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Commercial Real Estate: The Lure of Late-Cycle Lending

22 February 2024

4 min read

Clark Coffee| Chief Investment Officer and Head—European Commercial Real Estate Debt

Peter J. Gordon| Head and Chief Investment Officer—US Commercial Real Estate Debt

Investors who paint commercial real estate with a broad brush may be missing out, particularly at this point in the cycle.

If you go by what you hear on Wall Street and in the media, commercial real estate (CRE) may seem like an asset to avoid in 2024. We disagree. But how investors get their exposure matters. When putting private capital to work, we believe it’s better to be a lender than an equity investor at this point in the credit cycle.

We expect to see attractive opportunities for private credit investors this year. Banks continued to shy away from making CRE loans in 2023, a secular trend that appears likely to continue. Yet the need for financing remains great: In Europe, loans worth more than €600 billion will have to be refinanced over the next 24 months. In the United States, nearly $1 trillion of loans will mature this year alone, according to the Mortgage Bankers Association.

Banks in Europe account for a larger share of real estate lending than do banks in the US. But regulatory changes that require banks to increase the capital they hold against commercial real estate loans may start to push more borrowers toward alternative lenders for financing.

Weighing the Risks

But is it the right time to add commercial real estate debt (CRED) to a portfolio? It’s a question some investors may be asking now that higher interest rates mean debt no longer comfortably out-yields more liquid investment-grade fixed income, such as corporate credit and even government bonds.

Then there are the challenges facing borrowers: higher-for-longer interest rates and the potential for a recession before year-end. Investors may be wondering whether CRED today adequately compensates them for these risks—and whether exposure through private equity might offer stronger return potential, particularly if major central banks cut rates.

We think there’s a place for both CRED and private equity in a diversified portfolio. But at this stage in the cycle, we think debt offers a more attractive way to retain exposure while potentially reducing downside risk.

The Pendulum Swings—Toward Lenders

The way we see it, there’s an advantage to being a lender when the market appears to be nearing—but has yet to hit—a bottom.

First, many borrowers and sponsors who can afford to come to market late in the cycle tend to be highly creditworthy ones with superior collateral. Yet all borrowers are struggling to win attention from banks, who have cut back on commercial property loans amid regulatory changes, high interest rates and concern about the economy. This shifts the balance of power to private lenders who can pick the best borrowers and collateral and negotiate deals with high return potential and reduced downside risk.

Typically, it all adds up to strong protective covenants, including caps on leverage, revised property valuations, higher margins and lower loan-to-value (LTV) ratios. And with those protections comes a steady income stream driven by the cash flow of the underlying asset.

A Thicker Cushion

All of this adds up to a thick cushion that can absorb losses. Equity ownership offers greater upside in CRE deals. But it also comes with higher risk; equity claims are first in line in the capital stack—the hierarchy of funding sources used to finance a real estate project—to sustain losses should a project default.

In the following Display, we take a look at a hypothetical commercial real estate property with a 65% LTV ratio and a capitalization rate (the property’s expected rate of return based on net operating income and current market value) of 5%.

Equity Cushions Make Market Timing Less Important for Debt Investors

Current analysis for illustrative purposes only.
*NOI = net operating income
The case study presented describes a potential investment and there is no guarantee of any future investment, investment result, or return. This study is shown to demonstrate how declining asset values affect commercial real estate debt and equity differently. For each scenario, the exercise assumes a 50-basis point increase in the cap rate and the resulting impairment on asset valuations across the capital stack. Assumptions: Debt costs of 7.3% per annum (530 bps Secured Overnight Financing Rate + 200 bps margin). Any shortfall in cash flow to service interest payments is added to the debt balance. Free cash flow is used to pay down debt until initial face value of the loan is reached again and thereafter distributed. Full recovery is defined as an equity multiple of 1.0x. There can be no assurances that any case study will materialize as described herein.
As of January 31, 2024
Source: AllianceBernstein (AB)

An increase in the capitalization rate to 5.5% would result in a 9% decline in the property’s value, creating a 26% unrealized loss in equity value. And it would take nearly three years, with cash flows growing at 3% per year, for the equity value to recover at the new capitalization rate. It’s a different story with debt. In this example, the capitalization rate would have to hit nearly 8% before creditors would face losses.

Real Estate Equity: Better Late than Early

This makes it particularly important for equity investors to pick their spots carefully. Investing too soon before a market hits bottom can be costly. Even a modest valuation decline can mean having to wait longer to get back to par—and longer still to generate positive returns.

At this point in the cycle, it may make more sense to sit on the sidelines until the market turns. In other words, better late than early.

The higher-for-longer rate environment adds another wrinkle. Higher financing costs can significantly decrease distribution yields on equity investments, even at moderate levels of leverage. At today’s rates, cash generation may only be enough to cover the interest on the loan, with little or nothing left over to pay dividends. In extreme cases, the only way to make a profit might be to sell the property.

Floating Rates, Steady Cash Flow

Timing is less of a concern for debt investors. In the scenario detailed above, it would take a 38% decline in asset value for losses to pierce the equity cushion and for creditors to take losses. In other words, a lot would have to go wrong before a creditor incurs a loss. That can make it less risky for private credit investors to deploy capital before the market hits bottom.

CRED comes with additional appeal in the current market climate. Floating rates provide an inflation hedge, while steady cash flows create a reliable income stream. What’s more, loans are secured against the intrinsic value of the underlying collateral—the bricks and mortar that house multifamily apartment complexes, hotels and offices. Even properties with no cash flow can have value.

We believe there’s still value in commercial real estate debt. And at this point in the cycle, we think private markets provide an attractive way to retain exposure while reducing downside risk.

The views expressed herein do not constitute research, investment advice or trade recommendations, and do not necessarily represent the views of all AB portfolio-management teams and are subject to change over time.

About the Authors

Clark Coffee

Clark Coffee is the Chief Investment Officer and Head of European Commercial Real Estate Debt. His previous business, Lacarne Capital, was acquired by AB in 2020 to establish the firm’s real estate debt business in Europe. Previously, Coffee was head of Tyndaris Real Estate, where he was responsible for building the business into a top-10 real estate debt fund in Europe. Prior to that, he co-headed origination for Deutsche Bank’s European commercial real estate credit business and oversaw the risk management and restructuring of more than €2 billion of troubled loans during the global financial crisis. Coffee holds a BA in economics from Lake Forest College and an MBA from the University of Michigan. Location: London/Frankfurt

Peter J. Gordon

Peter J. Gordon is Head and Chief Investment Officer of the US Commercial Real Estate Debt (US-CRED) team. US-CRED oversees nearly $12 billion in committed capital from insurance companies, pension funds and banks, across four vintage closed-end funds and various other institutional mandates. Previously, he was managing director of Commercial Real Estate Debt. Prior to joining the firm in 2016, Gordon served as managing director and head of commercial real estate (CRE) whole loan originations at Angelo, Gordon & Co., a global alternative investment-management firm, where he led the CRE whole loan team, responsible for sourcing, pricing, financing and structuring transactions, as well as managing assets in the investment portfolio. Prior to that, he was a senior member of the real estate finance and investment banking groups at both Goldman Sachs and Morgan Stanley, where he was involved in all aspects of commercial real estate lending, from originations for balance sheet and commercial mortgage-backed securities to loan structuring, syndication and securitization. Gordon has been working in the commercial real estate space since 2001, including four years in construction management. He holds a BS in mathematics from the University of St. Andrews and an MBA from Columbia University. Location: New York

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