Once upon a time, in the not-to-distant past, the cost of borrowing to buy or refinance commercial real estate was ridiculously cheap. Low interest rates and higher leverage were the norm. Another benefit was that owners of properties with high net operating income could rest assured that cash flow and valuations would be more than enough to pay off any debt, while generating a tidy profit.
That was then.
Anyone who isn’t living under a rock knows that the Federal Reserve has taken off the gloves in dealing with inflation. Beginning in March 2022, the Fed boosted the effective federal funds rates; as of February 2023, rates had been increased eight times. This, in turn, is leading to an increase in interest rates on lender debt. Tighter loan standards mean borrowers need more equity to close on financing.
And yes, inflation is leading to an NOI and property values increase. But that increase isn’t keeping pace with the ongoing interest rate hikes. As a result, equity investments in real estate are losing ground.
Does that mean investors are moving away from real estate ownership? Not necessarily. But rather than putting monies directly into real estate, investors are increasingly eyeing real estate debt as a viable investment.
The Coming of Age of Debt Investment
For many real estate investors, debt represents a funding source, rather than an investment strategy. Because of this, debt-as-investment has been an under-the-radar asset class for many years.
Real estate has long been considered an alternative asset that offers both. After all, cap rates generally follow U.S. Treasury rates. Both are compressing these days. But real estate returns aren’t equal to the ever-increasing mortgage interest rates.
This is especially a problem for real estate investors with loans that are nearing maturity. In this situation, these investors have two choices. They can either refinance the property at a higher interest rate than the original loan. Or they must sell the real estate, which can create another host of disadvantages.
Real estate debt as an investment asset class can eliminate many of today’s challenges involved with real estate investments.
How and Why it Works
Investing in commercial real estate debt means institutions and individuals are buying the mortgages and debt that finance the real estate, as opposed to the real estate itself. The property acts as investment collateral. As such, if the owner defaults on the loan payments, the investors can repossess and sell the property to recoup their losses.
Real estate debt investments are available through a couple of methods. Those interested in the public route can buy shares from a lender or buy stock in a publicly traded mortgage REIT. There are also private equity debt funds that are available to accredited investors.
Once that debt makes its way into investment portfolios, it can offer the following advantages:
Predictable cash flow. The funds and mortgage REITs generate their income through mostly fixed-rate loan interest. Property owners enter into a payback agreement with lenders, which requires repayment of a loan either monthly or quarterly. Those who own the debt can count on consistent returns and cash flow on a regular basis.
In-stone termination. Real estate investments tend to have hold periods without a specific end date. Rather, there’s an estimated range, depending on market conditions and other factors. This isn’t the case with real estate debt. The investment ends when the loan matures and is either sold or paid off. This can help improve portfolio management and strategies.
Downside protection. Rather than potentially losing equity value in a real estate investment, investors can rely on expected returns, even if capital values are dropping. Low volatility, combined with solid income and cash flows lead to a steady, resilient focus.
Diversification and Relative Stability
While real estate as an alternative asset class has provided diversification potential and decent yields, returns and appreciation depends greatly on the real estate type, class and location. Additionally, due to current economic factors, equity investments are returning less value. Additionally, the Federal Reserve is committed to increasing EFFR for a while.
One solution is real estate debt as an investment. When used properly, real estate debt can help balance portfolios, lower risk and offer fairly regular cash flow.