Real Estate Foundations

Real Estate Foundations

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. Today, we’re going to touch on real estate, a different investment asset class than we’ve talked about before on this podcast, but still a very interesting and important sector. I’m joined by David Bennett, Director of Real Estate Investments, and Danny Quinn, Real Estate Investment Associate here at Thornburg. David and Danny have a lot of experience in this area, and we’re excited to dive into the topic. Guys, thank you for joining us.

Let’s start high level and kind of review how you would define the key segments of the national real estate market and the key moving pieces in the real estate market in such a broad term. Let’s kind of bucket a few of the key elements and moving pieces to start. And then we’ll dive deeper after that.

David Bennett:  In terms of kind of the four major asset classes within real estate, generally those are considered multi-family, industrial, retail, and office. And then you have more niche asset classes alongside that. Some of the larger ones are hospitality or hotel. You’ve got senior living, self-storage. And then you get into to even more niche asset classes such as, things like cold storage, or mobile home parks, some of those would fit into kind of a more broad residential category. But those tend to be kind of the four major food groups within, within commercial real estate.

Danny Quinn: I think just part of the reason why we are so focused on relative value is because, you know, market to market. You know, looking at different metro areas, you can have very different underlying dynamics. One, you know, cities that can be growing versus shrinking. And then even asset by asset, you can have two properties right across the street that have diverging performance.

Josh Rubin: So, just maybe we covered kind of the segments. Let’s also talk regions. And what do you think are the right ways to, you know, simplify, even if it’s to oversimplify, obviously we’ve got urban or suburban, we’ve got north versus south. But what are the key ways to think about the regions of the U.S real estate market today?

David Bennett: Yeah, this is actually an interesting conversation because there’s been some changes, you know, historically in the past you have the gateway markets and then you had some kind of primary markets and then secondary markets. As certain markets have continued to grow, that line has gotten a little bit more blurry. So, you know, in the past, gateway markets examples of that would be New York City, Los Angeles, San Francisco. Now there’s a case to be made that some markets like Dallas/Fort Worth may be a gateway market in the sense that if you look at transaction volumes, Dallas is always towards the top of the list. The other way to look at it is Sun Belt. So, a lot of the high growth markets in the US are located in the Sun Belt, and we can talk about some of the drivers there. And the results within the real estate markets based on some of the supply and demand dynamics that are going on in those markets. But you’ve kind of got, you know, you’ve got various regions, so you’ve got kind of the Eastern Seaboard, you’ve got the Sun Belt, you’ve got the Midwest, and then you’ve got the southwest and the mountain west and then the west coast. And so, each of those different markets has, you know, similarities and differences that then we can get into further.

Josh Rubin: High level, would you say, you know, our urban markets, the eastern seaboard, do they behave the same way that urban markets in the mountain west do?

David Bennett: I’d say it’s hard to oversimplify. In my view, each market is dynamic, has their differences in terms of what’s, driving demand. And then there’s also significant differences in supply.

Danny Quinn: Yeah, I would agree with that. I would say one area where you can draw sort of commonality across geographies is, if you look at sort of economic output and GDP, segmentation and you might see that there are certain markets like such as state capitals, that actually do tend to perform relatively similar similarly, just in that, you know, a lot of their demand for, say, office space is driven by, various government entities and or possibly, you know, legal users. Another example would be if you kind of look across, you know, markets that are auto manufacturing hubs. That would be, you know, a very interesting comparison between something like Charleston, South Carolina, or just north thereof, in Detroit. You know, those are two markets that probably, you know, since they’re both auto manufacturing dependent, they’re going to, be correlated based on how, auto purchasing demand is whether it’s growing or shrinking.

Josh Rubin: One other final question, sorta on this high-level topic. I would say kind of the last 15 or 20 years, a pretty consistent theme that I think real estate investors have been planning around is the aging of baby boomers. And then we kind of saw a slow burn theme through the 2010s tens around e-commerce and just questions for what was that impact going to be on the retail side. And then Covid may or may not have had a few other inflections, you know, whether it was, work from home and the impact on office.

Whether it was sort of like a hyper inflection in e-commerce or what that meant for retail. But also, the way people reset, and it wasn’t just baby boomers. Maybe moving north to south with retirement, but are there other things we should think about that even more impactful recent inflections, or there’s some other slow burn changes driving the market besides just baby boomers aging that are, you know, investible components or things you need to think about, as important components for investing in real estate?

David Bennett: Well, I think the Covid period kind of accelerated some of those slow burn things that were happening previously, including on the office side. Increased work from home, you know, that that is kind of shifted. But I think companies that continue to evaluate, you know, the need for office space and, I think they’re bringing people back to the office, but the usage of that office maybe looks a little bit different than it did previously. You know that that’s of course, the easy example. You know, the aging baby boomers, I think has is going to have a pretty interesting effect on residential, where, right now, for younger people, it’s very difficult to buy a house. You know, the average age of a first time home buyer is increased, I think, to forty years old or somewhere in that range today. So as baby boomers retire, maybe they downsize, look to sell homes that may unlock some additional housing for, you know, potential first-time homebuyers.

Danny Quinn: Another trend that I think accelerated that, you know, we were already seeing in the 2010s is sort of the, the differentiation between office assets. Throughout the 2010s, I think you saw B quality office properties, suffering to attract and/or retain tenants, or even A quality properties in B locations or secondary locations within a metro market. I think that, you know, if you still had those assets still by and large, had value, although it was deteriorating prior to Covid. And I think since Covid, what the capital markets are telling property owners and what buyers are telling sellers is that those properties are completely obsolete at this point. And that the evidence for that I primarily point to, you know, you see lots of headlines about the need for conversion of those properties away from the office used towards multifamily or something similar. The problem being that not all of those office properties are necessarily suitable for conversion, or at least not, economically speaking, without some sort of incentive. So that, sort of reallocation of space still remains to be seen how it’s going to unwind. But, that just to highlight David’s point about the acceleration of trends that were kind of already in place.

David Bennett: And then, I mean, I guess in terms of other maybe more macro trends that affect real estate, outside of you know aging baby boomers, I think immigration is one that we’re seeing play out today. How is that going to affect future household formation and demands for different types of real estate? I think that’s still to be seen.

Danny Quinn: You know, those are some long-term trends, I think, you know, in the near term, as far as what Dave and I, or at least what I’m looking for primarily in 2026 to see what’s going to unfolds in the near term. I think the two, key data points that I’m most interested in are where does unemployment go from here? I mean, it’s been very stable, under the new administration, and there’s not necessarily any, any signs of weakness that, that I see so far. And but also equally as importantly, I think is, real wage, growth and real wage inflation relative to CPI.

Josh Rubin: There’s a lot of moving pieces in real estate, but I think the way earnings are generated and the way that translates into valuations is valuable to talk about. Can you help us break down; we start with rents creating revenue. The overall cash waterfall of a real estate investment, cash expenses interest, you know, principal amortization where it happens. And then how that ultimately turns into a determined value that you’re using, or lenders are using for the final underwriting?

David Bennett: Yeah. So, we’ve talked about capitalization rates or cap rates, I’m sure the listeners have heard the term, but, really what a cap rate is, is the net operating income or NOI, divided by the valuation, of the property. So, it’s effectively kind of the yield on the value. So, when we’re underwriting deals in the current environment, the cap rate or the yield on costs is kind of one of the most important things that we’re, we’re looking at because, there, you know, it’s a very cloudy future in particular right now. So, some of the future underwriting, metrics that we would typically look at are, are difficult to underwrite right now. You know, things like rent growth that we’ve talked about in this conversation. So, understanding what your kind of going in yield is, or your cap rate, becomes one of the most important metrics like this. And so, you know, if you look at kind of the full risk spectrum of different real estate investment types, you would hope to see that that yield on cost or implied cap rate of a development project would be the highest. So, you know, if you’ve got a multifamily project that’s fully stabilized, in a market that is valued today at a five cap, you would hope that, yield on cost to develop a similar project in the same market would have some spread, call it 100 to 200 basis points. So, you know, maybe a seven yield on cost to develop that property today and take that risk.

Danny Quinn: Yeah. I think, one thing just to add is the cap rate we do look at in isolation. But another key consideration when we’re underwriting is the cap rate relative to your interest rate or your cost of debt. Because obviously real estate, by and large, is a levered investment vehicle. And so, what the cost of that leverage is relative to your yields will determine whether your debt is accretive or dilutive to your return.

David Bennett: So, I was just going to say so looking at, you know, kind of your if you’re to make an investment in real estate and you’re, looking to underwrite the overall returns, you would anticipate some of the return to come from that yield that you’re earning at the outset, which effectively is your cap rate if the project was unlevered, and then you’ve got, you know, future rent growth, as well, which would then result in appreciation of the property. So those are kind of the main drivers of your return in a real estate investment.

Josh Rubin: And when you think about kind of how the cost of capital gets embedded into ownership costs right now, obviously the clearest is I own a property, it’s a high-quality property, and I just have one good single senior loan against it. What are the reasons that I would take more expensive financing, whether in the form of, a bridge loan, whether in the form of mezzanine debt or more equity fund. Why would I choose a higher cost of capital, given that ultimately the property’s value relates to, you know, other forms of high-quality interest rates around the world?

David Bennett: You likely wouldn’t, you know, the reason you would is that your debts coming due, with your current, you know, lower cost loan. Or the other reason you might is if there has been significant value appreciation at your property and, you can cash out finance. And maybe it’s at a higher interest rate, but you’re going to be able to take some equity off the table.

Danny Quinn: Usually, the key component of the analysis also is, you know, even though the incremental financing or the new financing is higher cost, if it’s lower cost than your expected equity return, than it’s it would still, in theory, be accretive

Josh Rubin:  What about, you know, the other trends that have been the case in the United States for the last 40 or 50 years is larger corporates have displaced mom and pop businesses, of any type. Is real estate still a market where smaller players can operate and have attractive returns or is it also a place where bigger is better? The more Ivy League degrees to run the Excel spreadsheets, the better, you know, etc.

Danny Quinn: I do think that scale, remains a competitive advantage even in the current landscape. But it does seem to me right now that, being a smaller player actually is equally as advantageous. You know, if you’re, you know, a large institutional, private equity fund manager, there’s a certain critical mass of that you of assets that you need to acquire in, in a single check. So, you know, that leaves a lot of room to navigate if you’re a smaller player, particularly, say, a mom and pop landlord. We believe that in a smaller check size, you know, call it anywhere from maybe a $10 million to $60 million check size range, where we’re not really competing with large institutional capital groups. And that that leaves a lot of room for value add, and for, you know, for us to find attractive investment opportunities for our clients in our capital.

Josh Rubin: Okay. So, let’s now break this apart into the key components of a transaction. You know, part one. Suppose if there’s an equity buyer. And that may be to help us think about, I think for most people, whether it’s 50 million or 300 million, that’s that is a pretty large total price. And when we’re talking about range, are we talking a single professional buyer, whichever background they have, a single professional buyer or syndicates or consortiums of buyers, number one. Number two, help us think about from the lending side, you know, for most of us, we get a home mortgage, we just got one bank we’re working with. There’s no senior subordinate, multiple tranches, etc. so help us think about once we’re in real estate of this size, maybe what’s the same and what’s different compared to most of us when we actually just buy our homes or do something else simple as a mom and pop?

David Bennett: So, the typical kind of real estate capital stack, will utilize kind of 50 to 65% leverage, and that is in the form of a senior loan. And then in a standard deal, the remaining percentage would be your equity contribution. And that’s typically, a sponsor of some sort, whether it’s an institutional real estate manager or maybe a syndicator, or an operator that then raises, you know, LP equity, from partners.

So that’s kind of the standard capital stack. One thing that’s interesting is, as the market has evolved and, equity returns have become somewhat less attractive, there’s less equity available for real estate investments. And so, you’ve got a lot of groups that have come in with things like preferred equity, mezzanine debt. And they’ll fill in that gap in the capital stack. So, if you’re a sponsor and you’re not able to raise, call it 35% equity, they might be able to raise, you know, 10 to 15. And then they’ll fill in that remaining percentage with pref-equity or mezz debt. You’ve got development, which is kind of the highest risk. You’ve got value add where you acquire property and you make substantial changes to the property to improve the operations. And then you have core and core plus, which are kind of more stabilized, properties that may require, you know, less, less capital. And so those tend to be kind of the different, investment types within, within real estate.

Danny Quinn: The other dynamic at play is we’ve seen lenders become more conservative in their underwriting, whether they’re originating a new loan or refinancing an existing. And so where previously, you know, using round numbers, that $100 million property with a $60 million loan at 60% loan to value, you know, lenders have backed up a little bit. And where previously they were maybe offering 60 million in proceeds, they’re now only willing to refinance at $50 million of proceeds. And so, you know, again, just a hypothetical example using round numbers. But that $10 million gap in the equity, in the capital stack is an area where, you know, we’re seeing attractive investment opportunities to provide capital, usually with some sort of structure. You know, we tend to be more in the preferred equity or mezzanine debt space. But, yeah, we find those, those returns pretty compelling for, for the risks.

Josh Rubin: Great. Let’s kind of walk through the mix of these, elements because I think, again, everybody’s sort of familiar with a Triple-A investment grade bond or down to a triple B investment grade bond and high yield and so on. So, first and these are sort of generalization, but let’s say we continue living in the world of a ten-year treasury of around 4%. Ballparking it, you know, accepting, real estate, local, sort of a ballparking it. How would you think about kind of, whether it’s a cap rate or different valuation metric on a Triple-A asset, compared to something that needs some, some improvement after it’s purchased. Compared to, you know, just walking up the, up to development, but kind of everything, you know, the 3 or 4 major categories from a perfect asset, to taking development risk. What’s the return differential in a 4% interest rate world?

Danny Quinn: A lot of transactions that we’re seeing today, tend to be, properties that are being acquired, where the going in yields on the property is lower than the interest rate, to marginally higher. So, call that, you know, if the ten-year Treasury today is call it 4.2%. You know, using a multifamily example where you have access to agency debt, let’s assume that the spread on that debt is about 100 basis points. So, you’re talking about a loan at 5.2%. We’re seeing transactions anywhere from kind of what we would call a going cap rate of 4.75 to 5.5. And so and that would be for a core asset, again, you know, fully stabilized on occupancy, you know, relatively healthy rental rates, which, which is why you have access to an agency loan there as opposed to another debt source. You know, in that type of world, you know, we would underwrite our assumptions largely hinge on what you’re assuming for an exit cap rate. And as properties age and require, you know, larger capital outlays just to maintain the quality of the asset and, you know, replace expensive things like roofs and so on and so forth. We are always underwriting cap rate expansion to, you know, accommodate the, the, the added risk and added age to the asset. And so, we’re talking probably high single digits, IRR for that type of investment.

David Bennett: Yeah. In a typical environment, as you go further out the risk spectrum, you, you’d see that cap rate or that spread to the Treasury, increase. I think that’s broken down a little bit in the current environment, particularly if you’re getting into development and looking at yield on cost. Where, you know, you’ve had significant run ups and the cost to develop property. And you haven’t necessarily seen the sort of rent growth that kind of supports that new development. So that’s, that’s something that’s, pretty interesting to look at and, I think one of the reasons that a lot of groups, particularly that are active on the multifamily side, believe that you’re going to see increased rent growth in a couple of years just because, the new supply, although there’s been a lot delivered, kind of through early 2026, where we’re sitting here today. There’s not a lot of new projects that are breaking ground today because of because of that reason.

Josh Rubin: David and Danny, thank you for providing an overview of the key moving pieces in real estate, as well as the broad overview of the asset class. In our next episode, we’re going to go deeper into elements of real estate transactions, along with competitive advantages such as AI in the industry and how tariffs could play a role in this sector moving forward.

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