Interest rates are on the rise, the dollar is strengthening, trade wars are looming and we’re beginning to see more volatility across markets. Furthermore, institutional investors are changing their risk profiles and adjusting dramatically toward debt investments. As part of this adjustment, investors are now sending money into private debt as a means to protect themselves from an anticipated market correction while still earning stable returns. According to Preqin, private debt funds raised a record $107 billion last year.
With such volume of cash hurling into private debt, it can be difficult to identify value. One private debt sector that may be attractive to institutional investors is commercial real estate (CRE), which offers the potential for both diversification and an attractive risk-return profile at this late stage of a nearly decade-long bull run.
Many signs are beginning to point to a top in the market, and investors are starting to look for cover. Since 2015 the Fed has been lifting its key policy rate from historic lows, elevating interest rates and bringing a period of loose monetary policy and easy credit to an end. Though increasing, bond yields remain lower, and many returns on higher-rated debt securities remain generally modest.
Institutions looking to send money in CRE can typically decide between equity and debt vehicles, each of which comes with its advantages and disadvantages based on where the market is in the cycle. Early in the cycle, as CRE property values rise, allocating more toward equity instruments makes sense. Here, investors can buy a property outright or purchase stock in firms that specialize in CRE. They can also invest in mutual funds or exchange-traded funds that provide equity exposure to CRE.
With prices peaking, CRE debt vehicles can offer a more secure option, and an attractive middle ground between volatile stocks and zero-interest savings accounts, efficiently balancing risk and returns while providing consistent cash flow to a portfolio. Many CRE debt instruments offer the added benefit of short-term duration, allowing institutions to “roll up” the yield curve as rates rise.
Industry participants predict multifamily and industrial assets will hold the most appeal through 2018, according to a survey my firm conducted at a recent Mortgage Bankers Association convention. Lesser-known yet promising assets include student housing, senior housing, health care offices, medical facilities, laboratories, data centers, and even cold storage. Geographically, institutional investors can get exposure to opportunities that prioritize noncore, second-tier cities, particularly those away from the coasts, such as Dallas, Texas; Nashville, Tennessee; and Charlotte, North Carolina, which offer exceptional opportunities for growth.
Each of these factors suggests that the CRE market can weather the coming volatility, and that fixed-income investment vehicles with CRE exposure will continue to be a source of stable returns and risk mitigation for institutional investors.
