Posted on 25 April 2022
Real Estate Debt Offers Secure Income Amid Rising Inflation and Interest Rates
Featuring Natalie Howard from Schroders Capital
The prospect of rising interest rates has been a hot topic for investors for some time. The recent acceleration in inflation to multi-decade highs across the US, Europe, and the UK has made this the central issue on the minds of investors around the world.
Markets have been braced for a series of interest rate rises since Fed Chair Jay Powell’s comments in January, and the Bank of England raised interest rates in their February meeting. In addition to raising rates, the US, UK, and Europe are all on a path to tapering their quantitative easing programmes, fundamentally shifting the environment away from the ultra-accommodative environment.
With fixed income having experienced the most challenging start to a year on record so far in 2022, the question of how investors can access truly “secure income” in the face of rising inflation and rates remains hard to solve.
Natalie Howard, Schroders Capital’s Head of Real Estate Debt, explains why she is sanguine about the prospects for real estate debt in this challenging backdrop.
Real estate debt and inflation
Rising inflation and rising rates present two separate, but related challenges for real estate. Howard says, real estate assets are well positioned on inflation, with the value of the underlying real estate acting as a natural hedge.
“Commercial real estate leases are strongly correlated with inflation over time. That is to say, rents generally increase as a direct consequence of higher inflation. The value of the asset, a function of the underlying cash flow of the asset, therefore increases with the higher inflation and rental income.”
Real estate debt and interest rates
The question then, is how the asset class can perform in a higher rate environment. One of the key aspects of real estate debt that can offer it resilience in these conditions, Howard points out, is its flexibility. Real estate debt financing can be either fixed rate of floating rate, with the latter providing the opportunity to protect investor returns from raising rates.
"Using a margin over EURIBOR in Europe, or Sonia in the UK, is attractive when compared with fixed income instruments that lack this flexibility.” Howard says.
Howard is also, however, quick to point out that this flexibility doesn’t mean borrowers’ costs will grow difficult to control. “Our borrowers can take out an interest rate cap in the event that they use a floating rate loan. This protects their position in the event of sustained interest rate rises.”
But what about the value of the underlying properties? For holders of any type of asset-backed debt, valuations and the way in which rate rises can affect them is a key concern. Howard agrees, and says the likely impact differs widely by sector.
“Real estate valuations have risen this cycle as debt costs have decreased. That said, there has been significant divergence over the past 10 years, with logistics assets reaching all time highs and more challenged sectors — such as retail — seeing significant falls. As debt costs rise, investors will need to understand the potential impact on the value of the underlying real estate across all sectors, and overlay that with the structural changes happening within each sector.”
Howard believes that the key is not to be distracted by a borrower’s circumstances when the sea is calm and the sky clear. “We use sustainable yields to underwrite our transactions — looking at long-term valuation metrics rather than today’s valuation. We therefore give ourselves a significant margin of safety so that if there are falls in the underlying value of the assets, our loans can continue to perform.”
Howard continues, “We spend a lot of time thinking about our exit position at the end of our loan. We need to understand the re-finance risk, which is when most loans default. We assume an increase in the cost of debt financing for the borrower in our underwriting. We make sure that transactions have de-levered through the life of the loan, either through amortisation, or through an increase in the value of the asset to make sure the re-finance position is attractive to lenders. We also make sure that if a borrower’s interest cover ratio (ICR) is quite tight, and rates do rise, then the borrower has further equity they can inject into the deal.”
“Finally, we always have a significant equity cushion in our transactions. We have conservative loan-to-value-ratios which means that our loans are always behind significant equity from experienced sponsors who we have often worked with before.”
Crucially, Howard carries a healthy scepticism in assessing a borrower’s prospects, even if they lack it themselves. “We also consider the business plan of the borrower very carefully. Many business plans have increasing rental values baked into their assumptions. We consider that with debt costs rising across the board, the underlying tenants will be facing rising costs, and we ensure that we are very conservative in any assumptions.”
Keep calm to carry on
Asked to summarise her thoughts, Howard says the key takeaway is to be sure to think things through calmly. While the floating rate aspect of real estate debt makes it very attractive for investors, rising debt costs will inevitably impact all assets, and investors need to know the implications.
“By underwriting conservatively and considering the exit position of assets in the event of rising rates, we’re able to structure transactions which provide investors with secure income without the interest rate risk of may fixed income alternatives.”
This article was originally published in the Sensus Magazine. Click the image to flip through our most recent issue or browse through our previous editions of the magazine.