Listed real estate debt such as REIT preferred equity and CMBS can improve the risk profile of portfolios. James Cowen and Darin Turner explain
Balancing the desire for growth, stable income and lower volatility with portfolio liquidity has been a long-standing challenge for real estate investors. For indirect investors, daily pricing and liquidity engenders return volatility. For direct real estate investors, high conviction is required to lock up capital for prolonged periods.
For those seeking liquid real estate exposure, daily priced and traded commercial real estate-backed fixed income investments could provide an additional means of portfolio diversification while boosting income returns. The ability of real estate specialists to underwrite the underlying real estate in fixed income investments offers scope to source inefficient bond market pricing in a market dominated by general fixed income investors. Investing across the entire capital structure enables allocation decisions that manage against changing market characteristics throughout the cycle.
The global depth of the commercial real estate-backed fixed income market is broadly similar in size to that of the global real estate equities/REIT universe, at around $1trn. While the US issued universe is most developed and sizeable, Europe and Asia also offer opportunities. In almost all instances, investments can be traded daily on an over-the-counter basis.
There are three key real estate fixed income investments types, offering different levels of security within the capital structure:
• Commercial mortgage-backed securities (CMBS). As asset-backed investments, CMBS sit highest in the capital structure, meaning they are first-lien holders on the underlying property assets (and thus first payees in the case of default). CMBS are available with many different maturity terms and risk-reward profiles through the tranched nature of the pools.
• Real estate corporate debt (debentures/bonds). Listed company debentures may be secured against specific assets or have more broad recourse across the corporate entity. Maturity dates tend to be long-term.
• Preferred equity from real estate investment trusts (REITs). Preferred securities are lower than property specific mortgages in the corporate capital structure. Coupon payments are fixed and their term is often perpetual in nature. Preferred equity can offer the potential for significantly higher yields than fixed income securities backed by property-specific mortgages. However, sitting lower in the capital structure, they bear the risk of dividend cuts.
Dividend income from listed real estate equities tends to be attractive relative to other equity sectors and can be competitive with direct real estate fund distribution yields. However, income yields from real estate fixed income offer attractive opportunities across the risk spectrum, reflecting not only varying credit risk and positioning in the capital stack but also, to an extent, investors' familiarity with the instrument and underwriting expertise. Real estate fixed income provides higher yield opportunities at each comparable credit rating level, allowing investors to customise different risk profiles within their portfolio.
Investors seeking higher levels of yield are implicitly taking exposure to lower credit quality. In doing so, they should therefore possess market and property underwriting skills to conduct and compare valuations and risk. This places a skilled real estate investor in a position to possibly exploit market inefficiencies.
Real estate investment in its most basic form is the flow of various types of capital into the ownership of a property asset. However, the investment attributes for each part of the capital structure may behave quite differently from one another throughout the market cycle and in comparison to the underlying return of the property.
Historically, income-oriented real estate securities have displayed a materially differing risk-and-return profile from listed real estate equity while also showing lower correlations to real estate equities.
As with any investment, investing in commercial real estate fixed income is not without risks. The primary investment risks associated with these products can be segmented between real estate credit risk and capital-market risk. The credit-risk portion involves the potential loss of interest and principal payments due to the performance of the underlying collateral. These losses can be the product of loan-specific issues, such as tenant rollover, or other external issues related to declining market conditions. The inherent capital-market risk involves both rising interest rates and spread widening. An additional area of expertise is required in understanding the risks attached to certain of the loan structures.
However, in an uncertain environment investors may find the inclusion of real estate fixed income instruments a useful overall portfolio diversifier and beneficial to their recurring income return.
James Cowen is senior director and Darin Turner is portfolio manager at Invesco Real Estate Securities