U.S. Commercial Real Estate Debt: Discovering beneficial routes of exposure

Investors are increasingly viewing Commercial Real Estate (CRE) debt as a benefit to the CRE market, which was already the case prior to elevated interest rates. Global AUM of debt funds has been increased 22% per year since 2019 and 62% of global institutional CRE investors were looking to increase their allocation to CRE debt in 2023¹.

The case for commercial real estate debt

Debt could be an important component of any investor’s CRE portfolio over the long term due to its impressive risk-adjusted returns and diversification benefits. Debt has long offered benefits to portfolios, though given the market volatility today, the case for debt is an attractive one.

At this point in the monetary policy cycle, we believe real estate debt offers the potential of more compelling returns than it has in decades. With higher credit spreads off higher interest rates and arguably with less risk, loans are being made with loan-to-value (LTV) ratios of already reset values.

The rise in market interest rates has caused coupons to rise significantly, not just against September 2021 values, but also against pre-pandemic rates in September 2019. Interest rates on 10-year money have increased by around 370 basis points (bps) since September 2021². Over shorter terms the increases have been larger, with rates on five-year money increasing by 420bps since 2021 and 300bps since 2019. These market rates have been the main driver of changes in debt costs with spreads fluctuating around their long run trend over the same period. Overall, based on CBRE’s estimate of spreads, typical debt costs for a CRE 55-65% LTV fixed rate loan over 7- to 10-years were typically 6.25%-6.50% at the end o fQ2 2023, up almost 300bps since Q2 2019.

Managing lending risk to increase risk-adjusted returns

During the same period, the appreciation returns available to CRE equity investors have turned increasingly negative, partly in response to higher CRE debt costs. As appraisals have weakened, default risk has begun to increase but U.S. loan delinquencies remain at low levels outside the CMBS sector. (Figure 1)One reason for this is that the equity cushion underlying CRE debt investments protects debt investors from all but the most extreme falls in CRE valuations.

CRE debt investors could manage their risk by lending at moderate LTVs in markets and formats where valuation loss is limited by underlying resilience in occupier markets. This can offer a lower risk route to gaining exposure to their most favoured sectors. The secondary debt market can also offer debt investors a method to exit any mortgages they no longer wish to hold.

A funding gap is emerging

Traditional lenders have responded to the changing risk profile in wider CRE markets by reducing their lending exposure, rather than managing it. Many bank lenders have either stopped writing new loans or continued with reduced LTVs in select market.

MBA reports that U.S. bank originations are down 69% year-on-year in the 12 months to Q2 2023 while CBRE report that typical LTVs in CRE loans in Q2 2023 remained 4-5 percentage points below their long-run average, with the tightening more pronounced in multifamily than commercial. This has left an emerging funding gap for viable lending opportunities in the mid-range of the lending risk spectrum, at 55%-75% LTV. Returns for these loans are elevated by the increase in overnight interest rates alongside a marked increase in spreads available due to reduced lender competition.

Alternative lenders have a rare opportunity to provide this funding at elevated returns, potentially without increasing their usual lending risk. If we consider a 55-75% senior loan over five years, the returns to investors could be boosted by a spread in the range 275-350bps delivering a coupon of 8%-9%. At the same time, the 25% equity cushion embedded in the transaction will protect the returns to debt investors so long as the loan collateral avoids a value loss of more than 25%. Our forecasts suggest that this value resilience can be achieved in several markets by targeting loans collateralised by industrial, housing and alternative real estate.

In the alternatives space, the most attractive formats are manufactured housing, student housing and self-storage. These sectors have already experienced most of the value loss expected during this cycle, so new loans based on reset valuations are relatively insulated.

Combining our forecasts of value change and the historic volatility of sector valuations, we can simulate the likelihood that loans will complete their terms with collateral values remaining high enough to pay off the loan in full. All major sectors except office have a greater than 90% probability of full redemption of a -year 75% LTV loan over 2024-2028 with industrial and multifamily housing the safest sectors at 98% and 96% respectively. (Figure 2)

Development exposure could increase risk-adjusted returns potential

Lenders could increase returns by financing development projects, particularly since bank lenders are reducing their own development exposure. Additional spreads on these projects may add 100-200bps to expected returns, but lenders need to manage the additional risks involved; namely construction cost risk and leasing risk.

Fixed price construction contracts largely remove the first of these. Leasing risk can be managed by operating in sectors with low availability and strong tenant demand. These sectors largely overlap with the list of the strongest secondary debt markets, namely housing and industrial. In these sectors, strong tenant demand and a muted supply pipeline often ensure almost all new product is leased on or even before completion.

Alternative CRE debt lenders currently have a unique opportunity to generate above average returns in the U.S. CRE debt market due to higher interest rates, the retrenchment of traditional bank lenders and the opportunity to use market selection to manage risk. We expect this unique market environment to persist due to both structural and cyclical factors, allowing CRE debt investors to outperform in nominal terms as well as on a risk-adjusted basis.