Debt preferred over equity prior to normalisation of cap rates

A family office draws attention to an outdated real estate deal underwriting approach in response to rising Treasury yields.

Sasha Bernier, a senior vice president and investment committee member of Cheltenham Investments, a single family office focused on real estate opportunities, told delegates at the PERE Asia Family Office Hong Kong 2018 event that real estate debt investment managers need to take into consideration when underwriting a real estate deal that capitalisation rates will go down in the near term.

As the 10 year-treasury yield is rising this year, industry participants expect a normalisation of capitalisation rates, which are the rates of return on a real estate investment based on the income that the property is expected to generate against its current market value.

“The most important thing is understanding that US treasuries are going up and you have to account for that in your exit capitalisation rate,” said Bernier.

He told delegates that between 1998 and 2004, his family office was buying a lot of ‘multifamily value-added 1970s products’, buying them at 11 or 12 percent capitalisation rates and fixing up with granted treasuries which were around five percent, which gives investors the differential of a 500 percent basis point.

He also points out that people are buying the same product today at sub-five percent capitalisation rates. “[This] does not make any sense,” he said, adding that, “[Some sponsors are] using the same exit capitalisation rates which makes it seem as if it’s easy money with monetary policy still in play.”

The yield of 10-year treasuries was 2.9 percent as of March 9, according to the daily treasury yield curve rates, which gives investors a differential of 200 basis points given the above-mentioned five percent cap rates.

“They are not taking that [appropriate exit capitalisation rate] into account, whatsoever,” Bernier said, adding, “that is the reason why we are falling out of equity into debt because we want to take into account where we think an appropriate capitalisation rate is and should be.”

He also points out that the replacement value of a property is important. “If people are buying stuff at multiples of what it costs to build something, that is a problem. So, you really have to take into effect what the barriers of the entry are,” he added.

Another speaker at the event, Michael Zanolli, a managing director and head of real estate finance advisory, Americas at Natixis Securities America, also said that real estate investors’ shift towards debt instruments is foreseeable due to yield compression.

According to him, there is always a relationship between treasuries and cap rates. “We are in a cycle where cap rates tend to be stickier than treasuries, so if a cap rate is stuck at one level and the treasuries or rates go up, that compression happens and eventually things will have to move,” he added.

He noted that more sophisticated investors are looking at things from a mezzanine debt perspective, adding that, “what a lot of sophisticated investors are thinking about is picking a position within the [capital] stack where they can find value.”