An asset whose time has come

In a time of uncertainty, Jack Gay, TH Real Estate’s global head of debt, explains why commercial real estate debt may provide the relative value and downside protection that investors need

Q Why is commercial real estate debt so attractive to investors right now?

Commercial real estate debt offers a significant level of protection, as compared with many other alternative investment options.

We recognise that we are late in the real estate cycle and the economic cycle.This is true globally and in markets where we primarily invest, like the US, UK and Australia. The most attractive feature of commercial mortgages is the equity cushion within the investment structure, offering protection should there be a decline in the collateral value at any point in the future. That added security is the number one reason why commercial mortgages have gained interest in recent years.

A second attractive feature of commercial mortgages is the strong relative value, in terms of the return you can achieve when compared to other fixed-income investments.

Commercial mortgages as a private asset class offer a premium to most other fixed-income alternatives. Investments in commercial mortgages can achieve returns in the 6-9 percent range, which is relatively attractive in a low yield environment even compared to potential returns for equity real estate investments. Mortgage investments benefit from an equity cushion against the property value, but you still have a return which measures up well to both fixed income and equity alternatives.

In addition, as we continue through a prolonged low-return and low-interest rate environment, a lot of an investor’s return comes on current pay income, as opposed to the upside that might be driven by asset growth. So, in this low-rate, late cycle environment, investors in commercial mortgages can get a lot of their returns in the current income, not on a future hope for growth in asset value.

Finally, the commercial mortgage lending environment is attractive from a regulatory perspective. Since the financial crisis, there have been constraints on the more traditional regulated lenders which have diminished their risk appetite and their absolute volume appetite for commercial mortgages. This has opened the door for some alternative lenders to fill the void.

“The most attractive feature of commercial mortgages is the equity cushion within the investment structure, offering protection should there be a decline in the collateral value at any point in the future”

Q Looking at the largest markets across the globe, is there a particular jurisdiction the strategy favours right now? Where are investors focused on?

A big factor driving investor demand is what currency they want their returns in. The strength in the dollar has led to attractive opportunities in terms of yield when you invest dollars in the UK or Australia, for example. Yields in those countries have become more attractive to US dollar investors from a year ago, so preferred currency is a big driver.

Conversely, many Korean investors have recently faced currency headwinds in the US. If investors are trying to get their returns in Korean won, investing in the US has become more expensive than it used to be, so that might lead Korean investors to consider Europe, for example.

While currency is a big part of it, there are other factors that differ between regions as well, such as transparency of the country and legal enforcement remedies available to a lender. So, each region has features that make it attractive.

Q How do the two largest markets, Europe and the US, compare to each other for commercial real estate debt opportunities?

In Europe, we focus primarily on the UK, which is the largest market in the region and has the most liquidity. The index rates are lower in the UK but the spreads are a bit wider than in the US. One attractive feature of the UK market is that it is a very lender-friendly environment in terms of the enforcement rights. In the event of a default on a UK mortgage loan, the lender can foreclose on its collateral in a quick and efficient process. In addition, UK lenders receive attractive covenant protections in loan documents; more attractive and strenuous covenants compared to the US.

Q How are investors getting exposure to the asset class? Do co-investment deals feature prominently, for example?

Generally, the primary way to get exposure to the commercial mortgage market is through a mortgage-focused fund, or through a separate account managed by a real estate manager. The fund could have a particular strategy and the investor could target that fund based on their risk-return appetite. Funds could be anywhere from a moderate yielding, more conservative and less risky investment, all the way up to a leveraged vehicle that offers double-digit returns. The fund’s risk profile may be influenced by the types of loans the fund is making but also based on the amount of leverage being applied in the fund vehicle or in the loan structure itself.

“A big factor driving investor demand is what currency they want their returns in. The strength in the dollar has led to attractive opportunities in terms of yield when you invest dollars in the UK or Australia, for example”

Commerical mortgage debt funds are an easy way to get exposure because you can match your relative risk-return appetite to the fund strategy. Another benefit of funds – depending on the size of your investment portfolio – is you are investing alongside other investors, so you benefit from greater diversification in your investment mix. Portfolio diversification is a big advantage of commingled fund investing over separate account investing.

A separate account generally requires a larger commitment to the vehicle because you need to have a sizeable pool of capital in order for the manager to create a diverse investment portfolio within that segregated account. Generally, if you have a sizeable amount of capital to put towards commercial mortgages you may be able to have a separate account that is tailored to meet the investor’s risk-return appetite.

Q When looking at risk appetite, what strategies do different types of investors tend to favour?

Where commercial mortgages fit in an investment portfolio varies from investor to investor. On the one hand, you may have an investor who has a significant allocation to equity investments – whether it is in real estate or other alternatives. As we move into the late stages of the real estate cycle, investors are shifting some of their equity exposure into mortgage vehicles. That investor may favour relatively high-yielding commercial mortgage investments because the investor is de-risking from equity, but it is looking at the returns mortgages can offer against what it can achieve in the equity markets.

Insurance companies, by contrast, generally look at commercial mortgages as part of their fixed income allocation. For those at the conservative, low-return end of the spectrum, mortgages are still attractive because investors are benching their mortgage returns against fixed income alternatives, not against equity alternatives.

Q How does commercial real estate debt compare with other forms of real estate investing, and what advantage does it offer investors over REITs for example?

The important distinction between REIT debt and commercial mortgages is that one is in a public asset class and the other is a private asset class. One attractive feature of a privately negotiated instrument like a commercial mortgage is the illiquidity premium available in a private asset class. It is harder to access a private instrument like a commercial mortgage because investors need to build substantial teams and relationships in order to make investments.

Another important feature, particularly as we are late in the cycle, is that a privately negotiated commercial mortgage offers you protection and flexibility in the event of a downturn. With a mortgage investment, you have more of a one-on-one relationship with your borrower, so to the extent that you need to restructure the investment, you may be able to renegotiate the terms of your mortgage in an environment that has just a couple of parties at the table. If you are investing in a public bond, you are one of many bondholders and you don’t have the same control over the outcome.

This article is sponsored by TH Real Estate and first appeared in the commercial real estate debt supplement that accompanied the October edition of PDI.