By many measures, the US economy remains resilient and continues to outperform as the global financial crisis gets further in the rear view mirror. In 2018, US consumer confidence reached an 18-year high while the unemployment rate reached an 18-year low, according to Bloomberg. Moreover, the US economy is expected to grow between 2 percent and 2.5 percent in 2019 – slower than what we saw in 2018, but strong enough to generate continued demand for real estate. As we enter the tenth year of economic expansion, it begs the question: how will real estate fare when the economy inevitably slows, and is now the time for investors to increase their allocation to real estate debt in their portfolios?
A resilient and stable market
Investors are understandably cautious when it comes to assessing real estate risk at this point in the economic cycle. That said, US real estate fundamentals remain in balance and, broadly speaking, we expect valuations to remain steady or rise marginally throughout the remainder of this cycle. Still, it is a prudent time to think about positioning portfolios for the next downturn, and one of the most effective ways to diversify real estate holdings and provide an element of downside protection for portfolios is through real estate debt.
Much has changed in commercial real estate lending since the financial crisis unfolded a decade ago, and these changes have made the mortgage debt markets more resilient and stable. One of the most notable changes is that stricter banking regulations after 2008 prompted many commercial banks to pull back their commercial mortgage lending activity, providing opportunities for alternative lenders to fill the void. These direct lenders, which include insurance companies, asset managers and other originators of private credit, have taken a prudent approach to lending over the past decade, giving senior mortgages originated over the past decade many of the same risk-return attributes as investment-grade corporate bonds.
For example, overall leverage levels in the CRE debt space have remained in check at 70-75 percent loan to value, providing a significant equity cushion against any downward pressure on valuations. In addition, the underlying debt instruments are less complex than those originated prior to the GFC, with fewer multi-tranche capital structures and lenders in each deal. This has led to more prudent underwriting, as risk is now concentrated with those that originated the transaction, and improves decision-making.
For these and other reasons, commercial mortgages can outperform equity and provide downside protection for real estate portfolios during an economic downturn. Unlike other fixed-income instruments, lenders have more control over the structuring of the mortgage, which helps mitigate losses down the road. And when the economic cycle does turn, the bespoke nature of each underlying mortgage investment, and the greater optionality and control over the resolution process, also means lenders are in the driver’s seat when it comes to workouts.
That is not to say the markets are not likely to overshoot and repeat the same mistakes from a decade ago. And it is not to say all loans are created equally. The benefits that commercial mortgages may offer to portfolios during a downturn can be lost if the sourcing, originating and managing of the mortgages is subpar.
More investor choice
With the proliferation of real estate debt funds, investors now have a variety of ways to access commercial mortgage investments. However, superior commercial mortgage performance during a downturn will depend on a lender’s ability to pick the right assets, markets and sponsors, and the lender’s ability to leverage their debt and equity relationships. Scale and the ability to offer a full range of financing products, including fixed and floating rate mortgages and mezzanine, among others, will also be key to outperformance.
If the financial crisis has taught us anything over the past decade, it is that inflection points in the markets can make or break your portfolio performance over the ensuing decade. As we look over the precipice of the current real estate cycle, it is still worth considering the shock-absorption value this asset class can provide to a well-diversified real estate portfolio.