Morgan Stanley’s Hill sees robust run for US debt markets

Richard Hill, head of US real estate investment trust and commercial real estate debt research at Morgan Stanley, believes the commercial real estate debt markets will continue a period of strong growth as private equity funds work to deploy more than $300 billion of dry powder and the asset class becomes more firmly entrenched as an alternative to fixed income.

“The debt markets were as open and vibrant at the end of 2021 as I can remember in my career. Lending standards are back to 2013 levels, borrower demand is robust, and you have a variety of lenders targeting the asset class,” Hill told Real Estate Capital USA. “CMBS issuance was robust when you include conduit, single-asset/single-borrower and commercial real estate collateralized loan obligations. Banks have a huge appetite for commercial real estate loans right now. Insurance companies need the yield and debt funds, and mortgage REIT are now very active in the market.”

Last year’s strong performance stemmed from a faster than expected recovery from the covid-19 pandemic, Hill said.

“Fundamentals rebounded sooner and faster than people were anticipating. Said another way, commercial real estate participated in a V-shaped recovery. As of the third quarter, NOI growth at two-decade highs of around eight percent or so,” Hill said. “The second point is that the lending markets bent but didn’t break during covid. Borrowers and lenders saw the proverbial prisoner’s dilemma, which mitigated the amount of distress in the market. In fact, distress was almost non-existent and accounts for around 1.5 percent of all transaction volumes.”

Morgan Stanley believes understanding the debt markets and how they break down is critical to understanding the broader asset class.

“We have a core thesis that commercial real estate is an inherently levered asset class. We think it is north of a $10 trillion asset class, if you include infrastructure, and it’s encumbered by about $5 trillion of debt. About $4 trillion is commercial mortgage debt and the other a combination of senior and secured bonds and some construction loans,” Hill said. “Understanding how the debt markets are operating is a big input into how commercial real estate valuations are perceived.”

This kind of understanding is necessary as the market is seeing more interest from investors as an alternative to fixed income.

“There is almost $300 billion on the sidelines right now that has been raised but not yet deployed for commercial real estate, including debt investments. That’s about a trillion of buying power, if you add three or four turns of leverage on it,” Hill said. “In our view, real estate is emerging as a viable alternative to traditional fixed income. In a world where 10-year Treasuries are below two percent, real rates are negative, commercial real estate cap rates look attractive, even at the tight end of their range at 3 percent – especially if you put leverage on that so you can create a core-plus asset.”

Real estate’s big year

The interest in real estate comes as the sector experienced a remarkable year. Real estate investment trusts had their best-ever year and produced returns north of 40 percent. Additionally, commercial real estate debt spreads as measured by the commercial mortgage-backed securities markets moved to all-time tights and property valuations boomed. Year on year, valuations are up by the high teens, Hill added.

And without distress, valuations generally won’t decline. “In the GFC, valuations declined when distressed started rising and property valuations didn’t trough until distress peaked,” Hill said.

Bigger picture, there is a sense that commercial real estate is going through a sea change like it did after the SNL crisis. “There are certain periods of time when commercial real estate goes through these changes, and we do think this is one of the hallmarks of the cycle where it is a much bigger asset class for institutional investors than it was in the past,” Hill said.