Post written by
CEO and Founder of M360 Advisors. Gentry is an entrepreneur and innovator in bringing together technology, real estate, and investments.
Sep 13, 2018
As interest rates rise, the dollar strengthens, trade wars mount and heightened volatility across markets persists, institutional investors are adjusting their risk profiles and shifting dramatically toward debt investments. As part of this shift, investors are now piling capital into private debt in an attempt to protect themselves from an expected market correction while still earning stable returns. According to Preqin, private debt funds raised a record $107 billion last year. Fundraising through the first half of 2018 remains robust.
With such volume of capital flowing into private debt, it can be challenging to find value. One private debt sector that may be especially attractive to institutional investors is commercial real estate (CRE), which offers the potential for both diversification and an attractive risk-return profile at this late stage of a nearly decade-long bull run. With more than two decades of experience in this sector and as a commercial real estate direct lender, I’ve seen firsthand how CRE private debt can be a useful addition to diversify a portfolio with assets uncorrelated to equity markets. Although CRE prices linger around all-time highs, the healthy U.S. economy and favorable tax policy mean there are still ample opportunities to get exposure to an attractive asset class.
Risks Rise Across Markets With Interest Rate Shift
Many signs are beginning to point to a peak in the market, with investors beginning to look for cover. Since 2015 the Fed has been lifting its key policy rate from historic lows, elevating interest rates and bringing a period of loose monetary policy and easy credit to an end. Though rising, bond yields remain low, and most returns on higher-rated debt securities remain relatively modest. Risks rise as the credit cycle turns, so investors are prudent to shift allocations from volatile equities to more secure fixed-income instruments.
Institutions looking to invest in CRE can typically choose between equity and debt vehicles, each of which comes with its advantages and disadvantages depending on where we are in the cycle. Early in the cycle, as CRE property values rise, allocating more toward equity instruments makes sense. Here, investors can buy property outright or purchase stock in firms that specialize in CRE. They can also invest in mutual funds or exchange-traded funds that provide equity exposure to CRE.
As prices peak, CRE debt vehicles can present a more secure option, and an attractive middle ground between volatile stocks and zero-interest savings accounts, efficiently balancing risk and returns while providing consistent cash flow to a portfolio. Many CRE debt instruments offer the added benefit of short-term duration, allowing institutions to “roll up” the yield curve as rates rise.
Within the CRE private debt universe, direct lenders — nonbank creditors that use capital directly from their balance sheets to lend to borrowers — tend to offer safer exposure to the CRE market than most equity vehicles. That’s because direct lenders use physical property as collateral for CRE debt, forming a safety net of assets that minimizes the effects of a default. Direct loans with senior secured positions, where the lender is in the first position to be paid off in the case of a default, offer additional protection. By comparison, property values primarily drive returns on CRE equity instruments.
Strong Tailwinds Suggest A Muted Downturn for CRE
Some investors are understandably concerned about investing in CRE debt given what happened the last time the market peaked. But the overall CRE market is in a much stronger position than it was more than a decade ago because the massive over-leverage that characterized the market then does not exist today. There are also a number of encouraging growth factors.
Continued economic expansion, especially in secondary markets, supports investments in CRE projects, including both new construction and renovations. Expectations for looser regulations and favorable fiscal policy adds fuel to sustain the industry’s momentum. And according to a PwC report, lower corporate tax rates are likely to encourage more U.S. firms to expand domestically, bolstering demand for office and industrial space.
Industry participants predict multifamily and industrial assets will hold the most appeal through 2018, according to a survey my firm conducted at a recent Mortgage Bankers Association convention. Lesser-known yet promising assets include student housing, senior housing, health care offices, medical facilities, laboratories, data centers and even cold storage. Geographically, institutional investors can get exposure to opportunities that prioritize noncore, second-tier cities, particularly those away from the coasts, such as Dallas, Texas; Nashville, Tennessee; and Charlotte, North Carolina, which offer exceptional opportunities for growth.
Each of these factors suggests that the CRE market can weather the coming volatility, and that fixed-income investment vehicles with CRE exposure will continue to be a source of stable returns and risk mitigation for institutional investors.