Life insurance companies are proving that they aren’t afraid of a little healthy competition. Life company lenders remain firmly at the table when it comes to commercial real estate financing despite tighter spreads and a push by some borrowers for more flexible pre-payment options.
Life companies generally do a good job of holding the line on underwriting, yet they have had to narrow spreads along with other lenders due to competitive pressures in the marketplace. “Spread compression is our biggest challenge this year. We’re not getting as well paid for what we’re doing,” says Christine Haskins, managing director with PGIM Real Estate Finance. Haskins serves as portfolio manager and oversees PGIM’s general account commercial mortgage portfolio, which was valued at $53 billion in assets under management as of June 30, 2018.
Some of the value proposition has eroded in debt financing along with tighter spreads, but for diversification’s sake, life companies still like mortgages and are maintaining—if not increasing—allocations to debt financing. In addition, commercial mortgages still look good compared to investment alternatives. “The question has been where can the life companies find value? They already have a lot of investments in Treasuries and corporates,” says Haskins.
PGIM Real Estate Finance is maintaining its allocations to commercial mortgage financing. The company originated $8.1 billion in the first half of 2018, which was driven by strong production in industrial and multifamily loans. Originations that the life insurance company keeps on its own books accounted for $4.9 billion. “Those originations are pretty consistent with where we like to be,” says Haskins.
Life insurers are not prone to big moves or sudden surprises. So, history is always a good predictor of the future for them. That history points to a capital source where allocations have been stable, or even growing slightly as real estate has performed well for them in this current cycle, notes Jeff Weidell, president of NorthMarq Capital, a debt and equity provider.
Results from the latest CREFC and Trepp Insurance Company Investment Performance survey released in June shows that insurance companies were still reporting strong performance and increased allocations to commercial mortgages during the second half of 2017. According to the survey, commercial mortgage holdings ticked 52 basis points higher to 11.7 percent of total invested assets, while delinquencies remain negligible at 0.01 percent as of year-end 2017.
Battling tighter spreads
The big challenge for life insurance companies in 2018 has been pressure to narrow spreads. “For a few years running on a relative risk-reward basis, mortgage spreads were pretty good relative to the private bond market,” says Weidell. Early this year, spreads got very competitive. As Treasuries rose, spreads collapsed and the advantage that mortgages had relative to bonds went away.
“We kind of saw a chase to the bottom in spreads and then a bottoming out,” says Weidell. Now in the second half of the year, spreads have gone as low as they can and life companies are holding firm and passing on super low spread deals, he adds.
Each deal prices differently. However, if the bottom of the market a year ago was a 125-basis-point spread, then that spread has likely come in 25 basis points to a spread of 100 basis points today, notes Weidell. “There are many lenders saying ‘we’re just not going to a 100 basis point spread today,’” he says.
The spread compression is a function of liquidity in the market. There is plenty of capital available across the board from life companies, as well as banks, private equity debt funds, CMBS and other sources, and there are no indicators suggesting that liquidity will decline any time soon.
“The challenge is at what point do you get a pullback in your allocation, because it’s just not attractive enough for the organization,” says Haskins. Life companies want diversification, but they also have to be mindful of the risk-adjusted returns they are getting from their mortgage lending. There could be an inflection point where life companies have to pull back on allocations if they can’t find attractive enough deals. That hasn’t happened yet. “There is still value there. It’s just been more compression this year than we had hoped,” she says.
“We’re always looking at what kind of spreads we get on mortgage loans versus what kind of spreads our partners in the public investment side get for public bonds,” agrees Tom Zale, vice president and head of Northwestern Mutual Real Estate. The differential has gotten very tight with mortgage spreads that are clearly less attractive today than they were 12 months ago, he says.
Northwestern Mutual’s allocation to commercial real estate loans has remained steady, while its loan portfolio has been growing at a steady rate that is consistent with asset growth of the company, notes Zale. The company has been originating between $5 billion and $5.5 billion per year over the past three years, with about $33 billion in commercial whole loans in its general account. “We expect to continue to originate in that range over the next three to five years as well,” he says.
Dealing with competitive pressure
Some life companies have gotten into alternative loan products, such as mezzanine or bridge loans that they layer on top of the first loan that they provide on a property. It helps the borrower raise leverage to 75 to 80 percent, while allowing the life company to generate a higher yield with combined pricing. “That is a trend that we’re seeing with some of the larger life companies,” says Weidell.
In addition to tighter spreads, another shift has been lenders that are more willing to be flexible on pre-payment penalties. On a 15-year deal, for example, borrowers might be asking for—and getting—the last five years open with no pre-payment penalty. That’s more of a pricing issue that adds to the pain of compressing spreads, adds Haskins.
“There has been a very, very healthy appetite for commercial real estate loans from our direct and indirect competitors,” adds Zale. One sign of weakening underwriting criteria is a willingness by some lenders to provide more interest-only loans, which increases the refinancing risk in a rising interest rate environment. “That’s not something that we’re real excited about meeting in the market,” he says.
Northwestern Mutual also remains active investing on the equity side with new deals that typically range between $1 billion and $2 billion annually. The company has a deep position in multifamily on the equity side, with about half of its equity portfolio devoted to apartments. Much of that new investment is occurring by working with development partners on new projects in major metros. For example, the firm is partnering with Trammell Crow to build Glasshouse at Station Square East in Pittsburgh, a class-A project that will feature 300-plus units.
“Real estate continues to be a very important part of our general account portfolio. Some of the pressures that real estate is facing right now in respect to competition isn’t unique to real estate. All of the asset classes are facing similar pressures,” says Zale. “Our job in this kind of environment is to be very, very disciplined and make sure that our investment selection is never compromised.”