Ares Commercial Real Estate : The Growing Investment Opportunity for Commercial Real Estate Debt

The Growing Investment Opportunity for Commercial Real Estate Debt

Introduction

The commercial real estate ("CRE") debt market today is experiencing a confluence of market dynamics that we believe have created attractive near-term investment opportunities. The market environment is characterized by a decreasing availability of debt financing, resetting property valuations, and rising interest rates, which we believe could collectively result in favorable risk-adjusted return opportunities.

In this thought piece, we explore how directly originated CRE debt in the U.S., U.K. and Europe present a compelling investment opportunity in the current environment, with a focus on the following drivers:

Increased base rates

Widening credit spreads

which are expected to remain high for an extended period

resulting from the retrenchment of traditional lenders

Increased equity subordination

A growing funding gap

due to lower loan-to-value ("LTV")i detachment points

driven by structural shifts in the banking industry.

With market volatility expected to persist for the foreseeable future, directly originated CRE debt with healthy equity subordination and floating-rate structures, can provide investors with lower volatility and steady returns primarily through high levels of current income.

Attractive Portfolio Attributes of Directly Originated CRE Debtii

High current income

Diversificationiii

Shorter duration, floating-rate exposure

Complement or substitute to Investment Grade Fixed Income and Core Real Estate Equity

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Higher for Longer Base Rates	1

To tame inflation, central banks have aggressively raised benchmark interest rates since March 2022. As a result, the 1-month term SOFR, which is the predominant index rate used to calculate the coupon on USD floating-rate loans in the U.S., increased from near zero in January 2022 to over 4.6% by March 31, 2023. GBP and EUR rates followed suit with increases of 4.1% and 2.7%, respectively, over the same period. This material increase in benchmark rates has benefited floating-rate CRE debt by increasing coupons, and consequently, absolute returns.

Understandably, increased coupons in excess of property cash flows reduce debt service coverage ratios ("DSCR"), which may impact the borrower's ability to pay interest. To mitigate this risk, a loan's structure generally includes interest rate protection, which is paid for by the borrower that effectively creates a minimum DSCR. We believe that this interest rate protection and enhanced principal protections, discussed below, allow lenders to benefit from rising rates while mitigating potential risk to property cash flows.

Historical Base Rate

6.00%
5.00%
4.00%
3.00%
2.00%
1.00%
0.00%
-1.00%

3M EURIBOR		3M Compounded SONIA		1M Term SOFR

Source: Validus-Horizon as of April 2023

Although it is understood that the direction of interest rates can change quickly and materially, looking ahead based on the forward curveiv, base rates are forecasted to remain elevated in the near-term. As a result, forecasts indicate base rates will continue to provide a "tailwind" to commercial mortgage lending returns for the foreseeable future. Furthermore, with the ability to negotiate base rate

"floors" that are set at or near the current base rate, lenders have the opportunity to structure CRE loans with effectively high minimum coupons. This would allow lenders to continue to benefit from the currently high base rate environment on new originations, even if base rates were to decrease.

Forward Base Rate Curves

6.00%

5.00%

4.00%

3.00%

2.00%

1.00%

0.00%

EURIBOR 3M		GBP 3M LIBOR		SOFR

Source: Validus-Horizon as of April 2023

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Widening Credit Spreads	2

In addition to increasing base rates, we have observed a widening in credit spreads as traditional lenders, such as banks, face pressure on their balance sheets. Stricter capital and liquidity requirements for banks, has created a funding gap in the market. This trend is likely to be further exacerbated by recent volatility in the banking sector, evidenced by the collapse of Silicon Valley Bank and Signature Bank in the U.S., as well as the emergency acquisition of Credit Suisse by UBS in Europe. To mitigate concerns around contagion, additional government regulations are anticipated, which will likely impose further strain on bank balance sheets. Given the dominant role the banking industry plays in the real estate finance market (particularly in Europe), any retrenchment of bank lenders is likely to lead to a decline in credit availability for CRE, which may result in an attractive investment environment for CRE lenders. We expect this dynamic to continue to unfold over the next 24-36 months.

Furthermore, given the short duration nature of CRE debt, we expect continued demand for financing as these loans reach maturity. In the U.S., it is estimated that ~$450 to $500 billion of CRE debt will mature annually from 2023 to 2026v. While in the U.K. and Europe, it is estimated that over €390 billion of real estate loans are due to mature in 2023 alonevi. This demand for financing, at a time of lower supply, is enabling CRE lenders to negotiate for higher credit spreads across all risk profiles when originating loans.

As reflected in the figure below, using light transitional first lien mortgage loans in the U.S. as an example, we have already seen credit spreads widen by 75 to 100 bps over the past year. When combined with the current 1-month term SOFR rate of 4.80%, the unlevered return on equity has increased by approximately 550 bps when compared to similar loans originated in 1Q 2022. Lenders in the U.K. and Europe are benefiting from similarly enhanced economics on new originations.

Enhanced Economics Resulting From Rising Rates and Widening Spreads

10.00%

7.50%

5.00%

2.50%

0.00%

Total: 8.86%

					0.33%
					3.75%
				+550 bps
		Total: 3.38%		unlevered ROE
0.33%
					4.80%
3.00%
0.05%
		Q1 2022				Q1 2023
		Base Rate		Credit Spread		Amortized Origination Fee

For illustrative purposes only. As of March 31, 2023. Based on Ares Real Estate's current market observations. As such, our views are subject to change at any time. January 2022 utilized 1-month LIBOR. Current Market utilizes 1-month term SOFR. Key assumptions include: 1.00% origination fee amortized over 3-year term.

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Enhanced Principal Protectionvii

3

In addition to more attractive economics on newly originated loans today, CRE lenders can originate loans at a more secure position in the capital structure on higher quality collateral with values that are resetting to align with the current market.

Market value weighted capitalization rates ("Cap Rates") for the NCREIF Property Index, which represents 10,770 investment grade, income-producing properties with a market value of $933 billion, increased to 4.0% in 4Q 2022 compared to 3.8% in 3Q 2022. As a result of rising cap rates, we have started to see valuations of commercial property adjust downward, as reflected in the U.S. by a negative appreciation return of (4.5%) for the NCREIF Property Index in 4Q 2022. We expect this re-adjustment in valuation to continue throughout 2023.

As the funding gap grows amidst a retrenchment of traditional lenders, CRE lenders have an opportunity to negotiate better terms, which include offering lower proceeds such that their entry LTV is lower compared to similar loans originated in 1Q 2022. For collateral values that have not yet reset, the LTV ratio creates an equity buffer that can help mitigate potential downside risk. This is an important feature of CRE debt which allows it to deliver expected returns, even if capital values are falling. For example, at an LTV of 70%, a CRE debt position is unlikely to experience any losses until the underlying property loses 30% of its value. Today, lenders have the opportunity to originate loans at lower LTVs on collateral whose value has reset, resulting in an attractive detachment point compared to valuation in 1Q 2022. By providing stable capital returns and downside protection, CRE debt can generate attractive risk-adjusted returns during times of economic volatility, such as today.viii

Lower LTV Provides Additional Principal Protection

100%

80%

60%

40%

20%

0%

$100

$90

Ability to negotiate 5-10% lower LTV on reset values

70%		54% LTV of
	60%
	Jan 22 value

Jan-22		Current Market
		First Lien Position		Sponsor Equity

For illustrative purposes only. As of March 31, 2023. Based on Ares Real Estate's current market observations. As such, our views are subject to change at any time. January 2022 utilized 1-month LIBOR. Current Market utilizes 1-month term SOFR. Key assumptions include: 1.00% origination fee amortized over 3-year term.

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