Prudential’s David Durning Talks Lending Opportunities

Mr. Durning: We’re definitely feeling the volatility in the market, and we’re feeling that impact in our interactions with borrowers and also in our own CMBS activities. In that sense, the year that has passed so far has certainly been impacted by that. All that said, [when you look back at any year], there’s usually a quarter in the year where there’s some weather in the market, and that impacts what’s happening along the way, and industry expectations for CMBS are down for the year. I don’t have any reason to pull away from the idea that our appetite is $15 billion, and that our expectation is that we’ll fill that appetite. That view may change over the summer if the volatility and other factors persist.

The natural segue [here] is just that the part of the reason why we have a diverse platform is that investors react differently to different market environments. At least in the near term, some of the uncertainty about CMBS has resulted in benefits to us and other life insurance company lenders. [This] is why there have been some large transactions that certainly CMBS would have been an option or a much more strongly considered option, but instead borrowers were electing work with life insurance companies. Even some of the larger companies, it’s just their planning exercise. They’re aware of what’s happening in the world, they’re looking at where interest rates are in general—which are lower than they expected during the first part of the year—and therefore saying this is a smart time to transact if I can.

The largest and most high-quality regional mall is [also] probably a space where there’s a bit of a window of an opportunity for portfolio lenders now on those properties as CMBS is working through some of its issues.

Beyond picking up where CMBS cannot, where are you seeing the most opportunity?

Real estate fundamentals remain strong. There’s been more penetration from the growth in the economy that’s moved beyond the major markets into markets that are less primary. It is driven still strongly by larger transactions, portfolio transactions and we are continuing to work with borrowers who are active on a global scale. And frankly, we’ve still been active in the multifamily space with the agency business.

We’re seeing the strongest demand ever in our enhanced agency gateway program [EAGP]. There are two aspects to it: one where we make equity investments with real estate funds—it’s part of a larger relationship that we develop with them on the lending side—and the other part of the relationship is where we will finance properties that are targeted for a future agency permanent execution, but the property may need renovations or upgrades.

So those are bridge loans?

Yes. [They’re] not a stabilized properties [yet]. Our portfolio has really grown well there. We’ve probably had the busiest six months that we’ve ever had in that program.

Does that program have a focus on affordable housing?

I think there’s affordable with maybe a small “a” and a big “A”. What the agencies are really focused on is affordability, the big “A,” which is defined by certain area median incomes. But I think more broadly what their mission is is serving workforce housing. That’s something that specifically we finance in our agency gateway program. It’s possible that we might do a more high-end project, but a lot of these are unstabilized projects that are taking place. An example of a transaction is a property in the southeast that is sort of 1990s-vintage that will need about 10,000 units of upgrades with all new appliances and the kitchens redone, all the siding has to be redone, roofs have to be redone. But even today it’s 90 percent occupied, so there’ll be some increase in rents that will come from the fact that it’s going to be a higher quality property once it’s been renovated, but it’ll still be catering to a market with rents that are affordable for regular Americans.

Will PMCC be more active on a global scale this year?

On one hand, we’re building out our infrastructure so that we have the ability to invest more broadly, globally. We’ve already done transactions in virtually all of the major markets in Europe, but there are some of the smaller markets, like the Nordics and other places, where we need to do our spadework and we would anticipate having a broader footprint. And again, the strategy there is to serve borrowers who are involved in Pan-European investment strategies, and who may have a bulk of their portfolio in the U.K. or in Germany but they may have a project that’s in Stockholm, or they may have something in Belgium or even in Dublin. It’s almost a little bit of housekeeping in rounding out what we have.

What else will dictate your activity abroad?

From a market-timing base, we do get impacted by what’s happening in the currency markets and the swap markets. As it turns out right now, our ability to lend can be impacted in places on the continent. We are probably more competitive in the U.S. than we are in the U.K. That doesn’t mean we don’t like the U.K. We have some investor funds in native currency in the U.K., and in other cases we’re swapping dollars, so that has an impact. If I had to guess, I think it’s going to be a challenge to replicate the international volume that we had last year because of those market factors.

As far as the properties you have been lending on in other countries, what types of assets are they?

We’ve actually had more diversity in what we’ve lent on internationally than maybe I would have expected. In London, [we’ve done] large core office buildings. We’ve actually found that residential doesn’t exist in the same way in Europe as an investment type in any kind of scale. As a proxy for that we’ve done student housing finance and logistics, industrial buildings. In Australia we’ve done a student-housing deal; we’ve done self-storage transactions in Europe and Japan. A big part of our lending activity in Japan has been residential, so that is a market we continue to focus on. Japan would remind you more of like a New York. They’re smaller units, but it’s more regular multifamily.

In general, a place where we do less—and it’s harder to find—is retail. We have done some, but a lot of what we do in retail domestically is regional shopping centers and neighborhood centers that are grocery-anchored and the like. That is not what we see as much in international markets. It’s more high-street retail, which can have some attractive parts to it, but it’s not something we know as well.

As far as retail goes domestically, we are seeing so many issues with big-box store closures. Are you seeing retail across the board in the U.S. as less attractive now?

We’re being more selective. We’re very careful in the places we invest in, which is why we are much less likely to invest in what people have called power centers or lifestyle centers or big-box centers. We just haven’t seen the performance there to be as strong as what we’ve seen in the regional shopping centers.

The other thing is it’s very operator and owner dependent. We have relationships with firms where we will finance pools of retail assets, so you get the diversity of these different property types, and you’re able to in some cases smooth out the risk associated with an individual center where the volatiles might be higher along the way.  

The challenge of big-box retailers is internet-driven. The penetration of the internet and people’s shopping patterns is more profound than people expected. On the logistics side, and I’d say the latest move is this move toward same-day delivery, has had an impact on the market. I can’t say that we’ve done as much of that as some others. Part of it is our own concerns about a rapidly changing sector, and in some cases, there are very, very large logistics building, and it might be outside the generic scope.

With our apartment owners, whether it’s Japan or the United States, they have adapted to having to service Amazon-type delivery customers where in some cases they have some really cool technology where the Amazon [delivery] person can come in, and there are these lockers, and they’ll put them in, and they’ll email you a code so you can get your stuff. It’s a labor issue that the apartment owners have to deal with. Now it’s part of their marketing pitch.

Where do you feel like we are in the real estate cycle?

People say innings…I would say we’re in between the sixth and seventh inning. Part of the nature of this recovery, and the fact that the Fed has not been able to sustain the raising of interest rates and to be able to get inflation at a place where they want to yet, is supportive of real estate and real estate values. Typically, when the Fed starts raising rates, somewhere between 18 and 24 months  later [there is] a downturn. But the consensus is there’s not going to be a [rate increase] in the first quarter. And with activities in the world today, I think that tends to lengthen the cycle. Some of the air has been let out of the balloon because of the turmoil in the capital markets, which I think will prevent a downturn even as the U.S. economy continues to strength. I still think we’re okay for another couple of years. I don’t see any major problems over the next 24 months.

The more broad point is that we’re well into the recovery, and job growth is persisting, so the fundamentals are still pretty strong. The market volatility I think has potentially halted the compression in cap rates and given investors pause in some of the valuations that they were seeing, but it’s not related to the cash flow of the properties. That ultimately is healthy for the market.

What’s the company’s focus on agricultural lending like?

Agriculture is a very important industry for the United States, and it’s one in which the federal government is highly involved. And historically, it’s been highly fragmented in its ownership. But the demand for agricultural products is as constant as people’s need to eat. You have a factor where there is a secular trend of a growing middle class across the world which is seeking a diet that has higher quality foods and more proteins. The United States is very well positioned from a competitive standpoint in the world to compete in the global economy for food. Within that context, the farm system is one that used to have a lot more volatility. Farmers have become a lot more conservative in terms of how they leverage themselves. There’s been more recent institutionalization of the space, and we participate in that as both an equity player and a lender, and we’ve had very strong performance in that sector. You can get yourself diversified. It’s not just apartment, retail, logistics, etc. It’s permanent planting and annual crops. And it’s permanent planting—that’s nuts and fruits. It’s various types of nuts along the way. It’s vineyards.

You can get pretty well diversified within the agricultural sector from both a lending and equity perspective across these different crop types and across those different markets. You try to immunize yourself from water risk or weather risk across the country. And because of the federal government, there are insurance programs and the like that help you minimize specific property risks in terms of what might happen if there was a blight on a particular crop or something like that.

You put that all together, and you have world demand for this underlying product, whether it’s corn or soybeans or fruit and nuts or wine, and you’ve got a need for capital, and you’ve got a user of capital who are people who are committed to the businesses that they’re in for long periods of time. For us it’s a growing sector that grows with worldwide demographic trends and fewer private investors are involved in it. In both debt and equity, it’s a place where we have the embedded expertise, and it creates barriers of entry for others to invest in the space in the same way.

Until the 1950s, we had more agricultural loans than we had commercial real estate loans.