When it comes to investing, there’s no free lunch. Portfolio diversification is hard to find, especially in an environment where differentiated investment strategies aren’t always easily apparent. However, commercial real estate debt may provide one of those opportunities, an outsized market that may offer the risk-adjusted income you need.
Market dynamics are lining up
Today’s commercial real estate debt market is the perfect example of a supply-demand imbalance: rising demand for financing in a growing economy with little supply to meet it from traditional avenues.
Stringent regulations and higher capital requirements post-Recession prompted many commercial banks, historically the largest source of commercial real estate financing, to consolidate, pull back on many of their prior lending practices, or shut their doors. In fact, one-third of the top originators in 2007 are no longer actively lending, according to the Mortgage Bankers Association.1
Those that remain are far more selective (a nicer way of saying more risk adverse) with their capital, turning most of their attention to lower-leveraged, stabilized assets in prime markets. Instead of hitting loan-to-value (LTV) ratios in the 75-to-80 percent range typically seen before the Recession, most ratios are capped at 60-to-65 percent today. Banks are holding more whole loans on their balance sheets and are much less active in the commercial mortgage-backed securities (CMBS) market. Originations are down 40 percent year-over-year, and the total market is down more than 60 percent from its 2007 peak.
In short, it’s harder to get financing today.
Yet, demand remains high. There is more than $3 trillion in commercial real estate debt outstanding, and transaction volume remains well above historical averages, with 2017 volume one of the strongest on record, according to Moody’s/RCA. Contributing to demand is the growing need for refinancing, with over $1 trillion in real estate loans set to mature in the next three years, including $300 billion in the CMBS market.
Outside of core areas, debt is far less accessible. Borrowers outside top markets seeking 65-to-80 percent leverage on loans greater than $50 million are finding fewer traditional options. This provides a path for flexible alternative lenders not constrained by the regulatory or risk requirements facing many traditional banks and insurance companies. It’s these loans that present a potentially attractive investment opportunity.
Understanding an investment in commercial real estate debt
As an investor, you are the bank, investing capital used for loans and other debt financing to property owners, similar to an investment in any other loan or bond. Returns are based on interest income received over a set time period. Unlike many traditional bonds, interest coupons are typically floating rate and adjust higher or lower as market interest rates do the same.
The income paid adjusts in tandem with interest rates, which makes floating-rate mortgages especially attractive in a rising rate environment. Also, if a tenant defaults or property values decline, you are first in line for repayment, potentially preserving the value of your investment.
You can access these loans through investment vehicles such as publicly traded commercial mortgage REITs or institutional private funds. Whether you invest in a public or private vehicle, you can select from a wide range of strategies that are differentiated by loan size, geographic or sector focus, and loan-to-value metrics. Make sure to also assess the sponsor’s access to financing and its credit underwriting track record.
Publicly traded mortgage REITs may represent a more straightforward access point given their ready access to capital and easier path to scale. Specialized institutional private funds are also differentiated by loan size and risk retention, but they are more difficult to access due to high investment minimums and suitability requirements.
Where debt investments may fit into a diversified portfolio
Both real estate debt and equity investments may offer income-focused returns, but understanding key differences will help you determine allocations that fit your portfolio’s goals. As an equity investor, you are a shareholder in a portfolio of properties, similar to a landlord but without the management headaches. Returns are based on rental income and changes in property values, which are historically tied to changes in interest rates. However, if a tenant defaults on a lease or property values decline, you will experience first loss in value. For the increased risk, real estate equity investments seek to generate higher returns.
For comparison’s sake, take a look at how equity REITs and U.S. commercial mortgage REITs have performed year-to-date versus the 10-year Treasury. As rates have climbed, equity REITs have delivered a 4.3 percent return, while U.S. commercial mortgage REITs have returned 15.1 percent.
Current market offers investment options
The structural imbalance in today’s commercial real estate debt markets isn’t vanishing anytime soon. While President Donald Trump’s administration has battled over Dodd-Frank and attempted to repeal or water down other banking regulations, many still stand. And even if the pendulum swings back closer to pre-2007 levels, many banks may remain gun shy to revert back to previous practices.
Yet, demand for financing in a growing economy is likely to remain strong. The U.S. economy grew at its fastest pace in nearly four years this spring, piling on to the momentum it’s built up during the recovery.
This imbalance creates a void likely to be filled by alternative lenders like private equity and business development companies (BDCs), and the loans they provide to real estate owners present a potentially attractive income investment for investors looking to diversify their income-focused portfolios.
Just remember, real estate investing is not an “either or.” Leveraging both equity and debt investments may help you build a real estate portfolio that offers broad diversification, satisfies the returns you need, and generates attractive risk-adjusted income in today’s investment environment.