Ep. 7 Why Invest in Institutional Grade Real Estate Private Debt?

Bob Simpson: I'm Bob Simpson, your host and Co-Founder of privatedebtandequity.ca, a website to educate investors about concepts and opportunities in private markets. Today we're going to open the door to my private debt network and meet Adam Dean.

Adam is Vice President and Portfolio Manager at CMLS asset management. And he is here today to discuss the concept private debt as it relates to institutional grade real estate. That is lending to such things as residential and multifamily apartments. The MLS Canadian Home Index seems to have settled down over the past year or so after some crazy volatility since COVID and wild swings in interest rates.

According to the Canadian Real Estate Association, home prices in Canada actually rose 0. 6 percent year over year through the end of November. In the Canadian and U.S. Marketplaces, there's always a ton of interest in multifamily and sales volumes in that particular area, according to call years on their GTA Q3 report have fallen off the table.

Dropping from $627 million in Q3 2022 to $91 million in 2023. And the average price per suite declined 9. 1 percent year over year. So from that perspective, it doesn't sound great for lending to this asset class, but on the other hand, there have been some government incentives as there always seems to be. And rental rates have actually risen 10. 5 percent for a one bedroom and 7. 1 percent for a two bedroom. Which isn't great for those of you who are renters, as opposed to people who own their own properties.

Now, for most people, multifamily is about buying a small to medium size building, doing some renovations to make it more attractive for tenants, like upgrading the kitchens and baths to improve the overall value of the building. But today we're going to focus on lending to institutions who are buying and implementing their value add strategy to improve the value of their holdings.

In episode three of my private network, we looked at the topic why allocate funds to private real estate debt. One of our guests on that podcast was Adam who joins us today for a much more in depth discussion about the concept of institutional grade, real estate, private debt. If you want to go back and watch Adam's original session with us, it's in that podcast, episode three, go to the six minute mark and he'll show up about 10 seconds later. So here we go. Let's get going.

Adam, welcome.

Adam Dean: Thanks Bob.

Bob Simpson: Good to have you here. Now, before we delve into a conversation about what you do and how you do it, let's start with who is Adam Dean? What's your story? And kind of a personal question. Does everybody you meet mistake you for Roberto Luongo?

Adam Dean: Well, thanks, Bob. And really appreciate you having, having me on today.

So I guess starting with myself, you covered it. Well, I'm a portfolio manager with CMLS Asset Management. CMLS Asset Management is part of the larger cMLS group, which includes CMLS Financial and IntelliFi Corporation. My responsibilities primarily lie with our primary flagship mortgage fund, the CMLS Mortgage Fund, which invests in both single family residential, multi family residential, and commercial lending, as well as sub advisory work on behalf of leading Canadian mutual funds, which will be separate from the discussion today.

Myself personally, I'm based in Toronto here with my wife and and son who is six months old now and changing every day. I have been in Toronto for 13 years, but I am proud to say that I have retained my allegiance to the Vancouver Canucks over the Toronto Maple Leafs, despite having, having being a proud Torontonian for 13 years.

So the Luongo comparison is, is quite flattering. I would say that you are one of very few who have made the comparison. I, I certainly pale to Roberto and, you know, my ability to, to navigate Twitter or X or whatever it's called these days, and also pale in comparison to his stature physically, mentally and the fame that he achieved through through sport.

So thank you, Bob. But, but, it's a comparison that I haven't heard too often.

Bob Simpson: Hmm. Other than me. Well, it's the first time I saw you. We had that conversation on here and I, I looked, I went, I said, are you, is that Roberto Luongo? Anyway, Adam, we have listed on privatedebtandequity.ca under the concept Institutional Grade Real Estate Private Debt.

Now to most people that's investment talk. Can you just explain what, what you mean by that label?

Adam Dean: Yeah, absolutely. So I think institutional grade can, can cover a number of things. It can be how we find our investments, how we process our investments, how we manage risk, how we analyze risk, and I think you put that all into into one bucket.

And for me, it means investing in real estate debt, in the same manner as the larger institutions in this country do, the larger pension funds, endowments, foundations, and wealth managers that are investing with scale in real estate debt. And for us, being connected to a larger organization that has a fairly significant market share in commercial and multi residential lending in Canada, it allows us to access the largest property owners in the country and lend on the assets that we owe.

Bob Simpson: Adam, before we go deep on mortgages and real estate, I mentioned in my intro, you know, when we're reading the headlines about home sales and home prices, you know, we're seeing single family residential cool off, but maintain significant affordability challenges, right? So prices have come down, but they're still not really affordable.

They're not in that area. Commercial headlines are much less prevalent. However, what are you seeing in the commercial versus the more residential and especially maybe something like multifamily? What are you seeing in on the commercial side versus the side that most people see when they look at real estate.

Adam Dean: Yeah. I mean, in short, we've seen very strong performance from a lending perspective. You know, the stats that you quoted at the start of the podcast in terms of significantly depressed sales activity and some depression in prices over the past year for multi residential are, are interesting. But the next point that you made about the upward rental pressure, has created significant interest in multi residential part properties with the lending community.

So you've got owners that are struggling to interpret what the appropriate value is to place on the asset because you've got income that is increasing rapidly. But you've also got debt costs that have increased rapidly. And so we're starting to see some movement down in values, but also just very, very little transaction activity to really get a sense on what values should be in the market.

But as a lender, you know, when we're looking at a particular transaction and we're say lending 70 percent of what we believe to be the value of the asset, you know, a value decline of 5 to 10 percent still leaves us in a pretty good place.

And when the income that's coming off that property is what is then going to pay the required payments on our debt, is so strong and has increased so rapidly in the major Canadian markets over the past year due to supply constraints and just strong fundamentals, puts us in a really good position as a lender.

So that's translated through to very strong performance, not just in our fund, but also in CMLS Financial's broader commercial portfolio and multi residential portfolio. So at the end of last year, at the end of 2022, we had zero problem loans are zero delinquencies across the entire portfolio, which would have been about $20 billion at the time.

And in our fund, you know, since a few years back, we haven't had a single delinquent loan in the commercial and multifamily residential segment of the portfolio. On the single family residential side that typically is between one and 2 percent of the portfolio that has some form of missed payments. But we've been running at 0 delinquencies and in commercial and multi res for for some time now. Which is quite interesting because when you know, when you do see headlines out there, they're not as prevalent and people don't watch them as closely as single family residential.

But if you look to this past year and see the headlines that centered around commercial and multi residential property owners, there was a lot of negativity, right? You saw Starwood, Blackstone, JP Morgan, all these well known names and headlines that are defaulting on office properties in the U.S. Or you've got, you know, funds that are halting redemptions, you know, it's just a matter of where you play in the market.

The U.S. and Canadian markets are very different in terms of recourse that's provided on the lending. So, you know, we've been able to navigate through those negative headlines, focused on a multi residential asset class that has very strong fundamentals and performance has thus been quite strong.

Bob Simpson: Yeah. So, you know, I would assume that the biggest stress, well, number one, from a multifamily, let's say an apartment building, part of the value is based on the revenue of that building.

So if rents are going up, that's. helping on the revenue line, but it sounds like the major stress is really the interest rate cost if people hadn't locked in their financing for term. If they, let's say they were floating, like many homeowners are fighting with today.

Adam Dean: Definitely. So if we're looking at say single family residential versus multifamily residential, on the multifamily side, the value of those properties is much more driven by what we refer to as the cap rate for the income yield at that property.

And so if the income is going up then you would expect the value to go up accordingly. But what drives the level of those cap rates or the income yield is also the level of interest rates. So where we've seen the overnight Bank of Canada rate, government bond rates, and all those risk free rates since March of 2022 increase substantially, there's still a feeling out period as to what the appropriate yield or the appropriate rate is relative to those interest rates that drives an appropriate income yield.

So that's where you've seen investment volumes and property sales volumes go down so much. As both buyers and sellers are in a little bit of a standoff trying to figure out what's appropriate.

Bob Simpson: So I guess it's, you know, in a way based on your comments, we're in a bit of a buyer's market, aren't we? That prices have come down a bit, but for those who are looking at the revenue increases and can look into the future and see some of the rates coming down over the next year or two, that should pretty much stabilize or improve property values.

Adam Dean: Yeah, I wouldn't disagree, Bob. I think that if we were still looking at a market where inflation was increasing and people were concerned about rates significantly increasing beyond where they are today, I think that's what's really driven the standoff, the uncertainty, the lack of volume.

If we can see either stabilization of interest rates or, or start to see rate cuts and rates coming down. Our expectation is that that will at least provide a bit of a catalyst towards increasing transaction volumes.

Bob Simpson: So there might be some fire sales out there where properties just aren't carrying themselves anymore. But that's good for somebody who has money or has buying power. But just doesn't seem like anybody's jumping into the market right now.

With both feet saying, this is a great buying opportunity. They're waiting to see a bit more pain. Is that what you're, you think you're seeing today?

Adam Dean: I would say so. We don't see the level of pain at this point that would drive true fire sale activity and pricing declines beyond where they are today, where we've seen stress and the broader portfolio is largely focused on property owners that are focused on new development.

So rather than owning stabilized income producing assets, they're building assets from the ground. And when you don't have income coming off those assets, when you've got labor costs, having increased significantly materials costs that increased significantly through the pandemic and then the last nearly two years now significantly increased interest costs, that's where we've seen borrowers get into positions where they're a little bit, you know, beyond their comfort level and needing to sell off assets to generate liquidity.

But, but it's just not at a level that's prevalent and enough in the market to create a lot of that activity.

Bob Simpson: Are most of the loans in your portfolio, are they fixed or they're floaters?

Adam Dean: Historically, primarily fixed. We've had a slight increase in floating exposure from about 10 to 20 percent of the portfolio through the last few years as rates went up and we shifted some exposures to floating rate.

But in the current rate dynamic, we feel it's important to, if we are continuing to do floating rate, we're implementing floors and minimum coupons. So in the event that prime goes down and other floating rates go down, we're protected at a certain level.

Bob Simpson: So it takes a little while for investors in a fund like yours to see the increase in rates because you've got to wait till some of these things roll over as opposed to some other asset based lenders who are mostly floaters, much better for investors as rates have gone up quite so much over the last couple of years, right?

Adam Dean: For sure. Since, you know, March of 2022 and GICs responded very quickly in terms of the rates that were available on GICs. So, you know, for a while there, our relative yield, you know, we were doing everything we could to roll the portfolio and take advantage of higher interest rates. And about halfway through 2023 was really when we we're able to pull the entire portfolio over and start pushing yield up into the high single digits.

Bob Simpson: Yeah. So that's about where you are today. If you looked at the overall yield of your portfolio.

Adam Dean: Yes, we would, we would be doing loans anywhere from 9 to say 12%. And as we roll over the portfolio, that net yield continues to tick up.

We would right now be distributing to over 8%, around 8. 25%.

Bob Simpson: Yeah. So that's a good spread over GICs, which is one of the things that investors look at. So one of the things that I think people really don't understand is the difference between publicly traded investments and private investments. There are many factors that affect price and value of all of these, but let's just start with, with the idea of open ended versus close ended.

Adam Dean: Sure. Yeah. So you mentioned public versus private, you know, when you look at stocks or ETFs or funds that are traded on that exchange, that's closed ended structure versus something like our fund, which is open ended. And really, the main difference is that our fund would be consistently open to new investments and then open to redeeming the investment that you've placed in the fund.

And in each case, when someone is putting money in or taking money out, they're essentially dealing with the fund manager in doing so. So the size of our fund can fluctuate. Based on the number of investors that we have coming in or the number of investors that are taking their money out. Whereas a closed ended structure is a specific amount of money that's been raised.

When those are bought or sold, they're actually traded between investors. So when you're buying or selling a stock, you're essentially selling it to another individual, as opposed to redeeming from, from the fund itself or the, the investment, that the money's gone into.

Bob Simpson: Now, Adam, a term I've heard you use is weather proof deployment.

Adam Dean: For us, it just means implementing a strategy that is expected to perform well in different economic environments. And we kind of make the analogy in order to do that. We've got all seasons tires, and then we've got our winter tires. And our all seasons tires are the elements of the strategy that are expected to perform well across different environments.

So this would be something like credit scores above 700 with our residential borrower clients. Or it would be accessing investments that are debt secured by properties that are in major urban centers like the Toronto, Montreal, Vancouver's of Canada, where those properties are expected, whether the market's good or the market's bad, those properties would be expected to be more liquid and have more interest from the investment community.

So it protects the downside in all market environments. What we kind of refer to as our winter tires are elements of the strategy that allow us flexibility to shift our exposures in those different. Market environments. And so for us, that's having a flexible allocation between single family residential mortgages and commercial and multi residential mortgages, where the former is really focused on the asset value and the liquidity of a residential property and less so on the income of the property and the borrower itself.

Whereas the commercial and multi residential component were much more focused on underwriting the quality and, and resources of the sponsor or the owner of the property and the income at the property level. So because those two are exposed to very different factors, having the ability to shift our exposures between the two in different market environments allows us to, again, execute a strategy that performs well in multiple economic environments.

And the real time example today would be a lot of what we talked about today in terms of the fundamentals of multi residential, the income increases on those assets, and just the general institutionalization of that community and large asset owners, which has kind of informed our strategy to shift a little bit further into multi residential than single family residential in today's market.

Bob Simpson: I think it would be interesting for our listeners just to hear a little bit about multifamily. Let's just say an apartment building. You have an opportunity to lend to an institutional investor who is buying an apartment building. Just wondering how does a deal like that roll out? What do you do? What kind of factors do you look at?

So kind of asking you the story of, you know, what is the story of lending money to a borrower who is investing in multifamily?

Adam Dean: Yeah, and I could talk all day on this, Bob. It's a complex deal cycle and one that we've had a lot of history and buttoning down. But maybe just starting from how we access the opportunity itself is that, you know, CMLS would have 50 plus origination professionals across the country who have deep relationships with individuals and companies that own multi residential assets. And so from time to time, someone might be buying a new property, they might be refinancing existing debt, and they'll be speaking with their CMLS representative to find the right financing solution.

You know, whether that is that a short term bridge solution as they improve the property. Is it a long term, stabilized, low, low risk, low rate loan? CMLS will work with the client to determine the best fit. Now in the event that that's a shorter term, higher rate, more transitional loan, that's where we get involved with the fund.

Is it the CMLS representative will say, "Oh, we've got an in house fund that would work quite well for that, for this opportunity, let me get you a quote." And then they would come to us. So at that stage, it's a very preliminary review. We're looking at basic information on the property, financial statements, and determining whether or not we're comfortable making a quote.

To the extent that our quote's successful, that's when the real work starts and that's when that loan would be transferred into our underwriting department. So, individuals that are dedicated role is to look at a investment opportunity, look at location. Borrower asset. They've got third party reports from engineers, environmental specialists, appraisers, and essentially build an underwriting package that says, yes, this is a good investment or this is what we would change about the investment to make it a better investment.

So we've seen that preliminary look, then it goes through the factory and then it comes back and says, okay, now we've fully underwritten the deal. Are we comfortable actually committing to lend on this asset? And that's when we would put out a commitment letter to the borrower and say, as long as you meet these 10 conditions, within the next 30 days, we will fund this loan.

And then it goes through our funding team. Lawyers get involved and we place the loan on the asset. So it's a very long and arduous process from start to finish. But the biggest and most important part for us is that underwriting component. And assessing the risk of the deal. We're assessing the benefits and the risks and mitigants to the deal.

Bob Simpson: Yeah, so of all the deals that you see, what percentage would you loan against?

Adam Dean: Basically, when a loan hits our pipeline, we would expect that there's a 10 percent chance that that ends up being a funded deal. If we've issued a quote and that quote is accepted by the borrower and it goes into our underwriting function, we would then expect there's a 50%. probability that that loan funds. If we've issued a commitment and the commitment is accepted by the borrower, then we then expect a 90 percent probability that that funds. There's a kind of saying within the broader CMLS family that it's like baseball. If we're batting greater than 330%, then we're hitting the Hall of Fame when we retire.

So we kind of, we target a third, but the probabilities fluctuate as the deal proceeds through the process, as I mentioned there.

Bob Simpson: Right. So if you have a 900 plus save percentage for Roberto Luongo, you probably make the Hall of Fame.

Adam Dean: Yeah. Well, I, as, as the portfolio manager, that's save percentage is a better, a better analogy than, than batting average.

Cause we're, we're, we're playing defense.

Bob Simpson: Yeah. You're playing defense. You just, the main goal is to keep the puck of the net. It's not to, not to be a hero and score that fancy goal at the other end. Right.

Adam Dean: Exactly.

Bob Simpson: And that's what I think investors want to see. Investors want to see that you are primarily focused on protection of their capital because you're getting single digit returns, right?

You don't want to risk your capital for 9 percent returns or 8 percent returns. Yeah. So they want to make sure, and that's the reason I asked you that question is just so people had a little bit of flavor about how a deal works, all the background work that you do to get it there.

Adam Dean: Yeah, I think that it kind of comes back to that institutional grade handle where CMLS as a whole is doing, you know, $5 billion in lending activity in a given year.

You then roll that back with the 10 percent funding probability. CMLS is looking at $50 billion of, of opportunities in a given year. You know, in our, in our little fund, we're funding about a hundred million a year. Right? So if we've, we kind of have access to the entire market and finding the right investments.

Bob Simpson: So for an investor, what's a reasonable return objective for an investor in, in your fund?

Adam Dean: Oh, I think in our fund, we're targeting 300 basis points or 3 percent above the two year. Government of Canada bond and, and if we kind of just simplify that into today's market and what we'd be targeting on a percentage basis, you know, it's between 7 and 9 percent net net returns to the investor.

But I think the most important thing, just separating out our, our fund completely that the yield and percentage number is 1 thing. Everybody's focus should just be on making sure that that's appropriately matched with the risks that are being taken to get there. And 7 percent is no different than 3 percent if it's occupying a component of the portfolio that is targeting the risk profiles that match those returns.

Bob Simpson: So for an investor who is looking at this as an alternative to traditional fixed income, like bonds, you know, over the last couple of years, bond is bonds when rates were zero was a horrible, a horrible, horrible investment.

How over the last couple of years, would you say that your fund performed?

Adam Dean: Yeah, you know, I would say it's also something we talked about earlier today with the Delta between our fund and, you know, say risk free or near risk free products like GICs. I'd say over the past two years, it has taken time to adjust the yield within the fund up to a level that provides a good, suitable excess return over government bonds, over GICs, et cetera.

But if you think about someone who is holding a longer term bond portfolio with long duration at the start of 2022, either those have been sold at a loss or, you know, you're holding something that's yielding significantly lower than the current market rate.

So I think where our fund and other short duration mortgage investment funds, what, what we benefit from is that short duration allows us to adjust relatively quickly to movements and interest rates, and preserve a yield that's appropriate to the risk that's inherent in the investment. And what's great about it is that we manage that on behalf of the investor. So the investor isn't needing to re underwrite, reinvest in individual mortgages as loans pay out.

And that liquidity management and just constant turning of the portfolio and underwriting of new investments, is where managers like ourselves and others can provide value.

Bob Simpson: Yeah. So, you know, the history of your fund. If you looked over the last three to five years, how many negative months have you had?

Adam Dean: We would have, we would have had one.

And that wouldn't have been negative in terms of, in terms of actual dollar losses, but rather when the pandemic hit and there was a lot of uncertainty as to performance of investments. We decided it appropriate to take them, take a mark down on the portfolio temporarily. And so investors would have seen one month of negative return in that year in terms of distributions, losses on loans.

We've never had a loss on a loan in the fund's 15 year history and no, no negative distributions. So, yeah.

Bob Simpson: So Adam, before we break today, we always have concerns and we always have excitements. You know, like the Toronto Maple Leafs, we have excitement during the regular season and we have concerns during the post season.

As you look at your particular market, what are you seeing? What, what are you, what are you excited about and what are you worried about?

Adam Dean: Yeah, maybe I'll, I'll start with concerns just to end on a high note, but I'd say one thing that we watch closely and as an element of concern these days is just the consumer debt burden and depletion of savings.

You know, ultimately property values have remained steady. But, you know, we, we know there was a lot of excess savings that were built up through the pandemic. And I think that's helped a lot of folks weather the storm of much higher interest rates. So to the extent that these higher interest rates, you know, stabilize at where they are for a period of time or continue to increase, I think it's going to become harder for people to manage their debt load.

And so we're watching it closely. It hasn't resulted in, in poor performance or troubles as of yet, but it's just something we, we think it's prudent to monitor. And then second, maybe just a slight concern is there's very strong, and positive consensus around the housing affordability issue, both rental and ownership being driven by lack of supply.

Or supply constraints, and that's actually one thing that I'm quite excited about. But what I'm concerned about is that it has a tendency to become overly political, and I worry that that may lead to just instability of policy and potentially have a negative effect on the markets that we invest in in the near to medium term.

What excites me is very much the same, is that there is that consensus around that we need to do a lot to increase supply of affordable rental properties and affordable homeownership in Canada. And, and basically just being excited that we are in a position to assist with that through financing solutions for our borrowers as we navigate.

Bob Simpson: So Adam, we're, we're a bit up against the clock here. We try to keep these things, pretty tight to 30 minutes, but, you know, big thank you to you to come and join us today and share your valuable insights.

Adam Dean: Thank, thank you very much for having me. Much appreciated.

Bob Simpson: We'll do this again.

Let's do, let's do this again. This podcast episode will be available on privatedebtandequity.ca as educational content for Institutional Grade Real Estate Private Debt. To learn more about institutional grade, real estate private debt, visit privatedebtandequity.ca click on concepts and just simply look for that term.

Before making any investment decisions, it is essential to consult. A professional financial advisor to determine suitability. Full disclaimers are available on privatedebtandequity.ca. Now, please do not forget to follow us on your favorite podcast platform, subscribe to our YouTube channel or newsletter or both to stay updated on new episodes.

I'm Bob Simpson. It's been a pleasure guiding you through today's discussion. Remember knowledge empowers you. to make informed investment choices and reach your financial goals. Until next time, give me a call or drop me an email at bsimpson@privatedebtandequity.ca. Hope you have a great day.

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