Commercial real estate debt: Transitional assets deep dive

Figure 1

Importantly, transitional lending takes on the risk of business plan execution (i.e., value creation). But when structured correctly, these loans can maintain robust alignment with the borrower even when execution doesn’t go according to plan. In our view, a key strength of transitional lending is that loans are able to bend in times of distress but not break. 

Fundamentals vary significantly across CRE sectors, making it essential to be cycle-aware within each vertical. However, in CRE debt, and especially in transitional lending, we believe there are opportunities across sectors regardless of cycle. From our perspective, the key to navigating CRE as an asset class is knowing where the best relative value is at any point in the cycle (Figure 2). We believe this requires fundamental, bottom-up underwriting expertise at the individual property level (both in its specific micro location and broadly within the property type). Moreover, casting a wide net across property types and markets offers the ability to opportunistically pivot as underlying sectors exhibit their own cyclicality.

Figure 2

What makes transitional CRE lending different?

Transitional CRE lending is in some ways an antithesis to traditional (i.e., core) lending. Core lending has a backward-looking bias and generally assumes that stabilized core assets will remain competitive into perpetuity. We believe this reasoning has proven challenging for many long-term holders of CRE in the recent market. Over the past three years, the CRE sector at large has experienced a dramatic repricing with macro tides receding to reveal numerous examples of underappreciated risks within core assets. The unfortunate reality for CRE is that many are aging assets susceptible to obsolescence across multiple dimensions, including: (i) deteriorating physical quality or outdated amenities/technology, (ii) cash-flow deterioration due to tenant loss (which could be due to (i) above or shifting dynamics such as work-from-home), and (iii) a shift in highest and best use, such as an outdated office building better suited for conversion to apartments. As the world continues to change rapidly, the way we work, live, and shop will continue to be catalysts for further transitions in CRE. 

Generally, obsolescence occurs gradually over time, but a core asset can swiftly become transitional if a single-tenant property loses its sole occupant. By definition, a core asset is also stabilized, which limits its potential for further upside primarily to macroeconomic conditions (i.e., cap rate compression), while the downside risks (i.e., idiosyncratic in addition to macroeconomic) remain inherently larger. Through this lens, we believe transitional CRE lending offers a differentiated risk-reward profile, as the opportunities for value creation are distinct and significantly greater. 

What are transitional lending’s potential risks?

Transitional lending carries real risks — from execution missteps to market dislocations — and we believe success depends on how thoughtfully those risks are underwritten. While the asset class offers the potential for attractive risk-adjusted returns, it demands rigorous evaluation of idiosyncratic risks: collateral quality, business plan feasibility, tenant credit, market fundamentals, and sponsor capability. 

We believe this is where a bottom-up, owner’s mindset is essential to underwriting. In our view, CRE assets should be underwritten individually to best ascertain intrinsic value, as underwriting to the average can substantially miscalculate the true worth of stronger assets and overvalue weaker ones. Finally, transitional CRE debt’s downside risks can be better mitigated through robust loan structuring and meaningful alignment with borrowers, which begins with sizing of the loan to a defensible basis.

Where does transitional CRE debt fit within portfolios?

Asset owners who find the transitional CRE debt opportunity set compelling will likely look to understand what roles these allocations typically play in a portfolio. Allocators generally view CRE debt as either a fixed income replacement, a private credit diversifier, or part of a diversified real asset allocation. This is due to four key attributes of the asset class:

1. Current income: Transitional CRE debt has historically provided a relatively high current yield (low-to-mid teens levered) compared to traditional bonds. Returns are primarily generated from fixed or floating-rate (mainly floating for transitional CRE debt) coupons supported by cash flow generated by the property. 
2. Diversification: We believe transitional CRE debt offers diversification beyond traditional markets with minimal market correlation to public equities and fixed income. In addition, transitional asset loans are, in our view, complementary to fixed income investments and can provide a higher return profile than CMBS, potentially enhancing portfolio performance. Moreover, further diversification can be achieved through various property sectors and markets.
3. Asset-backed structural protection: Transitional asset loans are backed by physical assets and can include more robust financial structures relative to both corporate credit and CMBS, potentially enhancing security and risk control. The remedy process for lenders is tried-and-tested and provides a clear path to maximizing recovery in downside situations. 
4. Inflation hedge: As a primarily floating-rate security, during inflationary periods with rising interest rates, private CRE debt has historically enjoyed increased total yields. Notably, in declining rate environments, minimum returns can also be safeguarded through index floors.

Bottom line on investing in transitional CRE assets

The CRE debt market has steadily grown for decades and is a foundational asset class for institutions seeking current income with added downside protections. In our view, within the CRE debt universe, transitional assets offer a differentiated opportunity by historically providing attractive risk-adjusted returns both in uncertain markets like today and through cycles. 

¹Reprogramming examples can include investing capital into an existing office asset and converting it to for rent residential or converting an existing hotel asset into a student housing project. Other types of reprogramming can include taking a former multifamily rental project and converting it into a condominium project where units are sold to individual owners.