Evaluating Real Estate Capital Stacks in a Rapidly Changing Environment

Wesmount Realty Capital’s Cliff Booth says lower cap rates and rising interest rates of today’s market are increasing the future cost of debt financing.

Since the 2008 global financial crisis, commercial real estate has benefited from a persistent bull market due in part to historically accommodative monetary and fiscal policy, as well as increasing investor allocations into the asset class ranging from individuals to large pension funds, among others. Aided further by considerable rent growth, real estate valuations across risk profiles and markets have spiked while cap rates have continued to compress across many property types, despite the disruptions caused by the pandemic. Therefore, expected future returns are naturally trending downward.

Real estate returns have historically and recently been enhanced by employing leverage, given the lower cost of debt relative to equity. The amount of debt employed by real estate deal sponsors differs by appetite for risk and strategy. While debt has proven to be accretive to returns in good times, it can swing both ways. In the event of an economic slowdown or downturn, sponsors must navigate the market carefully or risk defaulting on loan obligations which would lead to large losses for equity investors.

Beyond sourcing conventional senior first-lien loans, real estate sponsors sometimes opt to employ additional leverage in their capital stacks, typically in the form of mezzanine debt or preferred equity tranches. While these tranches can help boost returns, operating cash flow can become increasingly absorbed by considerable debt service requirements. In the event of a slowdown in rent growth, decreasing occupancy, or unanticipated increases in capital and operating expenses, the risk of default on loan obligations becomes more prevalent. Since founding Westmount over 35 years ago, I have steered the firm away from extending leverage levels too high, even if the firm has likely left upside on the table.

We have recognized the rapidly changing investing environment, including the increasing global risk factors. It is imperative sponsors carefully structure their capital stacks and operate efficiently. The lower purchase cap rates and rising interest rates we are seeing in today’s market are increasing the future cost of debt financing. Despite the risks, some sponsors still choose to push leverage levels higher within their capital stacks, adding subordinated mezzanine debt and preferred equity tranches for new transactions. As a result, we may see increased loan defaults over the next few years because of overextended sponsors.