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Three Reasons Why the Debt Markets Outlook is Bright
Authored by Jonathan Needell, President and Chief Investment Officer
April 27, 2022
The debt markets are under a considerable amount of scrutiny and speculation this year.
With high inflation rates in play and the Fed indicating that several more interest rate bumps are ahead for 2022, commercial real estate stakeholders have been understandably concerned about the debt markets. Will investors continue to have confidence in U.S. real estate assets? Will lenders tighten their underwriting? If inflation continues at its current pace and interest rates keep rising, how will real estate lending be affected?
As seasoned investors in commercial and multifamily real estate, Kairos has been watching these events, and we have a balanced perspective on this situation. Here are three reasons why we believe investing in debt can remain attractive.
- Investors can strategically allocate for rate increases.
There are ways to approach real estate financing that compensate for the rising cost of debt. Allocating to floating rate mortgage investments is one attractive approach.
While inflation causes floating rate debt to adjust upwards over time, investors have the ability to adjust for interest rate increases by investing higher up in the capital stack in floating rate mortgages.
Positioning an investment as a senior mortgage, as we work to do for our investors, provides a considerable level of safety. In addition, as interest rates increase, being situated closer to the top of the capital stack protects against the equity erosion caused by inflation.
Utilizing this strategy allows investors to mitigate risk and more confidently invest in commercial real estate loans.
- Inflation is predicted to be transitory.
The market may be overly concerned about inflation’s impact on the economy. While at this point we are at nearly 9% inflation, this number is predicted to be close to 4% by the end of 2022 and to decrease to 2.7% by the end of 2023.
The main factor that has caused inflation to rise is the pandemic, a factor that is subsiding and not systemic. Delivery demand is decreasing as we recover from this crisis, with trucking spot rates peaking in early January before dropping $0.54 per mile. We are also hearing reports that other costs are beginning to normalize.
Although we did experience an unusual scenario in the 1970s of exceptionally high interest rates and inflation coupled with a recession, which stifles purchasing power, we are not in that situation today (yet) as we do have wage growth in many markets.
These factors all indicate that decreasing inflation or disinflation is not far over the horizon.
- The climate of inflation favors investing in debt.
If inflation proves not to be transitory, then floating rate debt is even more protective toward investors since it acts as a hedge against inflation.
Most floating rate lenders base the interest rate they charge on their debt on SOFR or the secured overnight financing rate – the cost of borrowing money overnight. SOFR is expected to rise from 0.29% (at the writing of this article) to 2.0% by the end of the year due to inflation. Kairos has invested in loans in our credit strategy that are based on SOFR, and this future rise allows us to potentially accrue better yields for our investors as SOFR climbs.
Ultimately, investors who lean into the debt market are positioned for greater returns even in an inflationary economy and particularly if unchecked inflation causes interest rates to increase more dramatically.
While inflation and rising interest rates are causing some real estate investors to question the debt markets’ impending health, we believe the debt markets are one of the most attractive places to invest currently. With investors able to strategically allocate to floating rate debt and positioned for interest rate increases, inflation predicted to be transitory, and – even if it isn’t transitory – an inflationary climate favoring debt investment, our outlook on the debt markets remains bright for the majority of investors.
* This content is meant for informational purposes only and should not be construed as a recommendation, an offer of services, or an offer to sell, or solicitation of an offer to buy a particular security or investment strategy. There are no guarantees that any specific investment strategy will be profitable or equal to past performance levels. All investment strategies have the potential for profit or loss. The views and opinions expressed in this article are solely my own.
For questions, contact Investor Relations at firstname.lastname@example.org or 949-800-8500.
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