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

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.