Should Investors Consider Allocating to US Commercial Real Estate Debt?

Yes. A record of roughly $925 billion of US commercial real estate (CRE) debt is maturing in 2024 and refinancing needs in future years are also significant. Some of these loans will be extended, but most will need to be refinanced; simultaneously, many traditional lenders are pulling back. The resulting rise in spreads, combined with higher interest rates, should generate attractive multiyear returns for CRE debt investors.

Spreads are elevated on CRE debt for several reasons. Roughly 50% of maturing 2024 loans were made by banks, many of which are shrinking loan books. Small- and medium-sized banks, which have the largest CRE exposure as a percentage of overall loans, face concerns over credit quality and pay more for deposits. At the same time, the largest banks, which tend to have smaller exposures, face pressure from new regulatory capital requirements. Meanwhile, falling property prices reduce the amount of equity held by owners and higher interest rates weaken debt servicing metrics, which creates an opportunity for mezzanine and preferred equity investors to help tweak capital structures.

Investors have several options when allocating to this market. Open- and closed-end funds offer a variety of exposures, including originating new loans as well as buying existing securities backed by CRE loans—such as commercial mortgage-backed securities (CMBS) and CRE collateralized loan obligations—in the secondary market. Many of these funds focus on new senior loans, but others will also extend mezzanine loans or buy preferred equity to help offset how property price declines have reduced equity cushions. Some funds employ leverage to boost returns by borrowing at the fund level; others may consolidate pools of new loans into a CMBS transaction and retain the “first loss” or “B-pieces.” Strategies vary across markets (primary versus secondary), seniority (senior versus mezzanine, etc.), sectors, and other dimensions.

Return potential varies according to approach. Managers extending new loans on stabilized buildings in sectors with strong fundamentals may target mid-/high-single-digit unlevered yields; with leverage, potential returns may be in the low double digits. In contrast, funds looking to buy secondary market securities (e.g., CMBS) at distressed prices may target low double-digit returns. Closed-end funds that are originating mezzanine or preferred equity may have even higher return targets, though the share from their cash coupon will be lower.

Real estate lending carries potential risks. Higher interest rates have put upward pressure on cap rates, and the potential for interest rates to remain higher for longer could put pressure on owners that have used floating-rate debt. Reduced transaction volumes in recent quarters reflect uncertainty around rates and raise questions around where property prices will stabilize. Fundamentals like vacancies and rent growth are also in flux for some property types. Many private funds are sitting on significant amounts of dry powder, which, if deployed, could increase competition for new loans and reduce spreads. Preqin estimates private real estate debt funds have around $77 billion of dry powder, and so-called opportunistic funds have another $200 billion+ they may be willing to invest at the right yield.

Still, some risks may be exaggerated, creating an investment opportunity. Excluding categories like office (roughly a quarter of the US CRE lending market), fundamentals look healthier in categories such as industrial and multi-family. Given recent price declines, new lenders are both obtaining more security (lower loan-to-value) and lower valuations. Further, existing dry powder seems small relative to the roughly $5 trillion of outstanding CRE debt. In other words, some opportunistic funds may never deploy if spreads retreat, potentially putting a floor under spreads.

Investors should ask how the real estate debt opportunity compares to other opportunities. CRE debt internal rates of return are likely to be attractive for current vintages, given higher rates and spreads. Whether they outperform CRE equity funds in future years will depend on several factors, including the direction of rates, property prices, and riskiness of the underlying assets. Regardless, debt capital can be put to work more quickly relative to equity. Within private debt or diversifier portfolios, CRE debt provides an opportunity to diversify away from corporate credit exposures, though leverage and area of focus will impact relative performance. For investors considering an allocation, we prefer managers that have experience investing through market cycles and can invest across different parts of the capital stack. We also prefer those that have in-house asset management capabilities, given managers may need to take possession of assets.

Wade O’Brien, Managing Director, Capital Markets Research