Debt investing has always been part of the real estate opportunity set, but it is growing in popularity. It allows investors to limit risk exposure compared to equity investments in a first-loss position, and looks increasingly attractive compared to slowing equity returns that are vulnerable to a correction.
As a result, real estate investors are increasingly turning to debt strategies to deal with the dilemma between taking on risk - to capture any further upside through the cycle - and being defensive to avoid the risk of capital loss and drag on performance in the event of a more severe correction.
The debt market is also growing rapidly owing to its attraction to fixed income investors, where increasing market scale and opportunity are encouraging capital flows to debt strategies. Since the global financial crisis, banks have remained constrained by an increased regulatory burden, creating an opportunity for alternative lenders to either expand from an established base, in the case of the United States, or grow significantly from a small base, as in Europe and Asia Pacific.
Expanding the opportunity set
The opportunity set for real estate investors is larger once debt is included than if only equity opportunities are considered. Of the estimated $20trn of real estate in global developed markets - excluding privately-owned residential - only $7.2trn is invested in private markets or held by firms listed publicly. In contrast, a debt investor can also potentially access stock that is non-invested, including assets that are owner-occupied or held outside of the institutional investment market, for example in the public sector or by high-net-worth owners.
Combining an assessment of prevailing loan-to-value (LTV) ratios on equity holdings with an estimate of current real estate debt holdings suggests a total opportunity set of $11.5trn of real estate available to lend against. While many equity transactions carry little or no debt, this is more than offset by the fact debt investors can participate in refinancing even if there is no underlying equity transaction.
While LTV ratios have been lower in this cycle compared to pre-financial crisis, lending activity remains significant. In the US, origination volume has averaged $495bn per year over the past five years, which is higher than the overall equity transaction volume of $420bn. In Europe, there is increasing scope for alternative debt sources to gain a foothold in what is traditionally a bank-dominated market.
Specialist lenders poised to profit
While origination volume is elevated, real estate investors are facing competition from capital sources that would have usually focused on traditional fixed income products. Private real estate debt has always been an alternative to fixed income - a core senior loan is broadly analogous to an investment grade corporate bond.
Compared to a publicly-traded investment grade corporate bond, commercial real estate mortgages lack secondary market liquidity and are not marked to market as regularly. However, investors are compensated in the form of a liquidity premium and have the advantage of taking a fixed asset as collateral. Recently, spreads on real estate loans have held up well, as quantitative easing has driven down yields on market-traded fixed income assets.
The excess spreads offered by real estate loans are increasingly attractive to a wide pool of investors, although conditions still favour specialist real estate lenders that can step in and manage a property to recover or grow values if the borrower defaults. While debt investors look set to face ongoing competition for deals, on the equity side, new debt sources add to the volume of capital available, providing ongoing support for pricing - despite perceptions yields are too low.
Peter Hayes, global head of investment research at PGIM Real Estate
