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PERSPECTIVESTHE CASE FORU.S. REAL ESTATE CREDITJUNE 2021For investors seeking yield in a ‘lower for longer’ interest rateenvironment, commercial real estate credit can offer a solutionwith attractive investment characteristics and risk-adjusted returns.However, extensive real estate and structuring expertise is neededto source, underwrite and execute on opportunities in this space.Todd SammannAs the ‘lower for longer’ environment grinds on, so does the search for yield. This isdriving demand from investors seeking opportunities that can offer yield premia abovethose of traditional fixed income strategies, without taking on excessive risk. Commercialreal estate credit fills this need by offering attractive relative value with a focus on regular,predictable income.KEY INVESTMENT CHARACTERISTICS:However, successful investing in real estate credit relies on a combination of skillsets –expert knowledge of real estate markets, alongside an understanding of credit risk andthe ability to effectively structure loans with protective covenants. Downside protection throughReal estate expertise is essential to understand the fundamentals that drive valuationsthrough cycles, and the factors that influence the appeal of a property or location totenants. Established networks and relationships within the sector are also needed tosource opportunities and originate loans in private markets. Meanwhile, the ability tomanage risk through effective structuring and underwriting is also vital. For investmentmanagers with this mix of capabilities, there are currently many compelling opportunitiesin the market.REAL ESTATE CREDIT INTRODUCTIONReal estate credit refers to private loans, or mortgages, secured against underlyingcommercial real estate assets. These loans are typically used to finance the acquisition ofa property (new loans), replace an existing loan which is maturing (refinancings), or fundimprovement or development projects. A well-functioning commercial real estate marketrelies on real estate investors being able to secure financing for these types of activities.In return, the lender receives regular income from the loan interest payments, typicallybacked by rents from the underlying property. In the U.S., approximately 2.3 trillionworth of real estate loans reach maturity and will need to be refinanced over the next fiveyears, creating an ongoing source of demand for real estate credit investors.Head of Credit Strategies – Americastodd.sammann@cbreglobalinvestors.com Stable, predictable income Higher yield than fixed income,with similar levels of riskstructuring and position in capitalstack Secured by high-quality assets Diversifier to direct real estate andlisted securities Attractive risk-adjusted returns“IN THE U.S., APPROXIMATELY 2.3TRILLION WORTH OF REAL ESTATELOANS REACH MATURITY AND WILLNEED TO BE REFINANCED OVER THENEXT FIVE YEARS.”
ATTRACTIVE INVESTMENTCHARACTERISTICSSTABLE, PREDICTABLE INCOMEReal estate credit offers the security of acontractual income stream, giving investorsvisibility and relative certainty of income overtime. Generally, average lease lengths exceedloan duration. This can be particularly useful forinvestors with long-term liabilities to meet.YIELD PREMIUM TO FIXED INCOMECommercial mortgages can generate asignificant yield premium compared tocorporate bonds or other fixed income productswith similar risk characteristics.DOWNSIDE PROTECTIONCommercial real estate credit can provideeffective downside protection with early warningsignals via loan covenants. Investors are alsoprotected by lending only up to a percentageof the value of a property, ensuring there is asignificant equity cushion in the event of valuedecline, and securing priority over other lendersin the capital stack.SECURED BY HIGH-QUALITY ASSETSCommercial mortgages have a secured interestin the underlying real estate, allowing a lenderto take title to a property following a loandefault. Lenders with equity asset managementinfrastructure are best suited to own and operatecollateral assets and maximize value.DIVERSIFIER TO DIRECT REAL ESTATE & SECURITIESWith only moderate correlation with traditionalbonds, and low correlation with high yield bondsand real estate equity, real estate credit offersvaluable diversification benefits to investors andcan offer a defensive addition to a portfolio tocomplement a real estate equity allocation.ATTRACTIVE RISK-ADJUSTED RETURNSConsiderate selection of non-core opportunities,and careful use of leverage can add additionalalpha potential within a real estate creditstrategy.2 CBRE GLOBAL INVESTORS CASE FOR U.S. REAL ESTATE CREDIT
UNDERSTANDING THE MARKETA GROWING NEED FOR NON-TRADITIONAL LENDINGHOW DIFFERENT TYPES OF LOANS FIT INTO THE CAPITAL STACKTighter controls on mortgage lending by traditional lenderssuch as banks and insurance companies has been a feature ofthe real estate market since the Global Financial Crisis.Figure 1: Priority of Cash FlowAs a result, banks have less ability and willingness to lend againstcertain types of real estate, leaving a gap in the market forcommercial real estate investors requiring mortgage financing.Non-traditional lenders such as debt funds, are stepping in tofill this gap. In recent years, private debt funds have increasinglygained market share from traditional lenders and been ableto finance income-producing assets in prime locations. Thesenon-bank lenders can be more attractive to borrowers giventheir flexibility in structuring, speed and ability to underwritecomplex deals and structure debt across the capital stack.It is important to note there is a role for commercial real estatelending across all stages of the real estate cycle. When the realestate transaction market is active, demand for acquisitionfinancing grows, but there may be fewer chances to winrefinancing opportunities from incumbent lenders. However,when real estate transaction activity slows, demand rises forrefinancing as borrowers seek to diversify funding sources anddistressed debt opportunities can emerge, demonstrating theenduring demand for real estate credit throughout the cycle.Equity 90-100% LTVPreferred Equity 80-90% LTVSenior MortgagesMezzanine 0%Loans- 50% LTV 70-80% LTVSubordinate “B” Notes 50-70% oanPriority ofCash FlowSubordinated "B" Notes 50% - 70% LTVMezzanine LoansSenior Mortgages 70%-80% LTV 0-50% LTVPreferred Equity 80% - 90% LTVEquity 90% - 100% LTVSource: CBRE Investment Management. For illustrative purposes only.RISK IN DIFFERENT PARTS OF THE CAPITAL STACKLike all asset classes, within real estate credit, investors arerewarded for the level of risk they are willing to assume. Whilemost investors are aware of traditional asset classes and theirrisk characteristics, many investors are not aware of the fullrange of funding options across the capital stack. Put simply,the capital stack defines who has the right (and in what order)to the income and profits generated by an investment, or inthis case, a property. Real estate debt can take a range offorms, but generally falls into two categories: senior loans andsubordinated debt.If a loan breaches its covenants or defaults on a payment, alender’s position in the capital stack determines the priorityin which cash flows are distributed among investors anddetermines who has control rights of the underlying property.Investors who are repaid first have the lowest risk of losing theircapital, therefore they also earn the lowest rate of return.3 CBRE GLOBAL INVESTORS CASE FOR U.S. REAL ESTATE CREDIT
NAVIGATING THE OPPORTUNITY WITH EXPERTISEThe market dynamics described above are pushing nonprime real estate borrowers towards non-traditional lenders.While ample credit is available for lower-leveraged, stabilizedassets in prime markets, debt is less accessible outside of coremarkets, causing the commercial real estate credit market tobecome bifurcated. Traditional lenders are focusing primarilyon lower-leveraged stabilized assets, while closed-end fundsare targeting higher-leverage and/or more transitional assets,redevelopments or new construction.In contrast, we see an opportunity to pursue attractive riskadjusted returns in between these segments where other lendersare concentrated. In our view, the middle-market segment –loans of 30-100 million – and Metropolitan Statistical Areas(MSAs) outside gateway cities represent two attractive areas. Wealso believe mortgage loans higher up in the capital structurewill benefit from continued economic growth, strong underlyingfundamentals, and healthy borrower demand.However, successfully sourcing and executing on theseopportunities requires considerable real estate expertise.PROTECTED BY THE QUALITY OF THE UNDERLYING ASSETA borrower’s ability to continue servicing interest payments ona loan typically relies on the rents that an underlying asset canproduce. So it is incredibly important to carefully select the rightassets to lend to, focusing on:Location and property valueDemand for some locations will remain sustainableand robust, even through market downturns.Property sector and demand dynamicsUnderstanding the factors that drive demand helpsto select properties that will be more resilient toeconomic downturns and changes in workingpractices.Ability to attract tenants over the long termThere are key characteristics which impact longterm demand from tenants, including growingexpectations around the sustainability of buildingsand their environmental footprint.This is where CBRE Investment Management, as a leading globalreal estate manager, offers investors a significant advantagein real estate credit. With access to extensive market data andinsights, we can identify, select and gain access to the bestopportunities within a sector and location. With a thoroughunderstanding of real estate market cycles, we can accuratelyassess and price the risk involved in a transaction. Finally, in ascenario where we are forced to assume control of the underlyingproperty, we can draw on the strength and capability of ourbroader team to manage the asset and maximize value for ourinvestors. Importantly, because we only lend a percentage of thevalue of a property, we only need to agree a sale price whichcovers the value of the loan.CAREFUL PORTFOLIO CONSTRUCTIONOur expertise in real estate markets and detailed understandingof the related risks have allowed us to design a real estate creditapproach which mitigates risk. We select assets carefully, butwe don’t entirely exclude certain sectors. We know that somesectors can fall out of favor, and all assets within the sector maybe ‘painted with the same brush’ by the market. However, not allassets within that sector will carry the same risk or be impactedin the same way as others by market dynamics. This can leadother investors to overlook compelling opportunities.To gain a full view of the risks associated with any deal, weunderwrite our assets carefully on a ‘through the cycle’ basis.Our strategy focuses on the top 35 MSAs, while our researchcovers the top 50 MSAs. Therefore we invest in markets we knowand understand well – how they’ve behaved in previous cyclesand the drivers that impact performance in the region. Accessto extensive data and market insights through the CBRE Groupgives us an information advantage that is difficult to match. Weconsider the lowest rents and highest yields for similar assetsthrough the last cycle to model possible outcomes and stresstest loans relative to those data points, so that we can be sure tostructure positions that can withstand volatility.We have set concentration limits to ensure sector diversification,and we also choose sponsor partners carefully to ensure wework with those who are experienced, understand tenants’needs and are well equipped to deliver on their business plans.Resilience to changing market conditionsEven in difficult markets, not all assets or sectors areimpacted equally. Insight into the mega trends anddrivers impacting individual sectors can help identifythose that will weather market downturns well.A thorough understanding of these aspects enables accurateunderwriting of an opportunity, determining and appropriatelypricing the level of risk while structuring strong protections tomitigate potential downside scenarios.If a borrower does default on interest payments or the ultimaterepayment of the loan at maturity, the final recourse is to takecontrol of the property. In that situation, the asset will need to bemanaged to continue generating rents while it is prepared forsale. This is an unrealistic option for many investors without realestate asset management capabilities or local market knowledge,highlighting the need for real estate expertise in managing risk.STRUCTURING FOR DOWNSIDE PROTECTIONWe take a cycle-aware approach to investment decisions. Ourinvestments are generally protected from value declines ofup to 30%. Although we don’t currently anticipate the marketrepricing to this degree, our investment strategy is designed towithstand it.We focus on assets with contractual income in place that shouldensure comfortable coverage of debt service and enablerefinancing at maturity. Our loans include covenants that allowus to identify and manage risks as soon as they arise, and theseprotections also give us ‘levers to pull’ in tricky markets and helpus identify risks well before they impact loan repayment.CBRE GLOBAL INVESTORS CASE FOR U.S. REAL ESTATE CREDIT 4
THE CURRENT MARKET ENVIRONMENTREAL ESTATE MARKETS STILL ACTIVE IN KEY SECTORSTHE SWEET SPOT FOR FINANCING DEMANDNot surprisingly, the global pandemic has impacted realestate markets in the U.S. Transaction volumes in 2020 wereapproximately 30% lower than 2019. This was due to a pausein activity at the start of the pandemic, followed by a gradualincrease in deal volumes in the third and fourth quarters of theyear. Despite this pause, existing loans will still reach maturity,creating a ‘wall of refinancing’ – loans that will eventually needrefinancing – on the horizon. Around 2.3 trillion in real estatelending is expected to mature in the next five years, comparedwith the 1.9 trillion that matured in the last five years. Thisshows the scale of the demand for real estate credit as well asthe opportunity ahead.During the pandemic, credit markets saw a flight to stable assetclasses, and as a result, sectors impacted by COVID-19 sawreduced liquidity. Meanwhile, the large agencies who typicallyprovide financing for multifamily assets, Fannie Mae andFreddie Mac, have recently focused their activity on affordablehousing. This has led to an increased need for non-traditionallenders to finance the market-rate multifamily assets that remainin demand.COMMERCIAL REAL ESTATE DEBT MATURITY SCHEDULEThe industrial and multifamily sectors made up 64% ofcommercial real estate sales in 2020, up from a historicalaverage of 44%. Again, we have seen that market downturnsimpact sectors, and even assets within a sector, differently. Forinformed investors, able to recognize value and ready to act,there are many attractive opportunities.Please refer to Figure 2 below. Despite the reduced transactionactivity, some sectors continued to see strong demand.In recent years, a huge amount of capital has also beenaccumulated by private debt funds focusing on higher risk/higher return strategies. In contrast, we have chosen to invest inthe less volatile ‘core ’ space. We believe these opportunitiesprovide more certainty over cash flows, and more secure accessto additional financing to enhance returns. With reducedappetite from traditional lenders and private debt funds, thereare many opportunities to finance prime assets in this space.TRUSTED LENDERS CAN BENEFITOur pipeline of opportunities is strong, and we are becomingwell-known for successfully executing light transitional loans.With a track record in place, we are respected by the borrowercommunity, which is becoming increasingly important asborrowers look to reduce execution risk and want to know theirlender can be relied upon to complete the deal.Borrowers also value lenders who hold their loans to maturity,particularly during turbulent times. We do not operate a ‘loanto-own’ strategy, looking to convert our loans into equityholding. Rather, we hold loans to maturity, but target thosefinancings with a shorter tenor to gain more certainty over thecash flow and business plans. However, if we do need to enforceon a position, we are well prepared to take the steps needed torecover value.Figure 2: Commercial Real Estate Debt Maturity Schedule 2.3 Trillion 600Commercial Mortgage Maturities ( Bil.) 1.9 Trillion 500 400 300 200 100 02000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026BanksCMBSLife CosSources: Trepp, as of 4Q205 CBRE GLOBAL INVESTORS CASE FOR U.S. REAL ESTATE CREDITOther
A CLEAR AND PRESENT OPPORTUNITYFor investors looking for defensive investments offering good relative value and attractive risk-adjusted returns, U.S. real estate creditis a promising opportunity, but it is often underestimated by investors unfamiliar with the asset class. It shares key similarities withtraditional asset classes, while offering more attractive and predictable yield alongside downside protection.With a continuing reluctance from traditional lenders to finance certain types of real estate assets and a wall of refinancingapproaching, we expect the compelling investment opportunity in real estate credit to continue in coming years. Successfully tappinginto this opportunity relies on considerable real estate investing experience. At CBRE Investment Management, we have the expertiseand market insight to source deals, identify attractive opportunities and manage risks. As investors continue to search for higher yieldalternatives to fixed income, we expect demand for real estate credit to grow at pace.DISCLAIMERTHE INFORMATION IN THIS DOCUMENT IS CONFIDENTIAL AND MEANT FOR USE ONLY BY THE INTENDED RECIPIENT. THIS MATERIAL IS INTENDED FOR INFORMATIONAL PURPOSES ONLY, DOES NOT CONSTITUTEINVESTMENT ADVICE, OR A RECOMMENDATION, OR AN OFFER OR SOLICITATION, AND IS NOT THE BASIS FOR ANY CONTRACT TO PURCHASE OR SELL ANY SECURITY, PROPERTY OR OTHER INSTRUMENT, OR FORCBRE GLOBAL INVESTORS TO ENTER INTO OR ARRANGE ANY TYPE OF TRANSACTION. THIS INFORMATION IS THE SOLE PROPERTY OF CBRE GLOBAL INVESTORS AND ITS AFFILIATES. ACCEPTANCE AND/OR USE OFANY OF THE INFORMATION CONTAINED IN THIS DOCUMENT INDICATES THE RECIPIENT’S AGREEMENT NOT TO DISCLOSE ANY OF THE INFORMATION CONTAINED HEREIN.CERTAIN ECONOMIC AND MARKET INFORMATION CONTAINED HEREIN HAS BEEN OBTAINED FROM PUBLISHED SOURCES PREPARED BY THIRD PARTIES AND IN CERTAIN CASES HAS NOT BEEN UPDATED THROUGHTHE DATE HEREOF. NEITHER CBRE GLOBAL INVESTORS, ANY FUND OR PROGRAM OR ITS GENERAL PARTNER, NOR THEIR RESPECTIVE AFFILIATES NOR ANY OF THEIR RESPECTIVE EMPLOYEES OR AGENTS ASSUMEANY RESPONSIBILITY FOR THE ACCURACY OR COMPLETENESS OF SUCH INFORMATION.CBRE GLOBAL INVESTORS HAS NOT MADE ANY REPRESENTATION OR WARRANTY, EXPRESS OR IMPLIED, WITH RESPECT TO THE FAIRNESS, CORRECTNESS, ACCURACY, REASONABLENESS OR COMPLETENESS OF ANYOF THE INFORMATION CONTAINED HEREIN (INCLUDING BUT NOT LIMITED TO INFORMATION OBTAINED FROM THIRD PARTIES), AND THEY EXPRESSLY DISCLAIM ANY RESPONSIBILITY OR LIABILITY THEREFORE.CBRE GLOBAL INVESTORS DOES NOT HAVE ANY RESPONSIBILITY TO UPDATE OR CORRECT ANY OF THE INFORMATION PROVIDED IN THIS PRESENTATION.6 CBRE GLOBAL INVESTORS CASE FOR U.S. REAL ESTATE CREDIT
Commercial real estate credit fills this need by offering attractive relative value with a focus on regular, predictable income. However, successful investing in real estate credit relies on a combination of skillsets - . 80-90% LTV Mezzanine Loans 70-80% LTV Subordinate "B" Notes 50-70% LTV Senior Mortgages 0-50% LTV.
