Why the real estate debt market just keeps on growing

Numerous private asset classes flourished after the global financial crisis (GFC), but the growth of the real estate debt market has been remarkable. Its momentum continues.  

Traditional sources of financing began to dwindle after the GFC, particularly as banks reined in their lending amid closer regulatory scrutiny. But the need for real estate loans remained. This is when private lending secured against commercial real estate stepped in to help fill the widening funding gap.

The decline in both capacity and appetite to lend has only been exacerbated by Covid-19, as lenders focus on their existing portfolios and potential balance sheet losses.

However, the withdrawal of traditional lenders only explains why private real estate debt supply has risen. To understand why demand has climbed to meet it, we must understand investor appetite.

Outstanding bank lending to commercial real estate (€, billions)

Source: PMA UK Forecast service 2020

What’s in it for me?

At the highest level, the hunt for yield and diversification arguments will be familiar. The policy environment has - for a decade now – repressed yields in traditional fixed income. Low rates have also driven equities to new highs, in part through pursuit of return and in part due to the effect on discount rates.

At the same time, correlations between traditional asset classes have increased – especially during bouts of elevated volatility. As conventional diversification or hedging strategies grew less effective, appetite grew for niche areas that offered genuinely differentiated sources of return.

These reasons are a major contributor to the increasing momentum in private asset fundraising since 2009. Indeed, the average private fundraising has consistently exceeded initial targets every year since 2017.

But what has made real estate debt in particular so compelling?

To begin with, we believe the medium-term outlook for real estate overall is positive. The Covid-19 crisis has left markets in good shape, with vacancy rates at record-lows in a number of areas. It’s true that genuine and sustainable economic growth (as opposed to a bounce back) is currently lacking, and rental growth may be weak. However, this is also balanced by limited new supply, chiefly due to pandemic-induced developer caution. Five year forecasts are encouraging.

UK all property total return forecast - underpinned by income

Source: IPF UK all property total return forecast – Autumn 2020

Real estate debt can offer investors attractive returns - derived mainly from income, plus an illiquidity premium – relative to similarly ranked corporate debt of 100bps to 150bps. Risk characteristics versus corporate bonds and equities are also favourable.

Downside protection is provided by the physical real estate backing, a significant equity cushion and robust loan structures. Sensitivity to the interest rate environment is also limited by floating rate loan coupons, adjusting when interest rates change. This helps to preserve value in a phase of rising rates or limit “duration”. Correlation to the S&P 500 index, meanwhile, has historically been negative.

Consistent premium vs. investment grade corporates

If a default does occur, lenders can usually negotiate directly with the borrower. This is because real estate loans will typically be held by one or few underlying investors compared to multiple investors in a public corporate bond issue. This direct negotiation process can give real estate debt investors greater bargaining power and the ability to proactively deal with emerging problems before they become significant. And it should also lead to a more streamlined “workout process” for any distressed loans.

Where a default cannot be avoided, the lenders can enforce their security over underlying properties and liquidate the property collateral to recover their loan. Holders of senior real estate loans, with first-ranking security and clear covenants, can typically ensure that this enforcement and liquidation can be done in a timely manner with a higher recovery rate than unsecured corporate credit.

The opportunity in the funding gap

The opportunity presented by the increasing need for alternative lenders puts investors in real estate debt in an advantageous position. With superior control and demand dynamics in favour of the investor, risk-adjusted returns are enticing, especially relative to conventionally-traded corporate bonds of similar credit quality.