You can stick it into any multi-asset optimizer and it'll work up against equities and fixed income. It's probably the only market in the world that has that level of transparency and that has, with its transparency, encouraged allocations over time. Elsewhere where that transparency is reduced or not available, allocations have been slower to grow and less persistent. So it's benefited the industry in many ways. It also allows – we call it as a joke, rubbernecking a bit. So there is sometimes a tendency to look over your shoulder at your peer group and be cautious about extending yourself beyond the peer group's activity for fear of career risk or performance risk. But for those that use it more as a performance benchmark and market indicator, it is really useful, as John was saying earlier, in terms of indicating asset allocation decisions – not only from core, but where is the non-core capital going to go and try and sell into in the future in terms of appetite from core capital? So it has a bit of a virtuous cycle to it. But the transparency is globally unique and with it has come enduring and persistent allocations because the consultant world, the advisory world, and the institutional market has a lot of trust and faith in being able to look back so far.
John Lippmann
Just on that transparency point, the attribution analysis that goes into ODCE returns is really, really unique and understanding what's coming from income versus capital appreciation within an investment vehicle, as opposed to just looking at your IRR based on wherever the point is of valuation and not really understanding what is coming from where, that's just a great element of transparency.
Liz Troni
Yeah.
John Lippmann
And investors appreciate that.
Liz Tron
Totally, and it helps you measure your alpha, right? You can actually clinically, numerically measure your alpha against your peer set. So you show up every quarter with a new performance ranking. You just have to resist that quarter to quarter because it is a long-term game. These are hard assets and typically investors invest for the long term. So resisting that quarterly rubbernecking is important, but it is hugely valuable in terms of understanding the value you're offering as an investor.
John Lippmann
I think really from a competitive environment, when you're in a race and it's a long race to build the cumulative excess returns that satisfy investors while mitigating risk, the ability to know where your competitors are, the ability to understand how they're pricing on their assets – and you can derive from that how they're a pricing risk – it's a really important tool and it is helpful. I think investors do that in their overall portfolio allocations, their portfolio constructions, their allocations to equity and then their allocations to different risk parameters within that. And in some cases, their reliance on the manager to make those allocations across different asset types. Even within a core vehicle or between vehicles, there is a–not everything has to be core within a car vehicle, not everything has to be through the investment sleeve. Sometimes the decision is left to the manager in terms of where that relative value lies.
Spencer Levy
Now, we had on this show maybe a year ago, our friend Drew Fung from Clarion, big debt guy, and he's trying to do a ODCE Index for debt for this very same reason. People say, well, I don't want this much rubbernecking of my competitors or that much transparency. He completely disagrees with that. He says, you know what? This is actually a good thing if there's transparency because the challenges of fundraising are hard enough. But if you give people less transparency, it's even harder. So speaking from the debt side, John, what's your point of view?
John Lippmann
Well, I think, you know, CREFC. Lisa Pendergast over there who runs CREFC, is working on a similar thing. And look, it's always good to know what the benchmarks are. I think everybody has to be honest with themselves about their own performance and be able to speak to that performance in terms of evaluating what alpha they're adding and to be able to attract capital. So I don't have any problem with benchmarking in any sense. I think you have to just understand how the benchmark is aggregated. And so that if there's a difference in terms of performance relative to that benchmark, that you can articulate why you're better or worse and what's driving that difference. If you're underperforming because you're not taking as much risk, it might be justified on the debt side. If you are overperforming because you are taking more risk, it might just be justified. The real important thing is to tease out where are you outperforming by understanding the risk better and taking less actual intrinsic risk by seeing opportunities where others aren't. And I think that's what every investment manager tries to talk to investors about and to demonstrate their ability. At Barings, we demonstrate that ability to our investors. And we try to attract more capital by demonstrating that ability. We think it's the most valuable thing to investors.
Spencer Levy
And I think what's important here is there are certain types of risk that are appropriate for your vehicle. There are certain that are not appropriate for your vehicle. If somebody's investing in a core fund, you're not going to go into a secondary market, build a highly risky asset type and hope for the best. That's very good for an opportunistic investor. And maybe they'll make higher returns. But also the beta on that one is – and since we've brought an alpha, let's bring in the beta – the deviation from the mean is something that would be even more. So you're limited in the types of risks that you can and should take. Fair point?
Liz Troni
Yeah, fair point. I break it down thinking of risk and bridging off what John was saying between leverage, repositioning and development risks. So depending on whether you're a core all the way up the spectrum to opportunistic, that leverage, reposition and development are your levers of risk to play with, if you like. And to John's point, I think it's really apt to speak to investors about the actual risk you're taking and encourage them to look on a risk adjusted basis at net outcomes. I think in real estate we're not necessarily there yet. I don't even know if the equities market is there in terms of investors’ interpretation of outcomes. But it's a critical point. I really agree with you. But typically investors are rushed. They have a lot of things that are managing at the same time and they'll look at the top line number and judge you as equivalent to peers that may have more or less risk within their vehicle. But certainly, Spencer, there's appropriate, if you like, risk to be taken within the different risk styles. But those three levers are common to all risk styles. You just dial it up or down depending on hopefully the communication and transparency with your investors and the appropriateness of that risk within your style.
John Lippmann
And I think my recollection is right. I think that the attribution analysis for the returns in the ODCE Index includes what the impact of leverages on that return. And so you can get a better sense of where the balance sheet strategy has added value on the right side, as opposed to just focusing on how the assets are performing. And I think ODCE funds are typically plus minus 30% leverage. And that's much lower leverage than is used widely in the market. And so understanding that as far as an ODCE fund is critical because you have a different leverage usage than you would in maybe more typical levered real estate investment.
Spencer Levy
So, Liz, I like the way you broke down risk because you broke it down into three categories. You broke it into leverage, reposition, and development. And John added the 30% plus or minus leverage that you have in core funds. I might add a fourth one, and I just, your point of view, which is – imperfect naming – market and liquidity. Is market liquidity a subcategory of that, or would you say that's another category of risk?
Liz Troni
I agree with you based on that simplistic breakdown would be another category. And that feeds into common hurdle rates for investors probably across all risk styles in terms of how much additional return am I requiring for this potential illiquidity of a smaller market. So I think there's a common approach to include that in a hurdle rate, and therefore require an excess return to a primary market. One can argue whether that's appropriate or not, and I agree with you that in this environment we are seeing advantageous understanding of secondary markets. I used to have an old boss who said, don't fear the second tier. And I feel we're back in a don't-fear-the-second-tier environment. And we are seeing in our own research – which we work with your side of the business all the time with Spencer – we've done an analysis called the next Nashville, trying to find where is the next Nashville in the country going to surface? And that's brought us not to New York City, not to San Francisco, clearly. It's brought us to markets in the Midwest. It's brought out West to markets that many of us wouldn't be that familiar with. Suburbs of Salt Lake City, not even Salt Lake city itself, looking for a common checklist of factors that are appropriate for core capital, but actually we would highlight as being underrepresented in the ODCE Index. So have a current lower institutional market. Saturation or even just general transaction activity and that being a positive rather than a detractor for their next Nashville ranking.
Spencer Levy
I think there are two great points there. First of all, “don't fear the second tier”. We are just a treasure trove of great expressions today. I'm stealing that one. We'll give Liz or Liz's former boss a credit for that one Taking the Salt Lake City example. What do you think about that, John?
John Lippmann
Well, I mean, Silicon Slope has been a fantastic area. It happens to be in between a world-class airport and four amazing mountains to ski. There's a lot of just attractiveness in terms of lifestyle and in terms of livability that brings people to an area that's also been able to generate the jobs to support them. So I think that's been a great opportunity just for that market. I think you're right, Liz. There are other markets that will follow that as affordability's important. People need to be able to live in a lifestyle that they're aspiring to. And people may find it more easy to do that in a secondary market than in one of the traditional primary markets. So I think capital will follow that. You look at the old block and tackle, again, of household formation, following job growth, following lifestyle. Those are key demand drivers of what's going to push every kind of real estate demand, from retail to industrial to obviously residential, and even office. And in those markets, we're also seeing more employers being able to attract people to the office, right? Because they don't mind going. It's sort of the path of growth.
Spencer Levy
I'll bring up one other market, and this is a show that we just aired a couple of weeks ago, which was West Palm Beach. We had Stephen Ross on the show, and he was focusing on West Palm beach, which was – it was very secondary. And when they built City Place, related built City place 20 years ago, it was not a huge hit out of the box. But now the highest rents achieved in Florida are in West Palm Beech. That is a example. What do you think, Liz?
Liz Troni
Yeah, as a investor over market cycles, there's a immediate reaction, which is, are we reaching for yield again? And is it that same reach for yield thesis? But when you look back, which has actually proven out, so that reach for yield thesis over the last 12, 15 years into markets like Austin, into markets, like Raleigh, into markets like Boulder has actually proven out to be successful, even in a QE, in a lower interest rate environment where we had a bandwidth of zero to 2% yields in an environment where we're four to 5% base rates, then certainly looking for excess return with a consistent checklist of factors, which I think West Palm Beach would qualify: lower cost of entry to primary, as John was saying, underrepresented, strong fundamentals, educated workforce, and in the case of Florida versus Salt Lake City, one of the largest drivers globally is temperature. So understanding that that move to the sunbelt was in part. A rational move to a better climate by that large swarth of a population, then I think there's a lot of merit in this. And excess caution by investors in terms of a natural reaction to that reach for yield. And will I ultimately be better served by the primary? I think we just need to unwind that behavior.
John Lippmann
Just to piggyback on what Liz was saying, it's important though – as investors stretch from traditional markets to secondary markets, tertiary markets – that they approach those investments with the humility to understand that they maybe don't know everything about those markets. It's another reason to really work with great local operators who understand the nuances of the market and local lenders who understand the nuances of the market to really tease out where that risk is and understand where the path of growth is in those markets. So whether it's Salt Lake City or West Palm Beach or anywhere in between, these markets, you have to approach them with the idea that you don't know everything about why that corner may be good or bad, or where the housing paths are or not, and just approach them with that sensitivity and caution. Not everything is gonna go maybe the same way in a new market, there are nuances that have to be considered.
Spencer Levy
And Liz used the term stretching for yield. I've heard another term, I think it's a synonym, it's called a yield trap. And what a yield trap is, is when you stretch to another market, say, oh, look, I can get this industrial deal for a hundred basis point less in Salt Lake City than I can in Southern California. But they may not have the durable demand drivers, or it's not as deep of a market. And to John's point, I think the liquidity and the knowledge base in Southern California, nothing personal Salt Lake City, is much deeper than it is in Salt Lake city. So the risk profile from just a pure underwriting perspective is lower there from knowing the market. Is that a fair way to kind of look at SoCal, say, versus Salt Lake sitting?
Liz Troni
Yeah, and I was just thinking, as you were clearly describing that, that for core funds who don't have the mandated exit, a harvest period, and then a mandated exit of returning proceeds that can be more flexible on their exit, the reach, if you like, or the search for value in secondary markets is probably more rational because one of the trade-offs of a less liquid market is potential volatility on your exit. If you have to sell at a certain time in a less-liquid market, you're likely to potentially take greater volatility on your exit price because there's probably a thinner bidder pool there.
Spencer Levy
That's very interesting because I've actually never heard it expressed quite like that, Liz. You're saying because of the time period differences that actually core funds have greater flexibility to go to some of these secondary, tertiary markets.
Liz Troni
Yeah, and I've got a great example. So in our fund, we lean heavily in the secondary markets and industrial. So not the Southern California, not the Port of New Jersey, but markets like Indianapolis, markets like Memphis. In the rise of those primary markets post-COVID and that extrapolated period of such strong growth for the port markets, we were underperforming. Now with the call that you made years ago around nearshoring, Spencer, and the marginal shift in production to the domestic market, we're actually reconsidering our exit in parts of Indianapolis and Memphis because now they may be more valuable to us than the primary. And that represents that flexibility of whole period within a core fund where if you were in a closed end vehicle required to distribute proceeds back to investors, your exit timing is less, potentially less flexible.
Spencer Levy
John, we talked a lot about secondary markets. We talked a little bit about the asset types. I also know that you're partners with one of our companies, the Trammell Crowe companies on a deal called Speedway Industrial in El Paso, which is exhibit A of going to a secondary market, doing new development in industrial. Tell us about that.
John Lippmann
Yeah, we're really excited about that opportunity. We have approximately 800,000 square feet under development with Trammell Crowe right outside of El Paso. It's a growing market. We started that development earlier this year, and we think it represents a great expansion of our relationship with Tramell Crow. It's our first joint venture with them, but there are obviously leaders in the market have a lot of local know-how and it's that combination of local know-how and institutional capital that we think will really make for a winning investment.
Spencer Levy
And by the way, I'm very bullish on El Paso specifically. And the reason why is, in fact, I love the cross-border trade because there are certain competitive advantages in Mexico, there's certain competitive advantage in the United States, and El Paso’s right at the crossroads.
John Lippmann
You know, there's one other thing about that investment that's important, and that is the willingness of the city to provide a pro-business investment environment that will attract that capital and attracts our partners to them as well. So I think the municipality, the overall economic story, the operating expertise, the institutional capital, it's sort of four legs of a stool that really should prove to attract more capital to those kind of investments.
Spencer Levy
So given that you're wearing two hats here today, John – both an equity and a debt hat – how do you see interest rates just generally impacting both sides of the house? But do you agree that for the last couple of years it was actually pretty good for debt funds in terms of getting equity-type returns?
John Lippmann
It certainly was, and that was a function in part of a lack of value growth. So the returns that were driving the debt side of the house has been just consistent income. Spreads have come in. There's a lot of liquidity that's returned to the debt markets, and there's plenty of additional dry powder on the sidelines. To the extent that there are higher underlying rates or lower underlying rates, that's gonna impact all investors. It may impact the debt capacity of assets going forward, so that just means there'll be a larger amount of equity that has to come in, and typically that just has a higher cost of capital, so that decreases value as the cost of the capital rises. But the fundamental returns that have attracted capital to the debt side of the equation, I think that will continue. There's another thing that's attracting capital to debt funds, which is the availability of senior financing in many regards. And so there's a leverage that's available within the debt universe to provide investors in private credit a higher risk-adjusted return for their retained positions, whether they're a one to one, two to one three to one leverage, and so forth. And there's variety of different ways to get at that. So when we look at debt investors, we really have to evaluate what are they looking for? Are they looking for maybe the more senior part of the capital stack wich is trading relative to where corporate bonds and corporate credits are trading and where that offers additional return on the safer side? Or are we looking more into the leverage stack where it's a levered play that offers a different return dynamic in terms of current pay versus appreciation relative to the equity? And so that back and forth and understanding those different links and what the investment in real estate is an alternative to in a more traditionally allocated portfolio is where we see different investors play.
Spencer Levy
So looking forward, Liz, we've had a stretch now where it was very difficult for core funds, but now it's getting better. Given where we are today, where are we going with core funds over the next couple of years?
Liz Troni
The big question for investors is this continual path into alternatives and or at the same time, a reassessment of basis on the traditional sectors, which can at one point sound conflictual or contradictory, but we are seeing volumes of capital focused in the alternative areas. The capital therefore is competing those yields down to levels that now are competitive with more traditional sectors historically in the basis on traditional office, the basis on retail, including open air, which is now very widely accepted, Spencer, thanks to your call years ago to be attractive. So, but still value there. And that's the question for funds that are in a privileged position, have some alternatives, and they're just trying to find the best relative value available. And is that a continual lurch into alternatives into early mover advantage in some of the areas that you outlined earlier? Or is it an acceptance and a behavioral open-mindedness that there is basis to be found? There is attractive entry points, once again, back where we started with office and retail.
Spencer Levy
John, how do you see the next several years playing out?
John Lippmann
I see a lot more capital coming into real estate, whether it's in private credit or private equity vehicles, in part as a function of increased allocations to alternatives within retirement accounts. That will be a major driver of liquidity into real state and will help drive down cap rates, even if interest rates rise. And I think it will help drive down spreads even if interests rates rise. So I think that there's a bullish case to be made for real estate, notwithstanding also the fundamentals, but just from a capital flow perspective. If that untapped pool of liquidity comes into real estate, and it looks like it will continue to come, that there will be enough additional investor demand that needs to be accessed that it will buoy a lot of investments to the good for everybody.
Spencer Levy
So on behalf of The Weekly Take, what a terrific conversation today with our friends from Barings and CBREIM. Liz, thanks for joining the show.
Liz Troni
Great to be here. Thanks Spencer.
Spencer Levy
John, thanks for joining the show.
John Lippmann
Appreciate it. Thanks so much, Spencer.
Spencer Levy
Appreciate you coming in today.
Spencer Levy
We'll have more investment focused conversations coming soon, including a return to London to learn about REITs in the UK. Plus, a conversation with an entrepreneur and author who will tell us how one of his book subjects, Pirates – yes, Pirates – can teach us about business. Shiver me timbers! You can stay on top of what's coming on the show by visiting our website, CBRE.com/TheWeeklyTake. You'll also find lots of other useful insights about investing, management, development and operations across the real estate spectrum with episodes and content archived there. It's available on all major podcast platforms too. So we encourage you to peruse our full catalog, and of course to share the show, subscribe and send us your feedback. As always, thanks for joining us. I'm Spencer Levy. Be smart. Be safe. Be well.
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