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Since the global financial crisis of 2008, commercial real estate has been under pressure due to historically accommodative monetary and fiscal policies, and an increasing allocation of investors to asset classes ranging from individuals to large pension funds. , has benefited from a sustained bull market. Cap rates continue to compress across many property types despite the turmoil caused by the pandemic, while property valuations surge across risk profiles and markets, fueled by strong rental growth. I’m here. Therefore, expected future earnings are naturally on the decline.
Given the lower cost of debt compared to equities, real estate returns have historically and recently been enhanced by employing leverage. The amount of debt used by real estate deal sponsors depends on their risk appetite and strategy. Debt has been proven to increase returns in good times, but it can fluctuate in both directions. In the event of an economic slowdown or recession, sponsors will need to navigate the market cautiously or risk defaulting on their loan obligations with significant losses for equity investors.
In addition to raising traditional senior first lien loans, real estate sponsors may choose to employ additional leverage in their capital stack, usually in the form of mezzanine debt or preferred stock tranches. While these tranches help drive returns, operating cash flows can be increasingly absorbed by significant debt service requirements. If rent growth slows, occupancy rates fall, or capital and operating expenses rise unexpectedly, the risk of loan default becomes more common. Since founding Westmount over 35 years ago, I have guided the company not to over-leverage, even if the company is likely to do well.
We recognize the rapidly changing investment environment, including increasing global risk factors. It is imperative that sponsors build their capital stack carefully and operate it efficiently. The future costs of debt financing are increasing due to lower purchase cap rates and higher interest rates seen in today’s market. Despite the risks, some sponsors still choose to push higher leverage levels within their capital stack, adding subordinated mezzanine debt and preferred stock tranches for new deals. Over extended, it could lead to an increase in loan defaults in the coming years.
In that case, new investment opportunities could arise on the other side and Westmount is ready.
Cliff Booth is Chairman and Founder of Westmount Realty Capital..
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