By Chris Furman
In the current market environment, income-seeking investors face a vexing tradeoff: accept paltry yields, or step out on the risk spectrum into areas that look increasingly dangerous.
In our view, the decision matrix facing income investors has rarely been so poor. As a review of standard income investments shows, the options in front of investors vary between futile … and fraught. Against this backdrop, we believe commercial real estate debt deserves a place in the portfolios of yield starved investors. Before considering the asset class’ merits, however, consider some of the standard income options in front of investors:
Treasurys: The 10-year Treasury currently yields around 70 basis points. Enough said. Fed policy following the coronavirus fallout and a rush into safe-haven assets has pushed government bond yields to unprecedented lows. In turn, this has compressed yields in other fixed income markets, which also face rising risks.
Investment Grade Corporate Credit: Low Treasury rates pushed many investors into corporate credit, putting a ceiling on yields. At the same time, investment grade debt may be getting more risky. In recent years, companies have piled on cheap debt to fund corporate buybacks. In 2016 and 2017, for example, corporate bonds funded as much as 30% of all share buybacks.¹
For many businesses, debt has simply not gone toward productive capacity to grow cashflow. For perspective, consider that in 2018, only 43% of S&P 500 companies recorded any research and development (R&D) expenses at all.² As these companies hit a recession, some will struggle to repay that debt.
High Yield Debt: An economic downturn never bodes well for the high-yield market as defaults increase. In addition to the segment’s increased risk, it is also highly correlated to equities, which means it will not provide the diversification or portfolio ballast most investors expect from fixed income.
MLPs: When markets become momentum driven, as they have in the recent rebound, MLPs face greater equity risk. Perhaps more troubling though, is the outlook for the energy complex. If oil prices remain stubbornly low, production cuts among shale operators will continue. MLPs require that production to make the returns they have produced over the past decade.
Municipal Bond Funds: Municipal bond funds offer attractive, after-tax yields relative to many other options in today’s market. The downside: Many funds use leverage to do it. Municipalities are experiencing budget shortfalls as revenue collections diminish amid the economic downturn, but pension obligations and other costs continue to mount.
When municipal bond prices fall in reaction to the budget crunch, leveraged funds may be forced to sell bonds to meet margin calls. Several large, levered municipal bond funds had to unwind positions in March, and we would not be surprised if levered muni funds face more trouble if volatility resurfaces.
Dividend Strategies: Dividend strategies also make up a component of some income strategies. These too, are looking less reliable as corporate earnings for most companies fall. Through the end of April, 83 U.S. companies and public investment funds such as REITs had either suspended or canceled their dividends, according to the Wall Street Journal.³ That marked the highest number since 2001, according to data used by the publication.
IN HUNT FOR INCOME, INVESTORS MUST LOOK FOR NEW OPTIONS
Given the risks associated with other income investments, investors could benefit from finding uncorrelated sources of yield. Commercial real estate debt may be a solution. As the table to the left shows, commercial real estate debt exhibits low correlations to fixed income markets and equities. The chart on the right shows the excess yield the asset class has offered over comparable indices.
The debt segment has several additional features that make it a compelling option relative to other income-generating investments. Commercial real estate debt is backed by hard assets, providing a level of transparency unavailable in many opaque, alternative fixed income structures. Long-term leases also support the cash flows of commercial real estate operators, making commercial real estate debt less volatile than traditional fixed income options.
Actively managing a commercial real estate debt portfolio provides an opportunity to further reduce the risk profile. Portfolio managers can utilize their real estate expertise to evaluate the real estate assets underlying the debt. They can also steer investments toward the strongest real estate sectors (multifamily, industrial, bioscience and self-storage in the current environment), and away from secularly challenged industries such as retail or hospitality. With low yields and rising risks in other pockets of the market, the asset class is worth a closer look.
¹ Harvard Business Review, JPMorgan
²Harvard Business Review, JPMorgan
Forum Investment Group is a private real estate investment firm with expertise and emphasis on generating current income and long-term value creation by accessing unique real estate acquisition, development and debt investment opportunities across the capital stack and real estate cycles. Since 2007 we’ve invested more than $2 billion in real estate and built a successful track record of high-performance investments, earning the trust of our investors and partners.
Chris Furman – Managing Partner
Forum Real Estate Group, a Glendale, Colorado-based real estate investment firm and affiliate of Forum Investment Group, has a focus on multifamily living and develops, owns, operates and manages properties across the United States.