Ten years have passed since the global financial crisis and the last commercial real estate downturn. While U.S. commercial real estate fundamentals are generally healthy, interest rates are rising, yields are being squeezed and prices are leveling off. In some markets and for some property types, values are even beginning to fall. In a market that is likely approaching its cyclical peak, it is time for global investors seeking a portfolio hedge to move out of commercial real estate equity and into debt.
Hedge your bets
Over the past decade, global investors driven by a lack of yield in conventional asset classes like bonds and equities have directed significant capital to alternative investments with comparatively favorable returns, especially commercial real estate. These increased capital flows have resulted in commercial property price appreciation and significant cap rate compression.
In addition, at the end of 2015, the Federal Reserve began raising its benchmark federal funds rate and has since raised it an additional seven times. The Fed has signaled its intention to raise rates again before year end and several times in 2019. The rate hikes, following the years of strong demand for commercial real assets, have also pushed down property returns.
Although high property values and cap rate compression have contributed to slowing acquisition activity, there is still significant equity capital seeking returns in the real estate market. According to research firm Prequin, at the end of first quarter 2018 global private commercial real estate equity funds had over $216 billion of dry powder. This capital availability is likely to continue to drive equity returns down as managers push to allocate funds.
Size matters
Commercial real estate debt investing is a strategy with a large addressable market. According to Federal Reserve data, at the end of 2017, outstanding commercial real estate debt (including multifamily) was approximately $4 trillion. Furthermore, maturing commercial real estate debt of approximately $300 to $400 billion per annum will need to be refinanced, creating sizable demand for capital going forward.
Of the $4 trillion of commercial real estate debt, approximately 70 percent is currently held by traditional lending institutions like banks. Traditional financing sources, however, have been significantly impacted by the regulations of Dodd- Frank and Basel III. Due to the tighter regulatory requirements, these lenders have become more conservative by curtailing leverage or retrenching from specific market segments, such as construction financing. As a result, demand for commercial real estate financing currently does and will likely continue to exceed supply, creating an on-going debt funding gap.
While alternative lenders like Crescit have been founded to fill this void, debt funds have barely made a dent in the commercial real estate debt market, accounting for less than 10 percent of the $4 trillion. According to Prequin, real estate debt funds raised $27.9 billion in 2017, up from approximately $24 billion in 2016 and $18 billion in 2015. Despite these increases, capital raised for debt funds still only comprised 25 percent of aggregate commercial real estate funds raised in 2017. This lack of debt capital availability means debt investors will likely have more opportunities to quickly and selectively deploy capital, while equity funds will experience increasing difficulty finding attractive acquisition targets.
It’s better at the top
Debtholders benefit from the enhanced safety of being senior to equity. As the first to be repaid, they are more protected from principal loss when property values fall. Conversely, equity investors are the last to be re-paid and the first to be impaired. During the 2008 downturn, some debt investors experienced principal losses; however, the property value declines experienced during the financial crisis are not expected this cycle because today’s market is not characterized by the same excess leverage.
During the years leading up to the 2008 financial crisis it was not uncommon for lenders to originate mortgages of as high as 90 percent loan-to-value (LTV). Post-crisis, traditional financing sources subject to tighter regulations have been unwilling to provide financing in excess of 60 percent LTV. Even the alternative lenders that have emerged to fill the lending void aren’t exceeding LTVs of 75 percent to 80 percent. As a result, equity cushions today comprise 20 percent to 25 percent of an asset’s capital structure on average. This means property values must decline by over 25 percent on average before the principal of a corresponding debt investment starts to erode.
Show me the money
At a time when there aren’t many fixed income vehicles providing a high current return, commercial real estate debt investing is an attractive fixed income alternative for investors searching for yield since it produces current cash income starting from the inception of the investment. Debt returns derive from interest and principal payments corresponding to each loan’s coupon, as well as loan origination and exit fees. Equity investors are also entitled to current income, but they receive property cash flow, which is subject to the uncertainty associated with rent and occupancy rates, operating expenses and capital improvement needs, rendering it significantly more unpredictable and volatile. In addition, nearly 100 percent of debt returns are received on a current basis, while the majority of equity returns are back-ended as they are derived from the ultimate sale or capital event at the end of the investment period.
A myriad of options
Within the commercial real estate debt space there are multiple investment options to choose from, each having its own corresponding risk/reward profile. On one end of the lending spectrum are lower risk, lower coupon term loans secured by stable properties. On the opposite end are more speculative, higher yielding opportunistic strategies like non-performing and construction loans. The risk also varies depending on where in the debt capital stack one participates in. More specifically, investing in the senior portion of a first mortgage is less risky than financing a subordinate note or mezzanine loan. By utilizing capital markets securitization technologies to finance and leverage a commercial real estate loan origination business, yields to debt investors can be strategically boosted even further. In today’s rate market, returns can range on average from 6 percent for unlevered lending to mid-teens for levered strategies. Ultimately, commercial real estate debt investing can generate returns on a risk-adjusted basis that compare favorably against expected equity returns, but with debt risk characteristics and benefits.
Joseph Iacono is CEO and Kim Diamond is head of structuring and credit for Crescit Capital Strategies, a commercial real estate financing platform that offers commercial real estate debt products, including construction, transitional and term financing, across all property types.