Investors who take a broad view of commercial real estate may be missing out, especially at this point in the economic cycle.
If you follow the narrative you're hearing on Wall Street and in the media, commercial real estate (CRE) may seem like an asset to avoid in 2024. We don't think so. But how investors gain exposure matters. When leveraging private capital, we believe it's better to be a lender than an equity investor at this point in the credit cycle.
We expect to see attractive opportunities for private credit investors this year. Banks are leaning back on CRE loans well into 2023, and this long-term trend is likely to continue. However, the need for financing remains high, with more than €600 billion in loans due to be refinanced in Europe over the next 24 months. According to the American Mortgage Bankers Association, nearly $1 trillion in loans will mature in the U.S. this year alone.
European banks have a larger share of real estate lending than their U.S. counterparts, but regulatory changes requiring banks to put down more capital in commercial real estate loans could see more borrowers turn to alternative lenders for financing.
Assess the risks
But is it the right time to add commercial real estate debt (CRED) to your portfolio? Some investors may be wondering, now that rising interest rates have made the debt no longer able to command much higher yields than more liquid investment-grade securities such as corporate and government bonds.
Additionally, challenges facing borrowers include high interest rates for an extended period and the possibility of an economic downturn before the end of the year. Investors may be wondering whether current CREDs provide sufficient compensation to compensate for these risks and whether exposure through private equity could potentially deliver higher returns, especially if major central banks cut interest rates.
We believe both CRED and private equity are suitable for a diversified portfolio, however, at this stage in the cycle, we believe fixed income is a more attractive way to maintain exposure while mitigating downside risk.
The pendulum is swinging in favor of lenders
In our view, there are advantages to being a lender when the market appears to be nearing a bottom, but has not yet reached it.
First, many of the borrowers and sponsors able to enter the market later in the cycle tend to have good collateral and strong credit quality. But they are all struggling to attract the attention of banks that are cutting commercial real estate lending due to regulatory changes, high interest rates, and economic concerns. This shifts the balance of power to private lenders who can cherry-pick the best borrowers and collateral and negotiate deals with high return potential and low downside risk.
All this typically translates into strong protection clauses such as leverage limits, property valuation review, increased margins, reduced loan-to-value ratios (LTVs), etc. These protections then create a steady income stream provided by the cash flows of the underlying assets.
Thicker cushion
All of this translates into a thicker cushion to absorb losses. Equity ownership carries greater rewards in CRE deals. But it also carries higher risk. Equity claims are the first in the capital stack (the hierarchy of capital sources used to finance a real estate project) to suffer losses if the project defaults.
In the following illustration, let’s look at a hypothetical commercial real estate property with a LTV ratio of 65% and a capitalization rate (the property’s expected rate of return based on net operating income and current market value) of 5%.