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Hybrids in Tough Real Estate Market

Report: Systematic Strategies

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HedgeNordic (Stockholm) – Swedish real estate companies have been active issuers of hybrids – notes subordinate to senior debt with both equity and debt characteristics. Regarded as partly equity by credit rating agencies, hybrids help issuers improve credit ratings and hence, reduce the cost of funding. The “real estate hybrids” space has experienced a tumultuous period since higher interest rates started eroding profitability and limiting options for debt refinancing.

Magnus Dahlgren

“Because most investors don’t like the real estate sector in this rising interest rate environment, the greatest opportunities can be found there,” says Magnus Dahlgren, a fund manager investing in hybrid securities. Dahlgren and his team at Carlsson Noren Asset Management see hybrid securities offering yields of 15, 20, and even 30 percent. “The higher-yielding opportunities are also associated with the greatest risks,” according to Dahlgren. Careful selection is paramount.

While the specific terms and characteristics of hybrid securities can vary widely, one of their bond-like characteristics is the payment of a pre-determined coupon not tied to operational performance. Hybrids also become callable several years after issuance (often, but not always, five years). Investors typically buy hybrids on the assumption of high call probability on the first call date. The decision not to call is often seen as a sign of financial weakness and can impact other instruments in the company’s capital structure. There is an incentive to call to avoid more expensive borrowing in the future.

“On the financing side, the situation is much worse because it is very expensive to raise debt. We have seen very few companies issuing bonds.”

The major problem real estate issuers face is the limited options to refinance an upcoming call with another type of equity-like instrument or cheap bond financing. “On the income side, the situation is quite good so far in the real estate sector. Most companies see an increase in revenues due to CPI-linked rents in commercial real estate, which is less prevalent in residential,” observes Dahlgren. “On the financing side, the situation is much worse because it is very expensive to raise debt. We have seen very few companies issuing bonds,” he emphasizes. “There is no business if companies issue bonds at high single-digit interest rates because revenues aren’t covering the financing costs,” elaborates Fredrik Carlsson (pictured right), co-founder of Carlsson Noren Asset Management.

Few real estate hybrids maintained their value in 2022, with most losing between ten to 50 percent, and in some cases, even 60 percent. “If investors expect issuers not to call their hybrids on the first or subsequent call dates, they have to put a high-risk premium on them because the duration becomes much longer. This is the so-called extension risk,” explains Dahlgren.

Issuers with better credit ratings saw their hybrids lose more value than lower-rated issuers in 2022. “All of these better-rated companies are just on the border between investment grade and high yield, most of them are around BBB or BBB minus. If they are rated at one or two notches down, many investors have to sell the senior bonds,” says Dahlgren. “But the main reason the better-rated euro-denominated hybrids lost more in value than the SEK hybrids is the high extension risk due to low coupon step-ups after the first call date.”

Avoiding Defaults Amid Wave of Maturities

Carlsson Norén’s fund investing in hybrid securities has only about one-third of its portfolio exposed to the real estate sector. “We don’t go for the highest-risk, highest-reward opportunities in this sector,” says Dahlgren, who is responsible for managing Carlsson Norén Yield Opportunity. “We would rather go for hybrids that yield 15 percent and have strong owners who do the right things than go for the riskiest opportunities,” agrees Carlsson. “These issuers will be the ones that can borrow from the banking system,” he continues. The team’s priority, after all, is to avoid defaults.

“We observed a very small volume of maturities in 2022, the wall of maturities is just starting. That is the stress in the market.”

Most real estate companies are working on improving their balance sheets in the face of higher financing costs, and lower expected property valuations amid a wall of debt maturities in 2023 and 2024. “We observed a very small volume of maturities in 2022, the wall of maturities is just starting. That is the stress in the market,” says Carlsson. Carlsson sees several options real estate companies can improve their balance sheets: temporary dividend cuts, asset sales, and rights issuance. “We saw several companies taking one or several of these actions during the last few months, and expect this to accelerate in 2023. Bank borrowing will increase,” according to Carlsson.

The Swedish real estate market faces a difficult environment amid higher interest rates, lower expected property values, and waves of maturities coming in 2023 and 2024. “We need to make sure this is not going to become a systemic risk as during the financial crisis,” warns Dahlgren. “The real estate sector today is too big to fail. Should the aggressive manner in which central banks raise interest rates continue, we will have big problems in the real estate sector that will spread into the banking system.”

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Eugeniu Guzun
Eugeniu Guzun
Eugeniu Guzun serves as a data analyst responsible for maintaining and gatekeeping the Nordic Hedge Index, and as a journalist covering the Nordic hedge fund industry for HedgeNordic. Eugeniu completed his Master’s degree at the Stockholm School of Economics in 2018. Write to Eugeniu Guzun at eugene@hedgenordic.com

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