Why real estate debt can stand firm in face of twin threat

Investors on the hunt for secure income face the dual threat of rising inflation and rates. Natalie Howard explains how real estate debt can help.

16/05/2022
SC_two_bears_fighting

Authors

Natalie Howard
Head of Real Estate Debt, Schroders Capital

The prospect of rising interest rates has been a hot topic for investors for some time. The recent acceleration in inflation to multi-decade highs across the US, Europe and UK has made this the central issue on the minds of investors around the world.

Markets have been braced for a series of interest rate rises ever since Federal Reserve chair Jay Powell’s said in January that he would do all he could to stop inflation becoming “entrenched”.

In addition to raising rates, the US, UK and Europe are all on a path to tapering their quantitative easing programmes. This represents a fundamental shift away from the ultra-accommodative environment of recent years.

Rising rates and inflation are of course anathema to bonds, and the start of 2022 was accordingly one of the most challenging on record for fixed income.

The question of how investors can access truly “secure income”, in the face of rising inflation and rates, has rarely been more challenging. We explain why real estate debt can help.

How does rising inflation impact real estate debt?

Rising inflation and rising rates present two separate but related challenges for real estate. On the first of these, real estate assets are well positioned. The value of the underlying real estate acts as a natural hedge against inflation.

Commercial real estate leases are strongly correlated with inflation over time. That is to say, rents generally increase as a direct consequence of higher inflation. The value of the asset, a function of the underlying cash flow it produces, therefore increases with the higher inflation and rental income.

What about rising interest rates?

One of the key aspects of real estate debt that defends against a tighter rates environment is its flexibility. Real estate debt financing can be either fixed rate or floating rate, with the latter providing the opportunity to protect investor returns from raising rates.

Floating rates offer a margin over risk free rates such as EURIBOR in Europe, or Sonia in the UK; an attractive feature when compared with fixed income instruments that lack this flexibility in an environment of rising rates.

But this flexibility doesn’t mean borrowers’ costs will grow difficult to control.

Real estate borrowers can take out an interest rate cap, in the event that they use a floating rate loan. This protects their position in the event of sustained interest rate rises.

Of course, for holders of any type of asset-backed debt, valuations and the way in which rate rises can affect them is also a key concern. Here, the likely impact differs widely by sector.

Real estate valuations have risen this cycle as debt costs have decreased. That said, there has been significant divergence over the past 10 years, with logistics assets reaching all-time highs and more challenged sectors – such as retail – seeing significant falls.

As debt costs rise, investors will need to understand the potential impact on the value of the underlying real estate across all sectors. But they need to overlay that with the structural changes happening within each sector.

The key is not to be distracted by a borrower’s circumstances when the sea is calm and the sky clear, and think about what could happen when the wind shifts.

How to make hay when the sun won’t shine

We use sustainable yields to underwrite our transactions – looking at long-term valuation metrics rather than today’s valuation. We therefore give ourselves a significant margin of safety so that if there are falls in the underlying value of the assets, our loans can continue to perform.

We spend a lot of time thinking about our exit position at the end of our loan. We need to understand the re-finance risk, which is when most loans default. We assume an increase in the cost of debt financing for the borrower in our underwriting.

We make sure that transactions have de-levered through the life of the loan, either through amortisation (paying back loans), or through an increase in the value of the asset to make sure the re-finance position is attractive to lenders. We also make sure that if a borrower’s interest cover ratio (ICR) is quite tight, and rates do rise, then the borrower can inject further equity into the deal.

Finally, we always have a significant equity cushion in our transactions. We have conservative loan-to-value-ratios which mean that our loans are always behind significant equity from experienced sponsors who we have often worked with before.

We think that in assessing a borrower’s prospects it’s important to carry a healthy scepticism, even if they lack it themselves.

We consider the business plan of the borrower very carefully. Many business plans have increasing rental values baked in to their assumptions. We consider that with debt costs rising across the board, the underlying tenants will be facing rising costs, and we ensure that we are very conservative in any assumptions.

Keep calm to carry on

The key takeaway is to be sure to think things through calmly. While the floating rate aspect of real estate debt makes it very attractive for investors, rising debt costs will inevitably impact all assets, and investors need to know the implications.

We underwrite conservatively and consider the exit position of assets in the event of rising rates. This means we’re able to structure transactions which provide investors with secure income without the interest rate risk of many fixed income alternatives.

Important Information

The contents of this document may not be reproduced or distributed in any manner without prior permission.

This document is intended to be for information purposes only and it is not intended as promotional material in any respect nor is it to be construed as any solicitation and offering to buy or sell any investment products. The views and opinions contained herein are those of the author(s), and do not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. The material is not intended to provide, and should not be relied on for investment advice or recommendation. Any security(ies) mentioned above is for illustrative purpose only, not a recommendation to invest or divest. Opinions stated are valid as of the date of this document and are subject to change without notice. Information herein and information from third party are believed to be reliable, but Schroder Investment Management (Hong Kong) Limited does not warrant its completeness or accuracy.

Investment involves risks. Past performance and any forecasts are not necessarily a guide to future or likely performance. You should remember that the value of investments can go down as well as up and is not guaranteed. You may not get back the full amount invested. Derivatives carry a high degree of risk. Exchange rate changes may cause the value of the overseas investments to rise or fall. If investment returns are not denominated in HKD/USD, US/HK dollar-based investors are exposed to exchange rate fluctuations. Please refer to the relevant offering document including the risk factors for further details.

This material has not been reviewed by the SFC. Issued by Schroder Investment Management (Hong Kong) Limited.

Authors

Natalie Howard
Head of Real Estate Debt, Schroders Capital

Topics

Real Estate
Alternatives
Private Assets
Inflation
Interest rates
Follow us

Contact Us

Level 33, Two Pacific Place, 88 Queensway, Hong Kong

(852) 2521 1633

Online enquiry: Please complete the web form below and we will reply as soon as possible.

Contact us

The investments mentioned in this website may not be suitable to all investors. The information contained in this website is provided for reference only and does not constitute any investment advice. Investors are advised to seek independent advice before making any investment decision.

Investment involves risk. Past performance is not indicative of future performance. You should remember that the value of investments can go down as well as up and is not guaranteed. You may not get back the full amount invested. Please refer to the relevant offering document including the risk factors.

This website is intended for Hong Kong residents only. Non-Hong Kong residents are responsible for observing all applicable laws and regulations of their relevant jurisdictions before proceeding to access the information contained herein. Schroder Investment Management (Hong Kong) Limited is regulated by the SFC. The website (excluding Schroder Provident Fund related pages) has not been reviewed by the SFC.

The website is issued by Schroder Investment Management (Hong Kong) Limited.