MetLife Invest… - Thu, 08/31/2023 - 12:55

Real Estate Debt: Highest Yields in Decades

Guy Haselmann, Head of Thought Leadership at MetLife Investment Management (MIM), recently sat down with William Pattison, Head of Real Estate Research & Strategy at MIM to discuss opportunities within the real estate sector, including why he believes strong opportunities currently exist with high-yield commercial mortgage investments.

Guy: It seems to me that Commercial Real Estate has received a great deal of negative press in 2023 and yet you believe that opportunities currently exist. Could you help bring clarity to that disconnect?

Will: I don’t think investors are accounting for the positive effects that the high inflation of the last 3 years will have on real estate returns later this decade. Inflation was low from the mid-1980s until 2021, causing construction cost growth to remain low, and therefore causing new supply to keep up with demand. Due to the relationship between construction costs and real estate supply, the market rent that real estate investors could command also grew at about the rate of inflation, or about 3%. In my view, that 3% rent growth assumption has become so engrained in the real estate underwriting and valuation industries that no one is questioning if it should be higher, given we are coming off a 6% or 7% inflationary environment. It’s unfortunate there is virtually no one still working today who was underwriting real estate in the 1970s as I don’t think the 3% rent growth assumption was always treated with such reverence.

Guy: How do you square the positive relationship with real estate returns and high inflation with what has happened to the sector over the last year?

Will: Real estate prices have been declining since mid2022 because of the higher interest rate environment. Outside of the office sector, these declines have been essentially only driven by the higher interest rate environment as occupancy rates and property income growth has remained strong.

Within the office sector, remote work is causing occupancy and property incomes to fall, and office sectors values are also declining due to the same higher interest rate effect. Today, it’s probably best to categorize office as one sector, and the dozen other commercial real estate property types as another sector, although they are sometimes all being lumped together by investors and regulators.

Guy: To monetize such opportunities, don’t you need a long investment horizon to let the imbalances work themselves out?

Will: The transactional costs of private commercial real estate have always made it a longer-term investment sector than public markets - with most core buyers targeting at least 5 years hold periods. I don’t think a longer-than-normal investment horizon is needed today, as higher construction costs are already causing a pullback in new construction that may be realized in rent and occupancy levels within the next 5 years. Within the industrial property type, for instance, tracking of new projects suggest that completed construction in the U.S. should total about 560 million square feet in 2023, followed by 300 million in 2024, and only 190 million in 2025.1 I think there could be an argument to wait on making new investments until the construction pipeline is further along the path of decline, but I don’t think investors need longer holding periods to realize the benefits.

Guy: Has the pullback from regional banks caused any market dislocations?

Will: Many traditional lenders, including regional banks, have pulled back from the commercial real estate sector. For banks this has been partially driven by regulators, which I believe is contributing to growing levels of forced selling at discounts to net asset value. For other investor types, concerns over potential losses from existing office mortgage investments has made them halt new investments on all commercial real estate property types. MIM has been active in the debt space this year, and with an emphasis on higher yielding debt. In my view, buying money-good assets from banks or identifying and quickly acting to fill gaps in the capital market structures is one of the best areas of focus in today’s market.

Guy: Outsized returns could certainly result from capitalizing on distressed sellers unloading assets at uneconomic prices. But let’s discuss yields. What generally are commercial mortgage yields today; and to gain some perspective, could you compare them to before the pandemic?

Will: Before the pandemic target yields on senior mortgages were generally 3.5% or 4.0% with targets on subordinated real estate debt commonly around 6%. With the current rate-tightening cycle, yield targets on senior mortgages are now in the 6% to 8% range and forms of subordinated real estate debt are closer to 12%.2 Of equal or more importance is the spread commercial mortgages are offering to sectors like corporate bonds, and we think that looks favorable from this perspective as well.

Guy: The range you mentioned, 6% to 12% is quite wide, is that the result of the type of structures?

Will: I don’t think so as I believe structures have generally stayed the same or become more favorable for the lender. One metric that we consider is the spread between senior mortgages and subordinate mortgages, which rose from 200 or 300 basis points pre-pandemic to around 400 basis points3 today. It’s not possible to give a full account as to why this has happened, but I suspect the pullback from traditional lender types has played a role. Although these higher risk loans should always be expected to have higher losses than senior mortgages, we think investors are being paid for the risk.

Guy: What constitutes an acceptable level of risk and how it is determined?

Will: That’s a good question. There are many people within MIM who are more focused on modern portfolio theory across a multi-asset portfolio than I am but what my team can provide to a CIO or portfolio manager is bond-equivalent rating estimates. MIM has been one of the leaders in estimating bond-equivalent ratings for commercial real estate debt, including supporting the development of many of the research reports and modeling tools that rating agencies and third-party rating model providers use. MIM also has the longest known historical commercial mortgage performance dataset which, in my opinion, can be helpful when estimating and pricing risk in the commercial real estate debt space.

Guy: What are the most important factors when estimating the risk of a commercial debt investment?

Will: MIM and Moody’s co-authored a research report on that topic about a year ago, although I’m not sure it was very well read as we gave it the somewhat bland name of “Commercial Mortgage Lending”. In the report we summarized and evaluated the efficacy of some of the most common metrics and ratios that investors typically use to assess commercial real estate debt risk, using MIM’s full commercial mortgage performance history dataset as well as the CMBS history available in more recent decades. We found that measures like the loan-to-value ratio are sometimes more and sometimes less useful at different points in the real estate cycle, and developed opinions on what market signals to look for to determine when different indicators should be relied on when making new investments. We also found that the commonly cited “debt yield” ratio could potentially be improved by considering it in relation to property cap rates, which has become an especially relevant point over the last year as cap rates have been rising. Those nuances aside, the core of our bondequivalent rating process is based on our more than half century of performance history, with loan level datasets showing factors like the underwritten loan-tovalue ratio and then how the loan ultimately performed. MIM, and my personal career, owe a debt of gratitude to whoever the MetLife employees were in the 1950s and 60s that decided to start the archive.

Read more from MetLife Investment Management

1 MetLife Investment Management, CoStar
2 MetLife Investment Management
3 MetLife Investment Management

This material is intended solely for Institutional Investors, Qualified Investors and Professional Investors. This analysis is not intended for distribution with Retail Investors.
This document has been prepared by MetLife Investment Management (“MIM”)1 solely for informational purposes and does not constitute a recommendation regarding any investments or the provision of any investment advice, or constitute or form part of any advertisement of, offer for sale or subscription of, solicitation or invitation of any offer or recommendation to purchase or subscribe for any securities or investment advisory services. The views expressed herein are solely those of MIM and do not necessarily reflect, nor are they necessarily consistent with, the views held by, or the forecasts utilized by, the entities within the MetLife enterprise that provide insurance products, annuities and employee benefit programs. The information and opinions presented or contained in this document are provided as of the date it was written. It should be understood that subsequent developments may materially affect the information contained in this document, which none of MIM, its affiliates, advisors or representatives are under an obligation to update, revise or affirm. It is not MIM’s intention to provide, and you may not rely on this document as providing, a recommendation with respect to any particular investment strategy or investment.
Affiliates of MIM may perform services for, solicit business from, hold long or short positions in, or otherwise be interested in the investments (including derivatives) of any company mentioned herein. This document may contain forward-looking statements, as well as predictions, projections and forecasts of the economy or economic trends of the markets, which are not necessarily indicative of the future. Any or all forward-looking statements, as well as those included in any other material discussed at the presentation, may turn out to be wrong.
All investments involve risks including the potential for loss of principle and past performance does not guarantee similar future results. Property is a specialist sector that may be less liquid and produce more volatile performance than an investment in other investment sectors. The value of capital and income will fluctuate as property values and rental income rise and fall. The valuation of property is generally a matter of the valuers’ opinion rather than fact. The amount raised when a property is sold may be less than the valuation. Furthermore, certain investments in mortgages, real estate or non-publicly traded securities and private debt instruments have a limited number of potential purchasers and sellers. This factor may have the effect of limiting the availability of these investments for purchase and may also limit the ability to sell such investments at their fair market value in response to changes in the economy or the financial markets.
In the U.S. this document is communicated by MetLife Investment Management, LLC (MIM, LLC), a U.S. Securities Exchange Commission registered investment adviser. MIM, LLC is a subsidiary of MetLife, Inc. and part of MetLife Investment Management. Registration with the SEC does not imply a certain level of skill or that the SEC has endorsed the investment advisor.
This document is being distributed by MetLife Investment Management Limited (“MIML”), authorised and regulated by the UK Financial Conduct Authority (FCA reference number 623761), registered address 1 Angel Lane, 8th Floor, London, EC4R 3AB, United Kingdom. This document is approved by MIML as a financial promotion for distribution in the UK. This document is only intended for, and may only be distributed to, investors in the UK and EEA who qualify as a “professional client” as defined under the Markets in Financial Instruments Directive (2014/65/EU), as implemented in the relevant EEA jurisdiction, and the retained EU law version of the same in the UK.
For investors in the Middle East: This document is directed at and intended for institutional investors (as such term is defined in the various jurisdictions) only. The recipient of this document acknowledges that (1) no regulator or governmental authority in the Gulf Cooperation Council (“GCC”) or the Middle East has reviewed or approved this document or the substance contained within it, (2) this document is not for general circulation in the GCC or the Middle East and is provided on a confidential basis to the addressee only, (3) MetLife Investment Management is not licensed or regulated by any regulatory or governmental authority in the Middle East or the GCC, and (4) this document does not constitute or form part of any investment advice or solicitation of investment products in the GCC or Middle East or in any jurisdiction in which the provision of investment advice or any solicitation would be unlawful under the securities laws of such jurisdiction (and this document is therefore not construed as such).
For investors in Japan: This document is being distributed by MetLife Asset Management Corp. (Japan) (“MAM”), 1-3 Kioicho, Chiyoda-ku, Tokyo 102-0094, Tokyo Garden Terrace KioiCho Kioi Tower 25F, a registered Financial Instruments Business Operator (“FIBO”) under the registration entry Director General of the Kanto Local Finance Bureau (FIBO) No. 2414.
For Investors in Hong Kong S.A.R.: This document is being issued by MetLife Investments Asia Limited (“MIAL”), a part of MIM, and it has not been reviewed by the Securities and Futures Commission of Hong Kong (“SFC”). MIAL is licensed by the Securities and Futures Commission for Type 1 (dealing in securities), Type 4 (advising on securities) and Type 9 (asset management) regulated activities. For investors in Australia: This information is distributed by MIM LLC and is intended for “wholesale clients” as defined in section 761G of the Corporations Act 2001 (Cth) (the Act). MIM LLC exempt from the requirement to hold an Australian financial services license under the Act in respect of the financial services it provides to Australian clients. MIM LLC is regulated by the SEC under US law, which is different from Australian law.
MIMEL: For investors in the EEA, this document is being distributed by MetLife Investment Management Europe Limited (“MIMEL”), authorised and regulated by the Central Bank of Ireland (registered number: C451684), registered address 20 on Hatch, Lower Hatch Street, Dublin 2, Ireland. This document is approved by MIMEL as marketing communications for the purposes of the EU Directive 2014/65/EU on markets in financial instruments (“MiFID II”). Where MIMEL does not have an applicable cross-border licence, this document is only intended for, and may only be distributed on request to, investors in the EEA who qualify as a “professional client” as defined under MiFID II, as implemented in the relevant EEA jurisdiction. The investment strategies described herein are directly managed by delegate investment manager affiliates of MIMEL. Unless otherwise stated, none of the authors of this article, interviewees or referenced individuals are directly contracted with MIMEL or are regulated in Ireland. Unless otherwise stated, any industry awards referenced herein relate to the awards of affiliates of MIMEL and not to awards of MIMEL.
1 MetLife Investment Management (“MIM”) is MetLife, Inc.’s institutional management business and the marketing name for subsidiaries of MetLife that provide investment management services to MetLife’s general account, separate accounts and/or unaffiliated/ third party investors, including: Metropolitan Life Insurance Company, MetLife Investment Management, LLC, MetLife Investment Management Limited, MetLife Investments Limited, MetLife Investments Asia Limited, MetLife Latin America Asesorias e Inversiones Limitada, MetLife Asset Management Corp. (Japan), and MIM I LLC, MetLife Investment Management Europe Limited, Affirmative Investment Management Partners Limited and Raven Capital Management LLC.


Sign Up Now for Full Access to Articles and Podcasts!

Unlock full access to our vast content library by registering as an institutional investor .

Create an account

Already have an account ? Sign in