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Commercial real estate lending funds represent an opportunity for investors worried about real estate valuations to move up the capital stack yet still earn an attractive return. Specifically, closed-end real estate debt funds, which often fund acquisition and development, should be able to generate high single-digit returns while avoiding significant losses if the real estate cycle turns. Investors pursuing this strategy should have realistic return expectations. Over a full cycle these funds are likely to trail real estate equity funds (as well as other traditional lock-up strategies like buyouts and venture). Given real estate fundamentals may be plateauing, careful manager selection is important for investors deploying capital to this strategy.
US commercial real estate (CRE) debt is a $3 trillion market. Much of this lending is done by banks and insurance companies at low single-digit yields. Securitization markets also play a key role and fund around one-third of new borrowing, with specialized players such as mortgage REITs and alternative lenders also acting as significant providers of capital. Yields on CMBS (which range from around 2.5% for AAA-rated paper to as high 5.5% for BBB-rated tranches) look attractive relative to other similarly rated credit, but may not help prospective limited partners meet return targets.
Investors that can tie up liquidity may find closed-end funds that originate higher-yielding loans more interesting. These funds operate outside the purview of the other traditional investors, in part, by offering “bridge” loans to developers to help fund prospective projects. Many of these funds are able to generate high single-digit returns by offering faster execution and/or larger loans than traditional lenders. Some managers aim for even higher returns if riskier underlying assets or instruments (such as mezzanine loans) are involved.
Relatively stable real estate fundamentals support this strategy. Vacancy rates have ticked up slightly in recent months but, at 7%, remain well below recent averages. Strong tenant demand has kept growth in net operating income to around 5%, above rates seen for many other asset classes. Supply dynamics remain favorable and seem unlikely to pressure these metrics. Construction activity has increased in recent years; last year’s $160 billion of new starts came close to the pre-financial crisis peak. However, more than half of this construction is of new apartment buildings, which are merely serving to offset depressed volumes of single-family home construction. Looked at another way, new commercial real estate completions represent less than 1% of GDP, around half of their long-term average.
Unfortunately for real estate equity investors, prices reflect these fundamentals and may mean upside is capped from here. The 5.0% cap rate on private real estate sits near a historical low, and is one reason why price appreciation has slowed dramatically over the last 12 months. Transaction volumes have also dropped, as buyers have grown increasingly wary of both rich valuations (particularly in gateway cities) and the direction of interest rates.
Real estate lending funds also compare favorably to certain other types of private credit. Yields on new middle-market direct loans average just 6%, creating a headwind for direct lending. Although pickings are currently slim, skilled distressed managers are likely to eventually generate higher internal rates of return, but their funds may require longer lock-ups and not offer the same current income component.
Favorable technicals may help explain why some types of CRE debt still offer attractive yields. A wave of CRE loans originated just before the financial crisis has started to mature, and not all of the banks that originally participated will want to re-up their commitments. Higher capital requirements are forcing some banks to pull back from riskier lending, while new risk-retention rules impacting securitization are having a similar impact on other types of specialized lenders. The good news for potential creditors is that less competition means lending criteria are becoming stricter; average loan-to-values on new loans have fallen in recent years to around 60%, though some rating agencies think asset values are much lower.
Investors taking a closer look at this opportunity should bear in mind a few caveats. Given the real estate cycle is fairly long in the tooth and more capital is coming into this space, manager selection is important. The due diligence process should examine what the fund’s competitive advantage is (deal sourcing, etc.), and explore how the manager performed during the previous downturn. One of the things investors should examine is how the manager previously handled nonperforming loans, or what happened when the borrower handed back the keys. Again, fundamentals do not suggest a turn in the current cycle is imminent, but history has an odd habit of eventually repeating itself.
Wade O’Brien is a Managing Director on Cambridge Associates’ Global Investment Research team.
Originally published on September 12, 2017
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