With investment returns across geographies and strategies narrowing, investors should consider a barbell strategy pairing two distinctively different risk-and-reward buckets, reported Principal in its annual strategy outlook for 2020 report.
On the core, low-risk spectrum, high-yield real estate debt and private real estate with strong credit and lease durations attached should be favored. On the high-risk, opportunistic spectrum is shovel-ready development projects given strong margins.
Principal said it favors debt over equity due to the global economy. With the Fed joining the ECB’s easing stance and lowering benchmark interest rates, debt investment returns are likely to come under pressure in 2020, especially if lenders start to compress margins in order to remain competitive. Structurally, however, real estate debt is well positioned to offer investors (a) the ability to provide capital for both de-gearing and re-leveraging strategies and (b) a subordinated equity cushion if real estate values fall.
Real estate debt opportunities will offer investors lower returns in 2020, relative to 2019. Within the senior debt or core mortgage bucket, long-term liability lenders (such as insurance companies) will still find relative value compared to sovereign bonds but will struggle from an absolute level of return.
There will be better relative and absolute value in higher-yielding real estate debt instruments, particularly in the United States, where the mortgage credit curve is steeper, past the loan-to-value (LTV) levels of 40 percent to 55 percent. Investors in U.S. high-yield real estate debt can hope to achieve total returns in the 6 percent to 8 percent range, which makes it very competitive to core equity real estate. In Europe, the absolute levels of high-yield real estate debt yields are lower given the much lower level of interest rates. The European mortgage credit curve is similar to the U.S., thereby offering investors a greater potential return above 65 percent LTV levels.
Subordinate debt will offer attractive yield relative to corporate bonds as well as yield to maturity that is attractive relative to unlevered, private real estate equity, especially on a risk-adjusted basis. Furthermore, subordinate debt investment strategies offer attractive flexibility in the current environment, and during a potential late cycle, as investors can move up the credit curve in response to weakening economic conditions and/or wider credit spreads.
