Seeking shelter in residential debt strategies

Even as interest rates increase, the imbalance between supply and demand will keep driving new residential developments. There are 'more resilient factors' that keep capital flows stable, Precis's Randeesh Sandhu said.

The US residential housing market continues to experience a severe supply-demand imbalance that is leading investors to diversify from their equity investments in the sector with debt.

“US real estate is the largest, most liquid real estate asset class in the world and investors feel they should have and need to have exposure to that through the equity and the debt side,” Eric Atlas, who heads US residential debt strategies at Man Global Private Markets, tells Real Estate Capital USA. “If we were having this conversation even 10 years ago, [residential debt investor loan origination] would have been very regionalized. But now, we see institutions wanting to be closer to the residential investment loan side and a lot of non-bank lender acquisition activity, too”

“Inflation is real and the Fed hiking rates is real, but expectations are that we are still going to near-historic lows in rates”

Eric Atlas
Man Global Private Markets

The sector’s historical stability and ability to act as an inflation hedge is also behind the interest.

“Inflation is real and the [Federal Reserve] hiking rates is real, but expectations are that we are still going to near-historic lows in rate space when you look at LIBOR expectations and fed funds moving forward,” Atlas says. “You have the large housing deficit on one hand, and on the other you have inflation, raising rates and geopolitical instability.”

London-based global investment manager Precis Capital believes the shift is part of a broader move toward commercial real estate debt investments that has stemmed from a pervasive low-yield environment following the global financial crisis.

“Despite this increased institutional interest in real estate, and living assets specifically, on both the debt and equity sides in recent years, there remains huge scope for residential development lending to attract more institutional capital,” Precis CEO Randeesh Sandhu tells Real Estate Capital USA.

When comparing investor demand geographically, Precis reckons North American institutions approach the sector more openly, while European institutions’ allocations to non-bank lending and development finance have historically been lower.

“By comparison, North American investors tend to have a longer track record of allocating capital to higher-yielding real estate debt strategies, such as development finance, and therefore a greater appetite for these products,” Sandhu says.

Despite rising interest rates, the supply-demand imbalance in the US residential market will continue to drive new developments.

“More to the point, interest rates comprise only one driver of the influx of capital into real estate debt. There are other, longer term and arguably more resilient factors that we expect to keep capital flows relatively stable.”

Bridging forward

Over the short term, bridge loans are a sub-strategy that could provide downside protection for debt investors.

It can also be expected that banks’ diminished risk appetite and their focus on compliance with the increased risk weightings of development loans under the incoming Basel IV standards will only serve to further open up the market to non-bank lenders and therefore drive a further inflow of institutional capital, he adds. “The bridge loans may be lower leverage than traditional agency mortgages and they’re short term,” Atlas says. “When you look at the biggest one-year housing drop during the great financial crisis, it was 12 or 13 percent, and when you look at the amount of equity protection buffer over the course of a year from these short-term loans, it can be somewhere in the range of double that. So, from a macro perspective, the bridge loan structure may help mitigate downside risk.”