Schroders Capital: Office is the new retail

This article is sponsored by Schroders Capital

Schroders Capital has some $2.5 billion of loans backed by US commercial real estate outstanding. The firm is active both in private debt and debt securities, a factor which gives it “a good overview of what is happening across the different sources of financing for real estate,” according to Michelle Russell-Dowe, the global head of securitized products and asset-based finance.

The team operates at every stage of real estate financing, from land acquisition and pre-development finance, through construction financing and bridge loans, to loans on stabilized properties. Jeffrey Williams, senior portfolio manager, says: “By being relevant to borrowers through the lifecycle, we build strong relationships with them. This in turn helps our pursuit of good quality loans.”

Adding to this, the team is happy to make loans of $50 million or less, accessing the less competitive middle market. Banks, or commercial mortgage-backed securities lenders, have traditionally dominated in this territory. So as the current crisis deepens, and both banks and syndicated markets offer less capital, a myriad of opportunities is arising. Fundamentals are always the most important consideration, and it is additionally important now to watch your bank.

How have rising interest rates had an impact?

Michelle Russell-Dowe: We were ready for the current policy environment. We had a clear view that interest rates were going to rise from low levels that were obviously not sustainable. Therefore, we saw the importance of seeking protection from the impact of rising interest rates.

As I see it, there are three important ways in which lenders can do this: fundamentals, structuring and valuation. In terms of fundamentals, we believe it is prudent to stay in areas which we feel have secular strengths, such as the US apartment or rental market.

The chronic undersupply of rental property has long been clear to us, and in the current situation it will potentially worsen as renters are priced out of the homebuying market due to higher mortgage rates.

Clearly, rising interest rates exacerbates the issue of affordability and constrains individuals who remain in the rental market.

In structuring loans, we had a preference for those that were indexed to rising interest rates and where investors therefore benefit now. Equally, we are mindful of the potential burden of rapidly rising payments, and look for properties that would have growth in income.

Valuation protection comes in opportunities where someone needs to sell at a discounted price. It is an area we are actively looking at now, given the US regional banking disruption and the likelihood that we will see increased regulations and calls for reduced leverage.

In terms of fundamentals, what will be the risks of exposure to the office market?

MRD: We realized during covid that work from home represented a huge behavioral change that would persist over an extended period. We therefore expected to see the risk of oversupply in office in many markets, so we took the decision not to lend on office properties in central business districts, and on the liquid side of our business we carried out a series of sales in 2021.

Office will be the biggest headline in the real estate sector, even as delinquency is not yet very high. It is when the longer-term leases roll or when loans mature that the rise in delinquencies and defaults will be seen, and it’s unlikely that seasoned real estate professionals aren’t acutely aware of this. There is a fairly significant wall of maturities this year.

But the future shape of the office market is likely to be very much a case of the “haves” and the “have-nots.” Good quality and environmentally friendly spaces will still attract tenants. At the other end of the scale, older properties are likely to see a significant degree of obsolescence. With the negative headlines, many lenders won’t be willing to look at the opportunities on the better buildings, given the noise.

Jeffrey Williams: Yes, the chronic oversupply in the office market reminds me of what was seen in the retail space. Construction led to oversupply of retail malls, and  the rise of digital shopping (e-commerce) magnified the problem. No doubt the office market in the US will go through a similar structural reconciliation. It is worth remembering that, in the case of retail, this reconciliation took from 10 to 15 years. Oddly, the challenge in office will come when new supply in the US office sector is at record levels.

What sort of structural protection is needed to mitigate this risk?

JW:  The important point is we’re not now having to change how we structure loans or i

nsert new covenants. We were already very conservative. I think this is demonstrated by the fact that, during the pandemic, none of our loans on stabilized properties defaulted. Indeed, none of our borrowers asked for payment relief on these loans.

One of the loan covenants that we have long built into our structuring is major tenant event language. For example, if a major tenant gives notice of intention to not renew a lease that is expiring in the next 12 months, we are able to sweep up the excess cashflow. We were fortunate to have protections like this going into covid, and they are obviously particularly important now that interest rates weigh on the LTV calculations around an asset.

Bearing this in mind, one of the best protections is making loans on acquisitions, as this requires cash equity and an established valuation, which we believe are very important.

With all this in mind, how should lenders be approaching geographies?

JW: From a lending point of view, we see value in covering the whole of the United States. Having said that, we clearly have some areas we prefer to others based on their fundamental attributes. These include net migration, calculations of future supply demand and local economic circumstances. Diverse markets tend to be robust and tend to act like magnets to companies and to people.

As a result, we have focused our efforts on the southeastern and southwestern markets where there has been significant migration in search of more favorable tax regimes. The flipside of this is that we don’t have the same conviction for California. We do not have any loans in downtown Los Angeles or in San Francisco, which seem to be the epicenter of the current crisis in offices and where there is considerable sector concentration.

On the other hand, we see opportunities in cities such as Miami, Philadelphia and Dallas, where the markets are very diversified in terms of employment. These are markets that have all been much more successful.

Where do you now see opportunities?

MRD: We have not been alone in our love of the multifamily housing market. The US is short of some 3.5 million units, and it’s going to take at least a decade to make up that shortfall. I think it also has to be said that the presence of Fannie Mae/Freddie Mac in the background acts as a stabilizing factor, giving the housing market lower volatility and a lot of downside protection, as it’s the one property sector that consistently has access to capital.

I think there is opportunity here in development, as well as transitional loans. But it will be the office sector, as it comes through the crisis, where there are likely to be material opportunities. Emotional bias is a powerful thing, and there are a lot of lenders and investors that will be avoiding the sector, just as we saw with retail.

You offer a broad range of loans. Where are you seeing opportunities now as banks withdraw?

JW: I would say in the land acquisition financing area. Where we are offering pre-development loans, there has never been a lot of capital. We find the short-term nature of the loans attractive. We also like them because you can get into discussing a borrower’s business plan at an early stage and build a strong relationship from there.

This is also definitely an area of the market where the banks are now pulling out, and there is significantly less competition to provide loans. As the regional banking crisis worsens, I’m sure there will be even greater opportunities. This will likely be in development and construction financing, which is still largely done by the banks, and where they are increasingly likely to withdraw because of their less diversified capital base.

Where else do you see opportunities in the future?

JW: I think the significant requirement for the refurbishment of offices is likely to lead to greater requests for bridge loans, or financing on existing properties to improve the facilities and the open spaces. More recently, this has been financed in the commercial real estate collateralized loan obligations market, but, as that market offers less competitive financing, we believe this will provide opportunities.

I would stress this is refurbishment of properties to make them more attractive. I do not believe there is a significant market for conversion of office properties into residential properties. On paper, this would seem an ideal solution to the current crisis, but the reality is it is a very small part of the potential market and certainly less than 1 percent of the potential supply for multifamily housing.

The problem is that office buildings’ floor plates are too small, and at the center of most offices there is simply inadequate lighting for residential occupation.

MRD: Apart from refurbishment to improve the quality of office properties, I have no doubt there will also be opportunities around increased environmental regulations and the need for real estate to comply. People are likely to raise capital in a dedicated way in this space, and there is also likely to be dedicated demand.

Are there any corners you are seeking to look around and protect yourselves from in the next crisis?

Michelle Russell-Dowe: Yes, in the US, in the securities market and in the hotels and hospitality sector. We think the current low supply has led to very limited additional risk premium in this sector, which is more sensitive to economic downturn than more defensive sectors like industrial properties or apartments.

The securities pricing relationships don’t make sense. Current pricing does not reflect the likely impact of any recession that is coming, and so we favor selling out of these positions.

We do still have a few well-placed hotel loans, as it is in the lending markets when you can control quality and leverage and be compensated for liquidity provision. But this is a good example of how important it is to consider the macroeconomic conditions – not just to focus on the obvious areas of distress, but to predict the next one.