Sizing up the opportunity in short-term real estate lending

With inflation, rising interest rates, and market volatility weighing on investors’ minds across Canada, more are looking to defend their portfolios with alternative investments. And according to one expert, private debt within real estate could be ideal for the headwinds coming in 2023.

“Typically, short-term loans are structured based on floating interest rates, and that’s with a floor rate as well,” says Sandra Ferenz, Managing Director, Portfolio Manager and Product Strategy at Trez Capital.

According to Ferenz, the interest rate is usually set on a benchmark rate plus a credit spread. In rising-rate situations, the rates on the loans automatically reset upward, and investors in the loans get to capture the additional yield.

Aside from higher yields, real estate bridge loans come with shorter durations that lend themselves to quick turnover. With a two- to three-year time horizon, new originations are generated at prevailing market conditions, creating the opportunity for regular distributions that rise in pace with the changing interest-rate environment.

“We're in an environment where credit spreads have widened out. Everyone's saying there's less liquidity in the market, and people are more concerned about the current economic environment. Higher credit spreads are being priced in,” Ferenz says. “Naturally with the constant rollover of loans, you’re able to really capture that additional spread in rates and ultimately demand higher yields.”

The fact that they’re backed with real estate assets is another benefit. Properties like multi-family apartment buildings can raise rents along with inflation, so the value of the underlying collateral increases as well.

First-lien lenders within the private space will be in the senior position among creditors, according to Ferenz, which gives investors in those loans better recovery rates in the event of a default.

“You really have this great security that you're not going to find in bonds and even in certain corporate debt,” Ferenz says.

While the current economic environment has drawn many comparisons to the 1980s, she says one key difference this time is the still-favourable long-term fundamentals in a lot of real estate asset classes. That doesn’t apply equally to all categories: the persistent demand for e-commerce has challenged retail real estate properties, but benefited industrial properties.

For asset managers, lenders and real estate financiers like Trez Capital, the need to navigate around short-term noise and stay focused on long-term themes calls for even more caution and selectiveness.

“We were originally going to originate about six billion dollars in loans, but we saw that the environment was changing,” Ferenz says. “We decided to actually cut our origination pipeline, take a second look at every opportunity we come across, and pick only the absolute best. We’re also extending less leverage than we perhaps would have in the past.”

Under the umbrella of short-term real estate lending, Ferenz says there are even more subtypes – construction loans, loans for newly constructed projects in lease-up, and value-add loans, for example – each with their own unique features and risks.

Loans for lot development comprise a more niche space, focused on financing for the development of horizontal infrastructure – including sewers, water lines, and electrical supply – before home builders construct the buildings and properties themselves.

“I think some people confuse these with land loans, so they think it’s speculative financing where you’re looking to get land zoned. But it’s not,” she says. “All the entitlements are in place, and they’re a simpler build than vertical improvements. But you’d still want to lend to people with unique experience in the lot development space, and you’re looking for strong balance sheets. Some of the market risks can also be mitigated through pre-selling to home builders.”

From where Ferenz sits, the uncertainty from 2022 is starting to recede as central banks take a less hawkish stance, and the upward volatility in prices of lumber and steel appears to be normalizing. Looking ahead, she says the long-term shortage in housing across North America is a trend to watch.

“We’re facing a fundamental undersupply of housing that really started to shift after an oversupply of housing from before the Great Financial Crisis in 2008, which was fuelled by decades of underbuilding at the end of the day. Shortly after that we saw the market shift to undersupply around 2014, due to a building slowdown, which has lasted till today” she says. “From 2016 to 2021, the U.S. had 2.6% population growth, and only had 427 housing units for every 1,000 people. In Canada, there was 5.2% population growth and only 424 housing units per 1000.”

Given where mortgage rates stand, affordability is a key issue for many Americans, and an entry-level home costs more than renting in the top markets. That spells a real opportunity for construction in the multifamily apartment and single-family for-rent property spaces.

“I think with the prevalence of the work-from-home trend, you're seeing people moving to more suburban areas, and more need for home office space,” Ferenz says. “So naturally, I think those are going to be where opportunity lies right now.”