Click here to read the full paper including graphs: Real Estate Credit: Meeting the Need for Yield
Real estate credit can provide the yield premium that Local Government Pension Scheme investors need, alongside many other attractive characteristics, such as predictable and secure income, portfolio diversification and downside protection. Accessing these desirable features relies on expert knowledge of real estate markets: valuation fundamentals through different cycles, the networks needed to source opportunities in private markets, the ability to mitigate risk through careful structuring and the expertise to execute on these opportunities. For investors with access to these capabilities, there are compelling opportunities to enter this market and be well positioned for eventual economic recovery.
A wall of refinancing approaches
In simple terms, real estate credit includes private loans, or mortgages, secured against commercial real estate and used for financing acquisitions of new assets or refinancing existing loans. As an investment, it has historically enjoyed higher yields than similarly rated corporate debt, while offering diversification from directly held real estate and listed securities. Restrictions on commercial mortgage lending by banks have been a feature of the real estate market since the global financial crisis. Increased regulation, including more stringent risk and capital treatment for banks, has resulted in real estate receiving significantly less funding from banks overall, opening the door for a range of non-traditional lenders to fill the void. Non-traditional lenders are increasingly competing with established lenders to finance the acquisition of income-producing real estate as well as refinancing loans and providing capital expenditure (‘capex’) loans, which are reinvested into the improvement of the underlying properties. Their success can be attributed in large part to the flexibility of their product offerings, the speed of their execution and their ability to underwrite complex deals and structure debt across the capital stack. While acquisition activity has been subdued during the Covid-19 pandemic, there are still compelling opportunities for non-traditional lenders, as banks have been notably pulling back from new business to concentrate on helping customers restructure existing positions. Many loans have been extended rather than refinanced during the pandemic, which will increase the volume of loans that need to be refinanced once conditions improve. According to the Cass Commercial Real Estate Lending End of Year Report 2020, £129bn needs to be refinanced by 2023 in the UK alone, and given the tight regulatory restrictions in place, bank debt will need to be supported by other forms of capital to meet this demand. This approaching ‘refinancing wall’ creates a strong market entry point for alternative lenders.
Asset quality: income and protection
An attractive feature of real estate credit is the downside protection it can offer. Underlying assets can be selected for their resilience, allowing for the generation of cash flows through contracted interest and principal payments which are funded by the collateral’s net operating income. Typically, these are non-recourse loans, meaning lenders are reliant on recouping value from the underlying property in the event of a default. Therefore, a detailed grasp of property fundamentals, how they perform through cycles, and an ability to manage the underlying real estate should it be necessary, is essential when assessing risk. Real estate credit investments are structured to mitigate risk, by lending less than the asset’s full value at purchase. If there is a decline in the capital value, commercial mortgage loans are protected from valuation decline up to the amount of the subordinated equity. Nevertheless, the quality of the underlying asset and its future economic viability are essential to managing this risk.
Sustainability: risks and opportunities
Environmental, social and governance (ESG) factors are becoming increasingly important in the process of asset selection. Tenants are more demanding, expecting accountability from landlords and a preference for assets that enable sustainability and wellness. The Covid-19 pandemic has accelerated this trend: assets with poor ESG ratings are likely to see values decline more quickly, and risk of obsolescence, an important factor for credit investors looking forward through the life of the loan to repayment. For stronger borrowers, ESG is increasingly integral to the positioning of their businesses and assets. ‘Property-as-a-service’ business models are evidence of this shift, as are the growing number of landlords looking to emphasise environmental features in their buildings, such as zero-waste, sophisticated energy usage tracking and wellness provision. We consider sustainability at every stage of our investment process – the mitigation of risks presented by ESG factors, while seeking opportunities presented by the transition to a low-carbon economy through real estate.
An imminent opportunity for LGPS
The investment characteristics of real estate credit make it particularly attractive to LGPS investors. It has the potential to provide attractive risk-adjusted returns above the levels generally required by LGPS investors, alongside a secure and predictable income stream to enable liability matching. The downside protection offered through structuring and underwriting risk can also reduce overall portfolio risk. Lastly, the hard asset security appeals to LGPS investors looking to explore other ways to invest in real estate with security over the asset. Demand is strong and expected to grow as investors look to diversify investment risk and seek alternative sources of reliable income. We continue to see compelling opportunities for real estate credit across the UK in multiple sectors. As the economy regains strength, we expect that real estate credit investments, specifically selected for the strongest recovery opportunities, and carefully structured to minimise risk, will be highly sought after. While the pandemic may have created permanent change in the way we interact with the built environment, those managers who understand the future needs of the occupiers and owners of assets will be well placed to benefit from investment via credit into the new real estate economy.