Interest rates are higher than pre-COVID-19 and expected to stay high in the long term, which should support yields.
Real estate equity prices have fallen since early 2022, so new loan collateral values will likely be lower than previous peaks.
Proposed higher bank capital requirements could diminish bank lending, which non-bank lenders could fill.
The time may be right for investing in real estate credit. Interest rate hikes raised yields on a broad range of credit investments, including real estate credit. Proposed regulatory guardrails for banks, traditionally the largest providers of commercial real estate credit, may create opportunities for non-bank lenders. Here are the three reasons why we see opportunity in real estate credit.
The Federal Reserve’s 525-basis-point federal funds rate increase since March 2022 is one of the most aggressive rate escalations in US history. This comes after several years of record-low central bank policy rates during the 2008-2009 Global Financial Crisis (GFC) and the more recent 2020-2021 COVID-19 crisis. While rates are likely to moderate over the next few years, the likelihood they will return to near-zero levels is extremely low. (See chart below.) We believe this should support higher real estate debt yields going forward.
Source: Invesco Real Estate, utilizing historical data from Moody’s Analytics as of September 2023 and the Federal Open Market Committee (FOMC) median forecast as of September 20, 2023. Latest data available. The longer-run projections represent each participant's assessment of the value to which each variable would be expected to converge over time under appropriate monetary policy and in the absence of further shocks to the economy. Single-year estimates and forecasts are for the end of calendar years. Forward-looking statements are not guarantees of future results. They involve risks, uncertainties, and assumptions; there can be no assurance that actual results won’t differ materially from expectations.
Real estate values have fallen in almost all key global markets since early 2022 because of elevated interest rates and expectations of slowing global economic growth. For example, US commercial real estate private market prices peaked in March 2022 and have fallen by 16% on average, with variation by property type.1 Because of this, new loans will likely be sized against below- peak collateral values.
Property prices may decline further in the short term if interest rates remain elevated and economic conditions soften before eventually recovering. This highlights the importance of the quality of a loan’s underlying collateral, tenant credit, and sponsorship strength. It also makes sense to avoid vulnerable sector exposures (e.g., office) and to be realistic about current market value in the underwriting process. It also makes the credit slice of the real estate capital stack more attractive, in our view. New loans that are 50% to 65% of reset values can provide a sizable cushion for potential short-term price declines.2
| Since Jan 2020 | Since Mar 2022 (peak) | |
|---|---|---|
| Storage | 49% |
-14% |
| Industrial | 41% |
-7% |
| Manufactured homes | 22% |
-12% |
| Life science | 14% |
-7% |
| Retail strips | 2% |
-15% |
| Apartment | -1% |
-22% |
| Medical office buildings | -12% |
-23% |
| Office | -31% | -31% |
| Single-family rental | +5% | |
| Data centre | -12% | |
| All property | -3% | -16% |
Past performance does not guarantee future results.
Source: Invesco Real Estate using data from Green Street Commercial Property Price Index as of September 2023. CPPI data for single-family rentals and data centers starts after Jan 2020; data as of September 15, 2023.
Since the GFC, tighter regulations have strengthened bank lending practices, reducing some of the more aggressive financing activity in commercial real estate. Bank regulations are likely to tighten further in response to bank failures from earlier this year. Federal bank regulatory agencies have proposed that large US banks with total assets of $100 billion or more be required to:
If this proposal is adopted, it could be costly for banks and dampen their lending activity, in our view. Bank lending accounts for roughly half of the outstanding US real estate loan volume4 and a higher proportion in the Asia Pacific and EMEA (Europe, Middle East, and Africa). We believe a bank pullback would create opportunities for non-bank lenders.
Attention towards private real estate credit is growing in the current market environment and opportunities could expand for alternative lenders if proposed bank regulations reduce bank lending for commercial real estate. For more information, read our white paper Opportunity in real estate credit.
Private credit, including real estate debt and direct lending, may offer diversification and lower volatility, making it potentially an attractive option for investors seeking optimized portfolios.
A global and US real estate recovery with transaction activity re-accelerating and the start of a new real estate value cycle is close in our view.
Kevin Grundy, Managing Director, Fund Management, Europe, Invesco Real Estate, discusses the broader market environments in the region and where he is finding the most compelling investment potential for value-add and opportunistic strategies.
1 Green Street's Commercial Property Price Index®, as of September 15, 2023. The index is a time series of unleveraged U.S. commercial property values that captures the prices at which commercial real estate transactions are currently being negotiated and contracted. An investment cannot be made directly into an index.
2 A loan-to-value ratio range of 50% to 65% is common within the real estate credit industry with respect to the typical loan-to-value ratio of senior loan positions.
3 Federal Reserve Board, “Agencies request comment on proposed rules to strengthen capital requirements for large banks,” July 23, 2023.
4 Source: Federal Reserve Flow of Funds as of June 2023.
Defined terms
Basis point is a unit that is equal to one one-hundredth of a percent.
The federal funds rate is the rate at which depository institutions lend to each other.
Capital stack is the layers of funding provided on a real estate investment. Relative risk within the capital stack tends to be associated with payment priority of various positions within the capital stack. The two broadest categories of the real estate capital stack are equity and debt, with debt typically receiving senior priority on loan repayments.
A loan-to-value ratio is (LTV) determines the maximum amount of a secured loan based on the market value of the asset pledged as collateral.
The value of investments and any income will fluctuate. This may partly be the result of exchange rate fluctuations. Investors may not get back the full amount invested.
Property and land can be difficult to sell, so investors may not be able to sell such investments when they want to. The value of property is generally a matter of an independent valuer's opinion and may not be realized.
Alternative investment products may involve a higher degree of risk, may engage in leveraging and other speculative investment practices that may increase the risk of investment loss, can be highly illiquid, may not be required to provide periodic pricing or valuation information to investors, may involve complex tax structures and delays in distributing important tax information, are not subject to the same regulatory requirements as mutual portfolios, often charge higher fees which may offset any trading profits, and in many cases the underlying investments are not transparent and are known only to the investment manager. There is often no secondary market for private equity interests, and none is expected to develop. There may be restrictions on transferring interests in such investments.
All data is provided as of September 2023, sourced from Invesco unless otherwise stated.
This is marketing material and not financial advice. It is not intended as a recommendation to buy or sell any particular asset class, security or strategy. Regulatory requirements that require impartiality of investment/investment strategy recommendations are therefore not applicable nor are any prohibitions to trade before publication.
Views and opinions are based on current market conditions and are subject to change.
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