Through the years, the advantages of investing in Private Real Estate Credit (high-yield debt) have essentially remained the same: Attractive relative value, equity cushion to absorb asset stress due to unexpected events, real asset collateral to help hedge against inflation, floating rate/short duration to avoid major interest rate driven mark downs, and returns comprised primarily of income.
The capital gap has returned
The banking sector is under pressure on several fronts including bank management teams being concerned about how their books will perform going into the Federal Reserve (Fed) induced economic slowdown. Bank balance sheets are heavy from a flurry of activity in 2021. Banks are also under close scrutiny from regulators and face capital adequacy pressure from stress testing and other factors. In addition, existing loans are repaying at a slower speed as borrowers exercise loan extensions that have below-market spreads and above-market proceeds (capital infusion/pay down would likely be required if refinanced in many cases). Banks are still lending but are being very selective and offering lower amounts of leverage. Our expectation is these circumstances will persist until Banks gain confidence that the slowdown has been successfully navigated, allowing for a renewed focus on earnings. There are several steps, including the Fed reaching its terminal point and better visibility on the contour of the slowdown, before this conservative mindset begins to change.
When the banks tighten lending and offer lower loan- to-value (LTV) loans (i.e. 50% – 55% LTV loans instead of 60% – 65% LTV), borrowers will turn to subordinate debt capital sources to fill the capital gap. Loans that would have been all senior debt in late 2021 will now feature a conservative senior portion combined with subordinate debt. Alternatively, a borrower may take a stretch senior mortgage from a non-bank lender and pay a higher spread to gain the additional proceeds. The securitization markets will also look to use traditional subordinate debt to improve the certainty of the execution around the financing.
This conservative senior debt dynamic will improve the leverage levels of the debt investments made and help offset the reduced flow of slower acquisition activity. There will be existing loans coming due that need to be paid off and the borrowers will be required to refinance/recapitalize these assets. As observed during prior periods of stress, we believe the capital gap has once again emerged as an opportunity.
Reset values lead to better entry points and lower exposure levels
As interest rates—short and long end of the curve—have increased in 2022, the higher debt costs have put pressure on property valuations. This adjustment to a new rate environment will take some time to settle and the ultimate range of the 10-year Treasury will be a significant driver (as opposed to the projected next 12 months of SOFR [Secured Overnight Financing Rate]—temporary in nature). The classic bid ask, quasi stalemate will most likely exist for non-forced sales until investors feel valuations have reset to a reasonable level.
Whether the post inflation valuation decline is 5% or 20%, new debt investment/loans will be sized to reset values generating a fresh equity buffer and lower exposure levels. This is one of the reasons the 2023 and 2024 vintages should more than likely be in a favorable credit position versus legacy loans.
Private real estate credit remains a solid complement and hedge to core equity holdings
As highlighted, property values are in the process of adjusting to higher debt costs. Even the preferred property types are not immune to this dynamic. Although Principal Real Estate is still constructive on industrial and multifamily over the long term, coming off years of very strong appreciation, an allocation to credit with a current income focus is a logical complement to core equity.
Real estate credit investments are typically less sensitive to rental growth. Lease trade-out numbers remain impressive albeit are moderating in late 2022 for many projects, however, rental growth in years 2-5 is harder to predict with the pending economic slowdown. Again, the fundamentals in the preferred property types are healthy but the upside is less clear in comparison to a few years ago.
Relative value continues as in years past
For BB to BB+ type of risk in today’s market, yields of around one-month term SOFR + spreads of 450- 550 (8.5% to 10% depending upon tenor) are available for subordinate debt investments. Most of this return is in the form of current income, providing cash flow to investors as well as good relative value compared to corporate alternatives. BB corporate spreads as of late January were in the 280 bps range (ICE BofA BB US High Yield Index).
Understanding Real Estate Credit: A Key to Property Ownership
Real estate credit plays a crucial role in the property market by making homeownership and property investment more accessible. For individuals or businesses seeking to acquire real estate, credit options provide the financial support needed to fund such transactions. Without these financial tools, many potential buyers would find it difficult to gather the capital necessary for significant real estate purchases.
Real estate credit refers to loans or financing options specifically designed for the purchase, improvement, or refinancing of property. This type of credit is often secured by the property itself, giving lenders an additional level of assurance. For homebuyers, mortgage loans are the most common form of real estate credit, while commercial investors might turn to commercial property loans or real estate investment loans.
These credit products enable buyers to spread the cost of their property over several years, making homeownership and investment more manageable. Buyers can secure favourable loan terms, often with fixed interest rates, which allow for predictable payments over the long term.
There are several advantages to using real estate credit when purchasing property:
- Increased Purchasing Power
One of the main benefits of real estate credit is that it gives buyers more purchasing power. Rather than having to pay the full amount upfront, individuals and businesses can borrow the necessary funds, enabling them to purchase higher-value properties or invest in multiple properties over time. - Capital Retention
Buyers can preserve their savings or capital for other investments or expenses. By borrowing through real estate credit, funds that would have been spent outright on a property can be allocated to other ventures, allowing for a more balanced financial approach. - Access to Low-Interest Rates
Depending on the type of loan and the borrower’s creditworthiness, real estate credit often comes with competitive interest rates. Fixed-rate loans offer stability, ensuring that payments remain constant over the life of the loan. In periods of low-interest rates, locking in such loans can significantly reduce the long-term cost of the property. - Equity Growth
As loan payments are made, borrowers gradually build equity in their properties. This equity can later be used as collateral for additional loans or as a source of capital for future investments. - Tax Advantages
In many regions, interest paid on real estate loans is tax-deductible, providing an added financial benefit to property owners. This can lower the overall cost of borrowing and make real estate credit a more attractive option.
Real estate credit comes in different forms, catering to both residential and commercial buyers. Some of the most common options include:
- Residential Mortgages: Designed for homebuyers, these loans typically offer long repayment periods and come with either fixed or variable interest rates.
- Commercial Real Estate Loans: Businesses looking to purchase office buildings, retail spaces, or other commercial properties use these loans, which often have shorter repayment periods and higher interest rates than residential mortgages.
- Construction Loans: These are short-term loans used to finance the construction of new properties. Once the construction is complete, the loan is usually converted into a mortgage.
- Home Equity Loans: These allow homeowners to borrow against the equity they’ve built in their property, providing access to funds for home improvements, debt consolidation, or other expenses.
While real estate credit can offer numerous advantages, it’s essential to approach borrowing responsibly. Buyers should carefully assess their ability to meet monthly repayments and ensure that they are comfortable with the loan terms. Working with a trusted financial advisor can help ensure that borrowers secure favourable terms and avoid overextending themselves financially.
Real estate credit is an invaluable tool for those looking to enter the property market or expand their investment portfolios. With the ability to spread costs over time and benefit from potential tax advantages, real estate credit offers buyers the flexibility to achieve their property goals while maintaining financial stability. As long as borrowers manage their loans responsibly, real estate credit can open doors to new opportunities in both residential and commercial property sectors.
Real Estate Credit Investments Limited (LON:RECI) is a closed-end investment company that specialises in European real estate credit markets. Their primary objective is to provide attractive and stable returns to their shareholders, mainly in the form of quarterly dividends, by exposing them to a diversified portfolio of real estate credit investments.
