Ares Management is making loans on a selective basis in gateway US markets more than it was prior to the covid-19 pandemic, with the firm responding to a change in valuations and lower leverage requirements from borrowers.
“Pre-covid, we avoided the gateway markets. We felt that office and lodging assets [in those markets] were largely overvalued,” Bryan Donohoe, partner and head of real estate debt at Ares, told Real Estate Capital USA. “There are now green shoots appearing in gateway cities where office utilization has been increasing and we expect this will continue as a trend through the middle of next year.”
“While we will continue to focus on the areas where we’ve had success, we can now invest in these gateway markets that have had prices reset and are now attracting strong capital positions out of the equity side. We can provide moderate leverage at these reset values.”
Ares is expecting to see recovery in gateway markets, with Donohoe citing the case of New York.
“We will see recoveries, in New York for example, with people moving back and apartment rents accelerating or approaching pre-covid levels. The West Coast is a little behind for various reasons, but we are pleased that our portfolio is looking clean from an allocation to these gateway markets and there will continue to be opportunities to invest in this space moving forward.”
The office sector saw a tremendous impact from stay-at-home orders in 2020, and this working from home trend isn’t yet over. This has also led to an increased bifurcation between class A and class B assets.
“Office is an important recruiting tool for this war for talent that we’re seeing,” Donohoe said. “The class B office sector will largely be orphaned by larger firms, and what that means is that there will be a concentration of demand for the class A office.”
There is an interesting gap between class A and class B rents in the city, with levels for the latter stuck at around $50 to $55 per foot for several years. But class A rents, particularly for newly built trophy properties, can breach $200 to $300 per square foot. “That disparity is a pretty interesting phenomenon which we haven’t seen before to this degree,” Donohoe said.
Sticking to the playbook
The firm’s playbook over the past few years has been to focus on first mortgages and have a demographic footprint that put it in front of borrowers and sponsors in areas of demographic growth, like states in the Southeast, the Sunbelt and Texas that have seen an influx of migration due to factors that include favorable tax regimes.
“We have been able to achieve this approach given our broad geographic footprint of originators that we have throughout the country. And I don’t see this playbook changing any time soon,” Donohoe said.
The firm, which is active in the 30 largest MSAs and real estate debt and equity staffers on the ground in 11 offices. The firm employs a bottom-up approach to underwriting, taking into consideration every aspect of the property and sponsor as well as suitability for its strategies.
“We target markets with strong demographic growth engines, namely multiple stable economic drivers like technology, healthcare, government and in most cases a base of colleges or universities.”
Such growth markets include Raleigh, Durham, Austin and Nashville.
“We generally engage with top institutional sponsors in the real estate space, and they are targeting similar attributes in their target markets,” Donohoe added.
“For Ares, multifamily and industrial remain our highest conviction sectors, but we are starting to see some opportunities in select office markets and assets. [However] our focus on office type will shift depending on market dynamics. That being said, we are finding opportunities in highly amenitized destination properties in the current market environment.”
“Given that we entered the pandemic with limited exposure to this space across our U.S. real estate debt strategy, we’re coming at it from an optimal position and can be highly selective.”
Shift toward debt
Ares is seeing more interest in real estate as an investment strategy.
“The way we think about real estate debt is really as a fixed income alternative strategy that delivers consistent returns to investors,” Donohoe said. “I think what we see long term is the continued deleveraging of the space as it evolves to provide more of a steady income profile for investors. Demand is fairly robust and that goes across the capital structure from core returns through opportunistic and development-type structures that we see today, which provides a healthy backdrop for what we’re doing.”
While office is showing promising signs of recovery, the firm still views industrial, multifamily and other residential-derivative products, such as student housing, as very solid sectors in both its debt and equity businesses.
“These two main industry sectors are part of our DNA and will always be a great focus for us,” Donohoe said.