The last three years have been characterised by heightened global uncertainty as a result of the war in Ukraine, a rapid rise in inflation and subsequent increase in central bank policy rates. Unsurprisingly, commercial real estate has been impacted with significantly reduced transaction volumes and a wide bid-ask spread, driven by sellers’ expectations being rooted to historic prices while buyers’ expectations are tied to the rapid rise in the cost of debt, and the rising yield environment. Investors have been cautious to deploy capital, given the deteriorating macro environment and the uncertain outlook.
In recent months inflation has decelerated and visibility around the timing of peak interest rates has improved. Prospective investors are asking whether the time is right to deploy into real assets and the optimal route; debt, equity (direct real estate) or both.
Real estate debt markets are experiencing a confluence of trends which create an attractive opportunity today. Declining availability of debt financing, real estate yield re-ratings and rising interest rates have created favourable return conditions. Senior loans, which typically represent 50-55% of property value, are structured to provide stable cash flows to investors.
Downside protection is provided by the 1st mortgage structure (who gets paid first in times of distress), large equity cushion, strong covenants and cash traps that can be used to deleverage the loan. Returns depend on sector and location but in the current elevated interest rate environment, IRRs in senior loans are circa 6-7% over a 5-year loan maturity period. For cautious investors, this return will be attractive as the strong downside protection will help preserve their capital and income. For example, given the large equity cushion, property prices over the next 5 years would need to drop by a further circa 50% in order to erode away all the equity and start to impact the senior debt.
The risk adjusted returns from senior real estate lending look compelling.
Investors seeking more upside will either need to seek exposure in higher LTV debt strategies or selected real estate equity strategies, both requiring higher conviction and move up the risk curve. For real estate equity investors, the marked reduction in transaction volumes at -54% between January to August 2023 vs same period 2022 reflects the uncertainty of transaction price discovery and thus valuations. This is both a risk and an opportunity but reminds of the risk adjusted returns of senior lending.
It is noteworthy that there has always been a considerable range in returns within sectors. An analysis of MSCI data for European offices, for example, suggests that the average returns spread in offices have varied significantly - there has been an average annual dispersion between the 5th and 95th percentile of offices of some 35% over the last 20 years. Even in the office sector, that has to deal with several challenges, you can still outperform if you select the right assets at the right locations.
In times of heightened cyclical market uncertainties, real estate debt investments are in the spotlight on the basis of their attractive risk-return profile. For now, senior real estate lending protected by the cushion of high equity represents an appealing investment approach for institutional investors.
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