This is part three of a four-part series. Read part one, part two or part four.
Considerations when investing in real estate debt
In the current economic environment, there are a number of factors that investors need to contemplate when considering real estate debt opportunities. In part three of our series, Is private debt ready for recession? Senior Portfolio Manager, David Saija and Portfolio Manager, Lucie Bielczykova discuss the impact of rising inflation on real estate debt and where the pressures are to be seen for investors.
The spectrum of lending opportunities to real estate is quite wide, ranging from low Loan to Value Ratio (LVR) lending to stabilised commercial properties with strong tenants and long leases at one end of the spectrum, right through to large-scale residential development loans, which are typically highly leveraged, have no underlying cash flows to service the debt with lending based on an assumed future value of the property.
Similar to leveraged loans, Revolution focuses its real estate attention on the more conservative end of the spectrum. Any loan Revolution will advance needs to demonstrate that it can be serviced via cash flows generated by the property, with the asset value (in terms of being able to sell the asset to recover any outstanding debt) being secondary in nature. As such, Revolution favours lending to well established retail, industrial and office assets, with high quality tenants on long leases that generate a recurring cash flow and income stream to the asset owner.
Revolution is also quite conservative with leverage in its real estate debt transactions, with typical LVR of around 60-70% which provides a significant equity buffer and safeguards against the value of the property falling below the loan amount. There are also covenants which impose restrictions on borrowers such as a maximum LVR (which is typically subject to an annual external valuation to ensure compliance) or minimum interest cover ratios (or ICR), which must be complied with by the borrower, and may trigger a breach of the covenant and an event of default, enabling the lender to demand full repayment of the loan.
Similar to corporate borrowers, rising interest rates and inflation result in the cost of debt increasing for real estate borrowers. Further, a recessionary environment can weigh on the underlying tenants and their ability to pay their leases, while at the same time it has the potential to trigger a decline in property valuation which lenders take security over.
As such, strong tenants are also key in the equation. Revolution pays significant attention to, and conducts in depth credit analysis on, the underlying tenants to ensure serviceability throughout the cycle. Using a retail asset as an example, Revolution favours assets that rely on nondiscretionary spending with large, grocery-based anchor tenants such as Coles or Woolworths, with long leases in place that not only tend to generate a stable cash flow, but also draw foot traffic to the centre.
Where is pressure being seen or likely to be seen?
The impacts of the current economic environment are unmistakable in the real estate sector, with various high profile developers facing significant pressure and demand for residential development projects also declining due to reduced borrowing capacity and lower consumer confidence.
In Revolution’s view, areas that have or are likely to experience pressure are:
In challenging economic times, Revolution believes the winners will be those who maintain their discipline and focus on the underlying property fundamentals with conservative lending against quality properties, in good locations, with strong tenants that generate strong, recurring cash flows.
As a result of its strict lending criteria, Revolution currently has very limited direct real estate debt exposure in the portfolio, as senior secured lending to established commercial real estate has been dominated by banks to date.
Rising interest rates and inflation are set to increase the cost of debt servicing for real estate borrowers, while a recessionary environment may also drive a decline in property valuations (lenders security) and weigh on the underlying tenants’ ability to pay their leases (key source of cash flow for the property). As such, certain areas of the market could come under pressure and strong credit discipline will prove vital in the period ahead.
Is private debt ready for recession? – a four part series
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