Series: Is private debt ready for recession? Part 3 - The opportunities and challenges in real estate debt

 In the current economic environment, there are a number of factors that investors need to contemplate when considering real estate debt opportunities. In part three of our series, Is private debt ready for recession? Senior Portfolio Manager, David Saija and Portfolio Manager, Lucie Bielczykova at Revolution Asset Management (Revolution) discuss the impact of rising inflation on real estate debt and where the pressures are to be seen for investors.

The spectrum of lending opportunities to real estate is quite wide, ranging from low Loan to Value Ratio (LVR) lending to stabilised commercial properties with strong tenants and long leases at one end of the spectrum, right through to large-scale residential development loans, which are typically highly leveraged, have no underlying cash flows to service the debt with lending based on an assumed future value of the property.

Similar to leveraged loans, Revolution focuses its real estate attention on the more conservative end of the spectrum. Any loan Revolution will advance needs to demonstrate that it can be serviced via cash flows generated by the property, with the asset value (in terms of being able to sell the asset to recover any outstanding debt) being secondary in nature. As such, Revolution favours lending to well-established retail, industrial and office assets, with high-quality tenants on long leases that generate a recurring cash flow and income stream to the asset owner.

Revolution is also quite conservative with leverage in its real estate debt transactions, with a typical LVR of around 60-70% which provides a significant equity buffer and safeguards against the value of the property falling below the loan amount. There are also covenants which impose restrictions on borrowers such as a maximum LVR (which is typically subject to an annual external valuation to ensure compliance) or minimum interest cover ratios (or ICR), which must be complied with by the borrower, and may trigger a breach of the covenant and an event of default, enabling the lender to demand full repayment of the loan.

Similar to corporate borrowers, rising interest rates and inflation result in the cost of debt increasing for real estate borrowers. Further, a recessionary environment can weigh on the underlying tenants and their ability to pay their leases, while at the same time it has the potential to trigger a decline in property valuation which lenders take security over.

To safeguard against rising rates and inflation, commercial real estate leases include protection through lease escalations, which is typically the greater of CPI or a fixed percentage, say, 3-4% that is documented in the underlying leases. This means that the contracted cash flows are guaranteed to increase by at least CPI each year, providing protection against inflation. As a result however, the cost of leasing the real estate asset can increase significantly for underlying tenants.

As such, strong tenants are also key in the equation. Revolution pays significant attention to, and conducts in-depth credit analysis on, the underlying tenants to ensure serviceability throughout the cycle. Using a retail asset as an example, Revolution favours assets that rely on non-discretionary spending with large, grocery-based anchor tenants such as Coles or Woolworths, with long leases in place that not only tend to generate a stable cash flow but also draw foot traffic to the centre.

Where is pressure being seen or likely to be seen?

The impacts of the current economic environment are unmistakable in the real estate sector, with various high-profile developers facing significant pressure and demand for residential development projects also declining due to reduced borrowing capacity and lower consumer confidence. In Revolution’s view, areas that have or are likely to experience pressure are:

1. Development or construction loans: These types of transactions carry significantly higher risk, with no tenants or cash flow-producing leases and rely on the value (or future value) of the asset to sell the property and repay the outstanding debt. For example – the development of an apartment tower is a common private debt transaction that Revolution avoids, where lenders make loans on the basis that the apartments will be sold on completion of the development and the proceeds would repay the loan. There are several risks with these types of loans in an environment of rising inflation, interest rates and overall macroeconomic weakness, including rising building cost pressures (particularly when utilising fixed price contracts), labour shortages, demand for the apartments as consumers grapple with declining borrowing capacity and rising costs of living, and the potential for the overall property value to fall below the amount of the outstanding liabilities. Revolution avoids residential real estate, construction or any kind of development projects.
2. Highly leveraged assets: These assets have a thin equity buffer to account for any valuation declines, which could result in the value of the underlying asset declining to the point where it is less than the loan outstanding.
3. Weak tenants: Property tenants generate the cash flow that is used to repay debt. Accordingly, having a weak tenant base could result in tenants facing financial difficulties, not paying the rent on time and eventually vacating the property, creating a vacancy and a hole in the cash flows of the property.

The winners

In challenging economic times, Revolution believes the winners will be those who maintain their discipline and focus on the underlying property fundamentals with conservative lending against quality properties, in good locations, with strong tenants that generate strong, recurring cash flows.

As a result of its strict lending criteria, Revolution currently has very limited direct real estate debt exposure in the portfolio, as senior secured lending to established commercial real estate has been dominated by banks to date.

Conclusion

Rising interest rates and inflation are set to increase the cost of debt servicing for real estate borrowers, while a recessionary environment may also drive a decline in property valuations (lenders' security) and weigh on the underlying tenants’ ability to pay their leases (a key source of cash flow for the property). As such, certain areas of the market could come under pressure and strong credit discipline will prove vital in the period ahead.  

Is private debt ready for recession? – a four-part series

Missed the previous parts of Is private debt ready for recession? Click the links below to go to:

• Part one
• Part two
• Part three
• Part four – Coming soon!