Institutional appetite to allocate capital to real estate debt increased over the summer, coinciding with continued central bank interest rate rises. Real estate credit investment has a number of positive features – it provides a potential cushion against valuation declines and a visible stable income, as well as a level of protection to mitigate the impact of rising rates. In addition, the supply/demand imbalance in the credit market enables lenders, and ultimately investors, to achieve higher returns.
Over the past decade, we have noticed a rotation from fixed income investment to yielding assets such as private debt, infrastructure and real estate. The search for more certain yields appears to be driving investors to allocate to real estate credit.
Another advantage of credit is that an investor need only ensure that it has sufficient protection to be repaid the principal sum and to receive interest on it – there is no need to focus on valuations and growth. Therefore, real estate credit potentially provides greater protection from market volatility, both in terms of valuation and rental declines, given investors are not in the first loss position and receive interest rather than rental payments.
Real estate credit, depending on how loans are structured, may also afford investors some protection from economic volatility. Floating rate loans, which several of the debt funds originate, provide investors with higher returns as interest rates rise. In addition, profit participation in certain positions can allow investors to capture the upside associated with rising valuations in an inflationary environment.
Returns generated from real estate credit are expected to increase, given the current economic climate. The cost of capital has risen and the dynamics have shifted from a borrower’s market to a lender’s market. Those active in this sector can expect to see less competition, lower leverage levels and widening spreads across bridge lending and construction financing transactions.
However, investors must consider the risks attached to such investments, despite the potential benefits of real estate credit strategies. For instance, they need to examine leverage levels on a look-through basis, assess sponsor/asset quality and ensure they invest with experienced managers that can structure to mitigate risks, such as early repayment or cost overruns.
Overall, given continued market uncertainty, the institutional appetite for real estate credit is set to gain momentum.