Here we offer some compelling reasons for considering an allocation to commercial real estate (CRE) debt over other asset classes. CRE debt funds offer indirect inflation-linked income streams typically 100-160bp higher than listed debt with a similar credit rating. The investment horizon is typically 10 years, which suits long-term investors such as pension funds.
Rising interest rates are not a danger as loans are set and adjusted in line with changes to the base rate. As with other mortgage-type products, there is a 0% floor on interest payable, which means that negative yields are not possible.
Negative yields have been a reality for a lot of publicly traded paper, so we can argue there is extra value in the illiquidity premium. What are the risks to the principal in these strategies?
- CRE debt is fully collateralised. That is one strength of investing in bricks and mortar. Senior debtholders have first-ranking mortgages.
- Second, loan-to-value (LTV) ratios have been falling, which is another source of comfort because it means the borrower has more ‘skin in the game’. Our tolerance range in European CRE debt is for LTVs of 55% to 65%, which gives a generous cushion.
CRE debt – A source of diversification and capital appreciation
There is diversification. No worthwhile CRE debt strategy puts all its eggs in one basket. It is common to have exposure to over 2 000 tenants of hundreds of properties in different jurisdictions. So investors can take comfort that income – typically distributed quarterly – comes from a greater variety of underlying sources than for many other forms of debt.
It is worth noting the size of the CRE debt market – it stands at EUR 1.2 trillion in Europe, with EUR 200 billion in annual financing (the average loan maturity in this market is six years). 
Relative to owning the property itself, we would suggest that at current prices, holding senior debt in the capital stack is preferable to holding the building itself. Capital appreciation rates in Europe are about 3.0%, while senior debt is offering roughly 2.5%.  Subtract the fees and risks involved in realising equity value and right now the senior debt seems a more efficient form of earning returns.
For the shrewd investor, we see LTVs shifting in favour of lenders, but there are also other attractive elements. One office block we have backed in Munich ticks all the boxes for a workplace ready for a post-COVID world: close to urban amenities, including public transport and 26 different tenants, many of whom are state-owned. The workers get a convivial, flexible environment. The owner benefits from rents today below market rates, which ensures low vacancy rates.
Of course, not all deals are the same. So sourcing matters. There is a general trend under the Basel rules for banks to hold fewer ‘riskier’ assets on their books. Asset managers still need to have deep and broad relationships to source the right opportunities for clients. While we talk to all the relevant banks and sponsors, being part of the BNP Paribas group puts us in a privileged sourcing position.
Sustainability – Managing the NEC score
No discussion of an asset class is complete without discussing environmental, social and governance considerations. We assess all potential projects in terms of their net environmental contribution. The NEC evaluates properties based on their construction and operations, providing guidance to ESG-minded investors. For new-builds, we can influence both elements. For existing properties, it is just operations, although this can still be significant.
As an example, as part of a broader portfolio, we financed the acquisition of the landmark headquarters of a TV broadcaster in central Paris. The building’s NEC score on purchase was -4%, but we were attracted by the acquirer’s refurbishment plans. The basic concrete structure will remain the same, but energy and efficiency savings should take the NEC score to +43%.
NEC data is commonplace in Europe. We expect scores in general to shift in line with greater decarbonisation and energy efficiency. Our portfolios are already top-quartile.
In terms of sector exposure, we currently favour city-centre offices, logistics and residential. Logistics is fashionable: in 2021, amounts invested rose by 53% versus just 8%  for offices. We see this as justified as retail businesses continue to restructure their distribution and goods have to be moved more rapidly from point to point.
The sharp rise in value of logistics is a good reminder of an asset manager’s responsibility to be prudent when choosing which acquisitions to fund. Our risk assessment and due diligence includes the owner and underlying tenants on top of the buildings in which they sit. We have a suite of covenants to mitigate income impairment from borrowers or, indirectly, tenants.
We believe CRE debt strategies can be reliable, defensive elements in a fixed income allocation. They obtain regular, inflation-linked income from a variety of private and public-sector sources. Collateral security adds reassurance and peace of mind.
This is an abbreviated version of an article that appeared in IPE Real Assets (pagesuite-professional.co.uk) in the March/April 2022 edition
 Source: CBRE
 Source: BNP Paribas Asset Management and BNPP Re Research
 Source: BNP Paribas Asset Management and BNPP Re Research
Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients.
This document does not constitute investment advice. The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns.
Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions).
Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.