5 things you need to know about commercial real estate debt

Commercial real estate debt is gaining traction among investors as an alternative to more traditional modes of real estate investing, but why? PDI looks at some of the driving factors behind this increasingly relevant asset class

1. Investors are better educated

Classifying commercial real estate debt has traditionally been a challenge for investors. The asset class differs significantly from traditional real estate and other forms of fixed income investment. In his interview with PDI, TH Real Estate’s head of origination for the Americas, Jason Hernandez, describes it as an in-between product that has traditionally lacked a home among pension funds. But that has changed. Investors now recognise the relative value of commercial real estate debt versus other real estate alternatives and the stability of the underlying credit.

Investors like the Korean Teachers’ Credit Union were arguably at the forefront of this trend. Over the past five years, KTCU has increased its overseas real estate portfolio – of which commercial real estate debt is a part – from just 3 percent to over 11 percent. Not only has CRE debt increased its appeal among the investor community but it is also more accessible. The regulatory pressures brought about by Basel III and the Dodd-Frank Act that restricted bank lending have created opportunities for investors to access the asset class through alternative fund managers.

2. Brexit has not taken the shine off Europe

While Europe doesn’t have the scale and the maturity of the US market, it still ranks as the second most appealing. According to our survey, the vast majority of investors see the UK and continental Europe as anywhere between moderately attractive and extremely attractive. Brexit is unlikely to change that.

Christian Janssen, head of European debt at TH Real Estate, explains that the UK remains the largest real estate market in Europe. The market’s liquidity, transparency and better legal protections – when compared with the continent or even the US – makes it a draw for commercial real estate lenders. While the European private debt industry was a late bloomer – having only taken off in the wake of the financial crisis – the range of options for investors is expanding and becoming more sophisticated.

The uncertainty brought by Brexit will create some headwinds. The most notable will be delayed investment decisions in the run up to March 2019, when the UK leaves the bloc. For his part, Janssen remains enthusiastic about the prospects of the UK commercial real estate debt market and is sanguine about the potential impact in the medium term. He notes that alternative lenders will likely continue to see attractive opportunities for years to come.

3. Regulations continue to favour alternative lenders

As with the broader private debt space, regulatory headwinds faced by banks have turned into tailwinds for alternative providers of commercial real estate debt. This retrenchment of the banks has been a major theme of the private debt industry in general since the global financial crisis. While some banks have picked up their lending activities – particularly in the US – most remain conservative in their activity.

TH Real Estate’s global head of debt, Jack Gay, notes that changes brought about by the Dodd-Frank Act also disrupted another rival to real estate debt funders: commercial mortgage-backed securities. Risk-retention rules covering asset-backed securities make it far less attractive to be an issuer of CMBS. The result of this favourable environment has seen the number of investors in the commercial real estate debt space grow. Hernandez estimates there are now over 100 non-traditional lenders focused on the sector. Without the same regulatory restrictions, these are able to offer more flexibility than traditional providers.

4. Market conditions remain stable – for now

The consensus is that the real estate market remains well-balanced and economic growth is stable. At the same time, everyone recognises we are late in the cycle. For the commercial real estate debt advisors, this creates both risk and opportunities. One area of concern is oversupply in the US market for some property types. Hernandez notes this is the case with hospitality in some cities, while retail is also facing headwinds due to the impact of a growing e-commerce sector. But that does not mean selective lenders cannot thrive.

Inevitably, spreads have tightened, and deal terms have become looser as the overall market has become competitive. To some, this has echoes of the last crisis. However, drawing parallels with market conditions of 10 years ago ignores an important distinction. Leverage, which was largely the culprit of the last crisis, has remained in check. Indeed, according to our survey responses, two-thirds of investors agree that, on average, LTVs on junior and mezzanine loans remain below 75 percent.

5. Asia-Pacific shows growth potential

When it comes to commercial real estate opportunities in the Asia-Pacific region, Australia is the standout location, and for good reason. According to Martin Priestley, TH Real Estate’s head of debt for Asia-Pacific, the market offers the kind of transparency, stability and sustainability that is a big draw for investors.

This has been the case for investors from elsewhere in Asia-Pacific, especially those unable to get similar returns at home. It is Asian investors – not just assets – that are making their mark on the commercial real estate market. KTCU, for example, has been active in the US and Europe where CRE debt is seen to provide a better risk-return proposition than fixed income or real estate.

However, the fund is also setting its sights closer to home, increasing its commercial real estate debt exposure in emerging markets in countries like China and Vietnam.