By Beth Mattson-Teig |
Debt appears to be the new flavor of the month for both institutional and retail investors, and they are finding plenty of options to place capital in both corporate and commercial real estate debt.
Demand for debt is being fueled by a variety of factors, chief among them being the long stock market bull run. “That, combined with the volatility in the stock market in 2018, has led a good portion of investors to take some of the equity gains off the table and invest in debt,” says Don MacKinnon, portfolio manager – real estate, at Sound Point Capital Management. Many investors consider debt to be a more protected part of the capital structure, and it also provides the ability for investors to collect income with it, he adds.
The robust economy has produced strong performance across several asset classes, including real estate. “We see real estate prices, in many cases as being fully priced. And while there are still opportunities in real estate equity, you need to have great expertise to find those opportunities as compared to half a dozen years ago,” adds Mitchell Sabshon, CEO and president of Inland Real Estate Investment Corp. Investors also like the risk-adjusted returns, considering that debt is higher in the capital stack compared with equity. “Mortgage debt is particularly attractive on a relative basis given where we are in the cycle,” he says.
The Federal Reserve’s policy over the last decade that has kept interest rates near zero has led to extremely low rates across the entire fixed-income spectrum, both in credit risk and maturities, says Chirag Bhavsar, co-CEO of CNL Financial Group. “That has led to significant demand for yield from both institutional and retail investors. One obvious solution to that has been corporate credit funds in their various forms,” he says.
In particular, there has been growth in private bank loans and collateralized loan obligations, as investors shift away from straight bonds and search for more floating-rate securities that offer protection in a rising interest rate environment, adds Bhavsar.
Investors seek out higher yields
Investors are seeking risk-adjusted returns in a market where rising interest rates — both on short- and long-term rates — are changing the playing field. The Fed has raised the federal funds rate multiple times over the past year, and the expectation is that the Fed will raise rates further in the second half of 2018. “Investors are not sure where rates are going, but they know they can benefit by being in floating-rate funds,” says MacKinnon.
For example, three-year floating-rate first-mortgage loans are generating unlevered returns of 5 percent to 7 percent and levered returns of 10 percent to 12 percent. Typically, a lender gets 1 percentage point as an origination fee and then a rate on that loan that will range between Libor+ 300 basis points to 500 basis points.
Atlanta-based Peachtree Hotel Group provides debt financing to hotel owners and investors through its private equity real estate funds. One way the firm navigates the rising interest rate environment is by playing a “spread game,” says Rob Woomer, president of capital markets at Peachtree. “We tie our loans to some type of Libor or Treasuries or Prime. So, when we make loans, we lend on a fixed basis and a floating basis, but at the end of the day, we are looking for that spread between what we can negotiate,” he says.
Another key piece of the strategy for Peachtree is to hold a B piece of the loan. For example, if one of its funds does a fixed-rate loan at 7.5 percent and interest rates rise 3 percent, that could theoretically erode returns. However, the company brings in a fixed-rate partner to fund the A note, keeps the B note, and then takes the spread between the two. The same strategy applies to floating-rate loans. The firm brings in a floating-rate partner or line of credit that floats up and down together, but they still maintain the spread.
On the corporate debt side, credit funds have had a rough time so far in 2018, mostly because of the deteriorating credit prices and higher rates, adds Bhavsar. “For investment-grade funds, we are typically seeing a dividend of 3 percent to 4 percent. Speculative-grade credit funds usually have a higher dividend, anything from 6 percent to 10 percent annually, depending on the type of fund,” he says. Mezzanine debt, which is one of the riskiest sectors, typically delivers returns between 10 percent and 14 percent.
One of the biggest tailwinds for debt funds continues to be the robust U.S. economy, which helps reduce the credit risk in a portfolio. “That is why you have not seen credit spreads widen meaningfully, even though many people expected them to,” says Bhavsar. So far, none of the major indicators, including the Leading Economic Indicators, Purchasing Managers Index or business and consumer confidence, points to an imminent recession. “Furthermore, the U.S. government has provided a strong fiscal impulse through its tax reform and overall increased spending that is likely to support the economy over the next 18 to 24 months,” he says.
Opportunities surface post-recession
The private debt market has exploded in the post-recession era where a more conservative regulatory environment and new rules from Dodd-Frank and Basel III resulted in tighter lending. Banks are feeling more pressure from a risk-based capital perspective to focus on “middle of the fairway” first-mortgage lending, notes Sabshon. Specific to commercial real estate, it is tougher for banks to do credit-type financing that requires a little bit more expertise to understand the strategy of a property owner; property-level dynamics; and the ability of the owner/borrower to be able to execute on that strategy.
Peachtree is a hotel owner/operator that recognized the opportunity to provide short-term loans for groups that were buying and renovating hotels post-recession and were hungry for capital. The company started out making a few direct loans in 2012 and then launched its first $50 million fund in 2013. Its second $180 million fund is almost fully deployed. “The opportunity doesn’t look like it’s going to go away, in the hospitality sector, and more broadly across real estate,” says Woomer.
The Dodd-Frank rollback did ease some lending restrictions, but the focus is more on banks that have less than $100 billion in assets, and it was less impactful on commercial real estate lending. So, it is not likely that those regulatory changes will shift the current landscape in terms of shrinking the pie for non-bank commercial mortgage lenders. “It’s hard to tell at this point in time what some of the rollback on the smaller institutions is, but that will be something to monitor over the coming months and years to see how hard some of those players will come into the market,” says MacKinnon.
One of the challenges for debt investment products is that it has become a very competitive niche with dozens of different private debt investment vehicles in the market. On the real estate side, many players see plenty of business to go around in a commercial real estate debt market valued at nearly $3 trillion. In addition, there is less competition on loans today as compared to pre–financial crisis. These days, it is typical to be competing with two to three other lenders as compared to 12 to 15 lenders pre-crisis, notes MacKinnon.
Yet competition is something that the industry will have to watch going forward. “Even though competition in some respects may be less than it was several years ago, spread tightening is something that we have to be mindful of,” says Sabshon. “If there is a headwind, so to speak, it is making sure that lenders can continue to get, on a relative basis, attractive spreads on the loans that they have been taking on.”
