← Grant's Current Yield Podcast
Grant's Current Yield Podcast
THE NEXT MELTDOWN
00:29:11
With special guest Richard Byrne, president of Benefit Street Partners.
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- [00:00]
A
Foreign welcome to Current Yield, Grant's interest rate observer of the air. I am Jim Grant and with me as always, is the great deputy editor of Grants, Evan Lorenz. Hey, Evan.
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B
Good afternoon, Jim.
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A
And Harrison Wadil, who was in charge of everything in this office and is now also a sound engineer. So Harrison, thank you for doing that. And we have sitting to my left, as you can see, ladies and gentlemen, Richard Byrne, who is the president of Benefit Street Partners. We'll be talking to him in a moment. But before we do, Evan, I, I know I have noticed something strange ever since Donald Trump became not only the, the evident Republican nominee, but also now I guess again, a little opinion of the market. The presumptive President of the United States in a few months time. That seems to be at least today's consensus. Arguable to be sure, but it seems to be. Anyway. Doesn't it strike you that the vix has suddenly become lively, volatility is being.
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B
Reintroduced to the markets. The other weird thing is small caps are finally getting some love after years of being left out in the pasture?
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A
Yeah, they are. Well, I would say that Donald Trump is the avatar of volatility and that we are in for a great few years of journalism come what may. So I'm grateful for many things and not least journalism. Richard Byrne, it's important that you have something to write about. There's nothing worse than serenity. So I think we are, we're in good shape with him. So I've, I've just said hello to Richard, but I'm now going to introduce him in a proper fashion. He is the president of Benefit Street Partners. He has an authority on credit. Benefit Street Partners is a leading credit focused alternative asset manager. Has 76 billion or so under its wing, which sounds like a lot of money even when you say it fast, but it is as next to, to nothing compared to the 1.6 trillion that Franklin Resources Inc. Looks after. Franklin Resources being the owner of the wholly owned Benefit Partners and none of this matters compared to the 10 trillion that Larry Fink has.
- [02:16]
B
Personally, I think that's what he loses in the couch cushions each morning.
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A
Anyway, all these things are, my goodness, I am so old. I remember when a million dollars was like something. In fact $1,000 was, was. You wouldn't not bend over to pick it up on the sidewalk.
- [02:32]
B
I remember the progression of the financial crisis. First losing a couple hundred million dollars was enough to send banks down. Then a couple billion dollars and then if it was less than 10 billion, the bank stocks didn't Even react well.
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A
Richard Byrne, you have been a veteran of all these credit incidents and cycles. I mean, you were the president of Deutsche bank securities and you were at the top of the heap of leverage credit as the late lamented Merrill lynch now absorbed into B of A. And I have seen a cycle or two. Could we begin, Richard, by telling the listeners, and if there are any viewers, I don't know any viewers, at least.
- [03:07]
B
A few in this room, what is.
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A
A credit cycle to begin with? And where are we in this one?
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C
So, Jim, first of all, it's great to be here and see all of you this afternoon. Yes, we've definitely been through a lot of credit cycles. So certainly I have almost 40 years for myself of sort of watching things go up and go down. I don't think a credit cycle is any different than a market cycle. Um, you know, it's usually they give that metaphor of the boxer. The punch he didn't see is usually the one that knocks you out. And I dare say we used to do something with our clients. Maybe I'm getting too far off your question, but we used to do something with our clients back in the day. We'd host these events and we'd go around the table with some of the biggest portfolio managers in the world and we'd ask them for their predictions, tell us what's going to cause the next meltdown, and they inevitably all are convinced there's going to be a meltdown or something, and they'll give the answer. And it's usually the thing in front of their nose. It's the dot com, you know, it's whatever's, you know, in the news that day. And it's always something else, it's always something different. I don't think anybody saw Covid, that's for sure. The dot com bubble, you know, I mean, there weren't that many clairvoyant people around that certainly the global financial crisis, I mean, people talking about leverage. But there's only a handful of people, I think, that are documented to have sort of foreseen that. We've been through a lot and they're all different.
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B
I remember a certain former central banker who said that subprime was contained just as it was blowing up.
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A
Yeah, well, okay, Richard, you're not going to tell us what a credit cycle is, but I'll ask you this. What is the thing now? Now be careful. Don't tell us the thing that it's not.
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C
Yes, exactly. The thing it is now is commercial real estate.
- [04:58]
A
Everyone knows that.
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C
Yeah, but it's the story is so much deeper than the story that's being told. Well, first thing that happened to commercial real estate was interest rates. That's not dramatic, that's not a new story. Interest rates affected every asset class. Real estate's though, a somewhat easy, simpler asset class to understand. Rates go up, cap rates go up, values go down. How does real estate fit valued on the cash flow it produces? Right. So unless your rent roll and whatever you do, you're a multifamily or a hotel or whatever, unless your rent roll changed dramatically, which it generally didn't, then if your costs doubled or tripled because rates went up, then your property is worth less. And the amount that real estate is worth less doesn't matter what you are, what type of property you are, your, your base is down something like 20 to 25% just mathematically from how much interest rates went up. So that was sort of the blow. But, you know, I gave a boxing analogy before. Maybe I'll continue with that. That's sort of, that's only the jab. The cross that, you know, potentially knocks you out, though, is the office sector. Again, you're going to say, what's new? Not new, but office is a bigger problem than I think people are letting on that people kind of realize why. Because many of the people that get on TV or get written about that talk about office are generally the experts on office, which are the people that are long office. So they're trying to tell a more bullish story. And certainly there are more bullish sectors of the office sector than others. But as a general rule, an office property, I said any property is already down 20, 25%. Office is gonna, that's the starting point. Some will be generally fine class A office in big cities, and some will not be urban class B class C stuff, I mean, a lot of that stuff is parking lots. So if you think about your average office valuation, some will be down, you know, best case down 20, 25, some zeros, you know, it's down 50 or more on average, you know, depending on who you were and what kind of underwriter we are. The problem is though, that anybody who's in the commercial real estate business, we're in the lending part of that business. So any commercial real estate lender, it's almost impossible to not have exposure to office. And it's, you know, if you're a bank, it's probably about 25% of your commercial real estate lending book. 25%. So put a 50 or 40 on 25% of your portfolio and the rest of it's down also, hopefully not down more than the LTV margin for area had in the beginning. But anyway, I don't want to go too deep into the story, but that's what's going on. And add to that two other things that are like the nitroglycerin that makes it even worse. One is the maturity schedule. There's about a trillion 7 of real estate loans maturing over the next two years. Two years. And add to that that real estate investors, I always think of, whether you're the equity investor or the lender, they have one thing in common. If you do real estate, you love leverage. They have what they call, you know, alligator arms. They, their arms can't reach their wallets. They don't like to put their own money into deals. So, you know, almost everybody with exposure to real estate, all this office stuff, is doing it on a lot of leverage, which worked great. Well, everything went up for the longest time and money was free. But you know, now is sort of the reckoning for that, especially with the maturities.
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B
You've written recently that of that $1.7 trillion of commercial state real estate debt that's coming due over the next three years, that this is the single best opportunity for savvy investors out there, that it beats equity returns, that it beats returns you could find in private credit and other corners of the market. What does that opportunity look like and how big is that subset that's offering this attractive return? Is it distressed investing? Is it refinancing good properties that are doing okay? Could you give us a sense of flavor of where the opportunities lie?
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C
Sure. Well, I painted a picture that can't sound at all bullish. Right. Everything I described, it sounds horrible.
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B
So.
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C
But I think it's a double edged sword. So for a legacy book, for an existing bank or an existing private real estate lending fund, or for a commercial mortgage reit, it's not great. I mean the average office exposure is 25% and they're going to have to work through problems for, for a while until that stuff's fixed. Where the opportunity though is to your question is new money, fresh capital that goes, you know, up the fire escape when the fire is happening. Not, you know, not running for the doors because things are cheap. So I think there's a couple of places, I think there's three, but I'll save the best for. Last one is buying distress assets when people need rescue, you know, rescue financing or banks, as you know, the great trade, we always wait for On Wall street is when banks, they call it puke. Horrible word. But when banks, you know, regurgitate assets and unfortunately that doesn't happen with any predictability, any frequency, or sometimes not at all. But certainly being the opportunity to buy assets cheap that banks, you know, just can't afford to keep on their books. The other opportunity is providing gap financing, you know, being that mezz layer or something that helps somebody refinance their loan. Another is maybe buying equity of commercial mortgage REITs. Their average commercial mortgage REIT trades at under 70% percent of book value. So something, there's some disconnect there where we think the best opportunity is by far may not have the highest, you know, beta attached to it or highest return potential attached to it, but it is just making loans. It's what we've always done. It's what, you know, some of the best people in the world have done, but they got caught with their pants down. Anybody with office exposure that was historically making loans like the banks isn't making loans at the moment. There's been six consecutive quarters where 90% of the publicly traded commercial mortgage REIT sector hasn't made a single loan. And why? Because when you have losses in your book. Here's how I would say it. If somebody administered sodium pental True Serum to all of the lenders of real estate, especially the banks, and said, listen, here's your quarter, let's kitchen sink it. Why don't you mark all of your loans down to what they're really worth and then you'll have the greatest story going forward. Everything will be upside from there. Let's just get this interest rate cycle office sector problem off of our plates and let's start afresh. I think people would love to do that. The problem is that nobody has a big enough equity base to handle that. And as a result, what they're doing is they're hoarding cash. They're not making new loans. In some cases they're selling existing loans. You know, dividends in some cases are being cut. You know what banks are doing? I'm not exactly sure. One of the problems that banks has, 70% of the real estate loans held on banks is by small regional banks. It's not by the JP Morgans. They don't necessarily have the biggest diversified business models to get them out of this mess. So anyway, back to the point is, where's the opportunity? There's a light supply of new deals because, you know, M and A activity and building activity is low at the moment because rates are higher. But there's nobody lending. We're getting invited into rooms these days that we never were invited to for really nice deals.
- [12:21]
A
It's come to that.
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C
Yes.
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B
So what are the yields that you're getting offered on these first lien performing just run of the mill kind of deals that normally would go to banks?
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C
It depends on the flavor. Most what we're circling around is multifamily great fundamentals behind think of SOFR300, you know, I mean we've sort of translate this.
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A
So this is the secured overnight lending rate which is now at about 5%, 5 plus plus or 8%. You're looking at.
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C
Yeah, something around that with some upfront fees, some back end fees. So you know, we're looking at high single digit unlevered returns with a little leverage.
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A
Can the borrowers afford that?
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C
Well, this is what's happening. The the world has repriced. So think of it this way. If you made a loan in 2021, money was really cheap back in 2021, you probably did it and the lender, you know, provided financing for you, let's say at a 65, 70% LTV. So you bought a property, just easy number for $100 million. You know, you, you put down 30, 35 and the lender gave you the rest. That property as I described before, assuming it's performing on average is down 20, 25%. So the new loans we're making are only valuing that property at $75 million. Right. So even though the rate is higher, you know, the interest burden hasn't really changed. It just requires either a lower purchase price or more equity.
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B
Interest rates aren't the only expense that have been rising the last three or four years. Buildings, especially multifamily in Florida, Texas and California have had huge increases in insurance costs. You've had increase in maintenance, you've had increase in tenant improvements, whether those are rehabbing an apartment when a new person moves in, or offering a refresh of a floor plate for a new retailer or office. How have the other expenses that have risen in the last couple of years also impacted this equation?
- [14:18]
C
Yeah, you're absolutely right. So Sunbelt is the sort of, I think if there was ever an obvious investment thesis, it's you know, if you want to build or buy something, you know, for people to live, you want to build it where people are migrating to where people want to live. And that's generally think of Sunbelt, Texas, Florida, you know, the Carolinas, Georgia. And you're absolutely right. You know, certainly insurance costs have risen a Lot of the other opex has, has risen. I'll tell you the other thing that's gone on as well is there's been a lot of, again, cheap money tends to, to create a lot of new supply. So a lot of people put shovels in the ground in 2021 to build new buildings. A lot of those have either come on very recently or are due to come on. So there's pressure on rents at the same time expenses are going higher. So you heard me say before, very bullish on multifamily. How could that be? Right? So I think it goes back to using a lot of trite analogies or metaphors. But you know, what Wayne Gretzky used to say, say with, you know, not where the puck is, but where it's going. Even though, you know, all those new shovels went in the ground in 2021, when rates started going up in mid 2022, nothing has happened since. So if you look at the forward calendar, after the next few quarters of when the rest of the properties come on market, there's nothing, nothing, zero slated in most of these markets. So I think that'll take a lot of pressure off rents and I think rents are going to start rising pretty, pretty quickly to offset some of these higher expenses. But the bigger story for multifamily though is people need a place to live. So we're talking about pretty simple concepts to get behind. That's pretty simple concept. Right. And there's an undersupply of single family homes in the country. There was before COVID there is now. But even for those people that managed to squirrel away the money for their nest egg to buy that house, the mortgage payments just doubled or tripled. So, you know, it's now out of reach again. And what's your alternative, other than being homeless or living with mom and dad is to, is to rent. So I think that story is still very attractive. And the last reason is Freddie, Freddie Mac and Fannie Mae have not, you know, those are, that's the government's initiative to maintain liquidity in the, in the, in the home sector. And in our case multifamily, they've never stopped lending. So every time we have a lender that can't pay or we put a property on the market or maybe they wave in the towel and they sell it, there's a line of bidders for multifamily products. So there's liquidity in that part of the market to buy properties that I'm not sure exist, certainly doesn't exist in the office sector.
- [16:55]
A
Rich, please address this answer to the individual investors who might be listening. There are a lot of real estate investors, investment trusts out there. There are a lot of businesses that offer real estate funds. I'm thinking now, for example, of Blackstone's B reit, the publicly listed real estate investment trust, are selling at a deep discount from par value, the B REITs of the world or not. How should an investor, an individual, say, who is interested in yield? How does he or she navigate these complex rapids?
- [17:25]
C
Sure. First of all, we specialize, Jim, in credit. So, you know, that's our area of expertise. I think to be a credit investor, you kind of really have to understand the property investing or the equity side of the equation as well. So with that lens, Let me, let me try to answer your question. Real estate funds, whether they're REITs, like B REIT or any others, are likely to have seen declines if they're publicly traded, in some cases even more so because of the market volatility to any movement in their, in their, in their asset value. As I mentioned, the commercial mortgage REITs are trading 30% below what their valuations say. So, I mean, so the market has, you know, needs to put their stamp on what, what, where they think asset values are. And as I said, because of interest rates, assets are down before you even look at whether you own office, whether you own hotels, whether you own real estate, whether you own industrial, whether you own retail. The market's down 20, 20, 25% just because of rates. So some people look at that and say, wow, there's a 25% off sale. This is a great time to be maybe doubling down those investments. Or some people might say, hey, look, stuff's down 25%. I don't want to sell it. Now I have the upside. I think, I think that has more to do with our rate forecast. I'm personally not in the business. I've been wrong more times than I've been right on forecasting rates. But that's. I think there's more efficient ways to express your rate bets than buying real estate. But it certainly has got a high correlation. The way we've thought about it is even at the current value, I'm talking about not office, but a good multifamily property and some really good market sector, new vintage, you know, class A or, you know, worst case, you know, strong class B. If you, if the question is, do you want to lend it money or do you want to buy the property? The part I don't get or we don't get is why, you know, why there's so much liquidity in multifamily prices are down, but that's only. But there's a reason that prices are down. I think, you know, equity investors generally look for, you know, generally if you have a horizon of 15, 20 years, I think it's a great bet. But you're really not realizing a lot of that bet. In the near term, you know, your investment yield is quite low. Whereas the example I gave you earlier, we're generating unlevered high single digit return on current income on a loan. And I don't know if you'd consider this good or bad, but most funds use some external leverage. If you, if you use two turns of leverage on your fund, you're turning that into a teens return on a leverage basis. So I guess my answer would be most real estate you could buy in the public domain is property, is equity not lending. I think that's in the eye of the beholder. And if you're a long term investor it's probably a really good bet because prices are down. But to me the easier story to understand where there aren't that many investment choices is on the lending side. Because you're generating your return as current income, you don't have to bet on anything good happening.
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B
So you've pointed out that commercial real estate is distressed. Where are we in the distress cycle? Because you're saying so far the opportunity is primarily on new loans. How far have banks taken their marks on loans and how far is that asked relative to the bid that you'd be willing to put up for one of those loans? How far do banks need to continue, continue to accrue reserves, to write down these loans, to actually begin clearing away the backlog.
- [21:06]
C
So I think to think about timing you need to think about the two things that happened. One is interest rates. Again that's a rate forecast. If rates go down a lot then that'll accelerate. If they go up, that makes it worse. But office is going to be the 9010 rule here. The timing will be determined by is this, you know, when is the office sector right itself? And our answer is three or four to five years from now. It's going to take time. Why? First of all, rent rolls. You know, your average tenant in a building doesn't have a year to year lease. It takes time. So the world has changed. I don't need to retell the story but Covid has, you know, created a different work paradigm. There's, as a result, there's more office space than there are people that want to go to or firms that want to have people in their offices. Right. So there has to be a supply demand, you know, change it. Things have to balance themselves out. How does that going to happen? If put yourself in the shoes of a commercial office landlord today you want to either A keep tenants in your building or B for the ones that leave, you've got to refill that. That's a really tough dilemma for you because the TI packages that you're looking at now as a landlord are incredibly, I mean they're almost insulting. I mean you're literally subsidizing a tenant for three years just so they can be your tenant and then maybe you can start making money on the back end of that. But it's a prisoner's dilemma because if you, you don't do it, a lot of people don't even have a choice to do it because they don't have the capital. But if you don't do it then your building might end up being empty. And once the building gets a little bit more than half empty, it kind of, we see where that, you know, where its fate lies and it's generally not, not a good, good answer. So what the well capitalized property owners are doing are they're subsidizing just to do whatever they can to keep buildings full.
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A
Actually let me in interrupt if I may to ask on behalf of those listeners who like the sound of an unleveraged 8% relatively secure yield. Where does that individual go to get that?
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C
I think you go to, you want to invest in a new money lending portfolio because otherwise you're really going to have to do your homework and you're going to have to figure out what's broken in all the existing pools of lending portfolio. You want a new book that is putting out money today where you're lending to good properties at 75% of the value you were lending to when you were lending in 2021.
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A
What's the ticker symbol of that new money lender? Why don't you start one?
- [23:55]
C
We're working on it.
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A
Come on.
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C
Yep, we'll put that in the to be continued column.
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B
Rich recessions are usually credit negative after all revenues go down and borrowers default. Could a recession actually be good for office? And the reason I ask is part of the reason why work for home has taken off so much is during the tight labor market, employees had a lot of bargaining power and many of them wanted to work from home. A lot of businesses would prefer to have employees in the office to be more productive in a recession, labor loses some of that bargaining power, employers gain some of it. We could actually see office hours, attendance actually increase. Would recession be good for office for those reasons?
- [24:33]
C
It may not be bad. The other reason I actually think there's another reason why it might actually be good for office because it would just accelerate that three to five year ticking clock. It just takes too long for supply to meet demand. So what's going to happen is the landlords that can't keep their buildings full, those buildings will close eventually. Nobody's building any new office construction, by the way, nobody's lending. So even if there was somebody that thought it was an attractive opportunity to build office capacity, now nobody's lending the money. So they're going to have to do it probably 100% with equity. So eventually the office coming off the market plus the no new office to replace it is going to connect supply with demand and that's what it's going to be. And the other reason that it's going to take so long is because lenders that sodium pentothal example I gave you before, not only are they're just stretching this out, there's a PhD course one can theoretically enroll in in bank accounting, in fund accounting around when do you have to realize a loss if you have a securitization? When exactly do you have to get a new appraisal on a bilateral bank facility? When do you. What is the trigger that defines impairment?
- [25:49]
A
I think later is the answer.
- [25:51]
C
Yes, the answer is later.
- [25:53]
A
Let me ask you this in conclusion. I would like to know your opinion on how the real estate situation that you have described how this bears on the banking system, in particularly on the regional banking system and still more exactly on the likelihood of a replay of the regional banking difficulties of a year ago or a little more than a year ago now. Are we going to see a reprise?
- [26:17]
C
Jim, that's a great question. I'll start with. I'm not a bank expert, but 50% of the commercial real estate loans were made by banks about, by our estimate about 20 to 25, maybe closer to 25% of those loans are office loans. Banks also generally lend the regional banks lending in their geographies. And a lot of those are, you know, suburban regional. And that's not necessarily that, that's sort of adverse selection within that pool of office. So there's going to be losses for sure. The question is how long can they stretch things out and how, how much can they cover the funding gaps with, you know, with their Shareholder bases, and I'm not sure what I said earlier is 70% of these, of that 50%. So about a third of all the commercial real estate loans out there are by small regional banks. They're not the big banks that have the diversified business models that can kind of, oh, we lost money here. But look at all these other places where, you know, we, we can make that up. They don't necessarily have that. So they're going to be hurting for a while from this real estate exposure.
- [27:22]
B
What happens to this great hoard of office buildings that will never be occupied because we have all way more office supply than there is demand for, at least at the current levels. And eventually these buildings are going to be emptied out. They already are upside down in terms of like loan to value. What happens to them eventually?
- [27:38]
C
Parks, parking lots. You know, everybody was so bullish for a time on the, you know, turning an office building into a condo or some kind of multifamily. They did that very successfully down on Wall street. Down here, as you know, that's very expensive. I mean, think of that as the ti. As a TI package you're basically investing for, you know, that requires a lot of capital. So I think office will be a really attractive investment in a couple of years for, well, capitalized buyers that have the wherewithal to do things like that, to turn these properties into something else or, or just turn a class B into a class A. I think, I think that's the, the opportunity. It just seems too early right now.
- [28:22]
A
So. Richard Byrne, what a pleasure it has been to have you here. And I, and Evan and I are well aware of your formidable skills both as a runner and as a, as a martial artist. And we are properly grateful that you made no threatening gestures to us during this friendly interview. So thank you for being here. Richard Byrne, president of Benefit Street Partners, and we'll talk again soon, I hope, on behalf of grants and current yield, ladies and gentlemen, thank you for listening and we'll be back to you in a couple weeks.