Investing For a New Decade
The next 10 years are sure to bring a different set of opportunities and obstacles than the past 10.
Debt has always been a component of a real estate investor’s arsenal, but only in recent years has it become a more ubiquitous asset class for institutional investors.
As the global economy continues its longest-running expansion of the post-war era, investors who are interested in taking a more defensive position related to a potential economic slowdown are increasingly looking at debt strategies that, while not offering the upside of equity, come with structural characteristics that limit downside risk.
Indeed, part of the appeal of real estate debt in today’s economic environment rests in its potential to ease the dilemma between taking on risk – attempting to capture any further upside through the economic cycle and, if the eventual correction is modest, into the next one – and being defensive to avoid the risk of capital loss and drag on performance in the event of a substantial correction.
“Looking at the last downturn, some of the results that we saw coming out of real estate debt portfolios were related to poor construction of the underlying real estate debt — interest-only lending, lending on speculative development, leverage on leverage in excessive ways,” said Jackie Brady, Executive Director, Business Development, at PGIM Real Estate. “What we are seeing now are more protections being retained in lending. The asset class will look very different from how it looked in the last global financial crisis, largely because we haven't seen underwriting excesses in the same way. The underlying assets are real estate, so we don't expect that we will get a pass in another downturn. But we would enter that downturn on much stronger footing.”
Andrew Radkiewicz, Global Head of Private Debt Strategy and Investor Solutions at PGIM Real Estate, said investors shouldn’t view real estate debt as a replacement for real estate equity. They should instead consider their expectations of future potential changes in real estate value as the determinant to where they position themselves, with an eye towards their target return; an investor with a Treasury-plus-100-basis-points target will behave differently than one seeking a double-digit return.
“If one is expecting a downturn, there would naturally be some benefit in dialing up real estate debt and, in other times, dialing it down versus an equity return,” he said. “Although real estate debt gives up an element of future upside, the thinking should be what is that potential upside, and is that small or big enough to give you the downside protection at different parts of the cycle? From a portfolio construction perspective, we think adding real estate debt alongside private real estate equity investments is a good thing to do.”
The rapid growth of the market stems, in part, from its allure to both real estate and fixed income investors. For real estate investors, debt strategies look increasingly attractive compared to equity returns that, given the position of the cycle, are vulnerable to a correction. The attractiveness of holding debt, rather than equity, increases during a downturn.
What’s more, increasing market scale and opportunity are encouraging capital flows to debt strategies. One offshoot of the global financial crisis is that banks have remained constrained by a heavier regulatory burden, creating an opportunity for alternative lenders to either expand from an established base, in the case of the United States, or grow significantly from a small base, as in Europe and Asia Pacific. The excess spreads offered by real estate loans are also attractive to a wide pool of investors, although conditions still favor specialist real estate lenders that can step in and manage a property to recover or grow values if the borrower defaults.
In the last two downturns, the optimal strategy mix for an investor with a combined equity and debt portfolio would have comprised debt holdings of 80% to 90%. Those numbers suggest it would be beneficial to maintain an allocation to debt strategies through the cycle. Given concerns that the global real estate cycle may suffer a period of weakness or a correction in the coming years, the ability of debt investments to provide downside protection means that the asset class could remain an attractive proposition for investors looking to optimize their global real estate portfolio.
“People recognize that this is a large market, it offers a breadth of risk-adjusted return opportunities, and it has been ignored for too long,” said Radkiewicz.