Investing in Debt in a High Interest Rate Environment

Debt: the less sexy, unappreciated side of real estate investing.

In general, real estate investments can be categorized into four broad quadrants: public equity, private equity, public debt, and private debt. Though it mainly happens behind the scenes, unbeknownst to the general public, commercial real estate (CRE) lending is a massive, multi-trillion-dollar market. The focus of today's newsletter is diving into the debt side of the real estate spectrum and examining the effects of the public and private debt markets when the market slows down and interest rates increase.

While institutions tend to have decently-sized holdings of CRE debt, few individual investors hold a significant allocation of debt of any kind in their investment portfolios (<4% according to Personal Capital), with likely a fraction of those investments allocated towards real estate debt.

Real Yield: The effects of inflation on returns

In a high-inflation environment, there is a noticeable struggle of finding investments (especially in fixed income) that will produce a positive real yield, that is, a nominal return greater than the rate of inflation.

As the Federal Reserve hikes interest rates to compensate for inflation, lenders such as banks and mortgage originators respond by increasing interest rates on their loans. However, despite CPI-U increasing +8.2% YoY as of September, nominal real estate debt yields have yet to outpace inflation. As a result, many real estate loans will experience a negative real yield in the short term, with the long-term expectation that inflation will decrease. [For more on the relationship between yield and time during high inflation, see yield curve inversion]

Since yields on fixed-income instruments tend to adjust at less than a 1:1 ratio when inflation rates rise, there will generally be a loss in real yield during periods of high inflation. However, risk-averse fixed-income investing can certainly be used as a hedge against equity investments during uncertainty, as equities tend to decline. To achieve positive real yield in the near-term using real estate debt during high inflation, an investor will typically have to use high-yield, riskier investments such as funding opportunistic/distressed properties, raising LTV and DSCR minimums, or issuing subordinated debt.

Real estate debt investment types

When it comes to specific ways to invest in real estate, there are a few different options that offer varying levels of risk, experience, liquidity, and access to investors. Here are a few general categories:

Direct Lending

The closest to the transaction a real estate debt investor can get is to personally lend on properties. Rates can vary greatly between asset classes and loan terms. A bfinance survey of asset managers found that issuing mezzanine debt was the most popular strategy employed when aiming to deliver higher returns. The risk-reward spectrum of real estate asset classes is typically dependent on property quality, ranging from Core and Core+ at the relatively safest levels, and Value-add and Development at the riskiest.

Private Debt Funds

Real estate debt funds are generally private asset managers that pool together investor capital and lend on commercial real estate projects. Last year, the top 50 non-bank lenders raised over $224 billion in funds, a 20% increase over the previous year. Top global debt fund managers include PGIM, Blackstone, AllianceBernstein, and LaSalle Investment Management.

MBS Securities

While mortgage-backed securities come in many forms, the most accessible way to invest in them is through ETFs. According to VettaFi, there is currently around $45 billion in AUM across 16 top MBS ETFs, with the largest managed by BlackRock/iShares (MBB), Vanguard (VMBS), and First Trust (LMBS). While MBS ETFs provide more liquidity and accessibility with low minimum investments, they also carry management fees.