Real estate debt’s potential as a secured income alternative

Global markets continue to be impacted by inflation concerns, and with the US Federal Reserve indicating an increase in interest rates by next year, investors are looking for assets that have the potential to offer more resilience to higher inflation income streams with some inflation protection. We believe well executed real estate debt investments could offer just that. 

Structural supply offers attractive yields

As discussed in our recent white paper, real estate debt can offer yields at significant premiums to traditional fixed income investments. With the added feature of their asset backed nature, the security of these income streams can demonstrate resilience over and above the pure credit strength of the borrower. Of course, the devil is in the detail. It is vital to ensure loans within a portfolio are secured against good quality assets to good quality borrowers with an ability to retain tenants and add value.

Following the global financial crisis, traditional lenders (typically banks) impacted by greater regulation have taken a significantly lower risk appetite to the real estate sector, resulting in the opportunity for asset owners to lend at sensible loan to value (LTV) ratios and a significant yield premium over fixed income, but with the added benefit that many loans are floating rate, which should provide additional protection against inflation to the extent that interest rates tend to rise in response to rising inflation.

Valuations tend to respond positively to inflation

Importantly, in most scenarios where interest rates and inflation start to rise, the security on these loan positions can improve over time as rents (and therefore valuations) grow and borrowers are able to cover their liabilities.

The value of any property investment is derived from the capitalisation of its future income streams. The pricing of this income is set by the market rental appetite and are locked into place through a lease structure with reviews during or at the end of the contract. These lease reviews help protect a lender against refinancing risk on exit, while at the same time building in sensitivity to underlying rent inflation.

The right property in the right location

As an important driver of overall returns, rental tone is typically set by the quality of the building and its ability to attract tenants under typical supply and demand drivers. High quality assets in growth markets typically see competitive tension amongst tenants, which pushes rents up as demand outstrips supply. In an environment where we see interest rates rising this is advantageous because rising rents are often in excess of inflationary metrics as shown by the chart below:

From an investor’s perspective. The equity position on real estate has the potential to offer both an income stream (bond like) and capital value growth (equity like) characteristics. For those investors who want to lock away attractive income streams taking the bond position could be the way forward.

In fact, the choice of which properties to lend against is also to limit broader volatility in the price of the debt and the underlying loan to value.  We believe this “property first” lending approach is crucial to delivering reliable and attractive income streams for institutional investors.