“Stand on your own merit” Livewire Expert Insights

Lasky examines the risks in the commercial real estate debt (CRED) market and how it compares with the equity market. For him, there’s no one-size-fits-all borrower but instead, the investment philosophy must remain the beacon for discerning risk and new opportunities.

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Edited transcript

How do you assess CRED risk?

Most importantly, you’re doing very thorough due diligence on a mix of quantitative and qualitative aspects, but the two key aspects that we’re focused on really is the commercial real estate itself, which is the underlying security, as well as the borrower. So these are the two features that will absolutely be relevant in every single loan.

I think it might be more interesting conceptually to have a think about the manner in which we’re going about the assessment. So what we’re doing is a borrower will typically come and say, “Here’s the real estate, here’s the business plan associated with it, here’s a feasibility that sits beside it.” Maybe there’s some cash flow analysis to compliment it. There’ll be a raft of different elements, but what we will do is we’ll take this information, and we’re not going to sit there and say, “Okay, fantastic. So if the business plan goes exactly according to plan, then this is how we should conduct our lending.” What we’re doing is we’re conducting scenario analysis testing. So we’re saying, “well, we think there are some things that could go wrong, and so we’re going to have a look at well, if they do go wrong, are we still going to be protected in those scenarios?” It’s really only when the answer to that is a positive one that we’re going to actually lend the money.

A classic example of that is if you take, say a residential development, you might have 500 apartments in a residential development. You might have pre-sold a number of those apartments. What we will do is we’ll say, “Yes, but there may be some defaults in three years time on completion”.

So we’ll factor in some defaults, and there’s obviously going to be some residual stock left. So we’re going to factor in some diminution in the value of the underlying security. If we’re comfortable with the outcome there that the debt will be made whole, then we’ll absolutely proceed with the lending. But really only in those instances will we participate.

How does investing in CRED compare with CRE equity?

Well, I think it’s very similar when you’re looking at the actual real estate. Naturally enough, whether you’re in the equity or in the debt, it’s the same underlying security. So the only difference really with respect to the equity is that you’re typically coming in earlier, so there are more unknowns with respect to whatever the business plan might be. But what I would say is that the focus is absolutely different. The debt primary focus is capital preservation. The equity’s primary focus is how to optimise its return for the equity risk.

So when you’re thinking about the different focal points, really it’s a very different mindset, and it’s also a very different skillset. The best example I can give you is at MaxCap we have two completely separate businesses with two completely separate teams that are looking after, in one instance, the debt business, and in the other instance, our equity joint venture arrangements. It’s critically important to do that because both of those teams have different skill sets and they operate completely independently.

Is it easy to transition between debt and equity? 

A well-diversified portfolio should have an allocation to both debt and equity, and I think when you’re thinking about equity, it’s a truism in real estate that the profit is in the buying. So if the market’s running hot, it’s probably a good idea to consider weighting your allocation perhaps more in favour of commercial real estate debt, but that’s a general statement. There are always opportunities out there, and so I think that the key distinction for MaxCap is solving our client’s needs.

If you have a borrower who in one instance is looking at their capital stack and saying, “Well, my greatest problem that you could solve is on the equity side,” then we want to be able to provide that solution. Conversely, if all that’s required is some really competitive terms on the senior debt basis, well, then we want to be able to provide that solution.

Interestingly, from the investor’s perspective, when we were solely focused on debt we thought that was a virtue for a very long period of time until such time as a number of our investors came to us and said, “Well, the debt’s wonderful. You’re doing a great job. But what else have you got? Maybe something a little bit higher up the risk curve.” So it’s good to be led by the market, and I think it’s very good to be led by investors in that respect, too. That’s really what’s happened with respect to the evolution of our funding lines, be it debt or equity.

Do you provide finance across the capital stack? 

We’re really operating from first mortgages all the way through the capital stack to the equity in joint venture positions. So very often what will happen is if we’re originating a loan that may require a 70% or 75% loan to value in the capital stack, there are different ways of structuring it. You can structure it with senior, with mezzanine tranche above it.

What’s also in vogue today, a little bit of the plat du jure, if you like, is a lot of particularly offshore investors like the super senior. They like taking the zero to 40%, obviously with a lower return, naturally enough – considerably lower risk with say a B-Note or the senior position being from the 40 to 70%.

So there’s always different structuring that you can look at, but what I would say is how you structure the loan, again, is absolutely relevant to what the borrower’s needs are and has to be very much in line with your investment philosophy. So you never want to be straying from your investment philosophy just because there’s some interesting structure or you just want to enhance returns, never for the sake of the exercise.

Do you have a preference for real estate asset classes?

Well, I think the answer to your question is from a top-down or general appetite perspective, the answer is ‘absolutely yes’. There are certain asset classes that we have a preference for, and you mentioned industrial. I mean, in the last five years industrials, what was once the ugly duckling, is now the darling of commercial real estate. So we are very active in that sector. You mentioned retail as well, but what I would say is there’s a bit of a difference there between traditional retail versus what are called non-discretionary or convenience retail. So think about supermarkets and think about some of the large alcohol chains which proved to be pretty resilient during COVID.

So we like those asset classes at the moment, as well as the residential sector. The residential sector continues to perform pretty strongly. It’s a very broad umbrella when we talk about residential. So presently house and land is performing well. Medium-density – that’s more focused on owner-occupiers. So more of a domestic market is performing well, and selectively some of the higher-density projects. But what I would say is from a bottom-up approach, that’s the way you build a portfolio. It’s done on a loan-by-loan basis. Every loan’s got to stand on its own merit. We’re going to be pretty agnostic when it comes to the sector and when it comes to geographies because if it’s an astounding piece of real estate with a really experienced, well-capitalised sponsor with a fantastic team, we’re likely to want to participate in that transaction. If that’s in one of these asset classes that is perhaps not the flavour of the day, it doesn’t mean we’re not going to participate in it. I also think there’s always really good countercyclical opportunities.