Real Estate Credit Investments plc (LON:RECI) is the topic of conversation when Hardman & Co’s Analyst Mike Foster caught up with DirectorsTalk for an exclusive interview.
Q1: What is Real Estate Credit Investments?
A1: From investors’ point of view, an interesting way to get exposure to real estate is to invest in loans made to the owners of real estate. Real Estate Credit Investments – or RECI – is run by a major investment manager – a hedge fund if you will – Cheyne.
Cheyne has hundreds of real estate experts in many countries. It specialises in debt finance both to businesses and real estate. They are a quoted investment company dedicated to European, mostly UK, real estate debt sourced.
Q2: What are the main reasons to invest in the company?
A2: We like the manager, and, for example, we can see how it has avoided pitfalls in real estate in the decade-plus this fund has been in existence.
Obviously, sometimes the underlying asset can struggle. The fund did well through COVID-19, even though much real estate, retail and hotels in particular, did badly. In 2020, NAV did fall 10%, but it has maintained NAV since then. This is a strong outcome compared with REITs and helped by the choice of asset, the backer, that is to say the borrower, and the ability of Cheyne to work with the backer if there are problems. This worked particularly well in hotels during 2020-21, a sector where assets have come out the other side of COVID into a strong market.
Remember, as a debt fund, the investment case is to receive strong income but avoid volatility in asset value. Basically, loan principal values do not rise, they generate income. That said, NAV was on a very slightly rising trend prior to 2020.
Q3: So, the main reason is the manager?
A3: The main reason is the manager’s ability to add value in choppy waters, but, also, number 2 is avoiding difficult real estate segments in terms of asset class and geography and number 3 is being in markets where returns are good enough to be able to pick and choose.
Q4: What do you mean by pick and choose?
A4: RECI, Cheyne managers, have been able to predominantly pick well-financed borrowers who, if things get tough can often, not always, put in more of their own equity.
That protects their project but also obviously helps the security on the loan. It also means they have been able to get enough return to pay the good dividend out of predominantly senior loans. RECI flexes the loan to value of the project, the ranking of the debt – i.e. senior or mezzanine – and the risk on the actual asset, but, overall, it has evidenced in its detailed breakdowns asset by asset – i.e. loan by loan – that it seems able, repeatedly, to get double-digit annual returns from senior debt in markets and asset classes it chooses and, importantly, with those high-quality, well-financed borrowers.
Q5: It sounds strong if over 10% annual ungeared returns can be achieved with relatively low risk. Does it sound almost too good to be true?
A5: There is a gap in the market for providers of real estate debt. If banks lend here, it affects their risk profile, as calculated by the banking authorities, and the banks are then legally required to have less gearing on their own balance sheets. The regulators effectively force much commercial real estate lending off banks’ balance sheets.
Now, with much commercial real estate down-valued, even good assets with strong owners can see gaps when existing loans mature. Though these down-valued assets are not the core raison d’etre for them, it biases the market to higher, double-figure, interest rates.
Q6: What does this all boil down to for their shareholders?
A6: The proof of the pudding is more than a decade of unchanged dividends, even in the context of COVID and rising interest rates.
Q7: Is unchanged a little boring though?
A7: That’s the proposition, a high return generated by cash income.
By the way, our research note has upgraded the dividend cover in the current and next year. Cover had slipped as RECI de-geared. Now, we estimate a fully covered dividend going forward and indeed with global interest rates up, the momentum is for cover to continue to rise. Global rising rates extend the aspiration to dividend rises in the future, but that would be beyond our model horizon of March 2026.
Q8: So, what have been the risks, what might be the future risks?
A8: We have mentioned COVID and how they managed to maintain their strong dividend, though NAV fell near 10%. Global interest rates have risen and this could have put strain on. They did de-gear and that, as opposed to the asset performance, did slightly reduce net cashflow. It used to hold market-quoted bonds but has no material holding now.
As to the future, the asset sector allocation can always be exposed, but Real Estate Credit Investments has a spread. Hotels remain a larger component. Though currency-hedged, its exposure includes Euro assets; so, in the long term, investors should be aware of the currency. But loans mature and so the main risk is that global rates might fall were there to be a regulatory change encouraging banks to lend direct to commercial real estate. We do not see this as at all likely.
Q9: Finally, with interest rates much higher now and with so many real estate asset classes down valued since 2019, is real estate not an area to avoid, or at least to rate much more cheaply?
A9: Real estate does have more headwinds. That is, along with the allied regulatory one, why well-managed debt to commercial real estate is attractive, in our opinion.
