Andrew Putwain: Where is the Commercial Real Estate (CRE) market at currently – can you discuss what the challenges and opportunities are?

David Politano: The commercial real estate sector is emerging from what the next generation of industry practitioners will call the “2020s Real Estate Crisis.”

Prices and transaction volumes are improving, but the recovery process following a downturn has historically required two to three years to fully resolve. Although this two to three year-cycle creates stress for existing portfolios, it has historically also been an ideal entry point for new investments. The impact of the market volatility over the last week or so due to the ongoing tariffs/trade war situation is hard to predict at this time. If we are pushed into a recession, we can expect the recovery to be delayed if that is the case.

For commercial mortgage investors, it may be easy to see the lender-friendly loan structures and more attractive spreads offered at the start of a new cycle when liquidity is low. What we think is less appreciated is how the cyclicality of supply and demand impacts the risk of loans originated at different points in a cycle.

Typically, after downturns, the construction pipeline for most property types quickly diminishes, and that is also the case today. As an example, in the apartment sector, we expect around 280,000 units to complete in 2026, below the 2014-2024 average of 425,000 units per year. As a result, “overbuilding risk” is materially reduced, yet lenders are treating 65% loan-to-value loans today as having the same risk as periods like 2023 and 2024 when construction completions were 600,000 and 690,000, respectively.

We expect loans originated today to mature when the cycle is the healthiest, which is a significant opportunity for capital deployment.

Andrew Putwain: What are the effects of rates and inflation on CRE both acquisitions and debt?

David Politano: A sharp rise in construction costs and concurrent decline in real estate prices has caused new construction to nearly stop for all property types. This has created issues for our ability to find attractive construction projects, which have been an important part of our equity investing platform but also gives us more comfort in sourcing debt originations on asset values that we think could have upward pressure. Real estate pricing below replacement cost and lower supply coming online are both supportive of future price growth.

A risk to the market outlook is uncertainty around tariffs, immigration reform, and tax reform, all of which tend to be inflationary. We are less concerned about the direction of inflation given that inflation is positive for real estate income growth, but uncertainty about inflation could put unnecessary pressure on interest rates and stress real estate capital market conditions.

Andrew Putwain: Speak to the asset sector getting the most attention, and what is happening in office/return-to-office (RTO) in the US?

David Politano: The national office vacancy rate finally started improving in late 2024, and more than half of US cities are now seeing rising average occupancy rates. A portion of this improvement has been rising return-to-office mandates, but we think RTO is now at a steady state and is unlikely to significantly improve or deteriorate in the future. This means that looking forward, most of the recovery in office will be from population and office-using employment growth, as well as a flat or negative inventory growth as older assets are repurposed to residential or other property types. We expect the national average vacancy rate to improve by around one to two percentage points per year from the current level around 19% and don’t expect a full recovery to pre-pandemic averages until the late 2020s.

There are wide performance divergences across markets and building quality. For example, markets like San Francisco continue to struggle with vacancy around 25%, while markets like Miami have already fully recovered. Class A+ offices are generally performing well while commodity stock is struggling. Liquidity is slowly coming back to the office sector in these pockets of outperformance, and we expect high-quality office in stable markets to price as competitively as more favoured industrial and multifamily sectors by late 2026.

Andrew Putwain: Building on this, can you discuss commercial mortgages risk-adjusted return profile – what do they offer that other investments don’t and where do you see interesting facets in this market for investors?

David Politano: Commercial Mortgage risk-adjusted returns and performance can be evaluated by comparing commercial mortgage spreads to public corporate spreads. Commercial mortgage investments have on average generated a 95 basis points (bps) average spread pick up over Single A-rated corporate bonds from 2000 to 2023. This analysis is based on a comparison of the historical average credit quality of the commercial mortgage portfolio (“A” quality) from the ACLI Commercial Mortgage Commitments Historical Database of US fixed rate commercial mortgage loan origination by US life insurance companies to Bloomberg Barclays Point data of publicly issued US corporate and secured notes excluding financials, with ratings of A1 –A3, 2000 –2023.

A minimum spread premium profile for commercial mortgages versus comparable term and rated public corporate bonds are meant to account for both the higher costs of sourcing and managing mortgages relative to corporate bonds and the higher average degree of “illiquidity” associated with the additional effort and cost to sell a mortgage versus a corporate bond. Most capital market line (CML) investors view the asset sector primarily as a higher-yielding alternative to bonds and have relatively low liquidity needs for this segment of their portfolio. The market generally recommends a minimum average spread premium of 20 – 25 bps for commercial mortgages versus comparable term and risk (as measured by bond equivalent rating) corporate bonds. The profile is based roughly on a cost/fee for CMLs that is around 10-15 bps higher than for corporate bonds, and around 10 bps for illiquidity relative to corporate bonds.

Other interesting facets of CMLs versus alternative similarly rated investments include predictable current income in various market conditions with potentially higher spread premiums with lower loss rates relative to certain comparable public corporate bonds.

There are stronger structural protections (e.g. secured repayment protection, amortization and control over additional debt). It’s also a portfolio diversifier given its historically low correlation to many major asset classes, including real estate equity, and there are flexible term and rate structures, which may be ideal for liability-driven investing.

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