Capital markets are confronting some of their biggest challenges in decades as a result of the Federal Reserve’s continued efforts to restrain inflation through higher interest rates. Today’s economic backdrop has the U.S. moving from a low-growth, low-inflation environment to one with higher nominal gross domestic product growth and more inflation in the system.
Some of the notable factors contributing to this systemic change include a sustained federal financial spending policy, continued growth of wages and labor shortages. Other factors include a vacillating energy transition from fossil fuels to carbon-neutral sources and intensifying geopolitical concerns.
“Commercial real estate credit is attractive since it offers equity-like returns with lower levels of risk due to its seniority in the capital stack.”
Considering this new macroeconomic backdrop, a popular question is, what does this mean for investor portfolios? One prudent move would be to increase allocations in collateral-based cash flows backed by hard assets such as real estate.
More specifically, it makes sense to increase one’s exposure to private real estate credit as banks, which traditionally have been leaders in commercial mortgage lending, have restrained their lending practices. This has created opportunities for nonbank lenders to gain market share from bankable sponsors eager to get their projects financed.
At the same time, the asset class’s expanded revenues have created a compelling risk-adjusted yield, whereby when inflation moves up, so does revenue. This is a major change from the past 10 years when the theme was long growth, long duration and fixed income. We are now in a different environment where the playbook has changed and investors need to adapt.
Investment solutions
The ability to generate stable, inflation-linked income through commercial real estate credit offers a positive solution for investors who might be facing financial obligations or challenges. This asset class offers substantial variations in strategies, risk levels and the ability to invest across the capital structure, including both senior and junior positions. It also allows investors to tailor allocations that align with their long-term goals.
Pension funds, for example, typically seek low-risk credit funds that tend to lend against stable-yielding assets. These assets can generate cash flows that match required payments to their beneficiaries.
That said, not all investors are the same. Many have liabilities that are subject to cost-of-living adjustments that may result in higher payments when inflation rises. Traditional investment approaches typically use long-duration bonds to manage the long-duration liabilities.
During the recent market cycle, however, traditional approaches showed weakness as inflation and interest rates rose quickly. For instance, it is common practice to use swaps and other derivatives to replicate the bond positions necessary to hedge liabilities. As interest rates increased over the past two years, the values of these leveraged derivative positions declined, generating significant losses and creating a short-term liquidity crunch for investors who utilized substantial leverage.
Rethinking bond exposure
Historically speaking, if stocks go down, then bonds rally and investors seemingly always have a shock absorber in their portfolios. But this notion is changing.
Banks had more than $600 billion in unrealized losses at the end of 2022, according to the Federal Deposit Insurance Corp. The Federal Reserve, meanwhile, has about $1.1 trillion in unrealized losses in its System Open Market Account, with a large percentage of that total tied to U.S. Treasury bonds.
Therefore, every time there is a rally in bonds, what will the Fed do? Many believe they will sell, thus driving bond prices down. Moreover, Japan, which happens to be the largest foreign holder of U.S. bonds, is mimicking this playbook. These sales will eventually lead to an increased bond supply, along with investors such as banks and the Fed being underwater in their bond portfolios.
These conditions mean that investors need to think about how much they own in stocks and bonds, with a particular emphasis on the bond market. Alternative products such as commercial real estate credit can help them earn a bond-like yield without the same duration or volatility associated with traditional fixed-income products.
Finding yields
Private real estate credit vehicles that generate stable income while having some inflationary protection can help investors reduce surplus volatility. Investors can also earn higher yields to better achieve their capital-deployment goals with less complexity.
Furthermore, commercial real estate credit is attractive since it offers equity-like returns with lower levels of risk due to its seniority in the capital stack. Tighter capital standards, unrealized losses and higher loan-loss reserve requirements are forcing banks and other financial institutions to hold more capital and issue fewer loans, which is providing opportunities for nonbank lenders to fill the gap.
The multifamily housing sector is an excellent example of this trend in the commercial real estate market. There is a shortage of about 6.5 million single-family homes in the U.S. right now, a result of many factors that include a slowdown in construction dating back to the 2008 financial crisis. Even if multifamily rental units are included in this equation, there is still a deficit of about 2.3 million homes.
The lack of housing, coupled with the need for lenders to step up and fill the gap, provides an abundance of opportunity for well-capitalized nonbank lenders. They can deploy capital into high-quality loans at attractive spreads using relatively conservative underwriting metrics. Commercial real estate credit also offers a strong inflation linkage, produces recurring cash flows and helps to protect returns in a more volatile environment.
Having stable cash flow and the ability to grow income in today’s inflationary environment is highly attractive for investors. This cash-flow resiliency has been particularly true across sectors that private investors currently favor, such as built-to-rent homes and industrial warehouses.
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The Federal Reserve appears to be putting a pause on interest rate hikes for the time being, but many experts believe that the commercial real estate market will deal with what is being described as a “higher-for-longer” rate environment than what was originally expected. In the past, the Fed, the European Central Bank and the Bank of Japan used quantitative easing as a road map to indicate their desire to be protective against elevated rates.
Today, they don’t have that visibility as wages, the transition to clean-energy sources, geopolitical concerns and other fiscal issues are all disruptive variables. One thing being learned in the U.S. is that there’s more money in the system than many people had expected. The consumer economy continues to show strength, the services economy is swelling and wage growth has been only nominally subdued. Fed policymakers may not be done with their job until they inhibit the growth of the labor force.
As a result, this higher-for-longer rate environment has created unparalleled opportunity for commercial real estate credit. By staying patient, disciplined and at the forefront of the market, private lenders are strategically positioned to be major players among the sources of mortgage capital and should therefore have a place in every investor’s portfolio. ●
