In today’s complex market, real estate investments continue to provide opportunities for institutional investors due to the simplicity of the risk spectrum, particularly when comparing equity and debt, said Marc Weidner, managing director and head of global real estate at Franklin Templeton, during the Canadian Investment Review‘s 2023 Investment Innovation Conference in November.
“We think the case is pretty clear how the risk-return profile of the debt space outperforms here and now. But what is available on the equity side?”
In the next three to five years, the total amount of debts maturing in commercial real estate is $1.6 trillion. Half (50 per cent) of those loans are provided by banks and the overall volume of outstanding real estate is $5.7 trillion as of the first quarter of 2023. “It didn’t change that much recently because not much happened actually in terms of expansion this year, but it is roughly 50 per cent more than during the global financial crisis. Therefore, the credit market opportunity in real estate is significantly bigger today than in prior downcycles.”
Weidner noted there’s a wave of expiring loans on the horizon that will have a potential impact on lending. “Many loans have an initial maturity of three to five years, so if you bought something between 2019 and 2022, you may be entering into a difficult zone. Valuations have changed and it’s not certain that you’re going to be able to face the maturity of your loan and have enough equity in the asset to extend. So, the existing lender or the new lender will actually provide you with a new loan under a completely different set of terms.”
Banks are lending significantly less today, which has increased demand for loans from alternative lenders. “It’s very clear that there is not a large enough supply of loans today, which suggests that lenders can anticipate more favourable terms, better covenants and spreads and lower loan-to-value ratios.”
Read: Office real estate investments, valuations declined in 2022: report
Weidner said that residential real estate, particularly multi-family units, will likely continue to be a strong sector. Backed by strong demand and solid property fundaments, he isn’t concerned that the exact cap rate for these assets is difficult to assess. “Cap rate uncertainties are a big problem if you need to do equity. It’s less of a problem if you do debt.”
There’s a strong prospect for increased demand for housing, particularly for rental housing, driven by strong household formation, accelerating demographic trends and an increased propensity to renting versus owning a home in the U.S.
“Many people in the U.S. are locked into 30-year mortgages, so they’re not moving anytime soon. That means there will be a limited supply of residential housing units at a time where demand is still strong, especially for rental properties. The way we would look at a senior loan today is to typically lend at up to 65 per cent of today’s value, which is roughly 25 per cent to 30 per cent below the last peak. Typically, we would become concerned if we saw more than a 60 per cent peak-to-trough decline in value.”
Read: Uptick in U.S. commercial office real estate defaults concerning but risk in Canada low: expert
In terms of commercial office, roughly a third of leases are expiring over the next three years and the sector is adjusting amid a discussion of how much Canadian office space is needed moving forward. In the meantime, creative financing strategies will emerge because borrowers won’t be able to afford the new rates, said Weidner, adding challenges with securing refinancing will lead to a lot of secondary and distress sales.
“The next three years are going to be volatile for the office market as we are looking for a new equilibrium both in terms of rents and values. A lot of money is going to be made or lost on office space until we find those new price points.”
Read more coverage of the 2023 Investment Innovation Conference.