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
Source: MSCI, CBREIM
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
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…
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).
3. … And at lower cost
For the credit investor however, costs are far lower.
4. Downside protection is welcome where forecast uncertainty may be higher…
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…
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.
7. Credit is culturally a late adopter; return premia for emerging asset classes may persist longer.
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.