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%.
