Calculating real estate risk premium is an emerging challenge

Commercial real estate professionals give their thoughts on risk calculation after more than 18 months of interest rate hikes.

The consensus among commercial real estate professionals is that, after more than 18 months of interest rate hikes totaling 500 basis points, the Federal Reserve is nearing the end of the current phase of monetary policy tightening. The next question is how lenders and borrowers will calculate the risk associated with commercial real estate in a higher-rate world.

The impact of the Federal Reserve’s moves to fight inflation are being felt across the entire asset class. “This is inevitable when the cost of funding rises exponentially. Returns on risk-free money are much higher today and the question we have to ask is, ‘What sort of risk premium does an asset class like commercial real estate demand?’” Bill Sexton, chief executive of Atlanta-based real estate loan servicer and advisory Trimont, told Real Estate Capital USA.

The risk premium, or the return an asset is expected to yield in excess of the risk-free rate of return, is difficult to assess in a market where valuations are opaque. Joseph Iacono, founder of New York-based commercial real estate lender Crescit Capital Strategies, noted the US commercial mortgage-backed securities market and public REITs provide some signals.

“Being able to see where investors are buying bonds in CMBS deals is one of the best markers we have,” Iacono said. “We have seen the AAAs pricing at around 150 basis points over Treasuries, which is about 6 percent, depending on where the 10-year Treasury is. There are ways to deconstruct that pricing and re-engineer to figure out where the debt portion of the capital stack is trading.” REIT equity pricing also provides insight into how the market perceives underlying asset valuations.

Lenders and investors today have a clear advantage over previous cycles, such as better data, said Toby Cobb, co-founder and managing partner of national lender 3650 REIT. The quality of this data has allowed the firm to be active in the retail sector, for example. Last month it originated a $71.5 million acquisition loan on Creekside Town Center, a 95.6 percent occupied retail development in the Sacramento area.

“We used to go with sales per square foot, but now we can tell you exactly where people are, how long they are there for and their spending patterns,” Cobb said. “Eight years after the retail apocalypse started, you can actually go for the falling knife because the knife is now stuck in the floor. And in many markets, the losers are helping to define the winners.”

‘Reality sinking in’

Bert Crouch, managing director and head of North American real estate at Dallas-based Invesco Real Estate, believes lenders should look at what their basis is relative to replacement costs or what their basis per unit is, among other factors.

“In 2021, we saw one of the more challenging origination environments we have ever been in because spreads were tight, leverage was up and structure was limited,” Crouch said. “Lenders are being materially better compensated for the more limited risks we are taking today.”

Paul Rahimian, chief executive of Los Angeles-based construction lender Parkview Financial, said the question of calculating risk will continue to be critical. The amount of leverage on an asset could force an owner to sell at a discount. “There is a reality sinking in in the real estate world; the whole concept for higher for longer is finally being accepted by owners, for better or for worse,” he said.

Cobb believes the best way to solve the question of calculating risk premia is a combination of the new and the old, with data just one part of the equation.

“We at 3650 REIT have lived through many interest rate cycles. Maybe today’s cycle is more dramatic than in times past, but in our opinion, the interest rate cycle isn’t going to be the story in the long run. The amount of cashflow an asset has and its ability to attract and retain tenants is going to be the story,” he noted.