As asset values become more volatile and the real estate cycle matures, investors need to re-evaluate their portfolios in order to create and protect wealth. For those investing in commercial real estate, there is an investment vehicle that can help do just that. An allocation to floating-rate commercial real estate transitional loans can enhance a commercial real estate portfolio by dampening its sensitivity to interest rates and credit spreads, while bolstering its income potential.

Investors can allocate to transitional loans through investment vehicles such as publicly traded commercial mortgage REITs or institutional private funds. We estimate the size of the market to be greater than $135 billion, which is roughly 3 percent of the $4 trillion commercial real estate debt market. The transitional loan market has been a component of the alternative investment landscape for some time, but has only recently seen significant growth as lenders have become more sophisticated in analyzing risk through a property’s life cycle.

UNDERSTANDING CRE DEBT

Commercial real estate is an $8 trillion industry that contributes roughly 2 percent of U.S. gross domestic product. Well-established commercial real estate debt and equity capital markets exist in both public and private formats. Real estate equity offers income and capital appreciation when property values rise, but experiences capital depreciation when they fall. Real estate debt offers higher yields and is partially insulated from changes in property values, which tend to coincide with property cycles and economic cycles.

Commercial real estate debt is generally grouped into two risk categories: stabilized property loans and transitional property loans. Stabilized properties typically have physical conditions and occupancy rates that are consistent with the local market standards and are expected to generate consistent rental income for years into the future. Transitional properties typically have vacancies and need capital investment before they can be leased to generate consistent rental income as stabilized properties. Since all buildings age, most stabilized properties will at some point become transitional properties. Transitional properties comprise a broad spectrum from an office building in San Francisco that is updating its elevators and lobby, to an abandoned factory outside of New York City that is being converted into a self-storage facility.

WHAT ARE TRANSITIONAL LOANS

Transitional property loans are usually secured by non-cash flowing properties that are undergoing renovations. These loans have floating interest rates of LIBOR plus 3.0 percent to LIBOR plus 9.0 percent and shorter-term maturities of 12 to 36 months. They are underwritten based on the potential for future leases at current market rents and offer borrowers more flexibility to sell the properties or to refinance the properties with more attractive fixed-rate, longer-term stabilized property loans, after renovations are complete. This flexibility is very important in value-add/renovation property economics.

SENSITIVITY TO INTEREST RATES

Interest rates are a factor in commercial real estate property values and rising rates can make real estate income less valuable on a risk-adjusted basis. However, transitional loans are floating-rate instruments that pay higher coupons when rates rise, thereby preserving an investor’s value in an environment of rising rates. For this reason, an allocation to transitional loans may be a highly effective approach to managing interest rate risk. By way of background, U.S. commercial mortgage REITs returned 10.1 percent in 2018, while U.S. equity REITs lost 4.5 percent. During this time, the U.S. fed funds rate climbed 110 basis points to 2.4 percent.

CREDIT AND KEY RISKS

From a credit underwriting perspective, the real estate that is securing most transitional loans is located in well-established, liquid markets. These markets are typically characterized by strong job growth, modest new construction and current market rents that can be readily used to underwrite the potential renovation value of a transitional property. Typically, transitional lenders finance 60 percent to 70 percent of a building’s cost, which turns out to be 50 percent to 60 percent of its future value after factoring in a 15 percent to 25 percent value-add/renovation margin. The borrower/equity sponsor also typically funds the initial 30 percent to 40 percent of a building’s cost before drawdown on the transitional loan becomes available.

Of course, transitional loans have unique risks that are not easy to underwrite, such as execution and timing. Delays in renovation, construction or leasing can result in slower loan repayment. For this reason, transitional lenders carefully vet the borrower’s/equity sponsor’s plans and execution, and seek repeat business from proven relationships. Transitioning a property can take months or years, during which time market conditions could deteriorate. Transitional lenders mitigate this risk by building in equity cushions for some deterioration in property values. They also mitigate overall repayment risk by employing protective covenants and by requiring borrower/equity sponsor guarantees.  Unlike the corporate lending market, covenants have generally remained intact in the commercial real estate transitional loan market.

ACCESSING TRANSITIONAL LOAN INVESTMENTS

Investors can allocate to transitional loans through investment vehicles such as publicly traded commercial mortgage REITs or institutional private funds. Publicly traded commercial mortgage REITs represent a straightforward access point for investing in transitional loans and can provide diversification across different transitional loan strategies. Publicly traded commercial mortgage REITs also have ready access to capital, which provides lower financing costs and an easier path to scale. However, these securities have short-term correlation to interest rates and the broader equity market, which increases their volatility. Investors can also gain exposure to transitional loans through institutional private funds, which are less volatile than commercial mortgage REITs, but may have comparatively higher financing costs. These funds have been a regular component of the alternative investment landscape, but gained significant popularity and growth over the past two years. In most circumstances, retail investors cannot access these funds directly due to high investment minimums and suitability requirements.

Gene Nusinzon is vice president of Resource Real Estate.