3 minute read
It’s All About CRE
MODERN FINANCE
It’s All About CRE
By Philip Dudley
One of the hardest hit sectors from the Federal Reserve’s fight against inflation and subsequently the rapid rise in interest rates has been Commercial Real Estate (CRE) and more specifically, office. Three months into 2024, there is reason to be optimistic about CRE and a not too often discussed defensive exposure to express this outlook via CRE debt.
The data tells a good story for Global CRE Debt funds as the average Assets Under Management (AUM) has risen by double digits per year since 2019 and CRE investors are looking to add exposure to debt in the current environment.
Why would this make sense? In simple terms, there’s been a divergence in Net Asset Value (NAV) and Net Operating Income (NOI) growth. The substantial increase in cap rates has driven down NAV, but NOI has not followed suit, remaining resilient, and as a result sets up a nice potential total return going forward as cap rates come down with interest rates.
CRE debt has an attractive risk adjusted track record and is a nice diversifier for any well-rounded portfolios, especially for anyone uneasy about CRE under current economic conditions.
One of the benefits of fresh money is the discovery process, as current owners of commercial buildings are forced to sell or mark down the value to refinance. This price discovery is creating an environment where higher credit spreads off higher interest rates has been leading to underwriting loans with very favorable loan-to-value (LTV) ratios at lower values that have been reset.
A typical CRE loan in the current environment might look like this: 55-65 percent LTV with a seven- to ten-year year maturity at 6.25 percent to 6.50 percent, which is up a couple hundred basis points over the last five years.
CRE debt funds are managing risk by lending at these much improved LTV’s. They’re able to pick and choose the assets in favorable markets where CRE trends have held up under pressure due to the local demographics and other factors.
Not to pile on the banks, but traditional lenders have reduced their lending exposure and this has created a funding gap that is rapidly being filled by alternative lenders in the private market space.
Capital always flows where capital is treated best. In this instance, CRE debt has the potential to deliver equity-like returns with less risk because of strong LTV’s and cash flowing collateral. And just a suggestion: these days, it would be wise to avoid San Francisco, Chicago and New York.
