Debt is the New Equity

February 09, 2023

Real estate debt investors, relative to equity investors, are generally more insulated against downside risk with underlying properties secured as collateral. Mechanically, a debt investor is effectively lending money to a borrower who may require bridge or rescue financing to close on prospective property acquisitions or development deals. Lending to borrowers at higher interest rates allows for higher returns, as well as consistent cash yields.

Commercial mortgage-backed securities (CMBS)¹ — the public form of real estate debt — have seen market yields rise materially amid higher interest rates. Debt is en vogue again as yields are back to levels that can contribute meaningfully to portfolio returns. 2022 was a year of re-pricing due to the impact of higher interest rates. Public real estate markets quickly embedded a recession risk-premium into pricing while private market valuations trailed. If the economy enters a recession this year, debt is likely to perform relatively well based on conservative underwriting and performance that is not directly tied to a property’s net operating income growth. CMBS excess spreads have also widened out relative to corporate bonds to account for real estate-specific downside scenarios. As shown in the chart, CMBS yields are currently comparable to the yield of corporate bonds rated at least two full ratings lower. Though market risks remain, higher rates and wider spreads have created a potentially attractive relative value landscape for CMBS opportunities.

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¹Commercial mortgage-backed securities (CMBS) are fixed-income investment products that are backed by mortgages on commercial properties rather than residential real estate.