Article

Investors look to debt as interest rates rise

Global investors are increasingly pushing into the debt side of commercial real estate, a less-risky strategy that has become more attractive as interest rates start to rise and property yields hit record lows.

March 22, 2018

Real estate debt funds last year raised $28.6 billion, up from $23.6 billion in 2016 and $18.3 billion in 2015, according to Preqin.

Part of the attraction: Debt investment is one way to curb risk in a portfolio, a strategy increasingly on the minds of real estate investors.

Rising interest rates, coming on the back of strong economic growth, are being closely watched. While incremental policy shifts aren’t expected to roil real estate markets in the short term – investment is expected to remain robust this year – investors are remaining vigilant.

The Federal Reserve raised its key interest rate this week, and is expected to raise it at least three more times this year in an effort to address rising inflation in the world’s largest economy.

The Fed hiked its benchmark federal-funds rate by 25 basis points to a range of 1.5 percent to 1.75 percent. It was the sixth increase since December 2015. The Fed also expects to raise the rate in 2019 slightly faster than previously expected to 2.9 percent.

The rate hikes follow years of strong demand for property, which has pushed down office yields to record lows in cities around the world. For instance, Hong Kong and Tokyo both have core office cap rates below 3 percent, with New York and London typically hovering around 3.5 percent.

In the event that property values fall, debt investors are better protected than equity investors.

Lenders sit lower in the capital stack to equity investors, which often allows them to avoid the level steep losses incurred by the equity investors if property valuations come under pressure.

“Debt provides superior downside-risk protection,” said Nick Wilson, director of Asia-Pacific Capital Markets Research at JLL.

Not all debt comes with the same risk. Senior property loans are among the safest. Mezzanine debt, and construction finance, are on the riskier end of the spectrum.

Given different levels of risk, returns can vary widely. Most senior property loans return less than core yields, reflecting the large equity buffer that makes them significantly lower risk.

For some lenders operating in the mezzanine-debt space or real estate development, returns can be as high as 20 percent.

As rising rates continue to dominate the conversation, investors are looking at strategies that use debt to help shield them from potential volatility.

“At this point in the cycle, that can be an important consideration,” Wilson said.

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