With the Middle East crisis and the risk of rate hikes, how should investors view the asset class at this time?
Real estate debt, particularly senior debt, is a defensive strategy, and defensive strategies are particularly good when expectations change. That’s true both when rates go up or when they go down. When there are big changes, particularly if they’re driven by one-off events, then being on the defensive side can be particularly helpful.
So what we’ve seen in real estate, in particular, is a period of falling values or rising rates driving rising yields. So falling values – and that’s been obviously, a very hard time for real estate investors. On the debt side, we’ve had the benefit of not being too impacted by those valuation adjustments, while income has been coming through. What we do see is that the occupier market has been particularly resilient. And if we look at rising oil prices, we may see some impact there. So again, having a defensive strategy can be particularly helpful.
How does this asset class manage risk and return throughout market cycles?
Every asset class will have a cycle, and some of those are very pronounced, and others perhaps less so. But what’s interesting about real estate, in particular, is that of course it’s an illiquid asset class. And so what you find is that when you see the cycle turn, it can be potentially too late to really make big asset allocation changes.
And so if you’re in the equity, you’re writing the cycle down. If you’re in the debt, you’re obviously more protected, but potentially at some point you get impacted by big swings as well. But it’s not that hard for a senior lender to outperform the equity during bad times in the cycle. The bigger challenge – and I think the question we should all be asking – is how do you perform well in the rest of the cycle?
Because if you think of a typical real estate cycle, it actually spends most of its time rising. It’s just that when it’s not rising, it’s falling particularly quickly. So what do you do during the maybe as much as 80% of the time that the market is rising? It can be tempting to think that that’s the time that you have to be on the equity side.
Whereas in practice, I think you find that the market turns not based on real estate fundamentals per se, but maybe on external shocks. We had Covid, we had the interest rate rises. You could argue that the global financial crisis (GFC) was more of an internal shock, but even so, big movements typically come from external shocks. And so what do you do during the time that the market is rising?
And this is where our relative value approach, I think, is particularly valuable. Rather than being a price taker in the market, we try to find areas of the market where actually the competitive pressures are not focused on pricing, but on structuring of the deal or the speed of execution – other factors that are valuable to borrowers that they are willing to pay for, but are not immediately translated into risk. And we find that in the market we can charge for risk and other factors much better than on the larger end of the market.
How does real estate debt benefit a wider portfolio?
Real estate credit, I think, is particularly interesting because it is both real estate and credit. Clearly, it’s real estate because that’s where we take the risk – we invest in real estate assets, we judge the rental income, the management of that asset, and so on. It’s a real estate business, but we deliver a credit product. And so what we’re ultimately trying to do is deliver an investment performance that is uncorrelated to the real estate cycle.
When you see big shocks in the real estate cycle, our aim is not to be impacted by those – so much smoother performance through the cycle. And you might argue that that means lower volatility. I think volatility is a little bit of an odd term in private markets because of the illiquidity of the underlying asset class.
So what we’re really looking for is the range of possible outcomes rather than the volatility, perhaps, because there is no daily pricing. So range of outcomes is much narrower in credit than it is on the equity side – so on the real estate side itself. If you build a portfolio that has real estate equity and real estate credit, you can build a portfolio that is much less affected by inevitable cyclical impacts.
