Navigating Supply, Rates, and Opportunities in Real Estate

Navigating Supply, Rates, and Opportunities in Real Estate

Josh Rubin: Welcome back to the Thornburg Investment Insights Podcast, I’m your host Josh Rubin, and I’m a client portfolio manager at Thornburg Investment Management. We’re continuing our conversation on real estate with Thornburg Real Estate Investment team, David Bennett and Danny Quinn. In our last episode, we gave a broad overview of the real estate landscape, including regions, loan aspects and trends. Today, we’re going to go a little deeper and discuss transactional elements of real estate, as well as how AI and tariffs can play a role in the industry. David, Danny, thanks for joining us today.

So, help us understand we’ve got $100 million total price for a project, 30 or 40 million of equity, 60 million of debt. Talk to us. There’s a senior loan. Who’s that coming from? Number one. Number two, I think a lot of people aren’t necessarily familiar with what preferred equity is or, you know, from the credit side, sort of different from loan. So, talk to us about where to put those moving pieces are.

David Bennett: Yeah. So, so on the senior loan side, it’s going to depend on the, the type of asset. So if it’s a development project, really up until this point, some of the most active players have been kind of local and regional banks, that have pulled back a little bit, but they’re actually still somewhat active on the development side. You’ve also got, you know, private lenders. We talked about that a little bit earlier, but they’ve been one of the lender groups that has kind of grown, the most quickly over the last several years.

Josh Rubin: And private lenders would be like private credit, private focused on real estate.

David Bennett: Exactly, yeah. So, they’re still active on the construction side and really, you know, they tend to be pretty opportunistic. So, they’ll go into lots of different special situations. And then they also tend to be, one of the most active lenders in the bridge lending space, which, bridge lending is kind of, you know, it’s a short-term financing to bridge between either a longer-term financing or a future sale. So, if you’re a developer that developed a multifamily project, you had a construction loan with a local bank, that typically is a three-year term. So, you’ve got your project built, stabilized. And now you have to take out that construction lender. You may, look to a bridge lender if you’re if you feel like your project still has room to increase, maybe an NOI before you, take out a permanent loan or you look to sell the property. So, a lot of the private credit players are very active in the bridge lending space. And then you’ve also got, you know, the big banks as well that are very active and the larger financial institutions.

Josh Rubin: Ok, changing gears a little bit. So, we talked earlier about dynamics that have changed or inflected around Covid. Again, in terms of the demand for real estate. Let’s talk about, sort of what constitutes competitive advantage in the real estate industry and what’s the same as it always was or where competitive advantage is shifting. Is having a lower cost of capital, a competitive advantage or you want to sort of use your lower cost of capital to achieve the same returns as everybody else, so, it’s not a differentiator. Or does AI matter for making real estate decisions, etc.? You know, like whichever ways you think things may or may not have changed for how to be a good real estate investor today.

Danny Quinn: I do believe that cost of capital and scale are still, you know, durable advantages in the current landscape. But I guess, looking at dynamics that we’re focused on, you know, one thing that that I certainly still believe is that there are certain parts of the country that are really nice to live in. I think people will want to continue to live there. I know we’ve, we’ve seen a lot of headlines about, you know, California is dead and Texas is the future. Texas absolutely has tremendous job and population growth. I think they have a very bright future ahead of them. But places like California, New England, New York, you know, I think would continue to remain attractive places for people to live and work. My general theory on this is that the, the arc of, of the future bends towards globalization. And so I continue to believe that, you know, major deep sea ports in the US will remain, valuable locations for industrial production, and, and, warehousing to import goods that are made that, you know, quite frankly, no matter what happens, we’re never going to be able to grow bananas in the United States. So, you know, I think, there are certain just geographic, realities that that are going to remain unchanged.

David Bennett: Yeah. I mean, in terms of competitive advantage, when investing in real estate, I do think local market expertise is very important. We didn’t really touch on this, but in general, you know, our investment strategy is to act as a capital partner. A capital solutions provider to sponsors, you know, whether that’s developers, operators, etc. And so, for us, it’s very important that our partners have extensive local market expertise, and they really understand markets they’re operating in. You know, they understand the best submarkets within each market. And really, you know what, what is driving potential for future growth in each of those markets. You know, where are the employers located and where do people want to live? You know, how is the education system in each submarket, etc.? So, for us, you know, in our role, it’s important to, you know, kind of source local experts that are investing in markets that they really know.

Josh Rubin: And as you think about some of the challenges that have happened in the real estate market for the last 3 or 4 years. Again, I’m asking you big broad strokes here. Do you think there’s been more challenges on the development side or on the stabilization side where either occupancy and/or at least rates, these prices just weren’t as good as expected because of an execution issue? Or was it, you know, those things were fine, everybody was just too aggressive in their expectations around interest rates or, you know, the overall macro situation.

David Bennett: I think it was it’s a combination. You know, if you think back to kind of the Covid period and, you know, there were developers out there, dealing with, you know, lumber going through the roof or, you know, not being able to get certain parts delivered from, you know, other countries. So, yeah, it’s, but I think it is a combination you’ve got that combined with because there’s been this is specific to the multifamily market. But, because you’ve had so much supply delivered, you’ve then also seen occupancy rates go down, as well as rental rates. And, you know, every market is different, but this is particularly relevant to the kind of high growth, you know, high supply markets, places like Phoenix, Denver, Nashville, Austin. You know, I was in Denver over the weekend, kind of driving all over the city. And I was, you know, because you see it in the numbers. But to actually see it in person everywhere you turn, there was a new apartment building. And it’s again reflected in the numbers, the occupancy rate and the and the rental rate in the market.

Danny Quinn: Yeah, real estate can be a challenging business just because, there’s so many dynamics at play. And then just when it comes to delivery of new supply or, you know, just actually business plan execution, it’s time consuming. And so, you know, Denver obviously is a market where, they’ve had tremendous population growth. I expect that the population will continue to grow. However, we’re kind of at a period right now where there’s been and, you know, sort of an uneven influx of new supply of, you know, apartment buildings and, you know, at a time when population growth has tailed off a little bit, I’m sure that eventually those, you know, the market will reach a new equilibrium, or maybe it already has. But that’s sort of what makes underwriting investment opportunities extremely challenging, is trying to project and perform, each of these dynamics at play and what the, what the net impact will be on your investment returns.

Josh Rubin: If we were to use stock terminology, are there certain regions or segments that you would kind of classify as exciting growth areas or really attractive value areas right now?

David Bennett: No, I think we can, look at it within those categories. I think value is actually the easier one to answer. In my view, that would be, asset classes or markets where you have a higher cap rate, which as a buyer obviously is more attractive. You know, it’s the one area in particular is affordable housing. Where from what we’ve seen, cap rates tend to have a spread to, kind of more traditional, you know, call it class-A housing. And you’re also not competing with as much supply because a lot of the new supply that’s been built, recently is kind of class-A, higher end luxury apartments.

Danny Quinn: And durable demand dynamics in the affordable housing space as well.

Josh Rubin: I guess you could say if there’s durable demand dynamics, then it shouldn’t be attractively valued, it’s attractive value because it’s pricing in in macro concerns about lower income wage growth and therefore, you know, kind of delinquencies that make payments or pricing something different?

Danny Quinn: Yeah, that’s certainly a consideration. I think also just you know, overall concern about, new regulatory guidance, you know, that would prevent, NOI growth or revenue growth.

David Bennett: So within affordable housing, there’s what people in the real estate industry will call capital A-affordable and lowercase A-affordable. You know, one just being, you know, affordable to more people versus capital A-affordable, where you actually have to meet, certain rent levels based on. And so one of the reasons that you’ll see higher cap rates in, true affordable housing is because of that, you probably have the less potential for future growth, which, you know, that factors into the cap rate. The other thing is you need some expertise to be able to manage that type of property. So that’s also a barrier as well.

Danny Quinn: Yeah. It’s an example of a regulatory process that just, you know, requires expertise to navigate because it varies municipality by municipality, generally speaking.

Josh Rubin: In real estate, there’s two keys or there’s kind of three key sources of return: there’s income, there’s you put a certain amount of equity in, but that equity can grow because you de-lever and then the third part is cash flow from the property grows. Therefore, the total value of the property grows and so when you exit it you know that there’s a capital gain separate from, and in affordable housing, the capital gain component may be more limited because your rental growth is more limited. But the regulatory, you know, oversight, therefore, to achieve a similar total return over time, you need to start out with higher income, you know, higher income yield.

Danny Quinn: Exactly. Yeah.

Josh Rubin: Do you think there’s that debate about the outlook for rent inflation or everybody kind of agrees? We’ve got a couple of years where it’s going to be hard to push rents.

David Bennett: I think the debate is mostly about the timing. I think the groups that are most active right now, believe that you’re going to see, you know, increase rent growth in kind of the more near term, the next 1 to 2 years. And I think our view is a little bit more conservative that, you know, we see the thesis and generally agree with that, but we think it’s going to take longer to play out.

Josh Rubin: So, lower interest rates is kind of the key thing to unfreeze the real estate market.

Danny Quinn: I think that’s certainly a component. I think the other thing that could really sort of unlock the real estate market is just, growing conviction in the stability of the macroeconomic outlook, you know, and that being, you know, unemployment remaining stable, real wage inflation remaining healthy and strong and outpacing, CPI. And just you have, this sort of continued digestion of existing supply and you don’t have, you know, don’t necessarily have rapid acceleration, demand growth. So if you kind of see supply and demand come back into a healthy balance in certain markets where maybe out of balance, I think and, and combine that with the increase in conviction in the macro outlook, I think that could do a lot to unlock transaction volume and the real estate market without necessarily seeing a decrease in interest rates.

Josh Rubin: We should at least mention, AI and data centers. Data centers seem to be driving the US economy. You know, GDP statistics indicate it’s at least 40% of GDP growth this year. Spending on data centers, kind of total IT CapEx will be around $1.5 trillion in 2025, which compares to, residential CapEx a little over trillion and nonresidential a little under a trillion. So, any challenges that we’re seeing in general real estate, it’s not because all the money’s just going to AI?

David Bennett: I have not seen, cases where capital flowing into AI is necessarily negatively affecting real estate. But on the AI topic, one area that we’ve looked at that’s kind of interesting is, you know, one of the biggest issues with these data centers is lack of power. So, an opportunity that we’ve seen is, we have one partner in particular that’s working on this. They do a lot of land development. And if you can, you know, source land in the right locations where you get access to power and you get an allocation from whoever the power provider is. That creates a lot of value. Even if you don’t move forward with developing data center, you then have a site that could be, you know, data center ready. So that’s an opportunity that we’ve looked at.

Josh Rubin: Another thing we should definitely touch on that directly, but also very indirectly impacts real estate in a variety of ways is tariffs over the last nine months, let’s say. Can you talk about where tariffs, are meaningful or maybe they’re a narrative, but they’re not actually impacting it. Particularly given if they go into the cost of construction, but a lot of more recent construction activity is slowing down. You know, do tariffs matter as much. And are they impacting, you know, other elements of the real estate supply chain?

David Bennett: Yeah, I mean, I would say they’re just another headwind to development. But you know, anything that increases the cost is going to make it more difficult to make the numbers work to build new properties.

Danny Quinn: Yeah, absolutely. I completely agree. I mean, at the heart of it, I mean, real estate is, you know, raw materials assembled through labor. So, the cost of those raw materials and the cost that labor are your two primary drivers of, you know, development costs and therefore, you know, asset appreciation, you know, because your part of the valuation of a property is, comparison against replacement cost. I will say, though, I mean, you know, obviously the tariffs have been, a headwind since kind of the late 20 teens. I mean, we were we were coming up on about ten years of tariff headwinds, now, at this point. So, that certainly is an area where, it would be a relief to the cost of development.

Josh Rubin: David and Danny, thank you for that comprehensive look at the real estate investment landscape. It’s a broad sector and I’m glad you were able to help us navigate through some of the nuances of the space.

David Bennett: Sounds great. Thank you, Josh.

Danny Quinn: Thank you. Josh.

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