Unveiling Private Real Estate Credit, with guest Joe Ryu from Prospect Capital

Joe Ryu, manager of Prospect Capital's private real estate credit fund, shares his journey from investment banking through the Great Financial Crisis to his current role in real estate credit investing. He explains how private credit offers attractive risk-adjusted returns through specialized financing structures that combine agency lending with subordinated positions.

• Real estate private credit involves loans on commercial properties that don't freely trade, typically accessed through institutional investors
• Private credit investments often offer higher returns with less volatility than public market equivalents, though with reduced liquidity
• Prospect Capital's strategy creates value by partnering with Freddie Mac to provide borrowers with competitive financing while maintaining conservative risk profiles
• Unlike many competitors who use fund-level leverage, Prospect's approach avoids taking on additional debt at the fund level
• Private credit valuations are more straightforward than equity valuations since loans are only impaired if property values fall below loan amounts
• Focusing on stabilized, cash-flowing multifamily properties reduces risk compared to development projects or challenged office assets
• The real estate capital stack typically includes senior debt (60-70%), subordinated debt/preferred equity (10-15%), and equity (25-30%)

Join us for our next episode as we continue exploring alternative investment opportunities that can help diversify your portfolio while aligning with your financial goals.

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Disclaimer - These podcasts are not intended as investment advice. Individuals please consult your own investment, tax and legal advisors. They provide these insights for educational purposes only.

Chapters

• 0:51 Introduction to Private Real Estate Credit
• 9:26 Joe's Career Path into Real Estate
• 14:54 Defining Private Credit for Real Estate
• 26:25 Understanding Valuation and Liquidity Challenges
• 41:05 Prospect Capital's Unique Investment Approach
• 59:20 Risk Assessment and Market Positioning
• 1:05:05 Final Thoughts and Future Outlook

Transcript

Steve Davenport: 0:27

Hello everyone and welcome to Skeptic's Guide to Investing. Today we're fortunate to have a guest. Our guest is Joe Ryu from Prospect Capital. Joe is the manager of their private real estate credit fund and today we're going to talk about Joe and how we got into it.

Steve Davenport: 0:48

First of all this is a new thing for us we're trying to bring in other asset classes and other ideas on investing so that people who hear private credit will have an idea now what it is what you're investing in and how it might work for them.

Steve Davenport: 1:06

I think that we can spend a lot of time, clem and I, talking about these things, but I figured why not bring in an expert? And Joe has been doing this for a while and he's got a great fund and I think it's worth having his perspective versus just Clem and myself. So, again, we're doing this with video so that people can enjoy the banter and the faces and the hand motions that we're going to do to each other, some of them involving fingers, which may be, you know, less than polite, but that's the way it's going to be sometimes. So, joe, if I look at your resume and your career, it seems like you took a different path than a lot of people who typically want to work for. You know the private equity funds and the private or the equity management of individual names for investment banks and other places. Can you talk a little bit about your background and?

Joe Ryu: 2:10

how you got into private credit. Sure, absolutely so. I graduated in 2000 and, in a market where the idea was, you know, try to survive in the dot-com boom, get a job anywhere you could and you'd probably be better off than a lot of people suffering from where the market was, my desire was to go into finance. It had always been the direction I wanted to go, so thankfully I wasn't competing against a lot of my computer science colleagues that couldn't find a job. Ultimately worked in investment banking for many years and at a middle market shop called Duff and Phelps for the longest period of time, right through the great financial crisis, and it was in that organization that I got my first kind of flavor for real estate. And there was an IPO that we worked on of a office REIT in Santa Monica. They're still publicly traded, it goes by the ticker DEI, douglas Emmett, and they were at the time a public REIT manager. We had taken them public, but previously they had about nine private funds from primarily university endowments and invested in core office properties in markets such as Santa Monica, hawaii, west Coast, oriented Through the GFC and, working in banking, worked with various clients that were trying to raise liquidity and oftentimes the value of their real estate was worth more than the value of the going concern, and so they tried to monetize real estate holdings through various, say, leaseback structures, often bankruptcy processes where they were selling assets to try and resolve creditor issues.

Joe Ryu: 4:28

And so that's where I really started to see real estate and really get enamored with the asset class. And then I decided I would go into business school. I had seen where my career had taken me at that point and wanted to pursue a career in real estate. But at that point in time the only real way to go into real estate was either as a entrepreneur yourself and invest in real estate, or to become on the institutional side to work either on Wall Street as a analyst covering publicly traded REITs, which I didn't find as very appealing, or work for a REIT itself, and that I can get into more detail. But to tackle getting into real estate, private equity or real estate credit, a lot of those managers still to this day are very selective because they're very focused on hiring generally, like they try to say, individuals that have a strong background in real estate, that have already done it before, and so if you haven't done it before, it's really hard to get into that career path unless you try and use relationships or go through an MBA route, which is what I did.

Joe Ryu: 5:58

I went to the University of Chicago for my MBA full-time and there I did a MBA internship with the related companies during the summer. They famously developed the Time Warner Center in Columbus Circle and the Hudson Yards project in the west side of Manhattan, along with numerous other projects largest multifamily operators across the country, including a very large affordable housing component, which is actually where they got their start. The founder, steve Ross, was in affordable housing, was a tax attorney. Now he owns the Miami Dolphins. That's how lucrative it can be. Then I had an opportunity to then decide do I want to go into real estate development, um, or I had an opportunity to work part time during my second year of business school, um.

Joe Ryu: 6:59

Trying to recruit for a job, um, during school. Which is the primary goal of an MBA is you can take all the classes you want, but you really are spending two years to intern and recruit, network and get a job offer that you really want to pursue full time. And on the investment side it's very less structured. So if you want to go into consulting or marketing or investment banking, those companies, those big brands. They come on campus and they take you to dinner and they take you to a ball game and then they put you through a very structured recruiting process and they fly you out to their offices and then they take you through numerous super days and interviews and tests and exams and then they get an offer to you very quickly.

Joe Ryu: 7:52

But if you want to be on the investment side and something that's a little more niche-y, you have to really be entrepreneurial and figure out how to get an offer.

Joe Ryu: 8:05

I mean, there are programs for some large firms like Blackstone that might come on campus and say we have one job for this school and we have one job for that school and one job for this school, and you can imagine some feeding frenzy. So for everybody else, you know I networked and I found the opportunity to work part-time my second year of business school at Aries Management in Chicago and I was doing that during the day and at the same time I was still working part-time for Related Midwest because they had said hey, you're great to work with over the summer. We'll pay you $25 an hour to do your analytical work and for us it's free labor. None of these internships came with any guarantee of an offer, but it's the way to kind of get your foot in the door. I had to pivot all my full-time classes to the evening classes in downtown Chicago, so it was kind of regrettable it sounds like a lot of fun, like a good way to spend it.

Steve Davenport: 9:16

It was pretty regrettable. Can you just go back to the point about real estate, because it feels to me like if the market is collapsing in 2008 around you with all of this extra debt and leverage and all of the things with problems with individual structured products. I mean, do you like working with things that are chaotic or like why? Why was that attractive to you versus you know a good old, hey, let's study. You know corporate bonds and you know see if the J&J bonds are better than the IBM bonds.

Joe Ryu: 9:51

Right. Well, I'll tell you something else that's funny after this. But during that RMBS crisis that really we all famously know blew up on residential mortgage backed securities up on residential mortgage-backed securities it was very interesting to study it, particularly also in business school, to see how the sausage was made and how it blew up and how Wall Street will always find another way to create a product to sell to investors and generate fees. A product to sell to investors and generate fees. And in this interim period of holding the risk and balance sheeting some of these loans, you can famously get caught. And underneath all of that was the idea that you can diversify away your risk or you can stratify the risk away into certain tranches of debt capital. That, okay, this is AAA risk and this is risky, and we are so smart we can tell you what you can buy and what return you're going to get and how safe it is. The theory was fascinating. Now the execution of it was really greedy and so, looking at how it was done and the fundamental analysis that should have really dominated over the conversations about how to execute this, they really were sometimes really disjointed, but the fundamentals of it, when you think about it, they should actually work to a certain extent. And so the real estate credit aspect of that blow up really fascinated me. And although I never got into residential mortgage-backed securities, which is where that catastrophe unfolded the commercial real estate market, the CMBS market and CMBS 2.0, having learned from their mistakes in the past, was really fascinating to me.

Joe Ryu: 12:05

And getting into real estate credit in business school, um, was an opportunity to not just take okay, you can be an investor in real estate, but then take approach where again, you're not the first lost position, you, you have a little equity cushion and you can generate a pretty attractive return was where I was really focused on. Hey, this could be a really attractive market. And sure enough. As we all seen, the private credit space in corporate lending has blown up. It's just been a darling and continues to be. And when I was with Aries I joined Aries full-time out of business school that was the flagship business, private credit business and it kept on growing, and so the mantra from management was hey, real estate private credit should be just as big. Why can't we make that? What private credit in direct lending is? And now it's really caught up and it has a lot of learnings from what we've seen in GFC and COVID. So it's been a long road to get here, but I think all of that helped form who I am and how I think about real estate credit.

Clem Miller: 13:31

So, joe, I've got a few questions and they're more motivated by, you know, sort of the part of our audience who may be, you know, very unfamiliar with this particular asset class, and so so keep that in mind as you answer some of these questions. So, first of all, private credit for real estate. Can you just sort of define that area? I mean, what are, what do you mean by that? Where do the you know, where, who, who originates private credit? I think is a a question that, uh, that some might ask you know who are the typical investors, uh, in private real estate credit? You know, how would you, you know, how would you pair this with other types of asset classes so that you're not, so that you're, you know, amply diversified? You know questions along those lines. I got more questions than that, but I'll leave you to start.

Joe Ryu: 14:31

Yeah, sure. So private credit is effectively a loan that's originated on typically a commercial real estate property, and so it could be as simple as saying there is an apartment building in Brooklyn and there is a mortgage on it for about $100 million building and a $60 million mortgage. That mortgage is a private credit instrument because it doesn't freely trade. It doesn't freely trade. So when you think about the public credit in real estate, where can you find publicly traded real estate? And that's typically in the bonds that are issued by owners. So publicly traded real estate investment trusts that issue bonds, real estate investment trusts that issue bonds or they issue preferred equity or they issue any type of term loan facilities and anything that you can get that you can buy and sell freely. You might have a QSIP, you can buy from your Schwab account and say, okay, this REIT is paying me 5% on these bonds and these bonds mature in 10 years. They're trading a little bit below face value. I'm getting a little bit more juice on that return. So I'm going to buy this bond because I think it's money good.

Joe Ryu: 16:04

Now, private credit how does an individual investor get access to that mortgage on that building in Brooklyn?

Joe Ryu: 16:12

They say, hey, that mortgage in Brooklyn is actually paying 6%, but I think that's a better investment than giving it to that REIT that owns office buildings across the country.

Joe Ryu: 16:26

But I can't get that credit instrument in my portfolio For that reason.

Joe Ryu: 16:32

It's private and it's typically been the domain of institutional investors like pension funds that would invest into whether they're separately managed accounts or in real estate private credit funds to get access to those private loans backed by hard assets. And because these are large loans, it's typically the domain of the institutions that are supposed to be smarter and say well, we'll allocate some of our portfolio to real estate private credit to get some better returns and less volatility, because in the public world you'll see a lot of fluctuations based on market sentiment. So a really strong office REIT in New York City is going to be much different from an office REIT that has suburban office properties across the country. But all of them are going to trade down together in sympathy. So there are pluses and minuses on each side. But the private credit space has really drawn a lot of attention and a lot of retail investors are now, furthermore, thinking how can we get access to this market, and a lot of the large funds have created products for retail investors to get involved with here.

Steve Davenport: 17:54

Is there a way to do you look at the like a benchmark in this space and say I really hope this property gives me, you know, benchmark-like performance. And the benchmark for private real estate Southeast would be, you know, 4.6. And we're looking at a property and that credit is 5.2. Do we have that kind of detail, or is that kind of where the magic is in private credit?

Joe Ryu: 18:25

It's a little bit of both exactly. So you'll want to benchmark against other fixed income substitutes. And then, when you say substitute, you're going to say, okay, if I'm going to put my money in a private real estate credit investment on a office property, that fixed income equivalent is going to be a very risky bond the high yield junk bond, right, because who knows what the value of this office property is. But if you then are investing in real estate credit backed by stabilized cash flowing multifamily investments, that's pretty strong. So you'll then benchmark against fixed income equivalents, whether they're BBBs or slightly higher, depending on where your leverage is in the real estate portfolio. And then, on top of that fixed income equivalent analysis, you look at real estate property indices and there are numerous indices published by various sources that benchmark how real estate equity funds have, and not every fund is included in these indices, it's selected. So you want to benchmark against two types of competing products.

Joe Ryu: 20:04

There are the real estate indices, which a lot of institutions might follow. But, moreover, everyone's looking at benchmarking against fixed income equivalents Like where can I get that return, that kind of yield, on a bond, and do I feel that my credit in the real estate product is better than the credit backing. Product is better than the credit backing, whether it's a company in pharmaceuticals or a company in technology. You probably look at something a little bit more conservative in terms of their risk, something less volatile. Probably compare real estate to something more of a staple in consumer products and look at the pricing of those bonds versus the pricing of the fixed income equivalent real estate credit product that you can get in private credit.

Steve Davenport: 21:18

That's great Thanks.

Clem Miller: 21:20

Yeah, so basically it's income investors who are interested in this primarily, correct.

Joe Ryu: 21:29

So that goes back to Steve's earlier question about real estate equity and real estate debt. Yeah, as I mentioned, anybody can get involved in real estate. Everybody who owns a home is involved in real estate. That's a large part of a lot of household balance sheets and when you own your own home, you're an equity investor, right? So if the price of your home goes up, you've made an equity return and you haven't made a current income investment. However, unfortunately, you're actually paying your mortgage, so you're net negative on a current income basis, but your expectation is in 30 years if you pay down your mortgage. If you sell your house for a profit, you've made a gain. So equity real estate investors are looking less for a current income. They're looking for capital appreciation and those funds are geared toward a total return that is driven by really selling an asset for a profit. Now some funds will advertise and say, hey, we're an equity fund and we can still pay a current distribution of 3% to 4% and target an all-in return of somewhere between 12% and 16% once we sell all these properties.

Joe Ryu: 22:53

In this environment, if you don't think that real estate valuations have bottomed, a lot of investors on the equity side in real estate are sitting on the sidelines and saying, well, we're not quite ready yet to jump into real estate equity because they're uncertain about valuations and interest rates are high, so borrowing costs are high.

Joe Ryu: 23:16

There's all these headwinds, and then the real estate credit investor says today hey, I like this landscape, interest rates are high, I can get paid a lot of money by lending on it and I don't have to take the risk of that equity investor and hope that the value of this property appreciates. I have an equity cushion behind me so I can lend Steve $100 to go buy a building that he's going to pay $150 for, and I feel a lot better about that because along the way, every month he's paying to pay $150 for. I feel a lot better about that because along the way, every month, he's paying me a current distribution. Now there are some hybrids that give you a mix of appreciation and current income and we can get into this later. But we have developed a strategy that does that, but it's certainly focused on delivering capital preservation for investors and delivering a current distribution that is an attractive yield versus what you can get in money markets and treasuries, but delivering a very conservative credit product that has very little volatility.

Clem Miller: 24:32

So, joe, I've got a few questions. So first question is valuation Is the lower? You know, one of the obviously biggest complaints about private equity at least, is that valuations are. You know they're thought to be sometimes manipulable, right? Sure, because they're, you know they're done infrequently. There's less transparency about it because there's no market equivalence. So my question is is that an issue in private credit? Let me give you my second issue, which is liquidity. On these private credit funds, is there any gating, which means for our listeners it means that you know you can't. You can invest, but you can't necessarily pull out your money all at once. You might have to stay in there for a certain time. The second one or the third question I have I don't know if you're writing these downs One is valuation, second one is liquidity with the gating. And the third one is how many properties are typically in a private credit fund? And I guess the broader question is how diversified is an individual private credit fund across industries, types of properties, etc.

Joe Ryu: 26:06

Yeah, all great questions and these are all very relevant. The first on valuation. So private credit whether it's real estate, private credit or direct lending to companies that are private, not listed has always had this debate on valuation and it continues to. And it will continue to because, as you said, it's not transparent. What happens is the manager of a private credit fund either uses a third party to value all their assets or they have some internal methodology that's reviewed by an auditor, some formulaic type of process that they outline and say this is what we're going to do on a quarterly basis or a monthly basis, and then true it up annually on a quarterly basis or a monthly basis, and then true it up annually Now, because you're not investing in public markets where you can see the price of a security every second. An investor gets a statement that says here's the value every month and in between that there certainly are going to be differences in variation in price, right, so it's a double-edged sword, and this is why it's typically been an institutional market in the past, where institutions say okay in exchange for having less insight into I'm locked into this. I'm going to trust this manager to deal with the valuations on a process in a manner that I've reviewed and in exchange I'm getting a higher return. So there should be a trade-off right. If you can get the same thing in the public and you feel like you're getting the same amount of risk relative to your return, then certainly go to a low-cost ETF. But the private credit fund is supposed to give you more stability and a higher return in an equivalent fixed income product with less volatility. So in exchange you're getting a better return and less volatility, so that you're not deciding I want to sell this month, but I want to sell in about six months or maybe in 24 months. And so long as they continue to invest in similar types of underlying assets, there should not be much volatility to the price, and so you can plan as a life insurance company or a pension plan and say I can probably redeem this investment in about 30 months. It should be around this NAV and along the way I've collected an 8% distribution and I don't have all of this vol on a publicly traded stock price that I have to manage. So for institutions that are not looking for liquidity they're not looking for a daily NAV it's a perfect trade-off and that's why it's typically perfect trade-off and that's why it's typically been the universe of institutional investors. But now you know the retail universe is waking up to say, well, I want those benefits too.

Joe Ryu: 29:48

Now going back to the valuation front, the valuation one is tricky because, let's say, the manager bought a property for $100 and it was an equity strategy. That valuation is determined either by a third party or internally every quarter. And who's really looking over their shoulder to say that, oh, each quarter that valuation seems to be going up 10%. You know, really, the benchmarking there is where the policing gets involved, right. So it's more a matter of you know, these third parties look and say, well, does that look reasonable compared to the overall market? And if it is, they don't say anything really. But there's a lot of discretion that does get involved in whether even it's a third party or in-house that is ascribing a value to that asset. And so a lot of the critics of private investing say, hey, it's good when things are going up, right, and I get a statement every month that says my investments are going up in value. But when you get hit with a black swan event and your statement still says it's up 150% and the public market are down, there's some dislocation there that you have. Investors say how is this possible? And then they all demand their money immediately and they can't get it out because they're the gates that you had just mentioned and those valuations don't reflect reality the gates that you had just mentioned and those valuations don't reflect reality. So one way to mitigate that is, if you don't believe right now in valuations, then investing in a more conservative portion of the capital stack.

Joe Ryu: 31:56

Real estate credit or private credit is where a lot of investors have parked their money and say, if these valuations are too high, I'm not going to go into a private equity fund, I'm going to go into a private credit fund and I am going to take a lower conservative basis and get a distribution on that and invest in this fund that has an equity cushion above it. That's one way to do it. Now, even with a credit fund, there could be a valuation concern similar to what we just described. So a real estate credit fund, let's say, put its money across 10 different loans and each one was made at, call it, $10 million, each period, monthly, quarterly. The asset management team has to look at the balances of each one of those loans and say are they money good or are they impaired? One of those loans and say are they money good or are they impaired?

Joe Ryu: 32:59

The analysis, however, is a little bit easier because you're not looking at the value of the building right. So say we take that Brooklyn example and say here's a $60 million loan on a $100 million property. The asset management team at the real estate credit fund says every period is this $60 million loan impaired? And they would only be impaired if the value of the building is only worth less than $60 million. So there would have to be a significant decline in that property's valuation for that team to say, well, we've got an impairment issue. So that's why real estate credit or private credit is more attractive, because you know the valuation is set by a third party or some team that says, okay, that building's still worth $100. And then the team says, great, our loan, is money good.

Joe Ryu: 33:50

Next period they move on and say wait a second, there was an earthquake or there was a fire in Maui and our building is gone, right. Then that building's no longer worth $100, it's worth zero. And then that's when that credit fund takes a full impairment right. There's no reason to keep that on the books at part value, reason to keep that on the books at part value. But what they will do is say what is the insurable value of that property and, by the way, we're the first ones to get paid. So with that insurance policy, the owner of that building file a claim, get the money from the insurance company, and it comes in two forms. It comes in either the money to rebuild the property or, if it's a complete loss, the money to, you know, pay whatever their maximum liability is, and that money goes to the lender and whatever's left over after the loan is paid is goes back to the owner of the property. So there's a lot of.

Clem Miller: 34:54

So, joe, let me ask you about the stack OK. Refer to it especially in a bankruptcy context or, like the Maui fire was, I think, is a really good example that you raised. So you're in the top stack, ok, the senior secured, it sounds like. Sounds like you are, and so I got two questions. One is are you in that senior stack alone or is there some kind of syndication process? And then the second question I have is who's in the stack, like the mezzanine I don't know, mezzanine might not be the right word, but who's in the, oh, the subordinated stack just under you but above the equity?

Joe Ryu: 35:38

Yeah, that's actually who we are. We're actually in the subordinate. Oh, you're in the subordinated.

Clem Miller: 35:43

Okay.

Joe Ryu: 35:43

Correct, correct. And so here's how it's easy to describe. You have a $100 million building and we're only providing this capital to existing cash flowing properties that are what we call stabilized, meaning they've hit their market level of occupancy. These are stabilized properties that qualify for government agency senior mortgage financing and that's like the best you can get in market because it's the cheapest, highest quality financing and you can be an investor in real estate credit, either in the senior or the subordinate side or the equity. And we've created a strategy that likes to be in that subordinate tranche, but only when we're behind an agency senior loan. And that's because the Freddie Mac and the Fannie Mae senior loans on cash flowing multifamily properties it's very low leverage and it's very low cost. So you can get right now a 5% mortgage on a high quality apartment building and this is the government kind of business and preserving housing and creating liquidity in this market. You try to get a home loan at that rate and you're not going to qualify for something like that.

Joe Ryu: 37:14

So when we can go let's say in this example there's a $60 million mortgage on a $100 million property we can provide $10 million above that 60, so that the 60 plus 10 equals a $70 million total debt package. Alternatively, the owner of the building can go straight to a bank or a life insurance company or a debt fund and get that entire 70 and call it a senior loan. So although we're subordinate, we're actually not hired in any leverage than what you can get from any other institution. We're just splitting it in two pieces, sourcing that bottom stack from the cheapest provider in the market because we're approved to work with Freddie Mac and it's very difficult to get that approval and we can issue the subordinate preferred equity very debt-like, very mezzanine debt-like preferred equity behind Freddie Mac. And when we provide that to the owner of a building at a combined $70 million it's actually cheaper than what they can get from a debt fund at Blackstone or KKR or Apollo. Now those debt funds can offer that $70 million in a single stretch senior loan and give the borrower the convenience of only having to work with one party because in our structure there's Freddie Mac and then there's Prospect Capital, so there's two parties that they have to deal with.

Joe Ryu: 39:02

But we kind of make it seamless. Everything is coterminous, everything has the same maturity date, everything has the same rights, everything has the same offensive defaults, so the same provisions they have to abide by. But negotiating the documentation upfront is a little bit more laborious, but that's my job. To get it done and for that, for instance, the the first two deals that we did, the blended cost of capital was roughly around 6%. Once you put in prospect capital's preferred equity investment, the equivalent pricing you would get from a commercial real estate senior loan debt fund that gave you the same amount of proceeds but all in one nicely wrapped package, would be roughly 7.4%.

Joe Ryu: 39:56

So we have a value proposition that owners of properties would like. We're providing the same amount of total debt, we're not providing any higher risk and because we structured it this way, I can get the benefit and actually profit off of Freddie Mac. Because their rate is so low, I can charge a pretty high rate for my paper sitting behind it and Freddie Mac gives us that right because we are also an owner and operator of multifamily properties across the country and currently we have 22,000 apartment units under management and they don't allow anybody to issue that paper unless they can step in and correct a problem that's happening at the property. So if there's a broken roof leaking and the owner of the property refuses to fix it, we can default them and then Prospect will go in and fix the situation. So we're kind of the first line of defense for Freddie Mac. It's a really mutually beneficial arrangement that in the real estate credit world only works because we have an actual real estate equity business where we own and manage properties. But we can use that advantage to make our credit fund really provide a compelling risk-adjusted return for investors.

Joe Ryu: 41:29

These senior debt funds that I mentioned they're using a levered that I mentioned. You know they're using a levered return to generate, call it, 11 to 12% levered returns. We're not using any fund level leverage and we're generating right now 13.5% IRRs and we have no leverage. So you know we have kind of a resource non-recourse debt from Freddie Mac and provide that to the borrower. And because we're doing it in that fashion, our fund has no liabilities. We are not on the hook to repay Freddie Mac. That's a borrower obligation. We are not on the hook to repay Freddie Mac. That's a borrower obligation. So a more, we would say, thoughtful mousetrap to generate better returns on real estate credit investments like in Maui or there's, you know, any other kind of uh diminution of value.

Clem Miller: 42:40

Uh, freddie Mac gets paid out first, that's correct, and you get paid out second.

Joe Ryu: 42:47

Yeah, yeah, that that is correct. We are subordinate Um.

Clem Miller: 42:59

So you're not leveraged.

Joe Ryu: 43:00

You're not leveraged at your level in the stack, but you are subordinated, correct, yeah, but what investors should parse through is, if you look at the commercial real estate debt fund universe today, I think there's over 100 funds, but they're all advertising the senior loan strategy and they all use fund-level leverage.

Joe Ryu: 43:25

So when I was with Aries Management, same game you use fund-level leverage and they advertise senior loans because it sounds great First mortgage, first lien, senior secured Okay, sign me up. But if you read the fine print, every loan that is originated from that senior debt fund uses borrowings. So let's take that Brooklyn example. Right, that owner in Brooklyn gets a $70 million first mortgage from a debt fund. That debt fund gives them that 70, but behind the scenes only contributed 10 million from the fund and then went to the credit facility and borrowed 60 million your credit facility and borrowed $60 million. So then they issue the loan at that rate, 7.4%. But yet they borrowed $60 million at 5% and they lever that return to make that $70 million loan, which has a base rate of 7.4%. It now generates, for the fund that only contributed $10 million, 11% to 12%. So let's take that wildfire example in Maui. Who gets paid first in that commercial real estate senior debt fund? It's the credit facility. So all of those senior debt funds are also junior, but they don't tell you that until you really figure out wait a second what does fund level leverage mean? And it means you're not actually senior, because in order to get that $60 million advance from a credit facility, that fund actually has to exchange the mortgage to receive that advance rate. So the senior debt fund is actually a junior debt fund and that's happening in front of everybody's eyes. Now, when we were advertising these funds to institutional investors at my own firm, they all understood yeah, there's no way this mortgage that you originated for 7% is going to give us a 12% return on this. Yeah, some pokey pokey, right. And in the prior payments, yes, all of those lenders that lend to the fund, they're paid first. So it's the same amount of exposure. So it's the same amount of exposure.

Joe Ryu: 45:56

However, the added advantage we have is this let's say we have that Maui example, right. And let's say the insurance was inefficient, insufficient. So the insurance company says oh, you know what? This was an event that was an act of God, it's not covered under the policy. So you get zero from us. So normally, the insurance policy might come back and give us $70 million, right, because the lenders all review the insurance to satisfy the amount that we've lent. Right, we don't care about the equity, we just really wanna make sure that we get our money back, but if it's an act of God. You know insurance companies can be very difficult to work with. They say we're not giving you anything. Here's what happens Freddie Mac gets zero, we get zero, the sponsor's wiped out, but Freddie Mac still has a claim against this borrower. Right, and Freddie Mac can't come to our fund. There's a clear distinction. We were never the borrower from Freddie Mac.

Joe Ryu: 47:18

Freddie Mac can't come after our funds now how, if you go to a commercial real estate senior debt fund and the insurance claims resulted in zero return, the credit facility is going to say, hey, you still owe me 60 million dollars, right? And that's what happened in covid. When everyone left Manhattan and these office buildings were vacated, all of these credit facilities called on the credit funds and said you need to pay us back in two days. And you know what happens. The owner of those properties that were lent the money said, hey, we're gone. Sorry, but who is liable? Who is responsible for paying back the credit facility? First? It's a fund, right? So we prevent that from happening in our structure so just just one more question, uh.

Clem Miller: 48:09

that, I think, will round out my understanding of your business model. Sure sounds to me like, in effect, you're operating as a kind of sourcer and agent for Freddie Mac. You're like going to Freddie Mac you're saying here are some properties and Freddie Mac and you, or you on behalf of Freddie Mac, are then going to buy the property. You're going to take that subordinated or junior position. Freddie Mac takes the senior one. Freddie Mac is probably relying on you for the credit analysis, I would imagine. Or maybe you're relying on them. Probably more likely they're relying on you for the asset analysis, but you're sort of operating on their behalf or as a, you know, as a partner, as a partner.

Joe Ryu: 49:04

Yeah, we're really a partner because, you know, freddie is such a massive organization and they have their very rigid underwriting protocol, which have gotten very strict particularly under this new administration, and so they don't just lend to anybody, right? So if you've had a default, bankruptcy, fraud, anything, good luck. You're not borrowing from Freddie Mac or Fannie Mae. That helps us, because we don't want to lend to anybody that doesn't meet their standards. Weeds out all the chat.

Steve Davenport: 49:36

Where do those problems go? Can I just finish this Maui example, out all the chat? Where do those go? Can I just finish this maui example with the? Because the one part I don't understand is okay, you, you presented the worst case possible where the insurance plays zero. Yeah, I mean, I've usually seen in these situations that they usually pay pennies on the dollar for some of the stuff. And let's just say they paid, they had a 60 million insurance and they got paid 30 as 50% payoff on it, but you still own the land. So you can Freddie Mac can turn around and sell the land to someone else to get up, because I guess when I think about a property, I think about its land and then the improvements to it. Sure Is it? Usually the land is about a third of the value and the improvements are two thirds. Isn't that the?

Joe Ryu: 50:27

It depends by market, but that's not a bad benchmark.

Steve Davenport: 50:30

Right, right. So when in reality you're getting 60 plus, you know somewhere around you're getting fully paid back because half of it is coming from the land and half is coming from the insurance. And if you got fully insured, you would have you know there'll be money, even for some of the equity holders, right.

Joe Ryu: 50:50

Yeah, now that's. That's typically the case, particularly in Maui and in the Palisades, where the land has incredibly strong. The problem is, it's just been a, it's been a catastrophe that nobody can then see the commercial viability of developing there.

Steve Davenport: 51:08

Uh, because of all the toxins in the land and city constraints and well plus if they can't insure it now, exactly because once you, I mean I don't know when these policies, like it feels to me like the whole space around Florida and some of these fire areas is really, you know, like I noticed here, and you know, every time I look at my insurance bill, it goes up, yeah, and I sit there and I say, well, we're worried about hurricanes affecting roofs. I'm saying my roof is six years old. What are you talking about? Oh no, we can't, you know, and I just, I find the. I mean, I like the fact that Prospect Capital is in the middle, with more experience in these and more ability to act than if I was to try, more ability to act than if I was to try, Like, I think that sometimes you and I look at things Clem, as how could I do this myself?

Steve Davenport: 52:08

And this is one case where I think it's very hard for us. You know, first of all, we don't have access to the deals. Second of all, we don't have the full understanding of how all the different machinations work. And thirdly, you guys are running properties, so you have that. You know. So when somebody says, oh, my property is 85% rented or 90, what is the number Like? Because I think that we're talking about the property itself. But if the property was not wiped out, but it was mainly damaged by a storm, the cash flow that you're getting from the property still covers the note right, when somebody is 95% rented, does that mean it's a 1.2 coverage? 1.5? Like what's a standard coverage when you've got something rented.

Joe Ryu: 53:00

Yeah. So Freddie Mac uses a benchmark where they're 1.25 on a amortizing debt service, which means when you buy a home, your standard mortgage payment includes principal and interest payments. It's not just a interest only payment, that payment. Freddie Mac takes the rate that they give you and say, if your monthly payment includes principal, pay down and interest, I need a one, two, five, x. That's why they're so, you know, conservative.

Steve Davenport: 53:38

Right Leave this really thick cash stack 20% of the property were damaged and weren't able to be drawn. The residents weren't there. You would still have full coverage from the 80% of the residents who are still operating.

Joe Ryu: 53:57

Generally so. Most of the deals we're closing on are probably 95 to 97 percent at least, so you know we can provide.

Steve Davenport: 54:09

Yeah, there's more cushion there than other right I'm just saying that, yeah, it's another form of cushion if the property has first of all the insurance being payable as one big item. But again, we're only talking about a case where an item is completely annihilated, as in a Maui versus Right.

Joe Ryu: 54:29

Yeah, we were given some really draconian examples just to underscore. But to your point, there is cash flow every month coming from all the tenants they direct. You know we direct them where to pay their rent every month and that keeps the lights on and then some. So in real estate there's a spectrum that we define as core, being stabilized properties, cash flowing, fully leased, and that is where most institutional investors have typically resided. They want to invest in core real estate, which means fully leased, cash flowing and in prime gateway markets. So New York City, boston, los Angeles, san Francisco used to be one, but, as you can see, real estate also has some transition. And then core, core plus value add and opportunistic. And the further you get from core, the less cash flow comes off of a building. So at this end of the spectrum, opportunistic, is your classic development story. Let's go buy this piece of land. It's not generating any income. In fact, we have to spend money on it, we've got to pay taxes, we've got to pay insurance, we've got to pay security and maintenance until we get it developed, entitled, first permitted, approved and then developed, and so for three years or more you're not getting any cash flow. And then, once it's built, you get a certificate of occupancy and then from there for the next call it two years you spend to lease it up and you finally generate cash flow. That's an opportunistic type of play where you're not getting any cash flow.

Joe Ryu: 56:14

The deals that we're looking at are all on this side cash flowing stabilized. We're not looking at construction. On this side, cash flowing stabilized. We're not looking at construction. You can make a lot of money lending on construction but there's a lot of execution risk, particularly with all these tariffs and particularly with buying out construction costs. Labor costs are skyrocketing. There's a lot of risk. So we're looking at this side. Core we're looking at maybe core plus in terms of quality, but all cash flowing, because we want to target the lowest volatility asset class within real estate and go to the most conservative type of asset, that's cash flowing, and deliver the best risk-adjusted return to our investors. And we're providing that capital preservation, we're providing an equity cushion so we're not in the first loss position and we can generate an equity-like return at 13.5% IRR without having to do all this work. And this one area called the value add. So there's opportunistic and there's value add, value add strategies right now in real estate equity they're marketing 12 to 16 percent returns.

Joe Ryu: 57:43

Uh, and you're in the first loss position yeah we're in real estate credit and we're delivering right down the middle of that fairway and we're not in the first loss position, we get a tractual coupon, okay let's go around and kind of finish our comments and we'll start.

Clem Miller: 58:00

I have one more quick question. Sure, no more questions for you.

Steve Davenport: 58:06

One more quick question. If you call it a comment, I'll let it go, but if it's a question you can't do it.

Clem Miller: 58:14

So let's say you've got three elements in the stack, you got equity at the bottom, you've got your position in the middle, and then you've got three elements in the stack. You've got equity at the bottom, you've got your position in the middle, and then you've got Freddie Mac at the top. What are the typical percentages of each?

Joe Ryu: 58:26

Freddie Mac's somewhere between. They're going to top out at about 60%, maybe as high as 70. They'll advertise going to 75, but generally you don't see that as often. And then we're the next kind of 10 to 15%, maybe sometimes 20%, but because we're expensive, generally the borrowers don't like to have us as a very big part of the stack. So we're typically in our deals ending at 75%, deals ending at 75%, and then 25% is the sponsor equity, common equity. And what's great is and this also goes to your prior question is a lot of these deals are coming to us from institutions that own real estate, multifamily properties, and say hey, property values have declined over the past three to five years because rates have gone up and so we paid 193 million for this building. It's now worth 170.

Joe Ryu: 59:30

And we're actually saying yeah we agree with you that value has declined but even at that reset value we still have in our analysis and the appraisal that we order at least 25 to 30% equity value behind us. It's not like we're reaching and saying yo, that valuation from five years ago. Let's continue to hold on to that. We're saying we're getting a new valuation today and we make sure that we have 25 to 30% cushion behind us. Evaluation today and we make sure that we have 25 to 30% cushioned behind us. And then that agent the question you said about agent agented activity with Freddie it's actually it's a two way street.

Joe Ryu: 1:00:15

A lot of times we have Freddie Mac senior loan originators calling on prospect because they want to do business with Prospect and provide senior loans on the properties that we own. So we're primarily all agency financed. We were blessed by borrowing long-term fixed rate during COVID, so we have no real maturities coming up until 2029. A lot of commercial real estate owners borrowed short-term floating rate and they're now in a pickle. But we have Freddie Mac originators calling on us because they want to do business with us and say, hey, we want to give you a new loan on that property. And we say why would we refinance. We're locked in these low rates. But they continuously stay in front of us because they want to do business with us and we say, well, you know what, we have our new fund. And when you go to another borrower and they actually need 10 million more or 12 million more, you know that we are approved by the agency to issue this paper. So we'll consider you guys on this deal. But call us whenever you have an opportunity.

Joe Ryu: 1:01:30

So it's kind of this two-way street. They come to us and bring us opportunity. We come to them and bring them opportunities, come to them and bring them opportunities and, having worked at a large real estate credit fund in the past, we, you know, had to compete based on our reputation and our pricing right. So we would say to an owner of a building say, hey, you know, we know you got 10 quotes from your real estate broker at CBR8 for a mortgage.

Joe Ryu: 1:02:02

We are a very well-known credit fund. We assure you that we can close within 45 days. And they say, fantastic, but you need to lower your rate by, you know, 50 basis points. Our channel is you know, there's still some competition. But we actually have the agency calling on us too to say, hey, we want to do this loan with this borrower, but they need 10 million more and because we have to size at a 1 to 5x coverage ratio, there's plenty of room here. Can you do this together and it's like a funnel that comes in this way and that's been a great source of our business that a lot of commercial real estate debt bonds won't get because they're not part of this ecosystem with Freddie Mac, and that's really one of our competitive moats that we're really proud of.

Steve Davenport: 1:03:00

Thanks, joe. I mean I think today was a great discussion but we didn't get to half of the questions I had because Clems Les jumped in front of me. We didn't talk about the Fed. We didn't talk about regional strengths of the South versus other areas. We didn't talk about you know real estate and how you know.

Steve Davenport: 1:03:23

AI usage and all the parts there was 15 better topics we could have covered, but we'll, we'll, we'll have to, that that just means that we'll have to have you back. I think there's a lot going on and I would love to get you know more perspective on how much interest rates move and influence what you do in terms of your being more aggressive or less aggressive, or do you think that we're going to see a recovery here with you know the lower rates and any? Anyway, I really appreciate you coming today and I think you did a great job.

Joe Ryu: 1:03:58

Um, thank you for our listeners I understand a lot more about this business that you're in well, I I, as I was saying, I can talk for hours, so I'll have to come back on um when I'm on the road meeting with investors. Uh, my, my sales team has to cut me off because I just keep talking. Um, I'm pretty passionate about it. I've been doing it for a while. I like that.

Steve Davenport: 1:04:23

Yeah, I think it's been great. I look forward to our listeners. I would say you have control of your finances and your investments. You can make a difference and you can invest according to your values and according to your goals. So this is an idea. This is all about education, and we're here to try to help you understand what's available in the market and what's available for you to consider as you look to allocate some of your funds, and I think that this is a great example of that. So, everybody who's listening, we appreciate you and we want you to realize we're here for you and if you ever have questions, please reach out and contact us and we'll try to get Joe back again in six months when he can tell us you know how the new Fed of the Fed is going to have lower rates and that's going to even be better for some of the real estate investments that we have. So thank you everyone. I appreciate you listening and share with others, okay, thank you.