Real estate lending can offer several important qualities to institutional investors through the current uncertain environment – and into the future.
With interest rates higher than they have been in years, the real estate debt sector is going through a period of change.
As borrowing costs rise, some may find restructuring is necessary. Others may find it much more challenging to fund operations – and with a recession widely expected in the near future , conditions are unlikely to improve in the short term.
For investors such as insurance companies and sovereign wealth funds, however, there remain many attractive long-term opportunities in the real estate debt market.
A turning point?
In recent years, real estate has experienced a period of severe turbulence. From the Covid-19 pandemic to the more recent surge in inflation and interest rates, valuations and rental income have come under pressure.
The pandemic has had a profound impact on some subsectors of real estate. Traditional offices are under pressure as some companies reassess how much space they need as more staff work from home. A recent PwC report cited industry experts’ estimates that 10-20% of office stock may need to be “removed or repurposed”.
Logistics assets and server warehouses, meanwhile, have become a vital part of the infrastructure of many countries as more and more services move online.
Rising interest rates are making things more expensive across the board, which is reducing short-term investor interest in real estate debt. However, for investors allocating to real estate debt, the focus should be on long-term trends.
Sustainable debt investment
Chief among these trends is sustainability. Regulators, policymakers and other stakeholders increasingly expect institutional investors to consider risks such as climate change when making allocations.
Real estate debt offers investors plenty of opportunities to invest positively to support environmental or social objectives while also generating a financial return. Examples include financing the developments of buildings that are more energy efficient, by regulating temperature and lighting without high energy consumption – or refurbishments of ageing properties to become more energy efficient.
Lending to properties with strong environmental credentials can maximise the potential for value creation as well as reducing refinancing risk. Most corporate executives believe sustainability is important to their businesses , making it increasingly likely that they will consider the environmental credentials of their premises when renewing leases or seeking new locations.
Opportunities in the commercial sector
Commercial real estate debt is another area of promise. As banks have become less willing or able to finance large or complex transactions, sophisticated institutional investors can step in to fill the funding gap.
Whilst the real estate market has recently experienced challenges, the European real estate debt market has notably remained resilient. In response to the recent macro uncertainties, sponsors have been taking a more conservative approach to lending, originating deals with lower loan to values (circa 55% LTV) compared to pre-Covid times. Essentially, we are seeing opportunities with less debt volume while maintaining the same levels of return. This therefore represents a favourable time particularly for investors focussed on security and stable long-term income.
As well as adding diversity to an investment portfolio, it can also offer investors access to predictable income streams . With more borrowers coming to market, there is a growing number of opportunities to allocate to these assets – and on favourable terms for the lenders, which can use this advantage to push for ESG-related conditions to be added to loan agreements.
Investors will have to keep a close eye on credit quality. If inflation remains high, rents should increase too – but this may cause problems for some tenants if they struggle to meet these payments on top of other expenses such as utility bills. Engagement with managers to understand the quality and financial security of tenants is an important part of the due diligence process.
Don’t fear complexity
With market conditions tightening, there may appear to be fewer straightforward lending opportunities. However, projects and operators will still need financing, and sophisticated institutions should look to use the premiums available from taking on more complex transactions.
Notably, there have been financing opportunities in the senior debt space with lower debt volumes (ie lower LTVs) while maintaining the previous level of returns. Furthermore, sponsors have also responded to the market conditions by focussing on different seniority or types of loans, representing compelling opportunities for investors seeking higher returns.
Whether it is through exploring niche subsectors of the real estate debt universe, negotiating strong collateral terms, or clubbing together with other investors to finance a larger project, those willing to innovate may be able to generate attractive returns despite wider market headwinds.
Navigating short-term challenges requires a long-term view, and real estate debt can fit well with a truly long-term investment strategy.
1 Source: World Economic Forum, ‘Chief Economists Outlook’, January 2023. https://www3.weforum.org/docs/WEF_Chief_Economists_Outlook_2023.pdf
2 Source: PwC, ‘Emerging Trends in Real Estate 2023’, January 2023. https://www.pwc.com/us/en/industries/financial-services/images/pwc-emerging-trends-in-real-estate-2023.pdf
3 Source: World Economic Forum, ‘Why sustainability is crucial for corporate strategy’, 9 June 2022. https://www.weforum.org/agenda/2022/06/why-sustainability-is-crucial-for-corporate-strategy/
4 See: BNP Paribas Asset Management, ‘The case for commercial real estate debt’, 9 September 2022. https://www.bnpparibas-am.nl/professionele-belegger/outlooks-research/the-case-for-commercial-real-estate-debt/