US High-Yield Real Estate Debt May Not Be So Risky

There’s long been a question, according to Yardi Matrix, about whether high-yield commercial mortgages get priced in line with the risk investors face. The problem has been data—or, rather, the lack of it. “Originators and holders of subordinated debt tend to be private operators that keep a tight lid on information for fear of giving away trade secrets,” Yardi noted.

But a new analysis from Michael Giliberto—a cofounder of the Giliberto-Levy mortgage indexes—in the Journal of Portfolio Management reported that “high-yield debt produced a return of 8.5% during the 2010s decade, more than senior instruments such as senior fixed-rate debt (5.5%) and CMBS (5.9%) and less than equity indexes produced by the National Council of Real Estate Fiduciaries: the ODCE fund index (10.5%) and NCREIF Property Index (9.4%),” according to Yardi.

According to the article’s abstract, the analysis used a “multimanager sample of loan-level data to assess the performance of commercial real estate (CRE) subordinate debt from 2010 through 2020.” Giliberto compared that data to “various real estate alternatives, including senior mortgage loans and real estate equity.” A sample of the loans became a data set to examine the risk-return trade-offs. The sample comprised 408 loans

The abstract stated three findings. First, over the sample time period, CRE debt saw higher average returns than senior loans and lower than the returns from real estate equity.

Second, investors generally received compensation for both greater financial risk (higher position in the capital stack) and real estate risk (value-add versus stabilized).

Third, loan defaults were infrequent. However, high losses had significant effects on portfolios.

Yardi points out two caveats. One was the small sample number of loans: 408 from the Giliberto-Levy 2 index. Although the full paper was not available to GlobeSt.com, Yardi mentioned two different collective values of the loans: $20.9 billion in one place and $209 billion in another, suggesting a typo in one of the values.

The second, more serious Yardi reasonably argues, was that during the sample period, there wasn’t a market downturn, as happened in the 1990s or between 2008 and 2010. The realization of risk isn’t evenly distributed, so a potentially large impact on defaults and the values of loans and properties that would affect returns couldn’t be measured.

So, while the study is valuable, the limitations are important. Without a sample that includes a downturn period, it is impossible to know what average performance and returns might be in times that included significant realized risk.