Why Chicago Teachers has not invested in RE debt in 18 months

The pension fund, among others, is concerned about the additional risks managers in the strategy are taking in order to meet higher return targets.

It has been 18 months since the Chicago Teachers’ Pension Fund last committed capital to a real estate debt fund, partly because the market environment has led the investor to be a bit more cautious. It tends to become more selective when it feels the market is at its peak, according to John Freihammer, portfolio manager at the pension fund.

Chicago Teachers has not committed any new capital to real estate debt funds since its board approved a $30 million investment in Basis Investment Group’s BIG Real Estate Fund I in March 2018. The public pension fund has previously committed capital to Morgan Stanley Real Estate Mezzanine Partners, Fortress Japan Opportunity Domestic Fund and Hudson Realty Capital Fund V, according to PERE data.

Freihammer explained that some managers might be stretching to reach higher return targets in their real estate debt strategies. With historic spreads over the long-term rate, it would be difficult for a real estate debt manager to reach double-digit returns without increasing leverage at the fund level or issuing debt at higher loan-to-value ratios. He also observed more covenant-lite loans creeping back into the market, though not at the level seen in 2008.

“With where interest rates are right now, I would echo concerns about strategies that came through touting mid-double digits to high double-digit returns in this type of environment,” he said.

A wave of new closed-ended real estate debt funds with higher risk-return profiles have launched in the last few years. In the last three years, 150 new credit funds raised more than $100 billion in capital for credit strategies, according to CBRE Global Investors executive managing director and head of credit strategies Todd Sammann. The majority of these funds are targeting double-digit returns, consistent with target returns in previous years. However, these returns were easier to achieve in the market environment when the firms were fundraising but are harder to realize now as increased competition has led to yield compression.

To meet double-digit return targets, Sammann says some firms may be tempted to offer higher levels of leverage on debt issuances – sometimes approaching 80-85 percent LTVs. Firms might also increase their use of internal fund leverage or move up the risk curve by lending to more operationally intensive deals, he said. For example, construction lending and condo inventory loans have become more common, according to Sammann. Investors need to think carefully about whether they will be adequately compensated for the risks in these types of deals.

Indeed, some real estate lenders have adopted high maximum LTVs. Real estate debt and preferred equity investment manager JCR Capital offers leverage up to 100 percent of land and construction costs and will defer the development fee until payoff, according to its website. Acore Capital will offer leverage up to 90 percent LTV in rare instances, and the firm clarified that appropriate leverage is determined on a case-by-case basis. Similarly, New York-based real estate investment firm Greystone will offer a maximum LTV of 90 percent (for current value) for multifamily bridge loans.

However, while some vehicles may be offering higher LTVs, that is just one factor when evaluating risk, according to Mack Real Estate Credit co-founder and chief investment officer Peter Sotoloff. The rights of the lender, the return profile, underlying real estate and cashflow of the asset all factor into the appropriate LTV level, while strong market conditions in certain geographies can sometimes justify a higher LTV, he said. Sotoloff is more concerned with select vehicles that are using warehouse financing to generate returns, though he clarified that this behavior is not endemic in the market.

Even with some managers taking on greater leverage and riskier investments, most are taking a more cautious approach in real estate debt investing, with the level of risk-taking today still significantly below that of 2007 and 2008, Freihammer explained. There is always risk in the late stages of the cycle, especially when the absolute level of interest rates are low, but the real estate fundamentals on the equity side are still healthy, he observed. Given the market environment, the pension fund says it is being more cautious but is still looking at real estate debt as a potential investment as it seeks to meet its 9 percent real estate allocation target.

“There’s still pressure on pension funds to come up with returns,” he said. “But you know, trying to capture an extra bit of spread for what in certain cases seems like a greater amount of risk, I don’t know if this is the time for that. CTPF will continue to monitor portfolio risk and seek stable risk-adjusted returns.”