A new report from Hodes Weill is projecting that commercial real estate debt strategies will continue to gain traction among institutions especially as such investors look to increase their sector allocations.
The firm’s 2023 Market Commentary highlighted a number of key trends expected to dominate the coming year, including why the firm believes there could be a rise in merger and acquisition activity, how a larger number of market participants are looking at the potential to convert obsolete or vacant office buildings into rental or mixed-use space and an overall need for more affordable and workforce housing.
But the case for debt as an investment will be one of the key themes in the coming year, David Hodes, founder and co-managing partner, told Real Estate Capital USA. The sector is learning to adapt to today’s higher interest rate and inflation environment, which is helping to shift lending activity toward non-bank lenders. This is particularly the case for transitional assets, he added.
As this shift occurs, the firm is seeing more interest from investors who like the way debt looks when stacked up against an uncertain equity market. Furthermore, the sector is also starting to present yields which are higher than what some core equity strategies are seeing.
“The debt markets are more heavily regulated than the equity markets and investors know, with an insurance company or bank, that the regulators will be asking every quarter about performance. The lender does not have the luxury of saying, ‘Well, there are not a lot of transactions and therefore we are going to just keep things at where the prior valuations are,’” Hodes said.
Hodes noted that the outlook for debt origination is slower than a year ago due to an overall slowdown in transaction activity. “Going into the end of last year, the markets shut down but are not reopening,” he said. “But the punchline is that the cost of debt has risen quite dramatically from this time last year. For new acquisitions, there is not much debt available and the question becomes, ‘Are you buying at a level where the debt makes sense?’”
Still, these questions are part of the path toward recovery and repricing in the commercial real estate markets, Hodes added.
The report tracked an increase in spreads of 150 to 600 basis points and that, combined with historically high base rates, has had an impact on the kind of risk-adjusted returns debt investments can achieve. What’s more, debt yields have started to eclipse yields seen on core equity programs, with an additional benefit of subordination to a sponsor’s equity.
“I think another aspect of it is from the lack of transparency on equity pricing,” Hodes said. “It just seems safer to go in on the lending side right now.”