Featured in Private Debt Investor’s US Special Report 2016: The Road Ahead
Mirroring the broader US economy, commercial real estate markets have largely recovered from the global financial crisis, and with few exceptions, values and operational performance have returned to levels above those reached before the recession.
Investment activity is robust and operators are seeking capital solutions in order to execute business plans, however, the $3.5 trillion commercial real estate (CRE) lending environment remains challenged and constrained.
Banks and CMBS lenders are subject to an increased regulatory and compliance burden (Basel III, Volker Rule, Dodd-Frank) that is making lending more costly and restricting advance rates on all types of property. These structural changes have long-term impacts on how banks lend and their role in financing commercial real estate.
For example, the Federal Reserve’s senior loan officer survey reported that bank credit began contracting at the end of 2015 with banks reporting tighter underwriting standards for property financing. The combination of these factors has resulted in more narrowly focused debt capital from banks, tighter lending structures and wider credit spreads.
The securitised lending industry has been further challenged by new regulations and bond market volatility. Issuance of new CMBS bonds has slowed in 2016 with revised annual issuance forecasts down 30 percent to 50 percent from 2015 volume levels of $100 billion. Over $1.0 trillion of CRE loans mature over the next three years and dysfunction in the securitised loan market is compounding problems for owners with maturing debt.
Many of the long-term loans made by insurance and securitised lenders were originated near the last market “peak” when credit standards and underwriting discipline were at their weakest point in decades. Further, a segment of these loans will require creative debt and/or equity capital solutions to meet their refinancing needs.
Against this contrasting backdrop of strong borrower demand for capital and conservative debt providers, a private lending market has grown to provide debt capital solutions through tailored structured products and today presents a compelling opportunity to investors looking for new core-like investments that complement their existing exposure to real estate.
Through Change Comes Opportunity
Not only is the private lender’s role steadily more defined, accepted in the marketplace, and expanding, but investors are increasingly evaluating the benefits of including a private real estate debt allocation in their portfolios. Serving as a complement to a direct equity strategy, the predictable income returns from private real estate debt offer a way to reduce volatility and counterbalance the cyclical asset appreciation/depreciation experienced in private equity real estate (see chart below), and is being embraced by investors as a tool to achieve resilient and predictable income returns.
For investors viewing the continued rise in today’s commercial real estate values with a watchful eye, investments in senior real estate debt are an alternative to core property that exchanges equity “upside” for the “protection” of equity subordination offered through tailored credit structures. In an environment where asset appreciation is modest or flat, the fixed returns from debt investments can provide income which outstrips comparable returns posted by core indices.
Historical ODCE Rolling Annual Income and Appreciation 1Q 1978 – 1Q 2016
Key Questions on Structure
Private debt takes many forms because it is often a solution to an investment-specific situation. Private lenders craft a debt product that best meets the project’s risk and return dynamics. Structured senior loans and subordinate debt are both structures that are commonly employed to solve investment-level issues and extract the right balance of risk and return for investors. While they vary in legal structure and other aspects, they all carry key features of credit products.
Private mortgage capital is more costly than traditional loan channels but borrowers will often accept the pricing “premium” in order to achieve terms that better match their own level of risk tolerance. Higher loan proceeds, non-recourse structures, or speed/ease of execution are each valuable points of distinction between private and regulated lenders.
As illustrated in the graphic below, sponsors using conventional financing sources will often find loans limited to 60 percent LTV with the balance of capital contributed through internal resources, a JV partner structure or a combined senior/subordinate debt structure. A single-source, high-leverage senior financing may require more equity than a senior + subordinate loan but provides a one-stop source of debt capital higher than conventional lenders. Full-stack senior loans can also minimise the need for a JV equity partner and keep control closer to the sponsor.
The Capital Stack
Ultimately, for borrowers evaluating the difference between these capital stack options, some of the important questions will be:
- Are internal equity resources sufficient to obtain conventional debt?
- Is a joint venture partner available and is the borrower willing to share “upside” through a JV relationship?
- Does mezzanine debt create too much “leverage” on the property?
- What are the debt and equity “costs” of a higher LTV senior loan relative to creating a senior + subordinate structure?
- Does the transaction timeline allow for negotiating a multi-lender capital stack?
Accessing Core Through Real Estate Debt
Investors seeking exposure to private lending will first need to evaluate the risks and parameters of the various debt strategies – senior or subordinate loans, construction or income-producing collateral, floating or fixed-rate structures.
For those seeking income returns similar to a core equity strategy, senior loans on income-producing assets will have the greatest appeal in terms of risk and return. Senior loans carry the least risk of private lending products since a fundamental risk mitigant for debt investors is the downside cushion provided by the borrower/sponsorship’s equity.
In an environment where property values have been on a steady climb, declines in value or cash flow at the underlying real estate are first borne by the borrower, and not until the borrower has experienced a total loss of its equity is debt investor capital considered to be at risk. Ultimately, private lenders trade off upside opportunity in the equity capital for a fixed and priority return on (and of) their capital as a credit instrument.
Senior loans on income-producing property typically utilise a degree of leverage to enhance the underlying loan rates of 4.0 percent to 5.5 percent. Depending on the amount of leverage employed, investor income returns can range from 6.0 percent to 10.0 percent, exclusive of other sources of return enhancement. And while yield is a crucial measurement of success – particularly in core equity strategies – successful core debt investors will focus on quality credit standards that can be maintained across economic styles.
Representative Effect of Leverage on Returns
Further, determining the appropriate amount of subordinate borrower equity in a transaction and making good asset selection decisions are keys to delivering compelling risk-adjusted returns and among the critical factors for lenders to consider at the outset of any debt investment. Ultimately, no investment structure can guarantee a specific outcome, but rigorous real estate underwriting and an adequate amount of borrower equity will insulate a debt investor’s capital and returns.
Leveraging Real Estate Experience
As commercial real estate markets evolve through the current business cycle, investors stand to benefit from employing a complementary debt strategy that exchanges “equity upside” for “credit protection,” particularly when employed as a long-term solution for shielding stable income from volatility.
However, private real estate debt investment requires expertise in underwriting markets and complex assets and tailoring financings that meet both the capital objectives of the borrower, but also the risk limits of the lender. Those who can identify and price risk quickly and accurately will capture the best opportunities.