Commercial real estate: life insurance companies
Hi, I have been having trouble understanding this and would really appreciate anyone's help!
"Interest of life insurance companies holding positions in commercial real estate debt market is more significant than their interest in equity because of regulatory requirements on risk-based capital requirements & matching their liability structure."
I understand that the regulatory requirements on risk-based capital requirements help mitigate risk and makes commercial real estate debt market attractive to life insurance companies.
However, I don't understand what it means by "matching their liability structure" - can someone help explain this portion? Thank you!
Life insurance companies collect premiums and then invest those premiums to ensure that they reach the return necessary to pay out claims later on.
Debt is generally a better vehicle for them because it is easy for them to get the 3-5% annual returns they need by doing long-term core debt deals.
Said another way, they have long term liabilities (clients are paying into the system now for a payout 40+ years in the future), so core debt with it's traditional 10 year WALT and steady returns makes sense.
In other words debt is more liquid than equity investment to pay people back, that makes sense, thank you!
Debt has consistent cash flows. You invested x and will get y back every month. Consistent income is what a life insurance company would be looking for so they can pay claims.
That makes sense, debt has consistent cash flow return whereas rent and other income from equity fluctuates depending on market
Debt has the best risk adjusted returns for life insurance companies given their liabilities because in the event a property goes bust, debt holders get paid out before equity investors, and can usually recoupe 70-90 percent of their initial investment. If a hedge fund goes bankrupt, you'll piss off a ton of investors but it's not out of the ordinary. If prudential loses money and can't pay back its policy holders, that's making national news which is why these insurance companies have much stricter regulations about what they're allowed to invest in.
Although from a lending perspective, I will say it makes the debt market more competitive since these new players are fighting against a lot of the traditional established banks. These life insurance companies are taking on bigger and more aggressive positions since owning senior secured debt is able to give vastly higher returns than other bond investments while still having very little risk because the odds of a stabilized class A property in a major metropolitan city defaulting is close to 0.
Wow thank you for the detailed and very helpful response, this completely makes sense!
I have another question I was hoping you would be able to answer as well:
"In CMBS (commercial mortgage-backed security), first mortgages (usually from several diff properties diversified by property type ie office, retail, multi-family etc and location) are pooled & held by trust which serves as pass through entity for bondholders"
Question: How are bondholders related to this and what does it mean by "pass through entity for bondholder"?
Thank you again for your help!
The standard way that a large real estate deal goes is that there is a short term construction loan on it, usually 3-5 year with a higher interest rate on it since it's not a fully stabilized property and holds more risk as any host of issues could derail the project. After that time period, and the building is constructed and/or leased out, they seek to refinance for a lower interest rate which is where the CMBS desk at a bank usually takes over. So my group would work with the CMBS group and move that loan off of our balance sheet and securitize the loan by issuing a mortgage backed security with the debt collection from the mortgage sustaining the bond payouts. The people and institutions that buy CMBS products are now the debt holders instead of the bank, and they are bond holders that receive a set payout from the security based off of its original underwriting and interest collections.
pass through entity is just a legal classification for tax purposes, it just means that income is not double taxed at the corporate tax rate then individual rate, you're just taxed at the individual income tax rate. It's not that relevant for the purpose of understanding the security.
The CMBS group works extensively with rating agencies to set the market clearing price on the bond as well as making sure the property is stable enough to become a securitized product. The work that a full service bank does in their real estate division is incredibly complex and there's a ton of different groups within it that all serve their unique role.
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