Essay | Global Vision 2022

Credit and the demographic dividend

By Dominic Smith


The potential for real estate credit to act as a complementary overlay, rather than as an alternative to or subset of, real estate equity, is frequently overlooked. Often, in industry surveys of investor intentions, for example, real estate credit is presented as an alternative sector alongside real estate equity; participants are frequently asked “will you invest more / less / the same this year in office, retail, logistics…. credit?”. Positioning Credit within the equity spectrum in this way is a common misconception, perhaps reflecting the source of capital from which such surveys speak. In reality, real estate credit is an asset class entirely separate from equity, offering a very different risk and return profile. It is on this basis that this article discusses potential reasons that investors might have for choosing to access via credit the demographic driven opportunities discussed in depth elsewhere in this volume.


How credit differs from equity

It is the structure of credit investments that has delivered a stable, predictable total return for investors. From 2003 to 2020, as shown in Figure 1, we estimate that a portfolio of core senior private credit secured against prime assets would have achieved a total return of around 4.0% per annum (p.a.), with an annual total return high of 6.4% and low of 3.3%. This compares to the average investment in a diversified UK core equity fund strategy of 5.7% p.a., with investors experiencing a high of 19.9% and low of -26.0% over the same period. In other words, while equity typically delivers a higher return, credit gives a more stable one, with less downside risk. 


Real estate credit returns are derived from three elements: the interest rate (which may be fixed or floating), a margin above the interest rate, and any arrangement, non-utilisation, exit or other fees that may also apply. These are all known in advance, and the only way the return will not be achieved in full is if interest is not paid, or if the principal is not repaid on maturity. Loans are designed to ensure there is plenty of surplus cash in the structure above interest payments to ensure affordability, while lending only a certain percentage of an asset’s value (senior lending for example might not go over 60-65% loan-to-value (LTV)) gives a strong layer of protection should asset values decline – the first loss is borne by the borrower, not the creditor.

Real estate equity on the other hand derives its returns from rental income, which is known at the outset of an investment but may be variable (both up and down), and from changes in the value of the asset arising from a changing income profile and/or from changes in the pricing of that income profile by capital markets. Of course, in the event of income or values rising, credit does not capture that upside.

It is through combining these differing characteristics that investors can see the most significant benefits, as shown in Figure 2. This analysis of UK credit and equity returns between 2003-2020 shows that by adding credit to a real estate equity portfolio an investor will have achieved superior risk-adjusted returns, with the Sharpe ratio (excess return per unit of risk) increasing as the allocation to credit increases. In terms of absolute returns, as credit is added to the portfolio returns decline by around 9 basis point (bps) p.a.; however, adding credit has greater proportional impact on reducing a portfolio’s risk characteristics with volatility and beta all declining as the weight increases.


With that understood, why might an investor consider credit as a complementary way to access any opportunity, but specifically those identified in this publication as being demographically attractive?


Seven reasons to consider credit as a strategic and tactical means of exposure to the demographic dividend

1. Expanding the investible universe

In some cases, there is already a significant volume of investment grade stock in sectors and markets that we have highlighted as being demographically attractive – the UK student housing sector for example, while still having pockets of under-supply, is undeniably mature – but in others, opportunities are harder to source. Dementia care for example, as very much an emerging sector, can be problematic to invest in at scale.

If an investor can choose to invest via a credit route as well as an equity route, this naturally increases their investible universe. Perhaps not all assets will utilise debt, so the set of assets accessible to the credit investor may be a subset of the overall investible universe; but on the other hand, assets may seek debt more frequently or more immediately than they are transacted, meaning that in a given timeframe access to a part of the investible universe can only be achieved via the credit route.

2. Credit portfolios naturally re-weight more rapidly…

An investor seeking to realign an existing portfolio to demographically advantageous sectors (or otherwise) faces the practical challenge of selling physical assets in sectors they no longer prefer before reinvesting proceeds in sectors they do prefer. The real estate market is liquid, arguably more so than is often given credit, but the typical levels of liquidity are significantly below those seen in credit, which allows for much faster natural realignment of portfolios as loans mature. 

To show the extent to which this is the case, we can compare the typical turnover of investment markets with the duration of loans. Figure 3 shows the average investment volume over 2018-2020 as a proportion of the investment universe. The latter figures are an estimate and have a margin of error around them, but overall they give a good indication of the level of turnover across EMEA, which averages 10.8%. In other words, if a portfolio sold assets at the same rate as the market, the average hold period of an asset would be roughly 9.25 years – or to put it another way, it would take the portfolio manager 9.25 years to change every asset in the portfolio, if transacting at the EMEA market average rate of turnover.

By contrast, we estimate that the typical loan duration is a fraction of that 9.25 year duration. Figure 4 shows the loan duration and amount of a sample of 820 UK loans totalling £23.2bn assessed by CBREIM in 2019-21. The most common duration is five years, but with very few requests for longer durations, the unweighted and weighted average durations are 4.1 and 4.2 years respectively. One could factor in also that loans typically repay or are refinanced 6-18 months ahead of maturity, but even without this nuance factored in the data shows that the credit portfolio manager can effectively change every loan in their portfolio in a little over four years – less than half the time taken on the equity side. If speed of access to demographically appealing sectors is appealing therefore, credit definitely has something to offer.

Source: CBRE (investment volume), CBREIM (invested universe).


Source: CBREIM

3. … And at lower cost

It is not just in the speed at which portfolio realignment can be achieved that makes credit potentially attractive, but the relative (lack of) friction cost. It is not the intention of this section to describe in minute detail the various types and amounts of purchase, sale and/or capital gains taxes or professional (e.g, legal, valuation, transactional) fees that the real estate investor might be forced to incur, but in major European markets investors might budget for a “round trip” of 7% covering all the costs of purchase and sale of an asset.

For the credit investor however, costs are far lower.
Lenders are not subject to tax on purchase or sale nor on capital gain, since they do not purchase or sell assets themselves and make no capital gain.
Similarly, transaction fees are borne by the borrower. Some professional fees may be incurred but these are typically lower too. Overall, the fee burden on the credit investor is many orders of magnitude lower than on the equity side, reducing value leakage out of the portfolio to de minimis.

4. Downside protection is welcome where forecast uncertainty may be higher…

When embarking on investment in an emerging sector or market, the dearth of available data compared to more familiar, established markets can be disheartening. Lack of historical market information can make contextualising current and forecasting future conditions difficult, while sample size issues relating to what data does exist increase the margin for error further. By comparison, where data exists for markets across multiple cycles differing in nature, investors can have more faith in the predictive power of forecasts.

Arguably, part of the higher returns on offer from emerging sectors are compensation for this uncertainty. But some investors may feel that downside protection on part of their exposure would be welcome, given the lower confidence most would place on forecasts made of emerging markets rather than of established ones. Credit, as we have described above, can offer that downside protection, by providing a cushion against rental and capital value decline. Credit exposure may therefore complement equity investment from a risk management perspective.

5. ...and where specific risk may be higher…

Many of the opportunities presented by demographic change will be in new, emerging or realigning sectors. Investing in these often incurs exposure to greater specific risk, as asset level volatility can be higher in smaller markets. This is demonstrated in Figure 5, which shows for six sectors of the UK market, all of which can be said to have “emerged” to varying degrees as institutionally investible sectors over the last 40 years, how asset level volatility generally tends to decline as sample size rises. When sample size is below £1bn, the inter-quartile range in five-year capital growth (the length of a typical loan or investment horizon) more often than not exceeds 50%, but as sample size increases, as investment capital flows inwards, this figure falls to consistently below 30%. Making an investment in a larger market therefore confers a higher level of confidence that the asset’s performance will be closer to the median than an investment in an emerging market. For investors nervous about that volatility, the downside protection afforded by credit might be appealing.

Source: MSCI.

6. .and while upside doesn’t translate to higher return it does reduce risk.

As observed above, the credit investor does not benefit directly from capital growth of underlying assets. If an asset they have funded doubles in value, the lender receives back the value of their loan – no more, no less. With greater potential for value growth a key attraction of demographically appealing investment plays, this might appear a significant drawback for credit as an attractive investment route.

However, this view does not capture all elements of risk and reward. Certainly, lenders do not benefit from rising asset values in the reward sense, but they do in the risk sense, because as values rise, a lender’s exposure falls. For example, if a loan is made at 60% LTV on an asset that subsequently increases in value by 20%, the resultant LTV is 50%. Figure 6 shows worked examples of this for different levels of capital growth from 0-5% per year; at the higher end, LTV could fall from 60% to under 50% at maturity, effectively averaging in the mid to low 50%s through the life of the loan.

This is advantageous to the credit investor in several ways:

  • Default risk is much reduced; rising asset values mean LTV covenants will not be tripped, nor will the loan be in LTV breach at maturity. 
  • Refinance risk is reduced, as an asset with a strong track record will be attractive to other lenders should the current lender not wish to refinance.
  • With margin based on LTV at origination, a lower LTV through the life of the loan thanks to strong capital growth effectively means that margins in the later years of the loan are higher than would be the case if rebased to the current LTV; the lender can thus be argued to be getting a premium on the market return.

Source: CBREIM

7. Credit is culturally a late adopter; return premia for emerging asset classes may persist longer.

Often, at the macro level, credit is a later mover: equity typically finances start-ups, while credit markets find it easier to underwrite at scale more established, mainstream ventures. It is possible therefore that what might be termed the demographic premium could be longer in credit rather than equity. Demonstrating this is challenging due to the lack of market-level pricing series for credit, however Figure 7 makes the case for this using the example of the UK purpose built student accommodation (PBSA) market.

Over the last five years covered by the sample (the Bayes loan pricing data does not extend back any further), the UK PBSA market has matured considerably; this can be seen in the yield data, with investors no longer requiring the discounts to mainstream sectors that had once been sought. By 2020, yields on prime London PBSA stock had fallen to 3.90%, just 15bps ahead of the prime London office yield and a fraction of the 75bps gap seen in 2016. However, lending terms have been stickier, with the ratio of PBSA to office margins actually increasing a little over the same period (while LTVs have been broadly unchanged). This suggests that credit can perhaps expect to enjoy higher returns for longer on maturing sectors.

Source: Bayes Business School, CBRE, CBREIM.