Until the Global Financial Crisis (GFC) in 2008, the CRED market was dominated by banks, which maintained around 95% of the lending market. Banks have a less prominent lending role in this market now, mainly as a result of regulatory changes. This has created greater opportunities for institutional investors, such as pension funds and insurance companies, to provide loans. These investors are interested in the asset class because of its ability to offer predictable cashflows and an attractive illiquidity premium.

Why is CRED attractive?

Real estate investors are facing the prospects of lower returns as a result of higher interest rates and operating costs. The prospect of lower equity returns and the higher cost of debt poses a threat to investors, precisely at a time when the cost of living is also rising rapidly.  

Private real estate debt strategies can offer alternatives in this environment. There are two main reasons why CRED may provide better risk-adjusted returns to investors as interest rates continue to rise. Firstly, while the higher cost of debt erodes the income return from equities, rising interest rates provide a higher income for debt investors. Secondly, debt investors have the edge over equity investors when it comes to capital preservation, as debt is paid back first in the event of liquidation. Commercial real estate debt investors also typically lend at a loan-to-value ratio of 60-65%, which provides a healthy buffer against lower asset values.

CRED in the current environment

The pressure on borrowers is likely to be most acute from 2022 to 2024, as activity from central banks leads to higher borrowing costs. This is particularly the case towards the end of 2023, as real estate debt that is due for refinancing could jump significantly in 2024 and 2025. This is a result of surging commercial real estate transactions in 2021, the loans of which would be due in 2024 or beyond – assuming a tenure of three years or longer.

It is also because property owners refinanced and lengthened debt maturities in 2020 and 2021 when the debt market was more favourable. Therefore, the demand for credit to refinance existing debt could start to increase markedly from late-2023. Importantly, we think this would still be the case even if a new rate-cutting cycle were to begin in late-2023. This would likely be driven by a global recession, where lending would be more cautious and with limited access to credit.

What does this mean for investors?

There are two key themes that are relevant to commercial real estate debt investors. Firstly, opportunities for investment are likely to increase as regulations limiting bank lending are tightened, including loans for commercial real estate. To avoid a repeat of the GFC, lending activity from banks has been placed under increasing scrutiny by regulators for over a decade. This has created a larger pool of opportunities for non-bank lenders. We expect this trend to continue.

Secondly, the increasing focus on energy-efficient buildings and the role that sustainability-linked credit can play in reducing carbon emissions. According to CBRE’s estimates, over USD190 billion was invested in energy-efficient buildings globally in 2021. This represented a 16% jump from the annual average in the previous three years. The vast majority of spending is for new construction and energy-efficient appliances. CRED has a role to play in financing these changes. 

Private real estate credit that is linked to ESG (environmental, social and governance) performance metrics is therefore an area that could yield interesting opportunities for investors.