Pension funds are beginning to dip their toes in the real estate debt market. But will allocations become deeper and more widespread? Richard Lowe reports

One of Frankfurt's most prominent office buildings, the 166-metre tall Siberturm (or Silver Tower), changed hands in the second half of 2011, with Commerzbank selling the former Dresdner Bank headquarters to IVG Immobilien. It was a notable transaction in itself, but the most significant fact was it included debt financing from German pension fund Bayerische Versorgungskammer (BVK).

At the time, Daniel Just, deputy chairman and head of asset management at BVK, revealed this was likely to be the start of real estate lending programme focusing on core office buildings in Germany. It showed that pension funds, as providers of real estate debt, had well and truly arrived.

Dutch pension funds were some of the first movers, APG being the obvious example: the pension asset manager was the cornerstone investor in Pramerica Real Estate Investors' European debt investment programme. Bouwinvest, the asset management arm of BPF Bouw pension fund, was another investor in the club fund. Dutch pension provider Grafische Bedrijfsfondsen (GBF) - which recently changed its name to Timeos - was one of the first investors in M&G Investments' junior debt fund.

Other large European pension funds have looked at the space but not made any investments, including the UK's West Midlands Pension Fund. The pension fund of UK retailer Tesco has also indicated it is interested, in principle. Former Schroders' real estate multi-manager, Jenny Buck, who recently joined the Tesco pension fund in the UK as head of property, told delegates at the IPD/IPF Property Investment Conference at the end of 2011 that the institution would consider investing "across the capital stack" in a bid to target returns over and above those offered by core property investments.

Valtion Elakerhasto (VER), the state pension fund of Finland, has met with a number of prospective debt fund managers, but has not invested in the space due to "currency and structural issues", according to managing director Timo Löyttyniemi. The pension fund might be in a position to invest in 2012 "if a suitable product is available", he added.

John Mancuso, director of real estate for EMEA at Russell Investments, says he has been looking at real estate debt strategies on behalf of pension fund clients, but has yet to make any commitments. He says the investment opportunity is a compelling one, but has yet to find products in the market that meet his clients' specific requirements.

Research by IP Real Estate certainly suggests that those pension funds actively invested in property debt are in the minority. Of the European institutions surveyed, just over a quarter (26.7%) were actively invested in the space.

However, the picture looks set to change going through 2012 and into 2013, with one-third (33.3%) of respondents stating they intend to invest in real estate debt over the next 18 months.

Junior debt strategies appear to be most popular, although senior debt is evidently of interest to pension funds. Of those respondents with real estate debt allocations, a two-thirds majority (64.7%) are looking at mezzanine investments, while a slightly smaller proportion of investors (58.8%) are looking at senior debt. The proportion of respondents considering preferred equity and distressed debt/whole loans were 35.5% and 29.4%, respectively.

German pension fund Ärzteversorgung Westfalen-Lippe (AeVWL) is another large institution only cautiously making a move into the space, although real estate portfolio manager Marian Berneburg admits there is a very compelling investment case.
"The current developments from our perspective are not so much a new paradigm in the way real estate is being financed, but it is more a return to the old ways when a 60% debt and 40% equity financing was the norm," he says. "In those days banks and pension funds were equal competitors in providing commercial real estate debt, as their respective re-financing costs were comparable."

Berneburg says in the 1990s and 2000s there was a departure from this scenario and pension funds were priced out of the market by seemingly ever-cheaper bank financing. "We are now - slowly - returning to the old ways of real estate debt," he says. "So today, as banks are raising their loan-to-value (LTV) limits and requiring increased margins, there is a gap opening between real estate financing needs and available bank financing, and this gap provides an opportunity to alternative sources of financing. There is a chance reappearing for pension funds to step in, but there are several regulatory and operating obstacles in the way, as well."

The problems essentially fall into two categories. The first concerns the means of accessing real estate debt investments: whether to invest directly on indirectly. Berneburg highlights difficulties in investing in pooled debt funds, which due to their nature cannot be structured in a traditional way. "A classic debt fund is increasingly difficult from a German regulatory perspective to be set up for us," he says. "Extra structures - for example, through securitisation - will cost money and may make things difficult in the future."

For this reason, the pension fund is looking at entering into deals more directly if and when suitable opportunities are identified. "We are more looking on a deal-by-deal basis rather than committing to blind-pool debt investments, because we haven't come across a good vehicle that would cover our needs," Berneburg says. "But doing this deal by deal will also mean that the diversification is lower and ticket sizes are larger. Additionally, direct debt investments require a greater amount of admin and follow-up business. In other words, providing the debt becomes more difficult for us."

UK pension funds have been active through investment consultants and multi-managers. Paul Richards, head of European real estate, says the majority of Mercer's real estate manager searches for UK pension funds in 2011 were for debt strategies, "which is different to last year when the majority were for core funds".

CBRE Global Investors' multi-manager business, meanwhile, has been active on both the distressed debt scene, specifically in Japan, and was a cornerstone investor in one of the recently launched mezzanine funds in the UK. Jeremy Plummer, head of global multi-manager, says both strategies have been "very attractive".

A report published recently by Nabarro placed the appeal of debt investments in context. The law firm's Fund trends survey 2011/12 polled 195 global fund managers and investors about opportunities in the UK property market and found significant interest in mezzanine real estate finance and senior real estate debt strategies, although they were by no means the most popular. Traditional investments in London offices and out-of-town retail property were ranked top, with 83.8% and 42.6% of investors, respectively, identifying these two sectors as offering the best opportunities. By comparison, 22.5% of investors cited mezzanine strategies as attractive, and only 5.7% selected senior debt. Real estate fund managers were loosely in line at 19% for mezzanine and 10.8% for senior debt.

Asset allocation challenges

But it has not been a straightforward journey for either Mercer or CBRE Global Investors, since real estate debt is new ground for many UK pension funds and is unlikely to feature in existing real estate investment management agreements. In many cases it has been a case of speaking to the end-investors and proposing the widening of their real estate definitions to include such strategies.

"There is this perennial debate we get with the ultimate capital sources - the pension funds - as to whether debt is real estate and therefore whether they want it to be dealt with by their real estate manager," Plummer says.

The multi-manager outfit has to date invested in distressed debt situations in Japan - and Plummer says they could potentially back similar strategies in Europe and the US should the appropriate vehicles be identified - and is the cornerstone investor in a mezzanine fund in the UK. It is proof that some pension funds are willing to accept debt strategies within their real estate allocations.

"You have a downside cushion - with the equity piece in there - and the return very often on the mezzanine piece is as high or higher than traditionally you would expect to get on the equity piece," Plummer says of the mezzanine strategy. "You are getting the same return you might have traditionally expected when in the first-loss position. That in principle looks very attractive to us."

But Berneburg says there is debate to be had about the true risk of mezzanine investments and whether they are therefore a better substitute to investing equity. "The connecting risk largely depends on the way the mezzanine financing is being structured," he says. Mezzanine investments, which are sometimes promoted as providing returns of more than 10% can be close to equity investments in terms of their risk. "Then we ask ourselves why not invest in equity, because at least then we have more upside as well, while the downside protection of the mezzanine can be very limited."

AeVWL would ideally like to invest in the more secure senior portion of the capital stack, but this rarely offers the returns the pension fund requires. "While mezzanine is difficult from a risk perspective but offers sufficient returns, senior debt still often comes in at below our return requirements. We haven't seen the sweet spot - yet," he says.

The main issue for Mercer and many of its UK pension fund clients is that although real estate debt is seen widely as a very attractive investment, it does have its challenges in terms of asset allocation. "It's more attractive than some other sorts of fixed interest [income] investments and it's in some ways more attractive than direct real estate investment at the moment," he says. "Some of our clients who invest in this area will take it from their fixed interest portfolio. Some will take it from their real estate portfolio."

IP Real Estate research shows little consensus among pension funds as to where they should source capital for real estate debt investments. Almost half (48%) of the survey respondents invested or planning to invest in debt would commit capital from their real estate allocation (figure 4). Interestingly, 24% consider debt investments to form part of a fixed income allocation, while 28% would separate it from both.

Richards says the move into real estate debt is part of a wider trend to find fixed income and bond substitutes. But importantly, while some of the investment characteristics of real estate debt might be shared with fixed income investments, the underlying risks are very much property-specific ones.

"It's different from a real estate investment in that the plan is you will get a fixed coupon which will not vary with changes in the property markets - rental values may go up and down but your coupon will remain fixed," he says. "The way I put it is: it's not a real estate investment until it goes wrong, in which case you foreclose and you've got a real estate investment by default. And the reason it could go wrong is going to be a real estate reason. It's because of the tenant, it's going to be something to do with the building or the market."

Andrew Radkiewicz, managing director at Pramerica Real Estate Investors, is adamant that when it comes to junior debt strategies, it is very much a real estate investment. Pramerica prefers to look at real estate debt investments as a way of accessing property exposure rather than an investment in itself.

"We are 100% convinced by this," he says. "When you come to talk about a debt fund - unless you are dealing in purely investment-grade senior debt, everything else definitively sits within the real estate bucket. It made be well structured as a loan, it may have security around it, but actually in itself it is simply a method of investing in the underlying real estate.

"Where we have had most success with investors is presenting these debt strategies as a form of investing in real estate," Radkiewicz adds. "It gives them the opportunity to invest in properties in real estate that they can't buy or people aren't selling."

Future allocation trends
Pension funds have essentially undergone an education process over the past two to three years, as the real estate debt investment opportunity has opened up. "There was and still is, I'm not surprised to say, a perception that these debt investments, whether they're called mezzanine, junior debt or whatever, are some sort of hybrid derivatives or investments in themselves," Radkiewicz says. "The clearest way we have managed to get through to investors is basically all investments through debt are investments in the underlying real estate - that is, debt is simply the structure."

Richards agrees. "One reason for the need for an education process is the word mezzanine sometimes conjures up a picture of great risk," he says. "Once the trustees understand the risks and returns that's when they start to think: gosh, this looks like a good idea."

Dale Lattanzio, managing director at Duet, says "there was a tremendous amount of education that was required" when the real estate private equity firm began marketing its junior debt fund in 2009. He attributes this to the lack of traditional activity on the part of European institutional investors in the real estate debt space, in contrast to the US.

"Everybody [in Europe] was of the understanding that banks provide debt for commercial property and that's the way Europe works," Lattanzio says. "What was slower in terms of becoming understood was that several things had changed." He cites the two main drivers: Basel III regulations, which will constrain bank lending, and the phenomenon of traditional European lenders are retrenching from the financing market due to their own balance sheet problems.

The first movers Lattanzio describes as "a subset of pension funds that internally have pools of capital for opportunistic investments where they saw a window open and they were able to allocate". He believes this development will be superseded by a more substantial and long-term allocation to real estate debt from pension funds and other institutional investors.

"There were very few pension funds saying ‘this much is coming from my real estate allocation and I'm going to allocate to debt', because they hadn't gone through all their internal processes, particularly including their consultants. That just takes longer," he adds. "It has to become clear to consultants and CIOs that this will be an investment class with some duration and that returns will be within a band for the foreseeable future. Then it would merit taking it through a more thoughtful process of allocation, and I think that is what has been going on for the last couple of years."

Richards does not go as far as Lattanzio, but the consultant does admit that the opportunity to capitalise on constrained lending in the real estate market looks likely to persist for longer than he initially envisaged.

Stephen Tross, international investments director at Bouwinvest, also says the worsening crisis in Europe looks as though it will extend the window of opportunity. But the investment manager is not looking to make any new mezzanine investment outside its commitment to Pramerica's real estate debt programme until the club fund is fully invested and Bouwinvest is able to see how the investment "evolves".

"Last year when we invested we thought the timing was excellent," Tross says. "We thought the investment period of 2011 and 2012 was most favourable for these types of investments. We now feel that since the crisis has deepened again that the timing is good for a longer period; even after 2012 there will still be enough good opportunities in the mezzanine."