Talking Heads - Se mettre à l'abri de la volatilité grâce à la dette immobilière

This is an edited transcript of the audio recording of this Talking heads podcast

Daniel Morris: Hello and welcome to the BNP Paribas Asset Management Talking heads podcast. Every week, Talking heads will bring you in-depth insights and analysis through the lens of sustainability on the topics that really matter to investors. In this episode, we’ll be discussing commercial real estate debt. I’m Daniel Morris, chief market strategist, and I’m joined by Christophe Montcerisier, head of real estate debt. Welcome, Christophe, and thanks for joining me.

Christophe Montcerisier: Hi, Daniel. Great to be here.

DM: We’re talking about two topics that are a bit worrying these days: Debt makes us think of interest rates and we know what direction they’re going in. We’re still struggling with stronger-than-expected inflation. That’s leading to expectations for policy rates from the central banks to rise. The question is what’s going to be the terminal rate for this hiking cycle? What’s going to happen to inflation and growth? As for real estate, we’re all quite aware of the consequences of the pandemic. A lot of people listening to this podcast are probably doing it from home and not going into offices, so, there have been significant structural changes in commercial real estate that have not yet played out. It is a challenging time to be a manager. Could you talk about some of those challenges and the headwinds you’ve faced over the last 12 months and more in particular how European real estate debt has fared?

CM: The past 12 months have been characterised by elevated market volatility, which has been driven by a combination of rising interest rates, high inflation and geopolitical uncertainty. I think the pandemic is over today and, yes, it has had an impact on the real estate market and the impact is still unfolding, but it’s limited. Commercial real estate debt, which we call CRE debt, continues to demonstrate resilience thanks to the fundamentals of the asset class. There are a number of ideas that I can lay out here. One, the essential nature of services provided by properties. Basically properties are a shelter, with homes or any type of lodging from student housing to clinics or retirement homes. That’s true for offices or logistical properties, for example. Two, the underlying features of CRE loans need to be underlined. They are based on floating rates, so they benefit from an increase in rates. The lease structure is such that the cash flows can be assessed because you have leases for a number of years. Three, there is low volatility of demand for space, of vacancy rates in most markets. And here I’m talking about residential, but also office space or logistical properties. Vacancy rates in most markets and geographies are low. Last but not least, the well-known characteristic of property as an inflation hedge as price increases are captured through the lease indexation mechanism. So, CRE debt is well positioned in an environment of uncertainties.

DM: You’ve just talked about how CRE debt has been resilient in an environment of rising rates and high inflation, which is certainly encouraging. What then are the opportunities that you see in this environment, which is going to continue to be challenging? And in particular, what is the scope for being innovative in the investment solutions?

CM:  It comes down to the investment objectives and goals that investors have, especially in terms of risk and return. Let me walk you through one example, which is the enhanced commercial real estate debt strategy, which to us looks as an interesting and timely strategy. Why? Well, just because the quantity of debt that is being offered against the value of a property has been reduced. So, 12 months ago, property was worth, say, 100. The debt set against this property by senior lenders to acquire it was, say, 50% of the 100. Twelve months before that, it was probably in the region of 60. It  has decreased by 10 points. This  tranche between 50 and 60 is called subordinated debt. It’s interesting because lenders can increase the leverage that is being offered to borrowers and take it to the 60 or 65% that was offered by senior lenders previously and that they don’t offer any longer. There is an opportunity from this first point. The second interesting point is that the value of real estate is being reset. When deploying the strategy today, you lend against a property value that has been reduced. If it was 100 twelve months ago, it will be 90 or 85 today. You are going to apply the 65 percent to the new value. In  a nutshell, the debt per square metre you are going to offer against the property is going to fall. This is great because at the same time for this tranche, you are going to get a return which is between a 7 and 9% gross internal rate of return. This is close to what many equity investors are looking for when they invest in equity. Lenders are benefiting from an equity cushion protecting them because they only lend 65% in my example of the value of the property, instead of being the owner of 100% of the property. To summarise, we have a number of factors that have been and are still in play to offer great opportunities. One is the repricing of properties. Two, a lower proportion of debt offered against the value of a property. Three, higher coupons thanks to debt spread adjustments, but also the rise in base rates. And last, a very active refinancing market currently. We can build out of this context innovative solutions and offer them to investors.

DM: What are your views on the market over the next 12 to 24 months?

CM:  The outlook for CRE debt is positive in the near future. I would highlight at least three points. The first one is that real estate is a hedge against inflation. So, if you lend against such an asset class, it means that your collateral – the properties and its cash flows – benefit from this trend. The second point is that private markets for commercial real estate debt are much deeper and diverse than public markets. You have only a limited number of listed property companies which issue bonds. Private CRE debt that does offer more diversity and return expectations for similar ratings is attractive for this strategy. Third, the premium which is offered on CRE debt as compared to, for example, government bonds, remains significant – in excess of 200 basis points, for example.

DM: A final question: can you align your strategic priorities with ESG considerations?

CM:  Yes, even if there is a natural divergence in the goals of the investor and broader ESG and social impact objectives caused by the desire for higher returns. Now more than ever, investors are seeing beyond returns. Fundamentally, they are financing projects that benefit the environment and/or the local community. In the current market, as investors, we can be caught up thinking exclusively about preserving capital and seeking stable income. But there are many risks to society as a whole that need to be addressed. When investing, we use quantitative objectives in terms of ESG that we can describe more precisely to interested investors.

DM: Christophe, thank you very much for joining me.

CM: Thank you, Daniel.