Debt investment has moved to centre stage but with foreclosures a real possibility do managers have the necessary property management expertise? Do your due diligence, say Claude Angéloz and Eliza Bailey
The current credit crunch (with new US CMBS issuance dropping from $230.3bn (€163bn) to $12.1bn from 2007 to 2008, the term ‘crunch' seems sanguine) has led to a repricing of risk, which has driven real estate debt prices down to historically low levels and caused yields to soar.
While most attention on real estate debt is focused on the sub-prime market, all tranches and sectors of real estate debt have been repriced because of perceived risk that might or might not actually exist. Many investors and real estate managers recognise the emerging real estate debt opportunity and are now seeking ways to take advantage of debt repricing. Against a backdrop of a global economic recession and refinancing risk, it is crucial to identify the right market opportunities and invest with high-quality managers that have honed the necessary skills over many years, in order to generate the investment performance one seeks.
Real estate debt has offered and continues to offer investors the opportunity to limit their exposure to value deterioration by being more senior in the capital stack.
We estimate that commercial real estate values have declined at least 30%. As a result, the equity in many investments has vanished, making debt investments more attractive from a risk perspective.
Despite the lower risk profile of debt investments, a risk-averse market has cast a wide net over real estate, causing repricing of all real estate debt, regardless of whether risk has increased. Some tranches of real estate debt now offer strong risk-adjusted returns that one would normally expect from investments in equity.
Junior debt is being priced at swaps(1)+6500 basis points,(2) but senior debt prices have also spiked from swaps+25bps in February 2007 to their peak in November of 2008 at swaps+1400bps on AAA CMBS. While prices have since traded down to current levels of swaps+700bps, senior debt continues to offer low-double-digit unleveraged yields(3).
The current dislocation between risk and return of real estate debt has led to an explosion of new debt managers in the market, with a resulting increase in demand for screening. However, not all of the real estate debt managers, old or new, will succeed. Within the past year, Partners Group has reviewed over 120 real estate debt managers, many of whom were formerly considered top-tier, but have stumbled, either due to underestimating the breadth and depth of the current downturn, or because they lacked the skills necessary to execute in the current debt market.
There are two key characteristics to consider, among many others, when underwriting a real estate debt manager's ability to succeed in today's market - experience and expertise.
There are few managers with the necessary experience to manage through the current credit crunch, since the last major real estate crisis dates back to the late 1980s in the US and even further back in Europe. The RTC (Resolution Trust Corporation) days or the savings and loan (S&L) crisis is commonly thought of as the last US real estate crisis near the magnitude of what we are experiencing today. Few managers have distressed debt or workout experience unless they actively managed real estate debt investments through the S&L crisis, and even fewer have workout experience in Europe.
Keep in mind that living through the RTC days does not automatically qualify a manager as a distressed debt or workout specialist. Even if a manager claims to have this experience, investors must look below the surface to determine what role the team members served during the last real estate crisis. Most of the companies in existence during the RTC days are no longer in business and/or the team members now work at different and often new management companies. Thus the name on the door is not important; it is the team that counts.
Investors must also pay attention to the type of debt expertise a management team possesses. Prior to today, nearly all real estate debt managers could be slotted into one of two categories: financial engineers or real estate practitioners. One, independent of the other, is no longer sufficient. The global economic recession has put pressure on real estate fundamentals and resulting debt service coverage ratios on debt investments. Managers must be able to accurately determine the real estate cash flow drivers and not rely on market recovery or price appreciation to pay off the loan. Furthermore, it is critical to understand the full capital stack of each asset along with the control rights, covenants, and ultimately the refinancing risk associated with the potential debt investment.
Refinancing risk is significant in today's market. Managers must be prepared to take over the real estate if foreclosure is necessary. We estimate that there are hundreds of billions of dollars, if not more, of commercial mortgages scheduled to mature over the next decade that are unlikely to qualify for refinancing without substantial equity infusions from the borrowers. This makes foreclosure a real possibility and requires that real estate debt managers be prepared to become real estate operators, which requires very different skill sets. Few managers possess both.
At the end of the day, investors must realise that while the credit crunch has led to outsized risk-adjusted returns, one must be discerning about the types of real estate debt investments to be made and the manager(s) with whom to make them. There are many potential strategies, and no manager has the ability to cover the entire debt market.
(1) Market convention is to quote CMBS prices as a yield spread over swaps. "Swaps" are defined as the rate for a comparable maturity interest rate swap as determined by the current US Treasury yield and interest rate swap spread curves.
(2) Junior debt price of CMBS BB as of 29 May 29 2009.
(3) Senior debt price of CMBS 30% AAA as of 29 May 2009.