The economic expansion that began in June 2009 is the longest in U.S. history. It’s been going on so long that observers have been able to stick “late cycle” to it for a couple of years now. We don’t know when a downturn will happen, and there still appear to be good reasons to believe that we may be facing more of a slowdown rather than a pending recession; as we all know, nothing lasts forever.
At our firm, we have decades of experience identifying short-term, high-yield opportunities secured by commercial real estate (CRE). This investment strategy appeals to those interested in risk-adjusted returns, high-yield returns and principal preservation. What we’ve seen in the current market is that many investors are interested in financing commercial real estate versus ownership at this stage of the cycle, given the attractive characteristics of senior secured debt in the face of a softening economy.
Real estate values won’t go up if the economy goes down, but a well-managed portfolio of commercial real estate mortgage assets can offer investors a more secure investment while targeting equity-like returns.
Flexibility Is Helpful In Any Market
During the Great Recession, U.S. equities (including real estate equities) fell more than 50%. Residential property values fell by a third, and commercial real estate property values also fell by 30% over 2 years. A CRE mortgage asset portfolio, if secured by first liens at a low loan-to-value ratio around 65% (with 35% in equity), could withstand a downturn with minimal impact to invested capital.
A CRE mortgage asset portfolio is secured by tangible properties that generate cash flow based on long-term leases. In an environment where interest rates may be falling, these floating-rate mortgage assets maintain their yields because they are designed to float upward with a benchmark rate. If structured properly, there is a cap on the downside to protect investors by holding yields in a declining rate environment to the note rate at funding.
Yes, there will be defaults. But if the asset manager has the ability and willingness to work with property owners to restabilize the property, or foreclose and take over the property, full recoveries are possible. In fact, a nonperforming loan can result in a higher return than a performing loan. Again, proper structuring of these mortgage assets is critical to protecting the investors.
Although there would surely be some defaults in the event of a downturn, nonbank lenders have more flexibility than banks to work out the loans and don’t face the same pressures to sell loans at a discount. Banks generally can’t own distressed properties because of regulatory constraints, but investment managers face no such restrictions.
In advance of a potential downturn, we stress conservative underwriting as a core tenet to risk management, focusing on shorter-duration loans secured by senior liens at modest loan-to-value ratios.
The Small Loan Advantage
Over the last few years, billions of dollars have flowed into the private credit markets. The growth includes loans to small and midsized businesses, commercial real estate developers and owners and specialty finance arrangements such as litigation finance, product royalty licenses, commercial receivables and portfolios of unsecured consumer loans. Preqin forecasts that total capital devoted to private credit strategies will top $1 trillion by 2024.
This capital is largely being deployed by asset managers who are filling lending needs left by the departure of regulated banks from the real estate and business credit markets since 2010. Larger asset managers searching for the meaningful yield their clients demand tend to target larger deals so their investments can add up to meaningful positions in their portfolios.
This means that developers and real estate owners with properties worth more than $50–$100 million may find strong competition from larger lenders competing for their business. Meanwhile, other firms (ours among them) concentrate on small properties valued at $5–$50 million. Aspects of this market are underserved, so borrowers have fewer choices and are willing to pay a premium, sometimes as much as 1% to 2% annually. This gives lenders leverage in writing terms that protect their rights should things not go as planned.
The Short Duration Advantage
Particularly in a downturn, typical commercial bank loans may be riskier because of their long duration. Loans with 7- or 10-year terms are more vulnerable to economic shocks simply for being long-lived. It’s also more difficult to forecast property values the further out you go.
A portfolio of shorter-duration loans can also be constructed to create liquidity out of what is a generally illiquid asset. There is no secondary market for trading these mortgage assets, and that illiquidity is one of the reasons that the lenders can charge a premium rate. However, if you package 100 or so of these loans together in a fund, the nature of the business (making short-term loans and, upon maturity, redeploying into another short-term loan) creates a portfolio where some loans are maturing every month. Managers can use this tactic to create liquidity for fund investors that is greater than the underlying mortgage assets.
The Next Downturn
It’s a bizarre time: It feels like the economy is, indeed, softening, yet a lot is going right. Unemployment remains low, and wages are rising. The significant overleverage we saw in 2008 that led to the great unwinding seems absent.
If we’re at the peak of a normal cycle, rather than the precipice of cataclysm as we were in 2007, then we could expect commercial real estate values overall to begin declining modestly within the next few years, with very localized results so that geographic diversity will provide shelter that was absent a decade ago.
Investing in short-term, senior secured mortgage assets with low loan-to-values can offer investors layers of downside protection. And, when the downturn hits, investors will benefit if they align themselves with a strategy that allows them to work out or hold assets during the correction and capital to deploy at lower valuations as opportunities will abound.