Commercial Real Estate and Debt Fund Investment Outlook

As we head into the seventh month of the pandemic and global lockdown, COVID-19 remains in the forefront for real estate investors and occupiers. The economic effects of COVID-19 include staggering job losses, reduced consumer spending, and multiple business closures. While each country responded with its own set of virus control policies, major economies have all responded with unprecedented levels of monetary and fiscal policies. 

Most major economies are starting to lift restrictions allowing for some economic recovery. Normal activity will not fully resume until vaccines and therapies are widely available, which are projected to be late 2020 or early 2021. Current baseline forecasts are for minus 5%-10% in 2020 GDP followed by plus 5% growth in 2021 GDP. Most economists are calling for a “U” shaped or Nike swoosh recovery. Interest rates are projected to remain low for the next 24-36 months, maybe longer.  

Real Estate lags economic recovery and remains subdued because furloughed workers are being permanently terminated and workers have not yet fully returned to their offices. Real Estate investors need to be able to travel more freely and see more certainty on economic growth before gaining confidence and moving away from their cautious stance. 

Leading indicators suggest the economy is gaining momentum going into end of year 2020 and deliver strong growth rates in 2021. However, we believe there will be wide dispersion of real estate returns based on property types and regional locations. Hard hit sectors like hospitality, leisure, recreation, restaurant and retail will struggle to find their footing while industrial, multi-family, and homebuilding will continue to show growth.

COVID-19 has also accelerated the digital economy and real estate will have to catch up. Office employment has been resilient, but patterns of work are changing, and offices will have to respond. The growth of online retail sales has accelerated demand of industrial and is driving evolution of the retail sector. There continues to be a large amount of cash on the sidelines for real estate and even though investors are acting cautiously, it will only take a modest uptick in investor confidence to open the floodgates.

Based on this economic backdrop we recommend investors continue to remain cautious and focus on commercial real estate as an attractive alternative investment. We believe it is prudent to invest in commercial real estate where the asset managers invest in opportunistic properties that need to be re-positioned and in sectors that are beneficiaries of the new post pandemic landscape.

Given the ongoing volatility in the stock market, investing in alternatives remains a viable strategy for investors looking to diversify and to limit exposure to stock market volatility. Alternatives, particularly real estate, have a low correlation with the stock and bond markets and further diversify portfolio risks.

There are numerous approaches to invest in commercial real estate depending on your risk tolerance. If you want relatively safe investments, you can invest in core properties occupied with long-term credit tenants in major metropolitan markets – such high-quality core assets provide low to mid-single digit returns. If you are looking for capital appreciation, you can invest in higher risk development projects that can generate returns in the low to mid-teens.

Real estate investments can be all equity or a combination of debt and equity. Both the debt and equity can also have multiple tiers such as preferred equity or mezzanine debt. This is what is referred to as the capital stack or cap-stack.

Investors should allocate investments that have the risk-adjusted returns that are consistent with the investment objectives and risk tolerance. In commercial real estate this can be accomplished by investing in different segments of the capital stack. Low risk tolerance investors can invest in secured loans backed by the underlying real estate and higher risk tolerance investor may prefer to invest in development or re-position opportunities.

One of the main advantages of investing in real estate debt, particularly first trust deeds, is that you are investing in the safest area of the capital stack. You get paid back before all other investors and are the most secured from losses because you have the senior claim against the property. In the event of default, you are the most secured investor against the property and therefore have a higher prospect of recovering your investment. Investing in first trust deeds puts you in the most secured and safest position in the capital stack, which is where you want to be in uncertain market conditions.   

A great way to access these types of investments is through private commercial real estate debt funds that specialize in making first trust deed loans. Focus on funds that provide attractive risk-adjusted returns and capital preservation. Additionally, look for funds where the managers have their own capital at risk and where their incentives are aligned with those of the investors.

Proper alignment of interests between manager and investors include: a manager who puts significant capital at risk alongside investors; having all loan points and fees go directly into the fund to be shared with all investors; and implementing performance-based fees.

The keys to a debt fund’s success lie in originating the right projects[1] in the markets where the lender has significant experience, knowledge and investments with experienced sponsors, applying stringent underwriting standards, being judicious when structuring the financing, and focusing on capital preservation.

A well-run debt fund will also have controls in place to minimize losses, even in cases of default or an economic downturn. First, conservative underwriting standards and a rigorous analysis process are critical in avoiding losses. Second, a fund that primarily finances first trust deed loans can more easily recover from default by foreclosing and maximizing the value of the property. Third, debt funds that have low LTV’s have a significant equity cushion[2] in case of downward pressure on valuations.

Debt funds that have in-house commercial real estate development and property management capabilities are even better shielded against loss from default or an economic downturn. When a loan goes into default, these funds can take over the property at a fraction of cost, manage the project, and gain an even greater upside[3] once the economy recovers.

In summary, we believe investment opportunities will be forthcoming throughout 2020 and into 2021 as federal stimulus tapers, eviction restrictions are lifted, and the impact of unemployment and higher vacancies begin to work through the system. This increased supply of opportunities will be highly sought after by the high amounts of investment capital sitting on the sidelines waiting for entry points. Diligence, caution, prudence and patience will be rewarded over the long term. 

[1] PERE. Nuveen on whether late-cycle debt investing is a good idea. Accessed 1/8/2020.

[2] Ibid.

[3] National Real Estate Advisors. Investing throughout the Capital Stack. Accessed 1/8/2020.

This article was originally published as part of Lido Consulting’s Fall 2020 newsletter.