The rising cost of real estate debt for borrowers is strengthening the case for institutional investors to allocate capital to property credit strategies, according to CBRE Investment Management.
In a new research paper, the New York-headquartered manager’s forecasts, made in May, showed UK real estate debt was expected to deliver a higher return over the 2022 to 2026 period, as a percentage of an investment’s equity return, than credit investors could typically expect.
Furthermore, the firm told Real Estate Capital Europe that the continued increase in the SONIA reference rate since the May forecasts were finalised has led to credit returns rising further, meaning they are now set to outperform equity returns on an absolute basis in many parts of the UK market.
In the first edition of what it plans to be a biannual report – Credit Calls – CBRE IM, which launched its own real estate lending strategy in 2020, analysed in-house and external data to determine suitable credit strategies for investors with varying risk appetites and return requirements. It calculated the percentage of the equity return that represented a ‘fair return’ to the debt investor, with a prevailing return above that share suggesting credit offers relative value.
Taking the example of a 60 percent ‘mid-loan-to-value’ loan, 44 percent of the equity return represented good value at the end of May. Using this ‘benchmark share method’, CBRE IM found investors could at that time already earn outsize returns for credit compared with the benchmark share of equity in sectors including logistics, residential, office, retail and hospitality.
Dominic Smith, senior director, credit research at CBRE IM, said: “Our data to the end of May showed retail, office and hospitality were comfortably above the benchmark share, so they represented good value; with logistics and residential nearer to the line, and so representing fair value. Now, because SONIA has increased further, credit returns are higher than equity returns on an absolute basis across all those sectors.”
“This is the point in the cycle which is best to get into credit,” he added.
Emma Huepfl, co-head of EMEA credit strategies for CBRE IM, acknowledged the research analysed returns in isolation and explained the rising interest rate environment has enhanced risks in the lending market, likely to encourage more constrained leverage as debt service coverage ratios and refinancing levels become key considerations.
“After we began this research, SONIA rates increased and boosted credit returns. But the caveat is credit strategies should only be undertaken by managers and direct lenders with the capability to select the right deal and, if necessary, manage and be operationally involved in assets,” she said. “This research does not ignore the associated risks – but it helps investors identify outsized returns.”
As part of the research, CBRE IM identified parts of the market it believes provide strong opportunities for higher return-focused investors, as well as the more risk-averse investors that seek an uplift to traditional fixed income products. The manager said returns vary according to factors including sponsor, market conditions and asset specifics, but highlighted broad returns ranges within which it sees deals currently trading.
For higher return-driven investors, it highlighted bridge-to-sale funding for residential developments, which it said provides exposure to the new-build residential sector without construction risk, and via deleveraging loan structures. In addition, the manager said return-driven investors with appropriate capability could find value in office-led ESG refurbishment project financing deals, with returns of 6 percent to 8 percent on offer at up to 70 percent loan-to-gross development value in projects that create high quality schemes in core locations.
Retail, at 6 percent to 8 percent gross return at up to 65 percent LTV, was also identified as a strong sector for debt due to the limited amount of competing capital, but it warned the outlook is best for convenience-led and rebased retail park assets.
For fixed income-style, risk-averse investors, CBRE IM identified logistics funding as a suitable strategy. The manager said there is a broad return range, depending on asset maturity and leverage, with gross returns of between 3 percent and 7 percent at up to 70 percent LTV. It also identified the residential rental market, at a 3-5.5 percent return at 50-60 percent LTV, as a defensive investment in a competitive market, and student housing, at 4-7.5 percent at up to 65 percent LTV, as a sector benefiting from strong macroeconomic drivers.
CBRE IM said continued premia to corporate bonds is likely to support further allocations to real estate debt from fixed income investors but recognised economic uncertainty may delay new investors entering the market.
“Adding credit to an equity portfolio is a sensible thing if you are concerned about risk-adjusted returns from a long-term strategic standpoint,” said Smith. “There are always good or bad entry points into markets, and tactically, right now is a really good entry point to credit.”