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We’re all aware of the challenging landscape that exists for investors and financial advisors today, especially those seeking reliable cash flow from their portfolios. In this environment of historically low yields, income levels on bonds have continually and dramatically decreased while downside risk has measurably increased in most higher yielding fixed-income proxies.
Meanwhile, a proliferation of so-called "alternative fixed income" products has offered the market little beyond risky and opaque investment structures. These offerings are often commission-based products with relatively high fees and low liquidity, and many are too highly correlated with traditional assets.
In this blog, Forum will discuss a potentially smarter option -- Commercial Real Estate (CRE) Debt -- a robust fixed-rate vehicle that may provide portfolio diversification and offer an alternative source of income at a time when both are hard to find.
What is CRE Debt?
There are many ways to invest in commercial real estate, a broad category that includes direct investments, private real estate, and various real estate investment trusts (REITs), both public and private. And within CRE investing, there are two traditional ways to participate: equity and debt positions. There are misconceptions about how each works and how either might assist an investor to reach a particular goal. Here are the primary differences:
CRE equity investing typically seeks to generate a return for investors through rental income paid by tenants or capital gains from selling the property. In this case, the investor owns equity in a property or a portfolio of properties. The position in the “capital stack”, which represents the underlying financial structure of the deal, for these investors is subordinate to any debt investor. Equity investors are paid income and capital gains only AFTER the debt holders are paid any regular debt payments or the loan/mortgage is paid off upon the sale of the property.
CRE debt investing, on the other hand, involves issuing loans or investing in mortgages secured by a corresponding property or properties. When investing in real estate debt, the investor acts as a lender to the property owner or deal sponsor with the potential to earn a fixed rate of return based on the loan’s interest rate and the dollar amount invested. The capital stack position for these investors is senior to any equity capital investors – debt investors are paid any regularly scheduled debt payments with accrued interest prior to any payments to equity holders. CRE debt is the first debt paid off upon the sale of the property. **According to traditional priority on the capital stack, the settlement of debt and payment of the corresponding interest comes before equity is returned, or dividends/distributions are paid, to the equity owners. Although debt investments may be prioritized in payment, the collateral may not have sufficient value to repay an outstanding debt or loan resulting in a loss.
An Outsized Market
The commercial mortgage segment, while less well known and less utilized by individual investors, actually represents one of the largest fixed income asset classes in the marketplace. It’s estimated that CRE debt backed by hard assets and securitized mortgages ranks between U.S. investment grade corporate bonds and municipal bonds in terms of size. This scale represents an incredible and diverse opportunity for investors.
Given its magnitude and historical attractiveness of its long-term returns, one might expect the U.S. commercial mortgage market to be included in most strategic allocations. Yet individual investors remain under-allocated to the segment, in large part, we suspect, due to a lack of appropriate investment vehicles, limiting access to the asset class for most. On average, individual investors allocate less than 1% of their portfolios to commercial real estate while highly sophisticated institutions typically allocate 10% or more.
This disparity should act as notice to individual investors that they are potentially missing a significant investment opportunity.
Offering High Quarterly Cash Flows…
CRE debt has historically delivered better income than core CRE equity and other fixed-income instruments over time, including investment-grade corporate bonds. How? Through loan covenants, which by definition are promises made by the borrower to abide by certain terms and conditions of the loan agreement, and the ongoing borrower demand for first mortgage debt.
Demonstrating a combination of attractive features, CRE debt over the last 20 years has exhibited low volatility of income with historical default rates in line with investment-grade commercial bonds. Most recently, CRE debt has demonstrated particular resiliency across the COVID-19 pandemic, showing few defaults and providing consistency of payment. During this period of dramatic economic and business disruption, CRE debt held steadfast for investors prudent enough to have already allocated to it.
Low Correlation to the Important Asset Classes
CRE debt continues to exhibit remarkably low correlation to other asset classes -- even as excess liquidity around the globe increases the ability of investors to diversify portfolio risk.
1 Past performance is not indicative of future results.
2 Source: Bloomberg.com. Data from 12/31/2012 – 6/30/2021. Commercial mortgages are represented by the Bloomberg Barclays CMBS Investment Grade BBB Total Return Index. The index measures the market of conduit and fusion CMBS deals. US Stocks are represented by the S&P 500 Total Return Index. The S&P 500 Total Return Index is a benchmark of large-cap US equities. Loans are represented by the S&P/LSTA US Leveraged Loan 100 Index. The index is designed to reflect the performance of the largest facilities in the leveraged loan market. High Yield Bonds are represented by Bloomberg Barclays US Corporate High Yield Total Return Index. The index measures the USD-denominated, high yield, fixed-rate corporate bond market. Equity REITs are represented by the FTSE NAREIT All Equity REITS Total Return Index. The Index is a free float adjusted market capitalization weighted index that includes all tax qualified REITs listed in the NYSE, AMEX, and NASDAQ National Market. Government Bonds are represented by the Bloomberg Barclays US Treasury Total Return Index. The index measures US dollar-denominated, fixed rate, nominal debt issued by the US Treasury. US Agg Bond is represented by the Bloomberg Barclays US Agg Total Return Index. The index is a broad based flagship benchmark the measures the investment grade, US Dollar denominated, fixed rate taxable bond market. Corporate Bonds are represented by the Bloomberg Barclays Intermediate Corporate Total Return Index. The index measures the investment grade, fixed rate, taxable corporate bond market.
Asset class diversification of this sort should, by itself, be a primary reason for an individual investor to allocate a portion of his or her portfolio’s assets to CRE debt. But an allocation to core CRE Debt in addition to core CRE equity could even further enhance risk-adjusted portfolio returns, especially through difficult markets. A more meaningful allocation to CRE debt may even further dampen portfolio volatility.
How Might CRE Debt Help Investors?
In the current environment, CRE debt, which responds to changing economic and market conditions differently than other asset classes while generating relatively high historical cash flows, offers a particularly attractive tactical opportunity. But we’d rather emphasize the long-term inclusion of this asset class in portfolios as a strategic allocation opportunity for investors.
In addition to combining many of the positive aspects of CRE equity and fixed income, which include the potential for stable cash flows, a good degree of principal protection, and a persistent investor pool, we believe CRE Debt could enhance almost any portfolio.
Interested in learning how you can invest in CRE debt with Forum through the Forum CRE Income Fund (“FCREIF”)?
Forum Investment Group—with affiliate entities Forum Real Estate Group and Forum Capital Advisors—is a private real estate investment firm with expertise and an emphasis on multifamily investing throughout real estate cycles and across the full capital stack. Affiliate entity Forum Capital Advisors, LLC (“FCA”) is a registered investment adviser and manager of the firm’s fund investment vehicles. For more information, visit www.ForumRE.com.
Important Investment Considerations
Investors should consider the investment objectives, risks, charges, and expenses carefully before investing. For a prospectus or summary prospectus with this and other information about the Fund, please call 303.501.8804 or visit www.FCREIF.com Read the prospectus or summary prospectus carefully before investing.
Diversification does not ensure a profit or protect against a loss.
Investing in the Fund involves risks, including the risk that an investor may receive little or no return on his, her or its investment or that an investor may lose part or all of such investment. Therefore, investors should consider carefully the following principal risks before investing in the Fund. There is no assurance that the Fund will achieve its performance or investment objectives or achieve any targeted rate of return or return of capital or any target distribution yield. Shareholders may lose some or all of their invested capital, and prospective investors should not purchase the Fund' shares unless they can readily bear the consequence of such loss. Limited liquidity is provided to shareholders only through the Fund's quarterly repurchase offers. There is no guarantee that shareholders will be able to sell all of the shares they desire in a quarterly repurchase offer. The Fund's investments are also subject to liquidity risk. Funds with principal investment strategies that involve securities of companies with smaller market capitalizations, derivatives or securities with substantial market and credit risk tend to have the greatest exposure to liquidity risk.
As a non-diversified investment company, the Fund may invest more than 5% of its total assets in the securities of one or more issuers. The Fund may therefore be more susceptible than a diversified fund to being adversely affected by events impacting a single borrower, geographic location, security or investment type. The Fund's investments in real estate debt are expected to be secured by real estate assets. The Fund's concentration in the real estate sector may increase the volatility of the Fund's returns and may also expose the Fund to the risk of economic downturns in this sector to a greater extent than if its portfolio also included investments in other sectors. Further, there is no limit regarding the amount of Fund assets that may be invested in any single geographic area within the United States. To the extent the Fund concentrates its investments in a limited number of assets or geographic areas, the Fund will be subject to certain risks relating to concentrated investments. Commercial real estate debt instruments (e.g., mortgages, mezzanine loans and preferred equity) that are secured by commercial property are subject to risks of delinquency and foreclosure and risks of loss that are greater than similar risks associated with loans made on the security of single-family residential properties. The Fund expects to invest a portion of its assets in pools or tranches of commercial mortgage-backed securities (CMBS)*. In a rising interest rate environment, the value of CMBS may be adversely affected when payments on underlying mortgages do not occur as anticipated, resulting in the extension of the security's effective maturity and the related increase in interest rate sensitivity of a longer-term instrument. Subordinate CMBS are also subject to greater credit risk than those CMBS that are more highly rated. Mortgage loans on commercial properties generally lack standardized terms, which may complicate their structure and increase due diligence costs. Commercial mortgage loans also tend to have shorter maturities than single-family residential mortgage loans and are generally not fully amortizing, which means that they may have a significant principal balance or “balloon” payment due on maturity.
Placement Agent: Foreside Fund Services, LLC
*A security backed by commercial and multifamily mortgages rather than residential real estate.