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Outlining a “Defensively Nimble” CRE Investing Strategy with a Looming Recession

Principal Asset Management’s Indy Karlekar outlines the firm’s real estate investment strategies for 2023.

Institutional investors that have been tapping the brakes on deploying capital and rebalancing portfolios are now shifting their attention to how to navigate potential opportunities ahead. What sectors are likely to outperform amid expectations for higher interest rates, above-trend inflation, and an uncertain macroeconomic environment?

Tweaking strategies to generate yield is top-of-mind for institutions and their advisors. WMRE recently talked with Indy Karlekar, Principal Asset Management’s global head of real estate research and strategy, to discuss near-term opportunities and challenges impacting the U.S. commercial real estate (CRE) market, and how that’s likely to influence the firm’s investing strategies in 2023. Principal Asset Management currently works with more than 1,100 institutional clients in over 80 markets with roughly $98.5 billion in AUM.

This article has been edited for style, length and clarity.

WMRE: Where does Principal Asset Management invest within the CRE sector?

Indy Karlekar: We invest across all four quadrants of real estate—debt, equity, public and private—and we invest up and down the risk spectrum of core, core-plus, value-add and opportunistic. We do it through co-mingled funds, as well as separate accounts.

WMRE: A lot of institutional investors have pushed pause on new capital commitments in recent months. Are also pencils down across your different strategies and funds, or are you still deploying capital?

Indy Karlekar: We are fortunate because we invest across the four quadrants. So, we are always evaluating opportunities. As we look out over the next few months, we think it is a terrific time to be a lender. The debt markets are very conducive to providing solid returns from a lender’s perspective. We have been very active in the private real estate debt lending markets. We continue to see opportunities there, and we continue to make allocations to that space whether it is core mortgages, bridge lending, subordinate debt/mezzanine lending.

We continue to also invest from a debt and equity perspective into the alternative property types that have become increasingly more mainstream—data centers, single-family rentals, manufactured housing, etcetera. We think there are some interesting opportunities still available there, and we continue to put money to work, but we are very selective. We also are doing some selective development, whether it is industrial or residential. Even though the cost of capital has gone up, because of our ability to lock-in cheap capital, we are able to deliver development products to the market at higher cap rates and yields.

So, yes, we are able to put capital to work, but tilted more heavily to the debt side of the house and tilted very specifically to certain opportunities on the equity side, such as data centers and alternative property types.

WMRE: Looking at your equity strategies first. How has that strategy changed or shifted in the last 12 months?

Indy Karlekar: We’ve really taken the view over the last 12 months, even longer, that the core markets were something that were not of great interest to us given where values and capitalization rates had gone. We were not really active participants in core markets on the equity side of the house. We were doing primarily ground-up development in industrial and residential. That has continued, but on a more selective basis.

Where we focus a lot of our attention on the equity side is on the niche properties. We have started to allocate more capital towards data centers, manufactured housing, single-family rentals and self-storage. That has been a pretty significant shift within our equity strategy as we’ve really embraced the niche property types within our equity portfolios. We have stayed away from investing in core strategies as much as possible, because we remain of the view that core values are probably where the most challenges are going to come in the next 12 to 18 months because of higher cost of debt and the slowing economy, i.e. that’s where we believe repricing risk is the greatest.

WMRE: Everyone is focused on the Sun Belt these days. Are you focused on any particular geographic markets in the U.S.?

Indy Karlekar: We actually have a thematic strategy that we’ve been putting in place and investing alongside for the last four or five years. It identifies four or five key structural drivers of growth in the U.S. around the thematics of demographics, innovation, technology and globalization-led industries. We call this our “digital playbook.” We believe that any market that has some exposure to one of these thematics benefits the properties and markets around them.

Some of that framework has been found in the Sun Belt, because they have really good demographics and pretty good job growth in the more value-added parts of the industry, but it doesn’t preclude us from investing in the traditional powerhouses like San Francisco or New York given some of the elements of digital that exist there. We continue to see opportunities around the Bay Area, for example, and San Diego for life sciences and manufactured housing. We think this thematic strategy will continue to pay dividends for us over the long run.

WMRE: Do you have any examples of a new development project that might highlight that strategy?

Indy Karlekar: We are doing a life science conversion from an office building in the Bay Area, which we think is already attracting a significant amount of tenant interest from existing companies in the Bay Area. We are doing a fair number of manufactured housing projects in some of the Sun Belt markets that are working very well for us. We’re also doing a significant number of data center investments in some of these Sun Belt markets like Atlanta, Phoenix and even Portland, Ore., where we have looked at and done some deals.

WMRE: What are some of the sectors that you are underweight in and moving out of these days? Is office on the top of that list?

Indy Karlekar: Very much so, but it’s important to stress that it’s more the traditional CBD office. The big towers in New York, San Francisco and L.A. are the ones that we are most cautious about. We still think there are some interesting opportunities in medical office, life sciences, lab spaces, etcetera. But generally speaking, it is the big traditional office block towers in the traditional large gateway markets that we’re underweight in our portfolio.

WMRE: Turning to your debt strategy, what types of debt are you providing and where are you most active?

Indy Karlekar: We have been investing in debt for the last 60 years, and we do everything. So, we are big participants in the core mortgage market. Obviously, that is a pretty crowded space with commercial banks. We’ve also done a lot of investment in the bridge lending space, including bridge light and bridge heavy. And in the structured debt space, the mezzanine subordinated space is something that we have focused a lot of attention on. We see a lot of value in the sub-debt mezzanine space, because the SOFR curve has steepened and the credit curve has steepened, and that is leading to some very attractive spreads. We invest up and down the capital stack, but for now, we really think the mezz debt and bridge space are quite interesting, but perhaps with a little more bias towards the mezz subordinate debt.

WMRE: There has been a lot of disruption, where are you seeing the most borrower demand for debt these days?

Indy Karlekar: We are seeing a lot of activity in the core property types—residential and industrial, and we’re seeing sponsors coming to us for debt even on some grocery-anchored retail. We’re also seeing sponsors coming to us for debt on manufactured housing and single-family rentals. I think the feeling in the market is that office, for the most part, is pretty tough to finance. Yes, we will take a look at a really well-leased office in a great market with high-credit quality tenants, but it would be low on the totem pole in terms of putting credit to work.

WMRE: Are borrowers looking to fill a particular part of the capital stack—construction, refi, senior debt, mezzanine, or perhaps all of the above?

Indy Karlekar: It’s all of the above. Sponsors are finding that being able to tap the commercial banking market is more challenging. A lot of banks have withdrawn from the market until year-end and have said that they may look at tiptoeing back into the market in 2023, but it is uncertain what shape or form they will be back in. So, we really are seeing demand for all sorts of debt products. It all depends on the sponsor and the business plan. That’s the other part of the equation. We are underwriting business plans very carefully. For us, when a business plan makes sense, we’re happy to provide a quote. If it doesn’t make sense, even though the market may look attractive, we probably won’t quote.

WMRE: We’ve seen a number of institutions, funds and other non-bank lenders also focusing on debt strategies. What is that competitive playing field like these days?

Indy Karlekar: Debt has become the flavor of the day and has been so for a while. We find that there are other market participants in the market looking to place debt. We have our own proprietary risk rating system that really helps us identify where we want to lend and where we don’t want to lend. So, again, there are deals where we will actively provide quotes on and others where we won’t. It really depends on the bucket of the independent credit mix, internal risk ratings and the duration of debt that we want to put out. That also drives our determination of how we want to put capital to work.

Yes, we acknowledge that there have been more participants, but the most important part is that relationships matter even more so. For a lot of participants who are maybe new to the debt markets, they’re not going to be the first to get a call, whereas we have been doing repeat business with brokers, with syndicators, with investment banks for a really long time. So, we think we are very well positioned to execute from that perspective.

WMRE: Principal reported in your recent Global Asset Allocation Viewpoint for Q4 that you’re anticipating a U.S. recession ahead in second quarter 2023. Is that still the case, or has that view changed?

Indy Karlekar: Whether it is second quarter or third quarter is hard to tell. It might get pushed out to third quarter because there is still some underlying strength in the economy. Labor markets are in good shape. Consumer balance sheets are reasonable. But we still feel that the probability of a recession is reasonably high. The market has already started to price in more interest rate hikes for 2023. That gives us confidence in our expectation that we’re in for weakening in 2023.

WMRE: How are you positioning your real estate investing strategies to navigate a recession?

Indy Karlekar: Again, I’m going to lean on our four-quadrant approach. We are emphasizing most importantly the resiliency of cash flow. We think that investors should focus on preserving and growing their cash flow. The best way of doing that in an optimal world would be to proactively go with debt where we can, because debt has a focus on current income and debt also benefits from subordination with an equity cushion below you. We think in the event that values fall, debt is better protected, and ultimately, better protected from a cash flow perspective. We think that is a good way of navigating the challenges in the next 12 to18 months.

At the same time, we don’t want to preclude the opportunities that are going to arise from the dislocation. So, we also are trying to be nimble and telling investors that there are going to be dislocation spots that you want to participate in. We think REITs might be an interesting way to participate in market dislocations because they tend to lead. The CMBS market also is trading at a pretty interesting discount, and we think there could be some opportunities that arise from CMBS. So, what we’re telling investors is to be defensively nimble. Be defensive by bookending your portfolio around debt but be able to pivot to more opportunistic strategies as the year progresses and we get more clarity on the Fed and the shape of growth.

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