Q What types of borrowers do you find most attractive in the current environment?
We tend to target sophisticated and well-capitalised borrowers. Many of the transactions we evaluate for our floating rate loan programme contain a value-add component. In these transactions we are relying on the borrower to execute their business plan, which usually incorporates both an operational and/or capital investment component. Therefore, you want a borrower who is both experienced in executing similar strategies and also well capitalised if the business plan takes longer to execute or incurs additional, unexpected costs. If it costs more to renovate a property or takes longer to execute, we want a borrower who has the wherewithal to invest additional capital into the project and carry the deal through a rough patch.
If you look at our business, we generally target large well-capitalised institutional sponsors and/or strong local operators who have expertise in a particular property type or market. In fact, many times our borrower is a great local operator partnered with an institutional capital source. This approach is consistent across our commercial real estate debt strategy where we lend primarily to the four main food groups: office, multifamily, industrial and retail.
Q What is driving investor interest in commercial real estate debt? Is it coming predominantly from domestic or overseas investors?
CRE debt was traditionally viewed as a bit of a “tweener” or in-between product and lacked a home among US pension fund investors. These investors typically take a barbell approach to investing, combining low yield, liquid investments such as fixed income, which offers a 3-5 percent return with private equity and other alternatives (including real estate private equity) which are illiquid but offer higher returns at 15-18 percent. CRE debt offered superior returns to fixed income at 6-9 percent albeit without the liquidity but did not offer the 15-18 percent return that many pension fund managers wanted for traditional illiquid investments.
You had a situation where the fixed income groups liked the higher returns of 6-9 percent, but struggled with the illiquidity. Conversely, the returns were not high enough for the private equity groups to justify the illiquidity – so commercial real estate debt didn’t have a home among the broader US pension funds at first.
Therefore, most of the demand for CRE debt initially came from foreign investors, particularly in Asia, because they were attracted to the higher yields relative to the alternative in their home markets. This included Japanese insurance companies and other groups attracted to the returns.
Over time, as investors searched the globe for yield and the US commerical real estate debt market evolved, US pension fund investors began to focus more on CRE debt. They were attracted to the stability of the underlying credit, the relative value of CRE debt versus other real estate alternatives and finally, structural changes in the financing markets made CRE debt more accessible to potential investors. With CRE debt, investors may be able to achieve a stable 6-8 percent return from a secured credit with 25-35 percent equity subordination. The stability of that 6-8 percent return versus the expected return on core real estate equity is attractive and provides good relative value for potential investors.
Finally, the structural changes brought about by the Basel III and Dodd-Frank regulations, have really limited the amount of risk US banks can take in commercial real estate debt, making CRE debt more accessible to private investors. The combination of these factors has led more US pension fund investors to invest in specific CRE debt strategies.
Q Given the size of the US market, is there a lot of competition for deals?
I wish there wasn’t! However, if you take a step back and look at the data over the last four years – we have had over $500 billion in annual transaction volume in the US, so there is still tremendous dealflow. In addition, you have around $2 trillion in loan maturities over the next five years. We think the combination of these factors creates a $150 billion annual opportunity in the transitional loan space. While there are new entrants into the space and it is competitive, there are still significant opportunities available in the market.
Q Are there any regions in the US that you find attractive?
We take a top-down approach to market selection and are very research driven. We segment the strategy by property type: office, industrial and multifamily, and then prepare our list of “tomorrow’s cities” or target markets where we like to focus. This analysis is driven largely by supply and demand factors and liquidity in each market. As a lender, you want to be in markets where there is ample liquidity to ensure you have both price discovery and the ability to exit via refinance or sale. That doesn’t mean we are only focused on the 24/7 gateway cities. Most of the lending competition is based in New York or Los Angeles. There are fewer people stationed in places like Dallas or in the Midwest, so I tend to view those markets as less competitive from a supply of capital perspective. There’s probably some relative value to be had in those markets, driven by the fact that fewer lenders are on the ground there.
“The stability of that 6-8 percent return versus the expected return on core real estate equity is attractive and provides good relative value for potential investors”
Q Do you feel there are enough commercial real estate debt opportunities to absorb the amount of capital currently in the market?
Significant amounts of capital have been raised and it is competitive, but the US lending market is fairly segmented. The market is generally comprised of banks, the commercial mortgage-backed securities market, the agency/GSE market, insurance companies and non-traditional lenders. Each one of these segments generally offers a single product to the market. Banks provide low leverage floating rate debt, the CMBS market provides cost effective but less flexible fixed and floating rate debt, the agency/GSE market focuses on the single-family and apartment sectors, insurance companies generally provide long-term fixed-rate debt on core properties and finally the “non-traditional lenders” provide higher leverage floating rate debt, typically on transitional assets.
We remain competitive 1by offering flexible capital and providing our borrowers a full suite of financing options. We can offer long-term fixed-rate mortgage debt on a core asset, we can offer short-term floating rate debt on transitional properties and we can offer higher leverage mezzanine financing on either core or transitional properties, as well.
Q Considering where we are in the cycle, and that it is now 10 years since the last financial crisis, are investors expressing caution about the commercial real estate debt market?
I would not say there is caution around the US CRE debt market in general, but there are specific pockets of concern. We have seen some oversupply in certain property types in specific markets. For example, if you look at the hospitality sector there has been some oversupply in markets such as New York City and Miami. People are cautious as it relates to hospitality and some of that is warranted. There are also some headwinds in the retail space given the impact of Amazon and ecommerce, in general. That being said, we continue to see attractive opportunities in both retail and hospitality and are pursuing selectively.
When people think about the financial crisis, there is a tendency to equate where we are today with where we were 10 years ago. While we have seen spreads for CRE debt compress as new competition has entered the market and there has been some selective loosening of loan structure (with borrowers getting longer initial terms and greater flexibility), leverage has remained in check. Unlike last cycle, we are not seeing borrowers over-leverage properties.
The typical LTV on transitional loans is not getting above 70-75 percent, so you still have sufficient equity subordination supporting the loan. In addition, we generally target sophisticated well-capitalised sponsors and we feel good about their ability to weather any downturn and protect the asset. Things broke during the financial crisis not because spreads compressed or loan structure softened, things broke because there was too much leverage in the system and we are just not seeing that today. This gives us a lot of comfort on the health of the overall CRE debt market.
Q How are you finding the regulatory environment from commercial real estate debt in the US right now?
The traditional lending market, particularly banks and the commercial mortgage-backed securities market, are facing regulatory headwinds. Increased capital requirements are restraining the ability of banks to lend against transitional assets. In addition, risk retention rules are also impacting the ability of the commercial mortgage-backed securities market to compete.
It is these specific headwinds that have led to the emergence of the “non-traditional lender” segment. Specifically, 100-plus “non-traditional lenders” are currently active in the CRE debt market. These players are not subject to the regulatory headwinds and can offer greater flexibility to compete in today’s market.
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.