Recent Fed action to raise interest rates is shining a bigger light on investment opportunities in commercial real estate credit strategies, and piquing interest of major players such as Brookfield Asset Management.
Traditionally, Brookfield’s perpetual income strategies have focused primarily on investing in real estate equity positions. However, the needle is towards credit investments as the firm sees more opportunities in real estate debt positions ahead. On a normalized basis, Brookfield’s income strategies typically are 10 percent invested in real estate debt and 90 percent in equity. That could shift to north of 20 percent, according to Zach Vaughan, a managing partner in Brookfield’s Real Estate Group and the Global Head of Core Plus and Perpetual Real Estate Funds.
“We’re seeing a meaningful increase in the amount we’re investing in credit, but these are not mortgage REITs by any means,” says Vaughan. “We think it’s a good time to protect yourself on the downside and earn some great income in these strategies, but ultimately, these are equity strategies where we want long-term appreciation and cash flow growth as well.”
WMRE recently talked with Vaughan to hear more about how the firm views opportunities and challenges in credit in the current rate environment.
This interview has been edited for style, length and clarity.
WMRE: Can you briefly describe Brookfield’s portfolio in terms of number of assets, types of properties/assets you invest in and overall size or AUM?
Zach Vaughan: Our global real estate business at Brookfield has $256 million of total AUM. We operate across all of the major property sectors—multifamily, logistics and warehouses, offices and also the alternative real estate sectors. We also run our own properties, and we have almost 25,000 operating employees on the ground who handle leasing, marketing, property management and oversee any capital projects at properties.
WMRE: Under that umbrella, what investment vehicles or channels do you have?
Zach Vaughan: As it relates to real estate control equity, where we own the assets and manage them, we have three main strategies. One is opportunistic where we buy distressed assets or assets that need to be redeveloped or build property businesses. That is something we do through closed-end, more traditional private equity style funds. Two, we have a core plus strategy. These also are designed for larger institutions, but they are open-ended. We invest in real estate that is not distressed, but where we can reinvest a meaningful amount into the real estate in the first few years of ownership and eventually drive those cash flows and values up. Income is the third, and there we are focused on high-quality assets that generate good, sustainable cash flow that we can run ourselves and add value primarily through operations versus big capital investments. Those are generally stabilized assets that are leased long term or have great pricing power in the near term.
WMRE: Are you focusing on credit broadly, or more in one of those three particular strategies?
Zach Vaughan: It’s somewhat broad, but certainly as it relates to our income strategies, it’s very attractive. When we created some of these strategies, we wanted the ability to pivot between equity and real estate credit to the extent that opportunities presented themselves. What is unique in our partnership with Oaktree Capital is that we essentially get to work alongside their team. It means that we can really shift some of our capital towards real estate credit very quickly.
These positions are all portions of individual mortgages secured by high-quality single properties or portfolios of properties that have one borrower or one sponsor.
So, we are not investing in opaque types of credit investments where you don’t see or deeply understand the underlying collateral. Having those operating employees at our fingertips allows us the ability to ask an opinion about an asset or a sponsor. So, not only do we have the sourcing mechanism and credit skill through Oaktree, but we get a deep understanding of the underlying collateral we are investing in.
WMRE: There has been a lot of investor capital focused on credit strategies even before interest rates started rising. How have recent moves in interest rates influenced your interest in credit?
Zach Vaughan: Up until a couple of months ago, we were primarily equity focused. Our portfolios were probably sub-5 percent in real estate credit. That was because we just didn’t see the opportunity. Spreads were historically low. Rates were low, although we believed they were going to move. What we saw recently is a moving out of not only the base rate, but also the spread that you can get, particularly on the floating rate loans, which is primarily where we invest.
A combination of that means that we can make investments in an environment that’s quite volatile and generate attractive income for our investors at an attachment point or last dollar of risk that’s very compelling. In our view, we’re not taking equity-like risk and pretending that it’s credit, we’re very deep into the capital structure. In other words, the positions that we’re focusing on are typically sub-50 percent loan-to-value.
WMRE: What types of debt are you investing in?
Zach Vaughan: The vast majority of everything we have is floating rate instruments of medium-term duration, three years or less remaining term on loans. We participate in positions in the property mortgages. So, these are not bridge loans or transitional loans, these are good quality assets that are income producing, and we participate in portions of the individual mortgages of single assets or portfolios that have one borrower or one sponsor.
WMRE: What do you see for borrower demand for those SASB deals given all of the interest rate volatility that we’re seeing lately?
Zach Vaughan: It’s natural as rates and spreads move, they will rethink their leverage positions. There also may be borrowers that have gone quickly from a positive leverage scenario to a negative leverage scenario, meaning that the cost of debt may not be accretive anymore. That being said, people always need access to credit. It’s a very big, very deep market. What we are seeing across the properties that we’re financing is that the capital markets are still open for good quality assets and good quality sponsors. It is more expensive than it was previously, but there is still a lot of product out there.
WMRE: In the context of the broader CMBS market, SASB has seen good momentum in the past year, is that momentum still there?
Zach Vaughan: In March 2021, SASB was trading at record levels, with AAAs at plus 65 bps, the tightest pricing levels since 2007. After record issuance in 2021, SASB pricing has reversed course and is now at record-wide spreads, with AAAs at roughly plus 260 fps and whole loan spread roughly 200 fps wider. Between wider loan spread and wider base rates, all in financing is about 3 to 4 percent greater than one year ago.
That dynamic has impacted different sectors in different ways. If you think of something like logistics that have longer leased assets with flat income streams, lenders have gone from constructive to concerned because assets that were acquired at low going in yields with the expectation of sustained record rent growth now have negative leverage, and both lender and borrower need that rent growth to avoid term and maturity defaults. So, it may be trickier for a logistics SASB portfolio today than it would have been previously. Other deals are still happening, but spreads are moving out across the board.
For us, we wouldn’t participate in anything that we couldn’t actually underwrite or step into a situation with some capital or expertise if necessary, because that’s the real challenge with credit. If things move meaningfully against you, you have to be ready to step in and provide incremental capital and be able to run the underlying asset. But, to be clear, these are not distressed loan situations we are pursuing in our income oriented vehicles.
WMRE: One could certainly argue that there is more risk in the market with talk about slower growth and a potential recession. How are you underwriting risk?
Zach Vaughan: We’re always focused on, number one, preserving and protecting capital. That’s absolutely critical. We take a similar approach to how we evaluate investments, whether it is equity or credit. As it relates to the type of real estate debt that we’re investing in today, there are three things that we would take into account. First and foremost is the quality of the physical real estate itself.
Saying, “I’m investing in mortgages at sub 50 percent LTV”, is really not that meaningful unless you really understand what the future prospects are for the asset. We really want to understand the asset. Having these operating businesses and teams is really critical.
Second is where does that credit investment sit within the capital structure and where your attachment point is for your last dollar of risk. For what we’re buying today, we’re not the most junior or first loss position.
We protect ourselves first by selecting position in the capital structure that gives us a lot of downside protection and doesn’t have an enormous amount of refinance risk. Third is the caliber of the sponsors or borrowers. You have to know who is ultimately running the asset that you own a piece of the loan against.
WMRE: How do your investors view credit strategies these days? Any more or less interest?
Zach Vaughan: Investors are very receptive to having a portion of their investments focused on credit. I think it is a volatile time in the market. So, people are looking for downside protection. If you’re participating in, particularly floating rate instruments, it’s a very attractive way to get growth in your cash flow as rates go up. The strategy is resonating with investors, and I’m very positive on the landscape today. There are always moments in time where the credit markets, particularly with traded credit markets, react very quickly to what’s going on.
We saw that in the first quarter of 2020 and took advantage of it, but that window was very narrow and not open for very long. After trillions of dollars got pumped into the system, spreads moved back down. We think there is a longer opportunity today. So, it will remain an area of focus for us in the near to medium term. But the great thing about what we’re doing in our strategies is that we can move very quickly. We have Oaktree and we have our real estate operating companies that are sourcing property equity investments all the time. So, if we see compelling opportunities in either credit or equity, we can move very quickly, and that’s what we’ve done here.