Debt strategies are often off the real estate investment radar of pension funds. But they can be less risky than core equity strategies, says Ethan Penner

Many institutional real estate investors are struggling with the fact that there is an obvious void in the debt segment of real estate and today are faced with the challenge of measuring this risk.

The same calculus that governs real estate equity holds true for debt, be it mezzanine or first mortgage debt. To deploy capital well, one must understand the value of the underlying asset and determine where in the capital structure the risk-adjusted return is the best. It is only by looking at all of the choices - equity, mezzanine and first mortgage - that one has a chance to arrive at the correct conclusion.

However, there has always been a strict bifurcation between anything debt and anything equity. This way of looking at things has led the institutional investor community to over-allocate to a core equity strategy, believing it to be the least risky option, missing out entirely on a significantly less risky debt strategy. This same misunderstanding has also led lenders to underestimate the need to understand real estate and to overvalue bond and capital market savvy, which has contributed to the creation of bad loans.

A riskier core equity strategy offers a yield that is far lower than that offered by a much less risky first mortgage strategy. The graph shows the capital stacks of both strategies. In this analysis, assume the underlying property is identical. In the core equity strategy, the investor owns the asset and leverages it with a 50% loan-to-value (LTV) first mortgage. In the debt strategy, the investor makes a 66% first mortgage loan and then leverages it 85:15 to generate a leveraged loan position.

 Note the risk to either strategy is measured by the level of deteriorated value to the property at the point in which the investor would begin to lose money. In the core equity strategy, the first dollar of value lost would be lost by the investor, and having placed a loan on the property that loss would be two dollars for every dollar of value lost. In the debt strategy, the value of the property would have to erode by more than 34% for the investor to begin to suffer any losses at all. Simply, the core equity strategy is far riskier than the debt strategy.

It is not uncommon to believe that the introduction of the 85:15 leverage to the debt strategy has increased the risk level. The leverage certainly has concentrated the risk but the existence of the 34% equity cushion makes the debt less risky than core equity. Just like the core equity, wherein investors can choose to mitigate risk and loss by paying down debt in the unlikely event the property's value decreases below the "total loss line" of 50% LTV, the holder of the leveraged loan position can also pay down his leverage should the property's value deteriorate below his total loss line of 56%.

Simply, a first mortgage loan on a property is always a less risky investment than the equity ownership of that same property. The reduced risk stems from the fact that the owner of the property will suffer loss from any value deterioration, whereas the owner of the loan will be protected from losses due to value deterioration to the extent of the presence of equity. So, if there is a $70 loan on a property acquired for $100, then $30 of value would have to be lost before the lender would face any impairment, by which time the equity owner would be facing a complete loss of capital.

Investments that are less risky offer the promise of lower returns, while those that are more risky offer the promise of higher returns. But when risk is introduced there is also a higher risk of loss. And when one factors in the adjustment to yield for that increased risk of loss, it is not implausible that the risk-adjusted return for a riskier strategy closely resembles that of a less risky one. This is the result of a market being efficient: when a strategy offers outsized risk-adjusted returns, it attracts hordes of capital away from strategies with inferior risk-adjusted returns - that is, until the two come into alignment.

There are times when a strategy's risk-adjusted returns are out of alignment with the strategy's position on the risk spectrum - a superior risk-adjusted return. When we chance upon these seeming anomalies, it is important to be sceptical, since many are just mistakes waiting to be made. It's all the more important to be sceptical in a bear market, where mistakes will not be covered up by increasing valuations.

Investment in real estate debt today is that anomaly. One would not expect that investing in a first mortgage debt strategy with normalised leverage of 10:1 or below should offer a return that is higher than that offered by a strategy of owning property, especially a core equity strategy, which by its implication does not have superior upside potential. And yet this anomaly exists for a very good reason - debt has not been on the radar screen of institutional real estate investors.

In the most recent bull market the business of lending was truly unattractive on a risk-adjusted basis. Securitisation-based real estate lending was the poster child of the over-leveraging of that cycle, with the b-piece holder, who was the real lender of those structures, owning loans with embedded leverage of 39:1.

Of the $230bn (€174bn) of commercial mortgage-backed securities (CMBS) issued in 2007, only 2.5% of the bonds were rated single-B or unrated (that is, b-piece), with the remaining 97.5% constituting senior bond classes that effectively leveraged the loan ownership positions of the b-piece holder, or loan owner. That 97.5:2.5 ratio is equal to 39:1. In order to squeeze out more yield, these lenders/b-piece holders commonly re-levered their 39:1 positions with 1:1 or 2:1 warehouse lines or collateralised debt obligation (CDO) structures, increasing their overall leverage to 79:1 or 119:1. Clearly, whatever the notional yield was for these lenders, any loss-adjusted yield would have had to be quite low, or in fact very negative, given their inability to tolerate losses due to their leverage levels. It should not come as a surprise when those positions ultimately produce negative returns to their investors.

Today, with the wash-out of this undercapitalised risk transfer securitisation model, we now face a time when institutional investors must consider aggressive re-allocation of capital away from core equity and into debt in order to capitalise on the anomaly described above.

Any discussion of investment strategies must take into account the recent change in cycle. Until the spring of 2007, we were in a bull market flush with capital. Then the capital dried up and we began one of history's nastiest bear markets.

It is not a stretch to say that any investment made in 2005-07 has seen a decline in value, be it debt or equity, while the next couple years hold many good opportunities. Vintages, which are the reflection of the level of capital competing for deals in any given year, naturally have an impact on success. When competition for deals is in balance or, better still, scant, astute investors can apply traditional value analysis to a deal, still be in the game and not be outbid by momentum investors.

Any investor in real estate must carefully evaluate a property's value and its price volatility, reflecting the investor's assumptions of the market's direction and risk tolerance. In a bear market, one would be prudent to emphasise a bearish set of assumptions when discerning a property's prospects and an appropriate price to pay for it. Conversely, in a strong bull market, with surging rents, abundant capital and very high occupancy, one might overlay a set of assumptions to one's analysis that focused upon the upside potential of a property.

The cardinal rule of investing in a bull market - ‘protect your downside' - is often neglected in favour of the seemingly assured upside.

Perversely, it is during bull markets that investors generally feel great, are unconcerned with risk and make their largest capital commitments. The combination of increasing prices, positive economic momentum and the presence of many other investors competing for each and every deal provides bull market investors with a false sense of security that can lull them into relaxing their risk management standards.

In a bear market, the opposite is true. Bear markets mean losses on recent investments are piling up daily. Confidence is shaken. Investors can lose trust in their external managers and within their own firms; senior management can lose confidence in their deal teams. In such a market, there is a tendency to retrench. Managers riddled with losing portfolios hunker down, hoping to survive, as do in-house deal teams.

Yet it is in markets where competition for deals is scant that investors can find real value. In the bear market, an investor can apply traditional fundamental value analysis, assigning little or no weighting to an upside-scenario set of projections, and still deploy capital. Of course, in a bull market, with competition of capital deployment frenetic, only those pricing in the rosiest forecasts get to play.

Debt strategies must become part of the everyday landscape for institutional real estate investors, and at least first mortgage lending strategies should be viewed as being the truly lowest-risk strategy available to them. Only when the yields available through that strategy drop below what is available in a core equity strategy will the market be approaching a state of equilibrium.

Ethan Penner is executive managing director at CBRE Investors