Debt Funds: From core to coupon

Greater allocations to real estate debt are translating to a greater market share for non-bank lenders in the US

A  recent slowing in capital value gains in core real estate – reflected by a plateauing of the NCREIF NFI-ODCE index – has shifted investor demand towards debt strategies. Unlike real estate equity investments, they derive their primary performance from the income generated from the repayment of loan principal and interest charges.

The appreciation component of the NCREIF index has continued a steady downward trend this year, falling from 0.71% in the first quarter to 0.61% in Q2. By comparison, in Q2 2016, it was 1.01%. At the same time, the income return from core property tracked by the index held steady for the past three quarters, demonstrating a solid base for debt repayment from income-producing assets.

Steady income is of great importance to the performance of property portfolios at a time of low interest rates and price appreciation that has pushed cap rates on prime gateway assets to between 3% and 4%. Given the late stage of the current real estate cycle, investors are keen to allocate more capital to defensive strategies offering a buffer against principal value erosion should interest rates start to rise or economic growth falter. 

Property debt funds deliver on both counts, offering defensive qualities by exchanging some equity upside potential for more predictable income returns and – with prudent underwriting – a measure of protection against downside price movements that could negatively affect the value of equity holdings.

Demand for commercial property debt capital has returned to levels comparable to those seen before the financial crisis, according to Heitman.

Yield-seeking institutional investors are making more allocations to debt. Higher allocations to debt funds managed by non-bank entities are translating into increased market share for non-bank lenders. Pension funds originated 16% of the loans made in Boston for the six quarters between Q1 2016 and Q2 2017, and insurance companies originated 10% of the loans for the same period. Those market shares are based on a sample of $7.4bn (€6.2bn) in commercial real estate loan originations over that time conducted by CrediFi, a big-data platform for the commercial real estate finance market. If other non-bank entities are included, such as Mesa West Capital, a privately-held portfolio lender with a capital base of over $4bn, and Red Mortgage Capital, a multifamily and affordable housing lender and subsidiary of Tokyo-based financial services group Orix Corp, non-bank entities originated 34% of the commercial property loans in Boston during the period.

In fact, CrediFi found that two of the pension and insurance lenders among the top 10 largest property loan originators in Boston in the first half of the year were based in Canada: Toronto’s Manulife Financial and Oxford Properties, the real estate investment arm of the Ontario Municipal Employees Retirement System. The other three leading originators in the first half of 2017 in the CrediFi sample – New York Life Insurance Company and Hartford Fire Insurance Company, along with TIAA – were US-based. This is in contrast to 2016, when the top three originators were all banks: Morgan Stanley topped the 2016 list with over $1bn in loans, followed by JPMorgan and Deutsche Bank, both of which accounted for more than $500m of the $7.4bn sample.

The rise of non-bank sources of debt capital for property projects reflects fundamental changes in the capital markets. While debt capital is plentiful, “the type of loans, their risk profile, credit requirements and the processes of obtaining debt have taken on new forms”, according to Heitman.

Life insurance companies are originating first-mortgage loans on stabilised properties, but only in “measured volume” and historically low loan-to-value (LTV) ratios of 65% or less; commercial banks have become highly selective about the asset type, leverage ratio and sponsorship of properties on which they will lend; originations from CMBS are constrained by lack of certainty in execution and pricing resulting from volatility in the underlying bond market. As a result, Heitman says, “only the most conservative transactions are able to source well-priced debt capital from a variety of sources”, and even those transactions are subject to tougher underwriting standards and lower risk tolerance.

There is evidence that banks are tightening leaning. Respondents to the Federal Reserve’s July senior loan officer opinion survey on bank lending practices reported tightening credit standards for commercial property loans. It is a long-term trend: respondents also reported that standards on commercial property loans were tight relative to their historical range. One result of the more conservative stance – net demand for property loans from banks weakened in recent months.

This does not mean there is a shortage of available debt capital – property owners and investors have turned elsewhere for loans, and institutional investors from pension funds to sovereign wealth funds see that need as an opportunity to lock in favourable income streams. Almost 40% of sovereign wealth funds now invest in private debt in an effort to increase returns, and many are willing to accept the incrementally higher risk of mezzanine debt in pursuit of returns nearest to equity investments, with 70% of respondents in Preqin’s 2017 sovereign wealth fund review citing mezzanine debt as the most attractive instrument over the next 12 months. About 63% of wealth funds plan to target distressed debt, with 53% seeking direct lending opportunities.

The rising popularity of mezzanine debt is illustrated by fundraising and joint-venture transactions with foreign investors from China and South Korea targeting US real estate as a source of income that exceeds available fixed-income returns at risk levels below property equity strategies. Och-Ziff Real Estate Credit Fund raised $735m from investors, including the Industrial Commercial Bank of China Asia, for a fund that invests in mezzanine debt related to distressed land, casinos and senior housing, according to recent media reports.

TH Real Estate, a division of TIAA, has announced plans to expand its US real estate debt platform through a new joint venture with the Korean Teachers’ Credit Union, targeting investment of up to $1bn in commercial property loans.

“Property debt funds deliver on both counts, offering defensive qualities by exchanging some equity upside potential for more predictable income returns and – with prudent underwriting – a measure of protection against downside price movements that could negatively affect the value of equity holdings”

Heitman offers an open-ended vehicle – the Heitman Core Real Estate Debt Income Trust – targeting a net internal rate of return of between 7.5% and 9.5% from loans to income-producing core property (see Heitman plays defence with income trust). Samsung SRA Asset Management, the property asset management subsidiary of Samsung Life Insurance, last year launched a $270m fund to provide Korean institutional investors access to mezzanine debt on stable core office assets in the central business districts of six US gateway cities, appointing JP Morgan Asset Management – Global Real Assets as investment manager (see Samsung brings Korean investors into mezz).

This focus on debt is shifting the spectrum of investment performance to the income return portion of the performance evaluation. While property fundamentals will remain the main driver of financial performance for property assets, there will be a much greater need for institutional investors to focus on the factors that contribute to the performance of debt vehicles – underwriting rigour, credit analysis, and structuring expertise – and whether debt strategy managers possess those qualities.

Since 1993, investors have been able to benchmark commercial mortgage loans against the Giliberto-Levy Commercial Mortgage Performance index, which tracks fixed-rate senior loans held in institutional portfolios. As of December 2016, the index encompassed 14,700 loans or loan cohorts with an adjusted duration of 5.3 years with a current principal balance of $191bn and an average LTV ratio at market of 47%.

This summer, Levy introduced a range of indexes to measure the performance of higher-yielding commercial property debt instruments that are currently attracting significant institutional capital – mezzanine loans and other subordinate debt, preferred equity and B-notes, and high-yield senior mortgages. Dubbed G-L2, the new mezzanine index is the first of its kind, with data on some $8bn of debt, representing more than 200 positions of $15m or more.

The loans are concentrated in the office and multi-family sectors. Most were originated in the past five years, with an average expected return of about 12%, with loan-to-value ratios ranging from 50-60% to 85%. Levy believes the mezzanine index addresses the information needs of the non-bank lender coming into the property debt market.