CONTRIBUTORS
Richard Byrne
President,
Benefit Street Partners
With traditional lenders stepping back, we find ourselves in a unique moment reminiscent of Forrest Gump’s shrimping adventures—an expansive ocean of opportunity awaits. Commercial real estate (CRE) debt has emerged as a particularly attractive investment option, especially in comparison to CRE equity and investments in Business Development Companies (BDCs). This environment presents a rare opportunity for nimble investors to inject fresh capital into CRE debt, particularly as higher interest rates, limited capital availability, and looming maturity challenges create a compelling case. Expectations of rising defaults and delinquencies further underscore the potential of an asset class historically known for its resilience against inflation. Savvy investors should look beyond short-term market fluctuations and focus on the long-term advantages of CRE debt over equity and BDCs, as the true benefits are likely to unfold over the coming years rather than just a few quarters.
Where to invest? First, we believe debt > equity
Investors have a range of choices within commercial real estate (CRE), starting with the fundamental decision of debt versus equity. Is it better to buy properties or to lend money to property buyers? While CRE prices are significantly lower today than they were in 2022, suggesting that equities may be undervalued, we believe that the debt side presents a far more compelling opportunity at this time.
One of the primary advantages of CRE debt over CRE equity is the immediate cash flow it provides. This is particularly important in an environment where high interest rates significantly benefit lenders. Investors in CRE debt enjoy a steady stream of income from high interest payments, which are less dependent on fluctuations in the real estate market. In stark contrast, cash flows from CRE equity are heavily influenced by market performance and can be adversely affected by factors such as property vacancies, management inefficiencies, and fluctuating property values.
Moreover, CRE debt typically involves a lower loan-to-value (LTV) ratio, usually around 60% to 70%, compared to CRE equity, which often has effective LTVs of 100%. This lower LTV ratio signifies a reduced risk profile, as the debt is secured by the property at a value significantly less than its market price. This security feature provides stronger downside protection for investors, making CRE debt a safer investment, particularly in volatile market conditions.
Despite this lower risk profile, CRE debt investments have still delivered attractive returns.1 These returns are especially appealing given the current high borrowing costs, which can render CRE equity investments less profitable or even result in negative returns when leverage is employed. CRE debt’s ability to potentially offer substantial returns at lower risk makes it a compelling option for investors seeking a balanced risk/reward scenario.
Historically, CRE debt has served as an effective hedge against inflation. As inflation has risen, so have interest rates2, consequently increasing returns from CRE debt investments. This dynamic is not always true for CRE equity, where rising costs may erode profit margins and diminish overall returns.
CRE debt’s edge over BDCs
When comparing CRE debt to investments in BDCs, several factors make CRE debt more attractive. BDCs, which provide financing to mid-sized businesses, operate in a highly competitive market with numerous players vying for the same opportunities. This competition can lead to reduced returns and higher risks.
In contrast, the CRE debt market currently experiences significant dislocation, especially in sectors like the office market. This dislocation creates opportunities for investors to enter the market at discounted asset values, secure investments at low LTV ratios, and negotiate attractive terms. The less crowded nature of the CRE debt market, compared to the BDC space, offers a more favorable environment for investors looking to deploy capital efficiently and profitably.
Strategic market positioning
The current market conditions, characterized by high borrowing costs and economic uncertainty, have made CRE debt an even more attractive investment option. Equity investors, particularly those using leverage, face challenges in generating positive income, making debt investments more appealing. The strategic positioning of CRE debt in the market today allows investors to capitalize on these conditions, potentially securing high returns while managing risks effectively.
In conclusion, CRE debt offers several compelling advantages over CRE equity and BDCs, making it an attractive investment choice for those looking to balance returns with risk. Its ability to provide immediate cash flow, lower risk profile, attractive potential returns, effective inflation hedge, and favorable market positioning under current economic conditions makes CRE debt a standout option in the commercial real estate investment landscape. As the market continues to evolve, CRE debt remains a robust option for investors seeking stability and profitability in their investment portfolios. These advantages make CRE Debt a compelling investment option, especially for those looking to balance return potential with risk management in their investment portfolios.
CRE Debt’s Edge over CRE Equity and BDCs
Source: Benefit Street Partners.
Endnotes
- Sources: PitchBook, Bloomberg, Cliffwater, NCREIF, FTSE, SPDJI, Burgiss, Morningstar, Macrobond, Analysis by Franklin Templeton Institute 10-year period ending March 31, 2024.
- Source: Federal Reserve Bank of St. Louis as of September 2024.
WHAT ARE THE RISKS?
Past performance does not guarantee future results. All investments involve risks, including possible loss of principal.
Risks of investing in real estate investments include but are not limited to fluctuations in lease occupancy rates and operating expenses, variations in rental schedules, which in turn may be adversely affected by local, state, national or international economic conditions. Such conditions may be impacted by the supply and demand for real estate properties, zoning laws, rent control laws, real property taxes, the availability and costs of financing, and environmental laws. Furthermore, investments in real estate are also impacted by market disruptions caused by regional concerns, political upheaval, sovereign debt crises, and uninsured losses (generally from catastrophic events such as earthquakes, floods and wars). Investments in real estate related securities, such as asset-backed or mortgage-backed securities are subject to prepayment and extension risks.
Fixed income securities involve interest rate, credit, inflation and reinvestment risks, and possible loss of principal. As interest rates rise, the value of fixed income securities falls. Changes in the credit rating of a bond, or in the credit rating or financial strength of a bond’s issuer, insurer or guarantor, may affect the bond’s value. Low-rated, high-yield bonds are subject to greater price volatility, illiquidity and possibility of default.
Equity securities are subject to price fluctuation and possible loss of principal.
An investment in private securities (such as private equity or private credit) or vehicles which invest in them, should be viewed as illiquid and may require a long-term commitment with no certainty of return. The value of and return on such investments will vary due to, among other things, changes in market rates of interest, general economic conditions, economic conditions in particular industries, the condition of financial markets and the financial condition of the issuers of the investments. There also can be no assurance that companies will list their securities on a securities exchange, as such, the lack of an established, liquid secondary market for some investments may have an adverse effect on the market value of those investments and on an investor’s ability to dispose of them at a favorable time or price.
Diversification does not guarantee a profit or protect against a loss.