Real estate debt: a useful complement to direct property investment?
With higher interest rates and slower economic growth potentially weighing on real estate equity returns, real estate debt could be a way of hedging against volatility in the sector.
Direct property ownership is not the only way to gain exposure to the real estate market. Investing in a different part of the capital structure, such as senior secured debt, can provide a different risk/return profile in times of market volatility.
But first, let’s revisit some of the characteristics of the asset class that have led to an increase in interest from institutional investors over the past 10 years.
A stable and predictable income stream
Returns have typically been greater investing in real estate loans compared with similarly rated public bond instruments – we see illiquidity premiums generally ranging from 40-80 basis points. The return originates from a stable and predictable income stream generated from the underlying property’s rent. Net rental income typically covers the coupon by 1.5x-2.5x.
This is not the only downside protection; loan advances are ordinarily 50-60% of the underlying value of the property, providing a buffer to any possible reduction in the underlying asset value and therefore the principal repayment.
Furthermore, we believe senior secured credit investing provides exposure to several real estate sub-sectors without the disadvantages and transaction costs of operating or owning the asset.
Resilience during COVID-19
Some of the features described above have meant that the real estate debt market has navigated the challenges of recent years remarkably well. While most lenders paused on new transactions during the peak of the pandemic, existing loans within some sectors that saw reductions to rental collections still generally performed, and investor coupons were paid.
In those sectors more severely impacted by COVID-19, borrowers were incentivised to ensure coupons were paid to protect their asset, while lenders focused on the longer-term viability of the underlying properties.
The latest annual report on UK commercial real estate lending from Bayes Business School reports that, at the end of 2021, less than 2% of total outstanding loans were in default or breach of loan terms, which is below pre-2018 levels.
Can real estate debt act as a hedge against volatility?
While real estate has shown resilience in the face of market volatility, it isn’t out of the woods yet. Higher interest rates and slower economic growth could negatively impact real estate equity returns. As a result, we believe the stable and contracted nature of debt means that it could be a useful complement to direct property investments and may act as a hedge against volatility in the real estate market.
As the chart below shows, we believe yields on real estate debt look attractive relative to other income-generating asset classes.
Selectivity is key to sector and asset allocation
Sector and asset selection is, as always, important. Some sectors, while not guaranteed, are expected to perform better in weaker economic conditions. Examples include counter-cyclical assets such as student accommodation, or areas where there is shortage of supply, such as residential, multi-let industrial units and logistics.
Industrial and logistics transaction volumes continue to dominate the investment market, with rents continuing to increase and yields at all-time lows. These yields will require persistently strong rental growth to be justified. Supporting capable borrowers, strong micro-locations with supply/demand imbalances and sufficient yield on debt is paramount to underwriting.
We expect build-to-rent debt opportunities to increase over the medium term as property investors focus on bringing further schemes through planning, development and stabilisation. Also, within the residential sector, purpose-built student accommodation remains popular with investors, with structural drivers remaining strong and lending against properties in top university towns and cities a key focus.
The number of office transactions is beginning to increase, but we remain selective in this area, deploying funds against properties that are well-located, high quality and fitted out with the needs of today’s occupiers in mind. Sustainability credentials are also important.