Downturn in Commercial Real Estate Valuations Is Boosting the Appeal of Property Debt

Though those dynamics aren’t good for equity investors, there are some pluses for investors in real estate debt. That’s because lenders are now reducing the amount of leverage they provide to borrowers, and are charging additional interest to account for higher perceived risks. 

That means commercial real estate debt investors “in newly underwritten deals benefit from more sizeable equity cushions, better returns, and enhanced downside protection,” according to the report. 

The biggest misconception of commercial real estate debt “is it has the same risk profile as real-estate equity, and that couldn’t be further from the truth,” says Alex Chaloff, chief investment officer at Bernstein Private Wealth Management. 

Previously, commercial real estate debt offered returns in the neighborhood of 6% to 8%, but the current environment is likely to lead to returns approaching 11% for the next three to five years, Chaloff says. 

Buying real estate debt “allows you to get exposure to real estate but to do so with much more of a safety component than just simply buying the equity,” he says.

Commercial real estate debt refers to loans made to businesses, developers, or funds for buying or developing commercial projects. The loans can include first mortgages or subordinate debt, which have varying levels of risk. Though traditionally the domain of banks, wealthy investors invest in these loans today through vehicles such as debt funds and private credit. Moody’s estimates commercial real-estate debt comprises 4% of the private credit market, though non-bank alternatives are expected to play larger roles moving forward.

Chaloff spoke to Penta about how investors can make the most out of allocations to commercial real-estate debt in their portfolios.

Getting Started 

Bernstein recommends its income-oriented private wealth clients allocate about 7.5% of their portfolio to commercial real-estate debt. The outstanding market for these securities in the U.S. is about US$5.4 trillion, with banks holding nearly half. It’s more difficult to track what portion is private debt funding, Chaloff says. 

Industry watchers widely expect regional banks will exit or reduce their commercial real estate lending as higher interest rates, slower markets, and heightened scrutiny following recent bank failures make the category less attractive. That could push more lending into the private markets. 

“The asset class has great stability, and that’s part of the reason investors prize it,” Chaloff says. But they also need to watch it closely near-term because of all the moving parts. This includes whether distributions, appreciation, and the caliber of assets added to a real estate debt fund portfolio over time meet individual investor expectations.

Though commercial real estate debt funds—which often focus on strategies such financing retail developments or multifamily apartments—account for a small portion of the broader financing market, they may play a larger role in the future.

Investors need to select the right fund and the best strategy for their needs. They should also make sure they are comfortable with the lockup period, or the length of time they are required to stay in the fund. Some funds require a long lockup, while others can be too short with active redemption queues paying out sizable amounts of money to pools of investors. If investors before you already want out, “that’s generally a red flag,” Chaloff says.

He prefers shorter-term investment options, in the range of three years, instead of those with five- or ten-year horizons.

Invest for Different Parts of Rate Cycles

Investors intrigued by the opportunities in commercial real estate debt should avoid an urge to go all-in at once with an allocation to the sector. 

“Think about what your long-term allocation will be and then build to it,” Chaloff says. “In this environment, I would probably take a year.”

That’s because interest-rate cycles, not calendar years, can affect expected returns. “You want to have exposure to different parts of the rate cycle,” he says. If an opportunity excites investors, Chaloff suggests making investments over two quarters. “The deal flow has picked up meaningfully over the last 60 days,” he says. “But don’t go all in at once.”

Diversifying investments by different origination years is also possible to do through the secondaries market, which allows for purchases of previously issued securities. Through buying commitments from the initial fund investors, in whole or in part, secondary investors can potentially access discounts or shorter lockup periods. Many private-equity firms also specialize in secondary funds.

Avoid Duplicating Risk

When investing in commercial real-estate debt, Chaloff says it’s important to avoid overlapping risk profiles with other portfolio assets. The two biggest risks to commercial real estate are interest rates and recession. Investors need to review how much of their portfolio faces those risks already and then size their allocation appropriately to avoid duplication, keep a diversified portfolio, and maximize returns. 

The “low-likelihood” scenarios that would challenge the asset class are a recession stretching beyond “brief and shallow” and a continued interest rate pickup rising to the mid-sixes, Chaloff says. Instead, he expects a period where the market will muddle through peak interest rates.

“Each time an investor makes a new commitment to a fund is the right time to review your overall portfolio,” he says. If investors aren’t making new commitments, he adds they should review each time a fund in their portfolio offers liquidity to existing investors.