Commercial Real Estate’s Low Debt Levels To Create Defensive Investment Opportunity During Economic Downturn
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Despite concerns of rising debt levels throughout the global economy, which IMF warned about in its latest reports on the state of the world’s economy, research reveals the U.S. commercial real estate industry in particular is not overleveraged.
Cautious lending practices and conservative underwriting has kept U.S. commercial real estate debt levels below where they were prior to the Great Financial Crisis, according to a CBRE Marketflash report. CBRE Global Chief Economist Richard Barkham said this could present opportunities for investors looking for a defensive strategy when the next recession hits, which many economists and real estate experts surveyed in a Zillow and Pulsenomics report anticipate will occur in 2020.
“I think every cycle has an area that is overleveraged. I think government debt to GDP has gone up a lot and corporate has taken on a lot of debt on the balance sheet. Emerging markets debt is [also] potentially problematic in this particular cycle, but not so much in real estate,” Barkham said. “We don’t see that leverage and if there was a downturn, real estate would be a realistically safe haven.”
The commercial real estate debt to U.S. gross domestic product ratio in 2017 was 20.9% — 2.2% below its 2009 peak of 23.1%, CBRE reports. One primary factor behind the deleveraged state of the sector is the fact that more deals are being closed through equity, not debt.
“There is an overwhelming supply of capital that is going after real estate. The boom of 2007 was debt-driven and this one is far more equity led,” Barkham said.
Debt-to-market value sits at 41% as opposed to 2007’s 48%, the National Council of Real Estate Investment Fiduciaries reports, and CBRE found loan-to-value ratios fell to 59.8% in 2017 compared to 75.3% 10 years ago. That said, CBRE reports debt to GDP levels are still above the 1990 long-term average of 17.9%, though current low interest rates and inflation should keep debt levels manageable.
Barkham said the prime property market can now be considered a part of the bond market as big institutions like sovereign wealth funds look to investment-grade property to store excess capital. That said, extended cap rate compression, elevated supply pressures, a frustrating bid-ask spread and less than desirable yields have many investors sitting on the sidelines. This trend is expected to stifle transaction volume this year.
Global macroeconomic volatility as a result of interest rate spikes and rising inflation could pose risks for the real estate sector as it would other asset classes, but the sector’s lower debt levels should shield it from much of that volatility, CBRE reports. For example, Barkham said in the previous cycle when interest rates jumped, highly leveraged buyers rushed to sell, putting downward pressure on prices. The market is not likely to respond in the same manner this cycle due to lower property-level leverage, he said.
“Furthermore, if the rise in rates is accompanied by higher-than-anticipated inflation, real estate may serve as a more effective hedge than other sectors, such as corporate bonds and sovereign debt,” CBRE reports.