Commercial real estate (“CRE”) private credit has a place in every portfolio, especially in the current economic environment, which is marked by peak prices, volatility, and slowing growth. This asset class has gone from being virtually untracked 20 years ago to $60B in dry powder (raised but uninvested capital) in recent months.
Regulations on banks after the last financial crisis combined with new laws benefiting smaller investors have allowed this space to thrive in the last five years. Investors have discovered its appeal and we think it’s here to stay. Before we dive into what investors are finding so compelling, let’s define what “CRE private credit” is.
CRE private credit is an asset class that consists of loans backed by commercial real estate properties. The properties act as the loans’ collateral such that, in the event a loan does not perform, the lender can take ownership of the property. This structure can increase security for a lender and reduce the risk of loss on an investment.
Let’s dig a bit deeper:
- Commercial Real Estate (CRE) – CRE is the majority of real estate that isn’t a single-family home. The main CRE asset types are: office, industrial, retail, apartments, and hotels. The class also includes more fringe types such as self-storage, student housing, senior living, manufactured housing, and medical offices.
- Private – There is no public primary or secondary market to buy or sell these investments. Typically, investments are made directly with a manager or advisor, though there are a growing number of ways to invest through crowdfunding sites.
- Credit – This is just another name for debt. These investments are loans (mortgages or deeds of trust) secured by commercial real estate assets. A credit investment is senior to the equity, or ownership, position. Credit investors have repayment priority over equity and receive contractual interest payments on a regular basis.
Safer Than Equity
Let’s start with the basics: Debt investors get priority payment to equity investors, which makes debt more secure. This security is especially important when assets across sectors look so fully valued. Blackstone’s Chief Investment Strategist recently wrote that “the market isn’t pricing in a ‘just right’ Goldilocks scenario—it’s pricing in perfection”. When a market is priced to perfection, there is a lot more downside than upside for equity investors and credit can be an attractive alternative. CRE loans are typically originated only as high as around 75% - 80% loan to value (“LTV”). This means that asset values would have to decline 20% - 25%, wiping out all of the equity, before the loan loses any value.
Given the heady valuations seen in equities, debt could very well outperform equities for the next few years. Many sophisticated investors are privy to this, which is why “Credit Strategies” had the highest inflow of assets of all alternative strategies tracked by Preqin in 2018.
But can private debt live up to expectations? According to Preqin’s surveys, it’s doing just that. Recent surveys show that Private Debt has the highest investor satisfaction rating, followed by Real Estate (tied for 2nd with Private Equity) in the alternative investment universe. Survey results further show that the top benefits investors see for private debt are:
- Reliable income stream
- High risk-adjusted returns
These positive attributes are backed up by statistical research. In its 2018 paper, The Components of Private Real Estate Performance, the Journal of Alternative Investments found that portfolios “invest[ed] in private debt are better diversified and achieve higher expected returns for any given level of expected risk than portfolios that do not include private debt.” That’s a pretty resounding endorsement.
CRE – It Learned Its Lessons Last Cycle
Overvalued real estate and aggressive lending was one of the primary causes of the last downturn. In response, lenders became more regulated and investors became more cautious of leverage. Now CRE fundamentals are benefiting from the conservatism and are much stronger than they were late last cycle, especially when you compare them to other asset classes like public equity and corporate debt.
As an example, in 2005, the average LTV for Commercial Mortgage-Backed Security (“CMBS”) issuances was 70% and debt service coverage ratio (“DSCR”) was 1.56x. In 2016, those metrics were much healthier at 60% LTV and DSCR at 1.94x. The chart to below shows CRE values as tracked by Green Street compared to the Dow Jones Industrial Average (Equities) and the BAML High Yield Total Return Index (Bonds). While they’ve all had quite the run-up, in many ways, CRE’s valuation multiples and growth prospects are currently stronger than the public markets.
Steady Current Income
Borrowers typically pay interest on their loans monthly and that money is then distributed to the loan’s investors. Unlike equity investments, credit investors don’t have to wait years for capital appreciation that may or may not happen in order to get a return. All things equal, it is less risky to receive contractual income now vs. speculative income later. As an additional benefit, private credit funds that are formed as REITs (which many are) are benefiting from the Tax Cuts and Jobs Acts provision which states that investors can deduct 20% of ordinary REIT dividends from their income taxes. This provides a greater net return at no additional risk.
Real Estate’s Low Correlations
One of the benefits of private CRE credit can be its lack of correlation with other investments. Part of this is related to private investments’ low liquidity and lack of mark to market pricing (we’ll touch a bit on this later). But also, real estate in general just has a low correlation to the broader market. For example, of CBOE’s ten Select Sector Indices, the real estate sector showed the second-lowest correlation (after utilities) to the S&P 500 at 59% from 2012-2017. Even more compelling is a Nareit analysis that shows the REIT-stock correlation has actually been lower during months when the stock market has turned down even more severely. That’s the kind of diversification that can really be helpful in a pinch. Though comparing public REIT activity to private CRE credit is not “apples to apples”, both are backed by the same type of asset and share many attributes.
Why Bridge Lending?
While a strong economic backdrop can definitely help bridge loan performance, it is not a necessity. The bridge debt strategy capitalizes on opportunities that are agnostic to macro trends. A mismanaged property, a relocating tenant, a property repositioning, or a need for financial seasoning can all benefit from a bridge loan, no matter where we are in the cycle. And when the cycle wanes and transaction volume dips, bridge loans can be ideal for refinancing deals that require flexibility and are unwilling/unable to secure long-term financing.
Short Loan Terms
Bridge loans typically have initial terms of 1-3 years, which is much shorter than the 5-10-year terms typically seen with banks, life insurance companies, and CMBS originators. Fundamentally, short-loan terms allow less time for things to go wrong. An informed investor might have a decent idea of what the market might look like a year or two from now. But who can say the same for conditions five to ten years from now? By making loans that come due in just a couple of years, there is a lower likelihood of being blindsided by a new competing property being built next door, or a key tenant going bankrupt or unemployment jumping twenty percent. In a recent report by Kroll on CMBS defaults, they included the graph below and noted, “It isn’t surprising that defaults are low in the first two years following the loan term, as there is less time for things to go wrong in regard to fluctuations in rental rates or expenses.” All else being equal, shorter-term loans are safer.
Lending on Depressed Values
Bridge lenders seek to originate loans on properties with values that are depressed relative to what they could be on a “stabilized” basis. This lower value can be for a variety of reasons, but most often it is due to low occupancy and/or mismanagement of the property. This translates into less downside risk because, of all of the things that could go wrong with the property, at least some of them are already priced in. It’s kind of like buying low and selling high with equities. It's not market timing, but rather examining a property’s competitors in the market, concluding that the subject property is underperforming those peers, and then signing off on a borrower’s plan to bring the property up to market.
Direct Lending Adds Value
Direct lending is the bilateral origination of a loan between a single borrower and lender. This is as opposed to other types investing by credit funds that source debt through banks or other intermediaries. The table below from the Journal of Alternative Investments does a good job of outlining the main advantages of direct lending. Basically, the hands-on diligence and structuring (and subsequent in-house servicing in RRA’s case) allows the transaction to be custom-built to the borrower’s business plan while providing the lender extra protection through targeted, business plan-specific covenants.
For example, most of RRA’s loans include follow-on funding facilities that can be used by the borrower to pay for capital expenses, tenant improvements, or leasing commissions. This structure adds value to the borrower because it ensures adequate capitalization to stabilize the property. And it adds security for the lender because they are only advancing funds for pre-negotiated items that will enhance the loan’s security. Additionally, originating multiple loans with the same borrower over time, as RRA seeks to do, can enhance loan security and yields.
...but that table showed risks too
Notice that we were troopers and left the “risks” section in the above table because, hey, nothing’s perfect. So let’s go through some of the stated risks and associated mitigants:
- Lower liquidity: Because there is no public market for private CRE credit, it is relatively difficult to buy or sell quickly, especially without moving the price. Investments in a closed-end credit fund might be tied up for up to 5-7 years. So, if you might need to free up some cash, it is a good idea to have a decent portion of your money in other, more liquid, investments. Private CRE credit can be an excellent part of a portfolio, but probably shouldn’t be your whole portfolio because of its low liquidity.
- Greater Price Uncertainty: Because it’s illiquid (hard to buy and sell), it’s hard to know if your investment is worth more or less than you paid for it. But practically speaking, if a loan is current on interest payments and there is a high degree of certainty it will pay off without a loss of principal, it should be worth the same as when it was originated. Even if a loan were to increase in value due to a change in interest rates, most private lenders never sell their loans so the change in value would have minimal impact on an investor.
- The Rest… (Credit Risk, Complexity, Limited Track Record, Fund-Level Leverage): These are grouped together because, while they are valid risks, they are nothing a diligent investor can’t navigate. Most CRE credit funds are not credit risks, complex, highly levered, etc. This investment space is maturing and growing such that most investors should be able to find a manager they trust running a strategy they understand.
In conclusion, we think CRE private credit is a great way to get a low risk, high yielding, diversified asset class in your portfolio while minimizing macroeconomic risk through short-loan terms, low correlation, and intelligent loan structuring. We believe that an allocation always makes sense and is especially warranted given the high prices and volatility seen in public equity and debt in today’s markets.
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- Top 10 Things to Avoid When Trying to Secure a CRE Bridge Loan
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- Closing a CRE Loan: Top 5 Pitfalls for a Borrower to Avoid