UK real estate debt returns attractive despite margin squeeze, says CBRE

Returns to senior lending on commercial real estate fell  to 3.6% from 4.1% over the year to Q1 2015 , according to CBRE’s latest UK Debt Prospects.

The main culprit in reducing gross returns was a 33bps fall in margins, allied to a 10bps drop in interest rates.

“It is clear that average returns to senior CRE debt have fallen over the last 12 months or so. This has in large part been driven by downward pressure on margins. But it is important to put this into context and look at CRE debt versus the broader family of fixed income products,” said CBRE’s head of real estate debt analytics, Dominic Smith.

“What we see when we do this is that returns have fallen across the board, so that the premium offered by CRE debt relative to other forms of fixed income is still very attractive; we believe it is still over 2% versus gilts, it is more than 1.5% versus corporate debt, and it is just under 1% relative to AA CMBS. Investors driven by a search for relative yield will therefore still view CRE debt in a very favourable light. ”

Risk-adjusted senior debt returns fell from 4% to 3.5%, also reflecting the falls in interest rate and margins. CBRE believes that though capital growth prospects dimmed slightly in Q1, the probability of senior debt default and expected loss was essentially unchanged.

Gross returns to mezzanine debt — assumed to be a 65-80% loan-to-value ratio junior tranche — edged down from 8.2% to 8.1%, thanks to the interest rate dip.  But a slightly weaker outlook for capital growth from Q1 2015 has driven a small rise in the probability of default for mezzanine, so
risk-adjusted returns were 6.8%, down from 7.1% the previous quarter.

The gap between gross senior and mezzanine debt returns has widened by 40bps to 460bps;  for risk-adjusted returns, it has held steady at 320bps.