MAKING A CASE FOR CORE LENDING - MARCH 2022 - USAA Real Estate
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MAKING A CASE FOR CORE LENDING MARCH 2022
The Opportunity
The commercial real estate (CRE) debt market has over $5.0 trillion in loans outstanding (Exhibit 1), making it one of
the largest fixed income asset classes, offering investors a vast array of products and strategies.1 The asset class
combines many of the attractions offered by both commercial real estate equity and fixed income; this
includes stable, historically strong income returns while maintaining a level of downside protection
from real asset exposure and enhanced diversification potential. This paper will focus on the strong historical
risk-adjusted performance of CRE debt, highlighting why the current market environment is favorable for investors.
EXHIBIT 1: Comparison of U.S. Fixed-Income Investment Asset Classes by Estimated Market Size, Q3 2021
$ Trillions
25
20
15
10
5
–
Publicly-Held Residential Mortgage U.S. Corporate Commercial Real Municipal Bonds Leveraged
Treasury Debt Backed Securities Estate Debt Loan Market
Source: Sifma, Federal Reserve Flow of Funds, , USAA Real Estate Research. As of Q3 2021
1. Federal Reserve Flow of Funds, Q3 2021. Note - not including debt funds USAA REAL ESTATE | CORE LENDING 1
Private CRE debt investment can be categorized into two broad
categories: private CRE mortgages and subordinated debt, both secured
by the underlying property. Senior Private CRE mortgage holders have
priority, as well as certain bankruptcy protections over those holding
subordinated debt in the event of a default (Exhibit 2). Senior lending
carries lower risk than other real estate debt sources given
its senior position in the capital stack. However, loan structure,
property type, duration, a sponsor’s business plan, and loan-to-value
(LTV) are also important characteristics when evaluating risk and return.
EXHIBIT 2: Real Estate Capital Stack (Loan-to-Value)
HIGH
EQUITY 90 – 100 %
EQUITY
PREFERRED EQUITY 80 – 90 %
B NOTE / MEZZANINE LOAN * 65 – 80 %
POTENTIAL RISK & RETURN
DEBT
SENIOR LOAN 0 – 65 %
LOW
Source: USAA Real Estate Research. As of January 2022 *Types of subordinated debt.
Investors have become selective, choosing certain asset classes over others and focusing on quality assets in terms
of location, tenant covenants, and Environmental, Social and Governance criteria (ESG). U.S. CRE debt has been
increasingly sought after by pension funds, insurance companies, and other institutional investors, and the arguments
for including real estate in private-debt allocations appear to be strong. Senior mortgage lending strategies are
attractive because they potentially provide substantially more return than traditional fixed income in the
current environment, while likely taking materially less risk due to downside protection from real asset
exposure and seniority in the capital stack in relation to the equity position, thus offering favorable risk-
adjusted returns. This segment of the market has historically been dominated by large banks, commercial mortgage-
backed securities (CMBS) and life insurance companies that value the low volatility, high income relative to corporate
bonds, and liability matching qualities provided. However, an increasing number of investors are realizing this asset
class, particularly in the lower risk credit strategies, can be an accretive part of investment portfolios.
USAA REAL ESTATE | CORE LENDING 2
Why Now?
LINGERING CREDIT CONSTRAINTS
The investment opportunity is ripe due to the size of the market in the U.S. for senior secured mortgages; transaction
volumes averaged $530 billion annually since 2015, plus over $5 trillion in outstanding mortgages, a fair percentage of
which need to be refinanced each year.2 In general, providers of capital to this space are more constrained
than in the past due to the regulatory environment. Regulations imposed by Dodd-Frank and Basel III have
created a more risk-averse lending environment at the balance sheet level and within the securitization markets.
2. Real Capital Analytics (only includes Apartment, Industrial, Offices, Retail, Hotel, Senior Housing, Land),
Federal Reserve Flow of Funds, Q3 2021. Note - not including debt funds USAA REAL ESTATE | CORE LENDING 3
Broadly, the COVID-19 pandemic created an
economic setback that led traditional sources
of debt capital to retrench during the early
stages of the pandemic, and while most
have returned to nearly normal activity, loan
proceeds can be constrained as compared
to pre-COVID. Lending standards tightened
dramatically in 2020, as banks responded
to the uncertain economic outlook. As
demonstrated by the Federal Reserve Senior
Loan Officer Survey (see Exhibit 3), the
percentage of banks tightening lending
standards reached levels not seen since
the Global Financial Crisis (GFC). Lending
standards have started to loosen in
recent quarters but remain constrained.
EXHIBIT 3: Stricter Bank Lending Standards
% Net Tightening & Net Stronger Demand
100
80
60
40
20
0
-20
-40
-60
-80
'95 '96 '97 '98 '99 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15 '16 '17 '18 '19 '20 '21
% Tightening Standards Stronger Demand
Source: Federal Reserve Senior Loan Officer Survey, USAA Real Estate Research. As of Q4 2021
USAA REAL ESTATE | CORE LENDING 4
CMBS ORIGINATION REMAINS VOLATILE
The CMBS market, which has historically served as an alternative
capital source, remains volatile. CMBS originators were hit
particularly hard by the pandemic, capturing only 1% of total
commercial mortgage origination in Q2 2020. A year later in
Q2 2021, these originators were responsible for 18% of all new
commercial mortgages, a figure placing these groups just behind
regional/local banks as the largest source of financing.3 In a sign of
their more competitive pricing, CMBS loan origination in the first
nine months of 2021 totaled $77.1 billion, well above 2020s year-to-
date issuance of $40.7 billion.4 While CMBS originators have
steadily regained market share, recent volatility reinforces
the idea that alternative lenders are well-positioned to
take advantage of CRE lending opportunities arising from
dislocations in the capital markets going forward.
CHANGES TO RISK-BASED CAPITAL CHARGES
New risk-based capital charges could make CRE investments easier
to access for life insurers. Recent changes to the risk-based
capital (RBC) framework have significant implications for
the capital efficiency of real estate investments within life
insurance portfolios. The overall impact of the RBC changes at
year-end 2021 will vary materially depending on an individual life
insurer’s investment portfolio and liability profile. However, we
expect both CRE equity and Commercial Mortgage Loans (CML)
will look more attractive to domestic insurers on a capital adjusted
yield basis given the material changes to RBC capital factors.
CMLs look incrementally more compelling as capital charges did
not change, while bond charges increased on balance.
Reduced charges for CRE equity will potentially make it more
attractive to domestic insurers. Whereas RBC charges were
previously 15% for direct investments reported on Schedule A and
23% for joint ventures and fund real estate investments reported
on Schedule BA, the newly-adopted charges will be 11% and 13%,
respectively.5 Importantly, the closing of the gap between Schedule
A and Schedule BA RBC charges could make real estate investing
via funds and joint ventures more attractive than previously.
In light of these favorable changes, CRE equity and CMLs
may become more of a consideration in life insurance
strategic asset allocation frameworks going forward.
3. Real Capital Analytics, U.S. Capital Trends Big Picture, August 2021
4. CBRE, U.S. Lending Figures, Q3 2021
5. NAIC, Adopted Modifications to RBC Formula for Real Estate, June 2021 USAA REAL ESTATE | CORE LENDING 5
FAVORABLE DEMAND DRIVERS
Conditions are in place for the commercial mortgage industry to sustain high demand in the near term. Yields on
government and corporate fixed-income securities remain low by historical standards. As a result, relative real
estate valuations, as measured by the spread between fixed income securities and CRE lending rates, are above
long-term historical averages (Exhibit 4). Elevated levels of federal debt support the view that fixed-income
securities will remain low for a prolonged period and strengthen the case for increased allocations to
CRE lending.
EXHIBIT 4: CRE Lending Spread Rates vs. Corporate Bonds
Spread (BPs)
200
100
–
(100)
(200)
(300)
'00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15 '16 '17 '18 '19 '20 '21
vs. A Corporate Post-1999 Avg
Source: Bloomberg, USAA Real Estate. As of Q3 2021
Overall, commercial real estate fundamentals remain healthy. New deliveries have been well below long-run averages
in the current cycle across nearly every major property sector (except multifamily), and while construction pipelines
are beginning to accelerate, they are doing so at a measured pace and in response to improving demand. The
NCREIF Property Index (NPI) gained 6.15% during the fourth quarter of 2021 and advanced 17.7% over the trailing 12
months. Notably, all property sectors posted positive returns for the quarter.6 Capital flows have also improved
substantially since the depths of 2020, with transaction activity increasing 88% from a year ago.7
As monetary policy evolves, the impact on the economy and the commercial mortgage sector will depend mainly on
when the Federal Reserve decides to raise interest rates. If the economy is growing at a healthy pace, then landlords
can increase rents and Net Operating Income (NOI), improving debt service coverage ratios, which should benefit
both lenders and borrowers. Of course, performance will vary by market and property type, but interest rates are
likely to remain economically supportive in the near term. Therefore, the real estate sector should be able to absorb
a modest rate increase without any significant adverse impact.
6. NCRIEF Property Index, as of Q4 2021
7. Real Capital Analytics, U.S. Capital Trends Big Picture, 2021 Note: Compares 2021 vs. 2020 USAA REAL ESTATE | CORE LENDING 6
Merits of Senior
Mortgage Lending
RESILIENT ACROSS MARKET CYCLES
Senior lending has benefited from historically low volatility, with very low
default rates over the past 20 years. This is due primarily to the presence
of capital protection and cashflow resilience, even during periods of market
uncertainty. Conservative LTVs, averaging 64% since 1990, have provided a
significant buffer against declining property values.8 The most severe price
declines occurred during the GFC when core property values fell by 27%;
however, the market has never experienced an aggregate loss in value of
more than 30%.9 Disciplined levels of leverage will likely continue to
result in very low levels of default, reinforcing the view that core
CRE debt is resilient. The risk characteristics of core CRE debt are very
favorable, providing downside protection backed by real assets, a significant
equity cushion, and robust loan structures. Historically, core CRE debt has
outperformed relative to other assets types. As shown in Exhibit 5, core CRE
debt has offered attractive risk-adjusted return performance relative to other
asset classes over the last 15 and 25 years based upon the Sharpe ratio.
EXHIBIT 5: Risk-Adjusted Returns Across Asset Classes
Sharpe Ratio, Last 25 & 15 Years
1.4
1.2
1.0
0.8
0.6
0.4
0.2
–
Core CRE Debt IG Corporate Core CRE Equity HY Corporate S&P 500 REITs MSCI EAFE
Last 25 Years Last 15 Years
Source: Bloomberg, USAA Real Estate Research, As of Q3 2021
8. ACLI, Q3 2021
9. NCRIEF, Market Value Index USAA REAL ESTATE | CORE LENDING 7
POWERFUL PORTFOLIO ENHANCEMENT
Senior secured mortgages can potentially provide powerful portfolio enhancement. Along with lower volatility and
higher returns, core real estate debt has historically had a low correlation with stocks and bonds (see Exhibit 6).
For fixed-income investors, this low correlation can add diversification benefits.
EXHIBIT 6: Low Correlations to Other Asset Classes — Correlation of Returns Since 2001
U.S. AGGREGATE BONDS S&P 500 CORE REAL ESTATE CORE REAL ESTATE DEBT
U.S. Aggregate Bonds 1.00
S&P 500 (0.26) 1.00
Core Real Estate (0.18) 0.12 1.00
Core Real Estate Debt 0.51 0.04 0.02 1.00
Source: Bloomberg, USAA Real Estate Research, as of Q3 2021
Core CRE debt also stands as a strong complement to core CRE equity strategies. An allocation to core CRE
debt in addition to core CRE equity may further enhance risk-adjusted mixed-asset portfolio returns.
Exhibit 7 illustrates the potential improvement in diversification that can occur by adding an allocation to core CRE
equity and core CRE debt to a hypothetical portfolio of stocks and bonds (Portfolio A). The 20-year return/risk ratio
for Portfolio B (5% allocation to CRE equity and core CRE debt) improves by 15% over Portfolio A (no real estate).
Over the entire historical period, Portfolio C (10% allocation to CRE equity and core CRE debt) demonstrates a higher
return/risk ratio than either of the other two portfolios. This theoretical framework demonstrates the diversification
benefits of commercial real estate exposure; however, institutional investors have recognized this asset class can be
accretive to performance and are increasing their allocations.
EXHIBIT 7: Allocations to CRE Debt Can Enhance Mixed Asset Portfolios
PORTFOLIO A PORTFOLIO B PORTFOLIO C
Stocks 60% 55% 50%
Bonds 40% 35% 30%
Core CRE Equity 0% 5% 10%
Core CRE Debt 0% 5% 10%
RETURN/RISK RATIO
10-Year 1.25 1.32 1.41
20-Year 0.75 0.81 0.87
Source: Bloomberg, USAA Real Estate Research, As at Q3 2021. For illustrative purposes only.
USAA REAL ESTATE | CORE LENDING 8
Conclusion
Commercial mortgages, particularly senior whole loans, have been increasingly sought after by investors, and the
arguments for including core CRE debt in allocations appear to be strong. Commercial mortgages are an attractive
investment option in today’s market environment where credit standards remain somewhat constrained, borrower
demand is high, and underlying real estate fundamentals are healthy. With banks and CMBS lenders struggling
to navigate the strict regulatory environment, a gap remains between borrower needs and credit availability.
Consequently, there remains an opportunity for alternative lenders to fill this void, create velocity, and capitalize
on the robust demand in the commercial lending sector. As with any investment opportunities, real estate lending
has a certain level of embedded risk. Even with such a strong CRE debt outlook, it is important to ensure sponsor
alignment. It is critical to invest with a qualified and experienced investment manager who can navigate the
opportunities within this sector.
USAA REAL ESTATE | CORE LENDING 9Tim Stoner Alex Rapoport
Managing Director, Capital Markets Executive Director, Capital Markets
tim.stoner@usrealco.com alex.rapoport@usrealco.com
Will McIntosh, Ph.D Karen Martinus
Global Head of Research Senior Associate, Research
will.mcintosh@usrealco.com karen.martinus@usrealco.com
Mark Fitzgerald, CFA, CAIA
Executive Director, Research
mark.fitzgerald@usrealco.com
Important Disclosures
These materials represent the opinions and recommendations of the author(s) and are subject to change without
notice. USAA Real Estate, its affiliates and personnel may provide market commentary or advice that differs from
the recommendations contained herein. Certain information has been obtained from sources and third parties.
USAA Real Estate does not guarantee the accuracy or completeness of these materials or accept liability for loss
from their use. USAA Real Estate and its affiliates may make investment decisions that are inconsistent with the
recommendations or views expressed herein. Past performance is no guarantee of future results.
The opinions and recommendations herein do not take into account the individual circumstances or objectives of any
investor and are not intended as recommendations of particular investments or strategies to particular investors.
No determination has been made regarding the suitability of any investments or strategies for particular investors.
Research team staff may make or participate in investment decisions that vary from these recommendations and
views and may receive compensation based on the overall performance of the USAA Real Estate or its affiliates
or certain investment funds or products. USAA Real Estate and/or its affiliates or clients may be buying, selling,
or holding significant positions in investments referred to in this report.
USAA Real Estate Tel: 210.641.8416
9830 Colonnade Blvd., Suite 600 Web: www.usrealco.com
San Antonio, TX 78230
USAUSAA Real Estate Square Mile Capital 9830 Colonnade Blvd., Suite 600 350 Park Avenue, 15th Floor San Antonio, TX 78230 USA New York, NY 10022 USA usrealco.com squaremilecapital.com
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