Risk, return and reality in commercial property

Equity or credit in commercial property? We model the risk, return and downside trade-offs investors cannot afford to ignore.

Investors in commercial real estate often face a fundamental question: should they allocate capital to equity or credit?

Both strategies have merits but they behave very differently when it comes to risk and return. This difference in risk return behaviour is precisely why each of them has a logical position in diversified investment portfolios.

Understanding the differences is critical for making informed portfolio decisions.

At Trilogy Funds, we have been managing real estate credit and equity assets for more than 25 years and currently manage over $1.6 billion in assets. In this article, the risk and return realities of these investments will be unpacked and outlined.

A commercial property equity investment typically involves owning the property and financing it with leverage, often with around 50% debt. The investor benefits from rental income and any appreciation in the property’s value.

However, leverage can be a double-edged sword: it amplifies gains when things go well but magnifies losses when markets turn. Equity investors are also exposed to operational risks, market cycles, and refinancing challenges, all of which can significantly impact returns.

Real estate credit investments, on the other hand, involve providing a loan secured by property, for example, a first mortgage at 65% loan-to-value. Interest charged on the loan provides income that can be distributed to investors. The principal is recovered when the facility is repaid, either by disposal of the property or refinance and can be recycled into other loans.

Credit sits higher in the capital stack, offering priority over equity in the event of distress. This generally means lower volatility and stronger downside protection, but also a capped upside. Unlike equity, credit investors do not participate in property appreciation.

While this may seem elementary to seasoned investors, it gets interesting when we start modelling potential outcomes.

To illustrate the trade-off, let’s consider a $300 million property fund with a 6% average cap rate and 3% annual rent growth over a five-year hold. For equity, we assume 50% leverage at 5.5% p.a. interest rate: for credit, a first mortgage at 65% LTV with an 8.0% p.a. interest rate.

We then model three scenarios:

• a 20% decline in property value,
• a base case, and
• a 20% increase in property value.

The results are telling. In the downside scenario, equity delivers a negative IRR of -0.90%, while credit remains steady at 8%.

In the base case, equity returns an IRR of 7.20%, still slightly below credit. In the upside scenario, equity jumps to an IRR of 13.29%, whereas credit stays fixed at 8%. 

Market conditions will influence the value of property equity, and indeed the value of loan security (covered more below). However, market conditions alone do not drive variations in the borrower’s obligation to the lender – the contracted loan amount persists until it is repaid.

This highlights the fundamental difference: credit offers a higher degree of certainty, while equity offers more variability, both risk and reward.

Equity sits at a high-risk score with a wide range of potential returns, from negative to double digits. Credit occupies a low-risk position with consistent returns around 8% distribution yield. For investors, this means equity is a bet on growth and market performance, while credit is a bet on stability and capital preservation.

However, in the same scenario, the implied LVR on the credit investment would change and hence the risk profile which is often overlooked.

• At –20%, the lender’s cushion or buffer compresses: 81% LVR is still senior but much closer to the zone where default losses can emerge, particularly if sale/realisation costs and timetorecover are considered. A modest additional decline or a costly enforcement process (fees, price slippage, carry) can erase the remaining protection, leaving the portfolio vulnerable to a capital loss.
• At base, the lender remains in the “core/ coreplus” comfort band at the original 65% LVR, where recoveries are historically robust and principal impairment risk is low, assuming stable income and liquidity.
• At +20%, the loan derisks to ~54% LVR, materially increasing the margin of safety. Even a subsequent correction would be likely absorbed before the principal is threatened.

Tax implications add further considerations. Equity investors often benefit from depreciation deductions, which can shelter income, and they may enjoy favourable capital gains treatment upon sale. Interest on debt is generally deductible, reducing taxable income.

Credit investors, however, face less favourable treatment: interest income is typically taxed as ordinary income, and there are no depreciation benefits. This means after-tax returns for credit can be meaningfully lower than headline IRR, especially for investors in higher tax brackets.

Risk in commercial property investing extends beyond return volatility. Equity investors face market risk from cap rate movements, operational risk from tenant turnover, and refinancing risk when debt matures. Liquidity is another factor; selling an equity stake can be slow and costly compared to exiting a loan.

Credit investors, while senior in the capital stack, are not risk-free. They face default risk if property values fall sharply, interest rate risk on floating-rate loans, and enforcement risk during recovery. 

Understanding these dimensions helps investors weigh not just potential returns but the resilience of each strategy under stress scenarios.

So which strategy fits your portfolio?

Equity suits those investors seeking growth and willing to accept volatility, while credit appeals to those prioritising predictable income and downside protection. Ultimately, the choice depends on your risk tolerance, return objectives, and tax position.

Equity and credit serve different roles in commercial real estate investing. Equity offers upside potential but comes with additional risk. Credit provides stability but doesn’t benefit from the upside of appreciation and less favourable tax concessions.

In a diversified portfolio, equity exposure can provide investors with some exposure to capital growth, and potentially higher future earnings potential through a growing capital base. This is a particularly important consideration as life expectancies, and consumer goods prices, grow. In the same diversified portfolio, credit can bring complementarity, smoothing returns in volatile times and providing faster access to capital for unexpected life expenses or portfolio reallocation purposes.

Understanding these dynamics and how they align with investment goals is essential for building a resilient portfolio.

Outlook

Looking ahead, the relative attractiveness of equity versus credit will hinge on macroeconomic conditions and capital market dynamics. If interest rates stabilise or decline, equity returns could further improve as cap rates compress and financing costs ease.