If you want your commercial real estate management and investment decisions to be fully informed you have to know what CRE capital markets are and how they work. Commercial real estate capital markets play a major role in the CRE industry and the economy as a whole. This guide will help you learn more about the CRE capital markets, how they work and who utilizes them to optimize investment portfolios, property management, and income generation.
Capital real estate markets can be part of an investment portfolio, however, they don’t involve the direct purchase or sale of a property. The markets where real estate equity and debt instruments are sold and bought are known as capital markets. These markets are where capital flows from suppliers (institutional investors, etc.) to users (businesses, governments, etc.).
They can be primary markets in which new investments are sold directly for capital or secondary markets where existing securities are traded among security holders, not the issuing company. The secondary markets are where a lot of the activity occurs for real estate investors.
When an equity or debt instrument is attached to a commercial property it’s part of the CRE capital market. Real estate investment trusts (REITs) that allow investors to buy shares to earn dividends on revenue produced by a collection of properties are also part of the capital markets.
As you can see, there’s a variety of capital markets both in and out of the commercial real estate industry. The commercial real estate capital markets are broken into four quadrants. The four main categories of capital markets in commercial real estate are:
The markets are categorized this way based on the type of equity and debt instruments that are sold and bought.
Public bonds and notes for borrowed money that will be paid back with interest are sold and bought in the public debt capital markets. These capital markets offer investors more liquidity, transparency, and current income, but they tend to be volatile and it can be difficult to make projects. Collateralized debt obligations (CDOs) and commercial mortgage-backed securities (CMBS) fall into the public debt category. Mortgage REITs are also in the public debt quadrant.
The public equity capital market offers the same advantages of liquidity, transparency and income as public debt capital markets along with the same volatility and difficulty making projections. The difference is that the public equity capital market involves investment in equity securities from public companies that generate revenue. The payment for investors usually comes in the form of stock accumulation. Real Estate Investment Trusts (REITs) make up much of the public equity quadrant. It includes traded and non-traded REITs.
Private debt capital markets function in the same way as public debt capital markets, the key difference being they are originated privately and not bought or sold on the public market. One of the most common examples of private debt is buying a private mortgage loan and generating revenue on the interest. B-notes and mezzanine loans are in the private debt quadrant as well.
The private equity capital market involves equity securities from private companies. Instead of stock accumulation, investors typically receive regular distributions of a certain amount. Larger capital investment is typically needed for private equity investments. Investors will receive a private placement memorandum (PPM) that provides details about the investment and requirements, including how payments will be distributed. Private REITs are in this capital market quadrant, but it isn’t the only investment opportunity. The newest arrival to the private equity market is crowdfunding.
So, who is active in the commercial real estate capital markets? Many players are involved directly and indirectly at the various stages starting with the property owner that needs a mortgage.
The first step is originating a mortgage loan, which is done by a traditional bank, mortgage broker, mortgage banker, or private lender. Mortgage originators make money off of the fees that are charged to establish the loan as well as the difference between the loan interest rate and the premium paid by the secondary market (capital markets) where the loan is sold.
Aggregators are government-sponsored entities (think Fannie Mae and Freddie Mac) or large loan originators that buy original loans from smaller lenders on the capital markets. They pool the mortgages together to create either private or public mortgage-backed securities (MBS). Aggregators make money by selling mortgage-back securities for more than what was paid for the original loans.
Securities dealers are the ones who buy the mortgage-backed securities. They typically restructure the MBS into different types of securities that are then sold to investors. A securities dealer makes a profit by selling the securities for more than they paid for the MBS, which largely depends on how the mortgage-backed securities are restructured.
Investors are next in line. They can be individuals, also known as retail investors, all the way up to large global institutions. The debt instruments that are purchased generate income for the investor either through interest on the loan amount or revenue generation. Unlike other investments, the debt and equity securities provide regular income that’s usually received on a monthly basis.
Institutional investors are nothing like individual investors, and they are the primary players in the capital markets. For starters, an institutional investor is a company or organization that makes and manages investments for others using their clients’ money. They must also buy and sell securities in a large enough quantity to qualify as an institutional investor.
Institutional investors like the steady income generated by debt and equity securities because they have clients and account holders they pay regularly. They also use the capital markets to diversify their commercial real estate portfolios, and their size allows them to get better fees for investments.
Capital market institutional investors include:
Institutional investors are in the position to capitalize on investments with large buy-ins that are out of reach for most individual investors. They’re usually focused on highly rated securities with the exception of hedge funds. Hedge funds typically go after securities with higher interest rate risk and lower credit rating.
Commercial real estate is known for being volatile at times, and the capital markets have an influence on that volatility as well as the economy at large. The economy can’t function without capital markets because capital is needed for production and growth. It makes economic output possible.
When you’re examining the capital markets you are getting an idea of how funds are flowing between the macro economy and individual sectors of the economy. CRE capital markets are directly influenced by how the funds are flowing in and out the commercial real estate sector.
There’s no getting around the fact that today the state of the macro economy affects investor sentiment. And investor sentiment is one of the first things that impact the flow of funds to commercial real estate markets. This can in turn influence availability of capital and the pricing for commercial real estate.
Investors are primarily looking at two things in the macro economic data that can influence CRE capital markets: inflation and the potential ROI of other investment vehicles. Inflation feeds into the ROI of commercial real estate since it impacts interest rates, operating costs, demand, valuation and requirements for equity yield. Interest rates alone can affect how stable or volatile the commercial real estate industry is at the moment.
Right now the macro economy is strengthening. That’s a good thing for stabilization, but the concern is that rising inflation and interest rates could stall investment in the commercial real estate sector, thus slowing the post-pandemic recovery. In an industry that’s valued at $32.6 trillion globally, stagnation in the CRE markets would almost certainly have an impact on the larger economy as the ripple effect impacts other related industries such as construction and even retail.
The commercial real estate capital markets can influence some key elements of commercial real estate management. Most notably, it can impact operation costs and demand for space. Institutional investors must be keenly aware of what’s happening in the capital markets in order to make the best decisions when managing their clients’ portfolios.
The most evident role that capital markets play in the purchase of commercial real estate is their effect on interest rates. Loan originators that plan to sell loans pay careful attention to interest rates because it has a huge impact on their own potential profit if interest rates change before loans are sold. Of course, the interest rates are also a huge determining factor for investors in the capital markets since many earn revenue off of the interest rates of securities they purchase.
The capital markets and macro economy on a whole can influence whether investors buy at all. If the markets slow down and sentiment shifts downward due to issues with the larger economy investors are less likely to make purchases at all.
Any investor with commercial real estate to sell should understand that valuation is driven by capital markets. They are also huge drivers of liquidity and transaction activity, meaning that they have an impact on how many investors are looking to make a purchase. When capital is steadily flowing and the cost of capital is low, acquisitions ramp up along with property values.
The events of the last few years are a perfect example of how the capital markets impact investor interest in commercial real estate. With interest rates at record lows and liquidity at an all-time high, commercial properties were reaching near record level valuations. As a result investor interest has increased in both core and non-core commercial real estate segments.
If you want to see how the national economy is influencing investment in the CRE capital markets, take a look at the commercial property price indices. The indices include real estate market data on a national scale and for submarkets within the industry. And if you want to keep track of what’s happening in the capital markets and improve commercial real estate portfolio management using a data aggregation and analysis platform like RefineRE makes the process efficient and scalable so that the information is usable.