Hunker Down: Industry Pros Talk Downturns and the Late-Cycle Search for Yield


If any of us could predict exactly when the next big dip in the market would occur, we’d likely be on a private island right now instead of sitting in our offices. 

Although some segments of the commercial real estate market are undoubtedly already experiencing a correction of sorts, when we might feel a more ominous tremor — and what its source will be — is up for debate. Panelists at Commercial Observer’s Second Annual Fall Financing Commercial Real Estate Forum in Los Angeles last week happily exchanged views on that very matter in a discussion moderated by Paul Brindley, a senior managing director and L.A. office co-head at JLL (JLL)

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“PIMCO often publishes forecasts about recession risk and we put out a report that said there’s a 30 percent chance of a recession in the next five years — which basically was our way of saying that we don’t really know,” John Lee, an executive vice president and portfolio manager at PIMCO, said with a laugh. “We recognize that we’re late cycle, but we as an industry have collectively been saying that for four years now, and it’s unclear what will trigger a downturn of any kind.” 

“I think there’s a recession out there,” Lee continued. “It’s difficult to say exactly when it might happen, but it definitely impacts how we think about allocating capital on both the equity and debt sides.” 

As an investor in the residential sector, the corporate lending space and in commercial real estate, Annaly Capital Management is the recipient of numerous data points across various segments of the market, said David Sotolov, a managing director at the firm. While that information may help to inform Annaly’s view, “holistically it’s very difficult to lump everything together and say ‘This is where we are in the cycle.’” 

After all, fundamentals remain pretty strong on the commercial real estate side, and “gateway markets and major markets still feel they have a lot of tailwinds and a long runway still in front of us,” Sotolov said. “So, this late in the cycle it’s really got to be a market-by-market and submarket-by-submarket analysis.” 

In addition to primary markets, Annaly has extended its focus to secondary markets with good growth prospects combined with limited new supply, including Spokane, Wash., and Santa Maria, Calif. “While we love to be in the gateway markets, the spreads have compressed to a point where you’re not making any yield,” Sotolov said.

New York-based Monticello Asset Management recently opened a West Coast office in Westlake Village. Matt Downs, a managing director at the firm, said he’s looking to the ghosts of cycles past for reassurance that — for now, at least — we’re still in a pretty good spot. 

“Where we are right now is a product of what we’ve learned from our mistakes and from other people’s mistakes,” he said. “We’re all kind of waiting for something to happen, but I think we’ve shown that we’ve learned how to correctly underwrite deals and that’s why certain scenarios haven’t happened. From a lending perspective, we’re really sticking to the fundamentals and that’s what we learned 10 years ago.” 

Monticello plays in the $10 million to $250 million loan space, leveraging its health care group to find lending opportunities with the aging population in addition to affordable housing. Downs agreed with Sotolov that the submarkets are where yield is found today.

“I think the first thing we’ll see is a corporate recession, but I also think the next corporate recession isn’t going to impact real estate as significantly as the last one did,” Nik Chillar, principal of Belgravia Capital Management, said. “This time we’ve been good about holding the line in terms of underwriting. There’s more equity in transactions and I think that will keep things balanced and help real estate operators when they need to deal with situations where rents are declining or there’s some stress at the property.” 

Echoing previous panelist sentiments, Chillar spoke to the lure of secondary markets.

“In primary markets we see a lot of competition and we don’t see the kind of yields we’d like to see as lenders, exaggerated by the declining rate environment.,” he said. “We think the appreciation of real estate in secondary and tertiary markets leads to better investment opportunities as a lender today.” As such, “we find ourselves doing something a little contrarian, which is shifting into smaller markets later in the cycle where we think we have better control and a better understanding of the economics around the real estate,” he continued, pointing to the key factor being local economic drivers that will remain stable throughout a recession. 

Lee said he is seeing attractive growth across a number of markets right now but, “if I were to generalize, I’d say we’re constructive on the California market because of all the high-quality job growth.”

With both debt and equity funds under its belt, PIMCO is “cognizant of where debt structures are going on the equity side and we try to use our market knowledge to our advantage,” Lee said.  

PIMCO is, however, exercising caution on the equity side when it comes to taking any near-term rollover risk on office assets, and being doubly cautious when it comes to hospitality assets.

“[We’re steering clear of] anything that you can get stuck with an exposure to daily mark-to-market or where you’re trying to exactly time when there’s a recession,” he said. “We’re seeing that across the board, not just with ourselves on the buy side, but when we’re selling assets we see there’s a general caution on the equity side.”

But, putting the lender hat on, that situation presents an opportunity: “If I have a great sponsor with a great balance sheet and liquidity and they’re willing to take that rollover risk then I can [work out a deal] with them where I can get incremental pricing and structure.” 

Every cloud!