Over the last several years, we have seen an increase in the number of institutional investors around the world interested in adding real estate debt to their portfolios.1 In some instances, this is to replace an allocation to traditional fixed income, while in others it is both an enhancement and a way to further diversify their current level of real estate holdings.
Real estate debt versus traditional fixed income
Real estate debt differs from traditional fixed income investments in a variety of ways, primarily through collateralization, income generation, differing risk factors, the potential for securitization and its direct relationship to underlying real estate assets. In the same way that investors looking for reliable income streams and relative stability across a number of fixed income products such as government bonds or corporate credit, they can also turn to real estate debt investments.
One key differentiator for the asset class is that it is typically secured by tangible collateral in the form of real estate. Further, real estate credit investments benefit from attractive positions within a capital structure, benefitting from a subordinated first-loss position from equity, and also from negative control structures which give lenders an ability to proactively protect capital in a downside scenario. In contrast, traditional fixed income investments such as corporate or government bonds are usually unsecured and rely solely on the creditworthiness of the issuer.
For many institutional investors, income generation is a key objective and something that real estate debt investments can generate primarily through interest payments on the loan. These interest payments are often higher than on traditional fixed income investments such as sovereign or investment-grade corporate bonds. Additionally, real estate debt may also offer the potential for additional income through loan origination and exit fees, or in some instances, profit participation. Like other investments in any asset class, real estate assets are subject to market fluctuations and economic cycles. There are, however, additional property-specific risks that investors should take into consideration. These include factors such as underlying occupancy and cash-flow drivers as well as capital markets. Investors should also consider the wider macroeconomic and credit-risk considerations that investors in listed fixed income must factor into their decision making. Lending against property embeds the possibility of active takeovers, also known as workouts, requiring hands-on asset management expertise.
In some instances, real estate debt can be securitized, meaning loans are packaged together and sold as securities in the market. This allows investors to gain exposure to real estate debt through mortgage-backed securities (MBS) or collateralized debt obligations (CDOs). Traditional fixed income investments, on the other hand, are typically traded as individual bonds or included in bond funds.
Lastly, real estate debt investments are directly tied to specific properties or real estate platforms. The performance of the underlying property and its cash flows can impact the value of the debt, along with a borrower’s ability to repay it. Traditional fixed income investments are generally linked to the creditworthiness and financial health of the issuer, without a direct connection to specific underlying assets.
So why should institutional investors consider real estate debt?
As with any other asset class, real estate debt has its own unique set of attributes which, as part of a diversified, risk-adjusted portfolio, may provide investors with compelling reasons to include it within their overall strategy.
Key benefits may include:
- Stable income generation: Real estate debt investments can offer institutional investors stable, predictable income streams. Fixed income from interest payments on real estate loans provides a source of reliable cash flow, which can help insurance companies meet their obligations to policyholders or help pension schemes ensure that they have enough cash on hand to meet near-term pension payments.
- Risk-adjusted returns: Historically, real estate debt investments have provided attractive risk-adjusted returns. Investments in senior debt, for example, typically offer relatively lower risk compared to equity investments, while still providing competitive yields. This can be particularly appealing to pension schemes that prioritize stable returns and capital preservation.
- Liability matching and a long-term investment horizon: Pension schemes and insurance companies both have long-term obligations to pay future benefits. Real estate debt investments, with their typically longer durations and cash flow characteristics, can align well with these long-term liabilities. By matching the duration and cash flows of their investments with their obligations, pension plans can better manage their long-term funding requirements. Similarly, insurance companies typically have long-term investment horizons and investments with longer durations are often well suited to their needs. Real estate debt investments, with their longer repayment terms, can align well with the long-term nature of both kinds of liabilities, allowing for assets and liabilities to be more effectively matched.
- Diversification: Investing in real estate debt can help institutional investors to diversify their portfolios. By including real estate debt alongside other asset classes such as stocks, bonds, and even real estate equity, they can spread investment risk across different markets and sectors, reducing the overall volatility of their portfolio.
- Risk mitigation and capital preservation: Real estate debt investments are typically secured by tangible collateral in the form of real estate. This collateral can help provide a level of protection as lenders typically have the ability to enforce, which serves as a buffer against defaults and reduces the risk of principal loss compared to unsecured investments.
- Regulatory considerations: Some institutional investors, particularly insurance companies, often face regulatory requirements related to capital adequacy and risk management. Real estate debt investments, particularly senior debt, are typically treated favorably under such regulatory requirements, providing capital efficiency to investment portfolios.
As always, it’s important that real estate debt, like any other asset class, is considered as a component part of an overall portfolio of investments constructed with the underlying objectives of the investor in mind. When properly integrated into a portfolio, real estate debt investments have the potential to offer institutional investors the opportunity to generate stable income, diversify their portfolios, align their investments with long-term liabilities, protect against inflation, target attractive risk-adjusted returns and, in some cases, adhere to regulatory requirements.
Understanding the capital structure
The term “capital structure” in real estate investment is used to represent layers of debt and equity within an investment structure, each with its own risk-return profile and repayment priority. Investors choose a position in the structure based on risk appetite, desired returns and level of control or ownership in the investment. LaSalle invests across all layers of the capital structure.
Common equity represents an ownership stake of the property. These investors bear the highest risk but also have the potential for the highest returns. They participate in the property’s cash flows and profit distributions only after others have been paid. They have the greatest exposure to the property’s performance and value appreciation but also face the greatest risk during market downturns or property underperformance.
Preferred equity represents a hybrid investment between debt and equity. These investors provide capital to the project but have a higher claim on profits and cash flows than common equity holders. They enjoy a priority in distribution but still hold a subordinate position to debt holders. They often receive a fixed return, similar to interest on debt, and may also have upside potential linked to a property’s appreciation in value.
Mezzanine debt sits between senior debt and equity in the capital structure. Mezzanine lenders provide loans that have secondary priority in terms of repayment but carry a higher risk profile compared to senior debt. As a result, they tend to offer higher interest rates or additional equity-like features to compensate for the increased risk.
Senior debt occupies the most senior position in the capital structure and has the highest priority for repayment in case of default or enforcement. Lenders providing senior loans hold the first lien on the property, meaning they have the first claim to cash flows and proceeds in the event of liquidation and are usually secured by asset level security. Typically, senior debt offers lower yields compared to other subordinated positions within the capital structure due to its lower risk profile.
1 INREV Investment Intentions Survey, 2017 – 2024
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