With rising interest rates and inflation, investors need a two-pronged approach to ensure stable returns and potential investment upside. Commercial real estate debt is increasingly part of this strategy, particularly as it can also offer attractive Environmental, Social and Governance (ESG) characteristics.
Financial problems are mounting for governments the world over. Markets have been volatile due to global trade and military tensions, the lingering effects of the COVID-19 pandemic, natural disasters, maturing debt and rising interest rates, and lowered 2023 GDP growth forecasts1. Achieving positive returns in these difficult conditions is going to be a formidable task.
These challenges are also having a marked impact on financial institutions, such as insurers, pension funds, hedge funds and mutual funds, according to the IMF’s latest Global Financial Stability Report. Not surprisingly, these investors are looking for defensive, non-cyclical income streams that offer stability.
Commercial real estate debt, a relatively young yet promising alternative asset class, could help satisfy this demand. Traditionally, loans to finance commercial real estate – such as retail premises, office space, and logistical buildings – were largely provided by the banking industry. But in recent years private investors have had the opportunity to provide some of this funding and share in the attractive returns available — particularly on financing arrangements for larger projects which involve different funding tranches from a number of investors.
This trend has been driven by a number of wider economic and regulatory factors, which have given investors greater access to this market while also stimulating demand for such products.
Factors supporting growth in the commercial debt market:
- Rising interest rates – in the current climate investors are seeing greater upside in holding high-earning debt, such as commercial real estate debt, for similar or better returns over equity positions, setting aside any capital value growth
- Volatile markets – there is a need for predictable, secure and growing income streams, provided through proper calibration of debt quantum, regular debt payment streams and asset collateral
- Recent market activity – the major sell-off of commercial property by private fund managers following the UK’s autumn 2022 gilts and pension crisis has led to investors looking for new areas to allocate their capital
- Regulatory changes – banks and low-risk lenders are reducing quantum of debt offered in senior debt transactions as a result of economic uncertainties. Also, they are less active in the junior debt market. This has produced a junior debt funding gap. Both have created opportunities for investors
- Opportunity to diversify – investors can utilise bespoke risk diversification through a deal-by-deal portfolio approach rather than blanket sector or country strategies
How investors can de-risk through diversity
Now that we are entering an era of positive interest rates across the Eurozone, we expect investors to allocate more capital to commercial real estate debt because of the higher yield paid on these investments.
But this asset class isn’t only attractive to investors seeking a premium in less liquid assets. Investing in commercial real estate debt also has the potential to de-risk portfolios due to the predictable nature of these income streams. This can be particularly attractive to many professional investors, including insurance companies, family offices and sovereign wealth funds.
The commercial real estate debt market is a growing and diverse market with a range of investment options that have distinct risk/return profiles. The options available to investors have increased in recent years, with traditional lenders such as banks, less willing or able, due to regulatory changes, to invest in the junior debt options. These can offer potentially greater yields to investors willing to take on some proportionate risk.
At the same time, more borrowers are also coming to market to either refinance their debt or look for lenders that offer more flexible terms, which private market players can provide.
These new opportunities have made it easier for investors to diversify within the sector, be it by geography, type of asset, term, or risk/return profile. Rather than be tied to any single sector strategy, it is possible to seek out specific opportunities, including investment opportunities offering favourable ESG characteristics.
With regulation comes opportunity
Due to tighter lending standards and regulatory constraints, banks are having to decrease their equity positions in commercial property. For example, the Basel III liquidity coverage ratio and the amount of equity risk the banks are willing to take on, have reduced.
This has provided an opportunity for others to invest in key areas of commercial real estate debt. Banks tend to be understandably conservative due to these regulatory constraints and are less willing to take on equity risk or to grant on more junior pieces of the debt. This is now the territory of the private market players, such as real estate funds.
The banks’ transition away from junior debt has occurred gradually over the past two decades. Many banks were once distributing the senior piece of the loan and keeping the more rewarding junior slice of debt. But with today’s regulatory and economic restrictions, the inverse is occurring.
Fund investment boards are increasingly looking to junior commercial real estate debt because it can provide returns in excess of 7-8%, and that is in the current market. Assuming the yield applies to the equivalent of double B-rated bonds, this is attractive even when compared to liquid assets, such as public debt.
A look at junior debt
As previously mentioned, the current market context may be challenging for real estate equity, with the market consensus forecasting a 10% downturn in equity prices 2. However, commercial real estate debt, particularly in the junior segment, can offer an attractive investment solution for those still seeking real estate exposure. Naturally, given the increasing market volatility this year, we have witnessed a de-risking from both an investor and a lender perspective. From an investor perspective, we have witnessed investors withdrawing from equities and favouring more secure assets, while lenders have taken a more conservative approach, underwriting loans with lower LTV (loan-to-value) ratios – towards the end of September, the average LTV ratio was approaching 55% (from approximately 60% at the end of 20213 .
Figure 1: Loan-to-value ratio within real estate is trending upwards
Source: CBRE, July 2022.
This upward trending LTV ratio (Fig 1) represents an attractive opportunity for junior real estate debt, as it has created demand from borrowers needing financing at previous LTV levels of 60-65%.
Essentially, the current market context has created a situation where lenders can finance junior opportunities that have similar characteristics and qualities to senior loans. Given this dynamic where lenders are taking a conservative approach, it comes as no surprise that opportunistic strategies are forecast to grow by 5.9% per year.
Figure 2: Europe focused real estate AUM Forecast
Source: Prequin, Sept 2022
The scenarios presented are an estimate of future performance based on evidence from the past on how the value of this investment varies, and/or current market conditions and are not an exact indicator. What you will get will vary depending on how the market performs and how long you keep the investment/product
From a returns perspective junior commercial real estate debt continues to offer attractive returns even when factoring in the current yields of public debt markets. Over the second half of the year, we have witnessed junior commercial real estate debt offering returns in excess of 7 to 9%4 which is attractive even relative to equivalently rated European BB rated corporate bonds which offer approximately 7%5 . Furthermore, any return comparisons between real estate equities and public high yield debt need to take into account security considerations. While subordinated to senior debt, junior commercial real estate debt still possess covenants and collateral (unlike unsecured public high yield bonds), which provide additional security.
Junior real estate debt also benefits from having the equity buffer, where junior loans only experience loss with equity price drops of over 30%, see Figure 3. This shows that the junior debt (IRR mezz) does not experience any loss until there is a change in property value greater than 30% – ie there is greater downside protection. Otherwise the value of the debt remains stable in other conditions.
Figure 3: Change in property value during holding period
Source: CBRE, BNP Paribas AM, 2022.
In summary, junior commercial real estate debt represents a compelling solution in the current environment for investors seeking either higher return or those seeking greater security.
Institutional investors that want exposure to property markets without extending their equity exposure are increasingly considering commercial debt investment opportunities. These debt vehicles are filling a junior debt funding gap and can offer the stability, security and higher returns investors seek in times of high inflation and bear market cycles.
At BNP Paribas Asset Management, we are confident that with the due diligence and research support of our in-house sustainability centre we will find attractive medium- to long-term investment opportunities that not only meet or exceed our investors’ ESG objectives, but also lend a greater sense of financial security in these testing times.
2 Preqin, CBRE, Metlife, 2022
3 CBRE, October 2022.
4 BNPP AM, Oct 2022
5 BBG, 31 October 2022