Commercial real estate debt in a COVID-19 world
Investment opportunities from market dislocation
- Market distress and dislocation stemming from the COVID-19 pandemic are creating attractive investment opportunities in U.S. real estate debt.
- We see opportunities to selectively acquire discounted loans in the secondary market from forced sellers.
- Loans can also be originated at attractive spreads, given real estate’s continuing need for capital and the slower pace of new loan originations.
- We believe that today there is an evolving opportunity to capitalize on market disruption in both the public and private real estate debt markets, and to capture upsized return potential.
The COVID-19 crisis and the ensuring economic shock roiled global financial markets earier this year, stoking fears of an impending recession. As businesses and communities implemented precautionary steps to combat the pandemic, we initially witnessed elevated levels of stress in the public markets, both debt and equity, as investors reduced risk in response to the near-term economic uncertainty. The reaction was further compounded by the fact that the U.S. was already in the late innings of an exceptionally long equity bull market.
Although the public equity markets have since recovered from their March 2020 lows, largely in response to supportive fiscal and monetary stimulus policies, a general sense of uncertainty still prevails. Unknowns related to the duration and severity of the COVID-19 pandemic and the trajectory of recovery have cast a shadow over the economy. However, there are opportunities for astute investors to capitalize on the distress and the divergence of fundamentals from the prices of select securities in the market today. Along these lines, we believe that real estate debt offers an attractive value proposition; both traditional and alternative sources of capital are seeing greater demand across market sectors and are therefore stretched in meeting normal commercial real estate capital needs.
The market stress resulting from COVID-19 has begun to reverberate through the U.S. commercial real estate market. While the pandemic’s impact on private real estate equity valuations has been limited to date (we have seen some short-term stress in rental collections, most notably in the hospitality and retail sectors), the credit markets have been first to reprice.
The dislocation is largely fundamental in nature—real estate is a levered asset class that requires a continuous flow of credit to finance transactions. A pullback by the usual providers of debt has created a short-term need for new capital to fill the void. This restriction in the availability of commercial real estate debt is having an impact on credit spreads across the capital stack and in both the public and private credit markets.
As in prior crises, the public market has preceded the private market in repricing. In the publicly traded securitized market, commercial mortgage-backed securities (CMBS) spreads widened to over 1,100 basis points (bps) in April for certain new issues of conduit CMBS. Private loans followed suit in May, with credit spreads widening to 350bps.1 The CMBS market has seen a recovery in pricing as spreads have narrowed from their widest points with more conservative new origination and a focus on smaller pools of loans at lower levels of leverage. Private market lending has also grown more conservative as lenders have concentrated activity with top quality sponsors and at lower debt levels. However, at the time of this writing, spreads are at, or near, their highs for the trailing five years. (EXHIBIT 1).
Private real estate debt spreads are wide by historical standards
EXHIBIT 1: CORPORATE AND REAL ESTATE DEBT SPREADS—TRAILING 5 YEARS THROUGH MAY 2020 (BPS)
The real estate debt opportunities we see today have one thing in common: They are driven by a need for liquidity. The U.S. commercial real estate mortgage debt market amounts to USD 3.7 trillion2 and is composed of a variety of lenders. New sources of capital are required to replace existing lenders that are either under distress or looking to reduce exposure to the market in an effort to curtail risk. Because of this, liquidity providers have the opportunity to acquire loans from motivated sellers. What makes these opportunities attractive is that certain market participants have been, and are expected to continue to be, forced sellers of commercial real estate debt positions at prices that are less reflective of fundamentals than under normal circumstances. As a result, experienced real estate investors may have the opportunity to selectively acquire discounted loans at attractive prices.
In addition to the need for secondary market liquidity, there is a continuing requirement for new loan origination. The commercial real estate market requires an ongoing source of capital for acquisitions, refinancings or recapitalization of properties—today these loans can be originated at wider spreads (particularly for transitional and development loans) than those predating the crisis (EXHIBIT 2). This natural cycle of debt periodically coming due is estimated to be USD 350 billion to USD 450 billion per year3 and generates a recurring need to refinance senior debt, while also creating an opportunity for mezzanine loans, given the lower liquidity and leverage levels of traditional senior lenders.
History has shown that spreads widen as origination volume falls
EXHIBIT 2: COMMERCIAL REAL ESTATE DEBT SPREADS VS. ANNUAL DEBT ORIGINATION VOLUMES
On the secondary market, loans can be sourced from a variety of lenders with different motivations and liquidity needs (EXHIBIT 3). There has been an increase in risk aversion from traditional lenders, such as banks and insurance companies, with many of these lenders proactively tendering loan portfolios in the market in an effort to trim risk exposure and concentrate on lending to top quality borrowers. This can be contrasted with alternative sources of capital, such as mortgage REITs or private real estate credit funds, which have been forced into a more reactive mode. Many of these alternative funds utilize credit facilities from banks to increase returns. Recently, these funds have had their credit lines cut off or have been required to post additional collateral, given the uncertain environment—leading to the need to sell loans in order to raise cash. This pressure is further exacerbated in the event that their borrowers are delinquent on loan payments.
Another type of seller includes CMBS originators, mortgage banks and other institutions that originate loans using a warehouse line of credit with the intent to securitize and issue to the market. When CMBS markets froze in March, these institutions were left holding mortgages financed with shortterm credit lines that they couldn’t offload. Thus, they required other sources of capital to take over their positions.
The real estate market today is a lender’s market, and those with capital will have access to a wide spectrum of deals. EXHIBIT 4 (view in the full PDF) categorizes real estate debt by market (public and private) and according to risk level (core and opportunistic). A few examples of the types of loans that would fall in each quadrant are included. We believe that today there is an evolving opportunity set spanning the public and private markets, and that experienced investors can capitalize on the dislocation and potentially capture higher returns. To learn more about our views on investment opportunities view the full PDF.