Right now is a moment in the commercial real estate market when seemingly everyone who has dry powder allocated to the sector is interested in debt. Players ranging from private equity firms to institutional investors to family offices have been putting capital in debt funds and waiting for loan maturities and distressed loans to hit the market.
In fact, a recent insights report from private equity firm KKR noted that real estate credit appears to be a higher-yielding investment option in the current environment than real estate equity. The firm found that yields on private real estate debt exceeded underlying properties’ economic cap rates by anywhere from 10 basis points to 180 basis points on the four core commercial property types (the lowest differential was in the retail sector, the highest in industrial and multifamily).
For FS Credit REIT (FSCREIT), a non-traded REIT launched by global alternative asset manager FS Investments in 2017, investing in private, short-term real estate debt has been the focus since its inception. As of year-end 2022, the Philadelphia-based REIT had slightly more than $8 billion of assets under management, with the majority (94%) of its portfolio comprised of 135 private senior loans and seven mezzanine loans and the balance in CMBS loans and other types of real estate debt. The majority of the loans (61%) in the portfolio were secured by multifamily properties, 11% were secured by hospitality properties, 10% by office properties and 6% by retail, with the rest secured by industrial, self-storage, mixed-use and other asset classes. The REIT delivered income-based return of 6.09% on Class I shares for last year.
But unlike many of the real estate debt funds scouring the market today, FSCREIT concentrates on high-performing assets in strong sectors in an effort to preserve its capital and limit its risk exposure.
That doesn’t mean there won’t be opportunities for attractive returns for the REIT under current conditions, according to Chris Condelles, the recently appointed CFO of FSCREIT (Condelles also serves as COO of FS Investments). With acquisition activity stalled, most owners with stable properties will concentrate on improving cash flow, which will ultimately benefit their lenders, Condelles noted. In addition, the short-term, floating rate loans that FSCREIT concentrates on give it the opportunity to renegotiate loan terms as the market adjusts to higher interest rates. Ultimately, that’s an attractive formula for the individual investors the REIT targets—it allows them to benefit from the income and returns private real estate debt offers, while providing protections against downside risk, Condelles said.
As of February of this year, 14% of the loans in FSCREIT's portfolio were facing an initial maturity date within a 12-month period. The average loan-to-value (LTV) ratio for the senior loans in the portfolio stood at 67%, but the average was lower for loans on retail and office properties—at 60% and 54% respectively.
To discuss the non-traded REIT’s strategy, its relationships with investors and its view on current market conditions, WMRE spoke to Condelles.
This Q&A has been edited for length, style and clarity.
WMRE: Your website/investor relations page mentions that one of FS Credit REIT’s primary objectives is to invest in real estate debt as a way to manage market volatility and preserve capital. Can you talk about how real estate debt can help investors achieve that goal, especially in today’s climate?
Chris Condelles: We think that real estate debt offers an attractive opportunity to investors, especially in today’s market. Lending is very different from investing in equity—generally, loans benefit from having the property equity value as a cushion below the loan balance. So, from an investor’s perspective, being higher up in the capital structure, having that equity beneath you, ultimately provides you with a lower risk profile than equity. In our REIT, we are actually the lender on the property, which means we have a hard asset to support the loan. The debt [we provide] is private in nature, which gives us a greater ability to structure the loans and build up protections. Our loans are floating rate and often two, three years in duration, with extension options if borrowers meet certain criteria. So having that lower duration asset in a volatile market environment gives you protection by allowing you to reassess terms with your borrower earlier on. This is different than a 10-year loan where you don’t have the ability to reevaluate the terms in a market like today’s. Typically, the loans we are making in our vehicles are really about providing property owners the ability to improve the physical characteristics of the property, improve the tenancy, and often within a two-three-year timeframe, they will look to refinance. In a market like today, where mortgage rates are very high, they are more likely to extend. So, having a shorter-term loan gives you a lot more control in these types of markets to come back to the table when properties are not performing.
WMRE: So far, it seems FS Credit REIT has focused to a large extent on private senior floating rate loans and on loans supported by multifamily properties, as well as on loans on properties in the South, in the Sunbelt. Are you changing that investment focus in any way given the changing market conditions?
Chris Condelles: I would say we are generally flexible in the parts of the market we invest in. I wouldn’t say we’ve made a huge shift in our investment profile. We are fortunate in that our conservative risk profile and the timing of our capital raise allowed us to stay away from office properties. So, our office exposure relative to a lot of the mortgage REITs is very low. It is about 10% of the portfolio. We had a bias toward multifamily for a variety of reasons. We have, as we came into recovery through COVID, prioritized hospitality a bit more, but we’ve tended to focus on blue chip hospitality. A good recent example is we provided an approximately $100 million senior loan to the Four Seasons hotel in Nashville, Tenn. We were then able to take advantage of having available capital to opportunistically increase our loan position by approximately $50 million from a bank seeking liquidity. We’ve obviously been interested in industrial assets. We made a $300 million loan to a set of industrial properties that was very opportunistic for us. So, I’d say we’ve lined up with others in that we have deprioritized office, we continue to focus on multifamily and we continue to bet on blue chip hospitality. What’s a huge advantage to us is our partner Rialto Capital has over $100 billion in a loan servicing portfolio, so through having access to their platform and having them as our sub-advisor we have more informed views on what’s happening in different regions, and where we may or may not want to make loans. As a private lender, I always hesitate to say we won’t lend in one area, but office is obviously something we are staying away from. And hospitality is a good example of us being opportunistic, but still disciplined by focusing on blue chip hospitality.
WMRE: Have you tightened the underwriting requirements for the loans you are originating over the past year? To what extent?
Chris Condelles: We’ve always been a very conservative lender. First and foremost, we are always looking at the sponsor and their track record and their own financial wherewithal to support their properties in times of distress. We make a very stringent assessment of what the cashflow potential of the property and basis on the property is, we want to know exactly what it would cost us in an event of a foreclosure. LTV has been a critical factor—we’ve seen LTVs go down, largely as a result of the forecasting of the cash flow on assets and equity valuations, but I don’t think it’s been dramatic because we are generally lending on higher-quality properties. On LTVs, our portfolio weighted average LTV has come down from the low 70s into the mid-60s. We always advise our borrowers to hedge against interest rates. And then as I said having a partner in Rialto, which has a large special servicing portfolio, gives us an edge in underwriting loans and structuring terms to mitigate risks. So, I think you are scrutinizing the cash flow and the business plan more, you are making sure interest hedges are in place, and making sure you have a tight handle on ultimate basis of a property.
WMRE: Are you looking at any major investments right now that you can talk about?
Chris Condelles: From a positioning standpoint, we’ve come into this cycle relatively under-levered. We are about 200% debt to equity, and that gives us an ability to provide capital at times when it may not be readily available and our large size puts us in with few players that can write a larger size check. The larger peers in the REIT space are levered anywhere from 250 percent to 400 percent debt to equity. We’ve maintained a strong liquidity profile and a lot of discipline in the leverage we take on, and that leaves us a lot of dry powder as the lending opportunity continues to be more attractive over time. And I think that’s evidenced, when you look at everybody’s filings, we’ve had a positive origination over the past quarter or two and that’s allowed us to be a capital provider, where most have been marshalling liquidity to bring down leverage a bit.
WMRE: When you look at the real estate debt market overall, everybody has been waiting for new opportunities to hit the market. Are you seeing that wave already?
Chris Condelles: Transaction activity has obviously slowed. That’s been driven by a slowdown in acquisition activity as equity valuations have been challenged due to rising mortgage rates and a lack of equilibrium right now. The market hasn’t achieved equilibrium between buyers and sellers. The interest rate environment has moved very quickly, interest rates have been volatile, so you are seeing more property owners, if they have existing attractive financing, hold off on selling or refinancing. They are focused on just continuing to improve their cash flow. We think in this market a good portion of the go forward returns will come not from equity appreciation, but from income generation and property cash flow—and that’s actually good if you are lender, ultimately it will service our debt.
WMRE: It also seems like there are a lot of private equity funds being put together to target real estate debt, that almost anyone who has money to invest in real estate right now wants to play in that space. How do you feel about the amount of competition that’s gathering in the market?
Chris Condelles: In terms of competition, there’s been less transaction activity in the CMBS market, banks are still active, but the turmoil in the banking sector has taken certain players out of the market. That created an opportunity for us with certain borrowers. In terms of the funds, some of those funds are being raised as dry powder for properties that will experience distress and foreclose—which isn’t our strategy. Our strategy is really to underwrite good sponsors and properties with strong cash flows—we want to have low volatility, generate a sufficient cash flow for our investors and protect against downside risk. So, the headlines are—there is a lack of deal flow, we are seeing a shift from price appreciation to income and cash flow on properties. There isn’t an overabundance of supply of loans to be made due to the transaction activity being slow and that leads to what we really think will be an attractive opportunity ahead, which is the rolling loan opportunity. It’s really a great time to be a lender—there’s a significant amount of loan maturities that will have to refinanced and to be able to be a private lender with capital available is going to give us ample opportunity to deliver attractive returns.
WMRE: What kinds of returns are you targeting today?
Chris Condelles: Our strategy for our debt-focused REIT is to really serve as a fixed-income ballast in our client’s portfolios. We historically target delivering several hundred basis points over traditional fixed-income investments. And that depends on where the interest rates are. Today our distribution rate sits at 7.6%, and as the Fed has raised interest rates, we’ve delivered two distribution increases this year. All this being said, our continued focus is capital preservation, so we’ll see most of our returns come from income.
WMRE: We also wanted to talk about where and how you are sourcing new investors? How important is the wealth channel to you in that regard?
Chris Condelles: FS Investments was founded in 2007 and our mission is to provide individual investors with the same opportunities afforded to institutional investors. Our focus is providing investors with access to alternatives. You are hearing that a lot now, but we’ve been doing it for 15 years, we were one of the first in the market to do that. We’ve built a vertically-integrated distribution engine. Today, we raise our capital almost equally between the independent broker-dealer channel, the RIA channel and the wirehouse channel—Morgan Stanley, UBS, the bigger wealth management firms. So, we are going to all the channels serving individual investors.
To do that, we’ve built a very robust sales and distribution platform and focused on investor education. Our education channel allows us to provide a unique perspective into the asset classes our funds represent. We do podcasts, webinars, in-person presentations to financial advisors. Because for many, alternatives are still a newer asset class, we feel we can play an important role in providing content and education.
A lot of our investors are used to thinking of real estate on the equity side. So, we spend a lot of time educating investors on the difference between equity and debt and how being senior and rolling up the capital structure, where you have the equity cushion in front of you, is really helpful. And we have a distribution force in the field meeting with financial advisors every day, we have a very strong marketing and research presence to bring this education to financial advisors and that’s a foundation which has taken 15 years to build.
WMRE: Just to confirm, you said your capital-raising is split almost equally between the broker-dealer channel, the wirehouse channel and the RIA channel?
Chris Condelles: The channel that has accelerated the most has been the wirehouse channel as the traditional 60/40 model has somewhat broken down. We really think about our mission in alternatives—it’s to give these individuals that access and to deliver the education and content necessary to financial advisors on whether this could be a valuable investment to their ultimate clients.
We are a bit unique in that FS has an open architecture platform. We partner with outside managers for our real estate debt platform. So, when we approach our platform, we are not just selling product only internally managed by us, we are bringing product by other managers that excel in their asset class or strategy. Because one asset management firm doesn’t excel in every asset class.
WMRE: Given that you’ve said alternatives continue to be a newer asset class for a lot of people, how receptive are these groups to investment in real estate debt in today’s environment?
Chris Condelles: We’ve experienced positive net capital inflows over the past two years, including through the recent bank turmoil and some of the earlier redemption periods you saw in the REIT space. And so, I think that’s an indicator of the receptivity to our product. I think it’s hard to tell exactly how difficult it’s been to sell, but really our job is to provide education to advisors about how real estate debt fits in a portfolio, and to provide them with access to top quality private real estate debt. So, I think what’s been resonating to advisors is you generally want to roll up the capital structure in this market where you have equity beneath you and are the primary lender, allowing you to drive the outcome when problems arise. And when you then combine that with current technical factors where you think it’s going to be a great time to be a lender, especially if you are a lender with dry power. We expect income is going to be the larger driver of returns relative to equity appreciation, and debt offers NAV stability and downside protection. You can get a premium in the private lending market because it’s harder to access. I think ultimately, that resonates with investors.
WMRE: Anything else that you want financial advisors and others in the industry to be aware of when it comes to investment in real estate debt or current market conditions?
Chris Condelles: It’s probably two-fold. If I left you with one thing, it’s that we think it’s really a great time to be a lender with dry powder, given the loan opportunities in front of us. Maturities are going to come up, private lenders are going to play an important role there. And for investors, to be on top of the capital structure and still be able to earn attractive returns, is a really great opportunity. You’ll see attractive yields.
As a firm, what’s really important to us is bringing alternatives to individual investors. We have a long track record of working with financial advisors and the platforms they are a part of, and that has allowed us to build our education program and differentiated products to better meet their client’s needs. It’s not a new mission for us to bring alternatives to individual investors. It’s been a 15-year mission for us.