Credit Where Credit's Due - The Role of Real Estate Credit

Real estate debt is playing an increasingly important role in real assets portfolios, say CBRE Investment Management’s Isabelle Brennan, Todd Sammann, Emma Huepfl and Dominic Smith

Q: How would you describe investor appetite for real estate credit today?

Isabelle Brennan: We have seen an explosion in interest for private credit more broadly over the past few years and, within that, real estate credit has an important role to play. It all started with interest in mezzanine as banks retrenched post-GFC, but over the past few years the focus has moved more towards first-lien senior lending.

We have seen capital flowing in all directions, from EMEA to the US and vice versa and from Asia-Pacific into both of those geographies. Many of those investors already have active real estate equity portfolios and so it has been a pretty easy transition to the credit side. We have seen strong appetite from insurance companies, sovereign wealth funds and particularly pension plans.

Q: What are those investors looking for from real estate credit, in terms of their overall portfolio construction?

IB: Real estate credit is one of those asset classes that can serve a number of different purposes. It offers bond-like characteristics, which means it works as a fixed income substitute. But it also has real asset security, so it can look a lot like real estate equity. We see allocations from both buckets.

Real estate credit offers stable, predictable income streams and significant downside protection. It offers diversification benefits and is also a very efficient way to deploy capital because the transaction costs are much lower than for equity. Overall, it can really improve an investor’s risk-adjusted returns because it tends to reduce volatility in the portfolio.

Emma Huepfl: Some real estate investors may be under-allocated to real estate, having held back over the past 18 months. Credit offers strong deployment opportunity and the benefit of current yield, as well as market exposure without the entry or operational costs of owning assets. That can make it an attractive play, particularly if you can layer on additional value from parts of the market with lower debt liquidity.

The benefit of real estate credit has been highlighted for multi-asset credit investors through the pandemic. Corporates have failed but even when the real estate assets that back our loans have seen rent collections fall, we have experienced no missed interest payments or distributions to our investors. That is because we have early intervention mechanisms in place that bring borrowers to the table to work out the most effective way of protecting those positions. Real estate has really proved its worth to credit investors over the past 18 months.

Todd Sammann: The catalyst to much of the interest we’ve seen results from cap-rate compression, which has made it difficult for equity fund managers to produce current return. In that context, credit’s combination of contractual current yield and low volatility have proven to be attractive.

Dominic Smith: In the London office market, for example, CBRE is forecasting a total return for ungeared equity of 4.2 percent over the next five years. You can get more than 75 percent of that same return by making a senior loan at 55 percent LTV, at a more secure position in the capital stack with significant downside protection. Furthermore, in the Americas region, the five-year ungeared equity return is nearly 6 percent, while modestly-levered core-plus credit investments offer a 6-8 percent return, and if you want to further enhance returns, you can move into the value-add space.

I would add that newer sectors tend to be funded by equity. The credit markets then step in later when a track record has been established. What that means is that if a yield gap has normalized on the equity side, a premium may still be possible on the credit side. If an investor feels they have missed the boat with an emerging sector, they may have a second chance with credit.

Q: Which sectors are now the most appealing?

TS: In the US, multifamily has benefited from strong demand driven by a growing economy and home affordability issues. At the same time, it offers an inflation hedge and low correlation to equities. Under the Biden administration, Fannie Mae and Freddie Mac have been mandated to allocate half their origination activity to the affordable housing sector. That’s left a void in the market for market-rate assets and created interesting opportunities for private lenders.

Meanwhile, the office sector has taken a beating during the pandemic and many lenders appear to have red-lined the sector entirely. But while some form of work from home is clearly here to stay, workplaces will also have an important role to play going forward. The challenge, and the opportunity, is to identify the combination of office attributes that will attract the lion’s share of tenant demand and investor capital going forward. Meanwhile, a lack of competition means we can generate greater return through higher coupons and drive more robust loan structures than in other sectors.

EH: We see similar themes in Europe. There is a lot of competition in logistics and residential, which can make those sectors unattractive from a returns point of view, particularly when competing with bank capital which tends to lead on pricing. The way we address that is to underwrite assets at an earlier stage of maturity, by funding development, lease-up or capex or, particularly in residential, by bridging sale once a development facility has expired.

In the office space, where an equity case can be challenging and the outlook is very uncertain, credit is an interesting way for investors to maintain sectoral exposure on a lower-risk basis, while getting paid very well for doing so. With credit, you have those different lines of defense: the asset itself, and then the loan structure around that. Even in challenged sectors, you can create highly defensive positions and deliver attractive returns.

Q: What role does data play in real estate credit?

DS: There is an accepted truth that there is no data in real estate debt, but we don’t think that is right. Data is often in hard-to-reach places, but there is a huge amount out there which can move real estate credit closer to the equity side than people generally believe. For example, we have built a tool that will bring together numerous metrics from the perspective of risk, return and opportunity.

That tool helps investors understand downside forecasts, tenant default risk, returns versus fixed income, how much refinancing is coming due and what the competitive landscape is like, for example. It is up to individual investors to then decide if protecting downside risk is their priority, or returns, or simply getting money out of the door. That helps them decide which sectors and markets to pursue. It isn’t an easy undertaking; but we are privileged to have access to vast amounts of data as part of the broader real estate platform.

Q: How has the role of ESG in real estate credit evolved?

EH: Investors are much more discerning and exclude assets and borrowers with poor sustainability credentials. Borrowers, meanwhile, are asking us to collaborate to evolve their ESG policies. Credit may be a step removed from the asset, but there is no reason it can’t positively influence outcomes.

TS: We take sustainability very seriously and screen each of our investments aggressively against carbon footprint, air and water quality and flood risk, for example. The last thing we want to do is make a loan against an asset that might be underwater or functionally obsolete when the loan matures.

DS: From a macro perspective, we are seeing a huge funding gap for refurbishing assets. Upwards of 75 percent of stock in Europe doesn’t meet energy efficiency standards consistent with net-zero targets. Those buildings can’t just be torn down, because of all the embedded carbon; they need to be retrofitted up to standard.

Real estate is responsible for around 40 percent of energy emissions in the EU, so we have to get this right. Retrofitting is a significant one-off event; it can’t be financed through maintenance budgets and so there is a huge need for lenders to get involved. At the same time, UK banks stepped right back from development, particularly commercial development, in the wake of the financial crisis. New EU banking regulation will cause a funding gap there. Non-bank lenders really need to step up for the good of the industry and the good of the planet.

Q: What changes have you noted in terms of the way debt is being structured?

TS: Structure is a reflection of competitive dynamics and is one of a number of levers lenders use when competing for business. In a market that is oversupplied with capital relative to demand, you tend to see spread compression first, and then a weakening in structure.

There has been a proliferation of debt funds in the US over the past five years. Around 80 percent of allocated capital has gone to value-add and opportunistic strategies. The excess supply of capital in those segments triggered spread compression of as much as 300bps to 400bps. Structure then increasingly became a point of negotiation. In the core-plus segment, however, the supply/demand balance is far heathier. We haven’t seen nearly as much spread compression or any meaningful weakening in structure there.

Q: So, what does the future hold for this asset class?

TS: I expect to see real estate credit embraced as a truly institutional asset class. That will require transparency, however. The first step on that journey will be to establish a series of debt fund indices to facilitate analysis of relative performance to create proper accountability. Second, while we’ve seen a proliferation of debt funds over the past five years, I expect the next five will bring consolidation. My sense is that capital will flow to larger managers with demonstrable information and sourcing advantage, as well as investing and operational expertise.