Real estate managers continue to set up debt platforms in Europe. The business opportunity is potentially massive, but it is far from straightforward, writes Richard Lowe

Looking ahead, Europe faces at best a significant period of low growth. This is not good news for an asset class like real estate, which is very much tied to the fortunes of the underlying economy. Property has been holding its own against the wider investment universe because of its association with wealth preservation, strong income returns and potential to protect against inflation, at a time when interest rates are at historical lows. How long this situation will persist is unknown.

What is clear is the asset class is not going to enjoy the double-digit returns that became commonplace in the years leading up to the global financial crisis of 2008. If real estate investors want growth-driven returns they need to look to Asia or Brazil, not Europe.

To foreign investors, particularly those based in North America, Europe is sometimes viewed as a wasteland of distress, stricken by an ever-worsening sovereign debt crisis. US opportunistic investors have learnt that picking up portfolios at large discounts is not as easy as it was in their own backyard during the years of Resolution Trust Corporation.

So where is the opportunity? The answer lies in the numerous real estate investment managers rushing to set up senior debt and mezzanine lending businesses. The size of the financing gap in Europe is well documented, as is the increasing retrenchment of traditional bank lenders and the gradual influx of ‘alternative lenders' - namely, insurance companies.

But while insurers will help fill some of that gap, mainly in long-dated, core senior financing, there is still a significant opportunity for debt funds backed by pension funds and other institutions to operate in the shorter-date and less secure senior and mezzanine debt markets.

The term ‘debt fund' is music to the ears of capital raisers and placement agents at a time when the institutional fundraising markets in Europe are positively anaemic. One fund manager told IP Real Estate that raising a debt fund business had been identified as the only genuinely promising means of growing business in Europe in the current environment.

There is a lot of talk at the moment about how commercial property lending in Europe will come to resemble the US, where bank loans represent closer to half of the financing market, rather than over 90% as has been the case in Europe for some time. The question is how close the resemblance will ultimately prove to be.

"I wouldn't actually say it is a move to a US model. It's simply a move to a much more diversified model, which the US happens to have," says Peter Denton, a former banker at BNP Paribas and Westdeutsche ImmobilienBank. Now head of European debt at Starwood Capital Group, Denton says Europe will see the emergence of an "insurance class" and "manager class" of real estate lenders, as exists in the US. "We will also see something different to America: we will see the emergence of a pension fund class," he says.

Managers mobilise for market grab
Are we about to see the emergence of a major new investment class in Europe for institutional investors? The evidence is pointing in that direction, but a number of factors are preventing a clear path from emerging.

Some of the big Dutch institutions, including APG, and clients of UK-based pension investment consultants Mercer and Towers Watson have already backed mezzanine debt specialists, while some German pension funds have begun to move into the debt markets more directly. The handful of managers that successfully raised capital for mezzanine debt strategies targeting, predominantly, the UK lending market - namely, Pramerica Real Estate Investors, M&G Investments, Duet (now DRC Capital), ICG Longbow and LaSalle Investment Management - have been joined by a number of new entrants, either marketing new funds or simply announcing their intention to be active in the market.

Some would-be debt managers are biding their time: they see real estate debt as a significant commercial opportunity but are positioning themselves gradually with an eye on the long term.

Cornerstone Real Estate Advisers, for example, announced over the summer the appointment of Laxfield Capital to help it establish a presence in the UK financing market. Ostensibly, this was to enable its parent, US insurer MassMutual, to extend its senior lending programme to the UK. But Nick Pink, director for European investment at Cornerstone, told IP Real Estate that the longer-term vision was to establish a third-party debt fund business, targeting both senior and mezzanine finance.

Schroder Property is another considering carefully its entry into the market. "We are doing a lot of research and we're going about it in a methodical way to make sure that the product we eventually bring to the market is the right one," says Duncan Owen, head of property funds at Schroders. "We are not on the brink of launching a fund."

Others have been quicker. Henderson Global Investors hired John Feeney - a former Merrill Lynch and Bank of America real estate finance expert - at the beginning of the year to run its real estate debt business and has since approached the market with two debt funds.

At a seminar held at Henderson's offices in London, Feeney suggested that the initial wave of pure-mezzanine debt that funds have raised since 2009 would be superseded by a more diversified range of vehicles targeting different parts of the market and sections of the capital stack.

Speaking on a panel, alongside Feeney, was Hans Vrensen, global head of research at DTZ, a company that in recent years has been analysing and attempting to quantify the large real estate financing gap in Europe. Vrensen said if he was looking to operate as an alternative, non-bank real estate lender he would try to get as big as possible before the market became more crowded - a view Henderson appears to share.

Other real estate fund managers have looked at the opportunity in real estate debt and for various reasons decided against it. Speaking anonymously, the head of business development at one UK-based fund manager revealed that it came very close to establishing a debt platform but chose not to because of potential conflicts of interest with its core business.

Proliferation of strategies
The recent success in launching real estate debt funds in Europe was notable for two reasons: firstly, it occurred at a time when capital raising for traditional real estate funds was stagnant; secondly, for many of the investors involved it was an unfamiliar strategy. They were successful because the investment story was a compelling one: mezzanine strategies promised 12-15% returns by taking a level of risk more comparable to traditional core or core-plus real estate (equity) investments.

The issue today is the picture has changed and debt strategies - and the levels of return and risk associated - have had to adapt. In the past two years, traditional bank lenders have retrenched quicker than many anticipated. According to M&G Investments, typical loan-to-value (LTV) ratios on senior loans in the UK have fallen over the past two years, from 60-65% in 2010 to 50-60% in 2012. LTVs in 2010 were already significantly lower than pre-credit crunch levels.

This has important implications. The first handful of European debt funds were marketed as pure mezzanine plays, filling the 15-20% gap in the capital stack above the 60-65% senior slice. Today, mezzanine lenders have to target a wider 10-25% gap above a 50-60% senior slice.

The first implication is for return expectations, which under the new scenario are likely to be more moderate simply as a product of being lower down in the capital stack. That is not to say they will not be attractive on a risk-adjusted basis (since the level of risk will also be lower), but will they be compelling enough for real estate investors?

The second implication is that senior financing is more conservative and there is less available. This makes it harder to execute mezzanine deals, but it might also lend itself to the conclusion that there is a bigger opportunity to provide senior financing - or a combination of the two. The problem with senior debt is it is much more akin to a fixed income investment, albeit it without liquidity, creating an asset allocation challenge for institutional investors.

According to Natale Giostra, head of UK and EMEA debt advisory at CBRE, the first wave of debt funds, which sought 12-15% returns by providing mezzanine debt for refinancing and recapitalisations, are being followed by two new types of debt product. The first is what he terms "junior" or "stretched senior" strategies that would operate in the lower LTV environment, targeting 8-11% returns. The second are the senior debt funds aiming for 4-7% returns.

"In the last six months we saw another wave of debt funds going to the market," he says. "The news is that the strategy of those funds is changing radically from the original mezzanine lender, and they are targeting lower-yield type of debt investments."

Feeney goes further, outlining four main categories (in addition to a fifth, distressed debt) that future debt strategies will fall under:
• Core senior: low-risk senior loans against high quality assets at low LTVs, generating 4-6% returns;
• Funky senior: higher-risk senior loans against lower quality assets at higher LTVs, generating 6-8% returns;
• Core mezzanine: junior debt secured against good quality assets at relatively low LTVs, generating 8-12% returns;
• Established mezzanine: existing mezzanine strategies targeting returns of 12% and above.

Feeney might be right when it comes to his "proliferation of strategies" prediction. There is a distinct lack of consensus among investment managers as to whether the best opportunity - from a business or market point of view - lies with senior debt, mezzanine debt or a combination of both.

As already mentioned, Henderson is targeting both senior and mezzanine, starting specifically with what Feeney defines as ‘core senior' and ‘core mezzanine', with the potential to explore other strategies in the future. That said, Feeney does see senior as the potentially larger opportunity in terms of sheer volume of capital, whereas mezzanine is likely to prove to be a comparatively niche area.

Like Henderson, M&G Investments is raising capital for two distinct funds, targeting mezzanine and senior debt, respectively. And like Feeney, Paul Dittmann, head of senior commercial mortgages, believes the greater opportunity in terms of scale is with the latter. "There's a big cheque to write, going from zero to 50% in the capital structure," he says. "So volume-wise the need for senior funds is massive, especially in the sense that we have roughly €250bn to refinance every year for the next four years."

M&G is looking to exceed the £350m it raised for its debut mezzanine fund when it launches a follow-on vehicle, but the size of the senior strategy is expected to be even larger. The company already invests in senior debt on behalf of its parent insurer Prudential, and has been one of the most active senior lenders in the UK, transacting £1.2bn (€1.5bn) of deals over the past 12 months. The new senior debt fund will effectively replicate its existing strategy for third-party investors.

M&G argues that it has an advantage in the market by being able to provide both senior and mezzanine financing on deals, removing a lot of the complication that comes with bringing different lenders together. M&G says it can be the senior and junior lender on the same deals, describing itself as a "one-stop shop". Henderson in theory could follow suit, but Feeney says the senior and mezzanine funds would be forbidden from lending on same deals, citing conflict of interest issues otherwise.

The senior-junior conundrum
Other players are taking a different tack and maintaining a focus on mezzanine. Signa Holdings is one example. In March, the Austrian company hired Michael Morgenroth from German insurance investment arm Gothaer Asset Management to run its debt funds business out of Germany. The strategy is to focus on mezzanine investments in Germany, Austria and Switzerland, following a similar approach to that developed by Morgenroth at Gothaer.

Morgenroth says Signa will not be competing in the senior space where there are a number of large players, including insurance companies. "On the higher LTVs you really need specialists and there are not so many specialists in the market in that area," he says. "The area above senior is the sweet spot for investing at the moment, because you have the cash cushion from the equity part and the returns are really attractive."

Pramerica is another not planning to move into senior lending. The fund manager raised capital for a traditional mezzanine strategy last year, targeting 12-15% returns, but is now looking to widen its focus to include what managing director Andrew Radkiewicz calls "senior-subordinated" or "stretched senior", targeting a lower portion of the capital stack where senior lenders not long ago operated. "It is basically up to that level where you expect normal senior debt to be but it's not," he says. "That is really low-risk business, it's really good quality."

This strategy, however, is inherently less risky than Pramerica's existing mezzanine strategy and should be priced to generate 8-10% returns, rather than 12-15%. "It requires a different sort of capital to your traditional mezzanine fund," Radkiewicz says.

Pramerica is seeking to raise capital for both strategies to run side by side. "We have to be quite fleet of foot, because as the market has changed we need to raise money to be able to fill that market," Radkiewicz says. "By broadening our capital base, we can offer a more flexible approach to pricing and structure within a much wider range of 8-15%."

DRC Capital, which span out of Duet Group earlier this year and is still investment adviser for the £300m mezzanine fund launched under the Duet banner, is also looking to maintain its mezzanine focus. But Dale Lattanzio, who founded DRC Capital with fellow partners Rob Clayton and Cyrus Korat, does not rule out considering senior debt in the future.

"We will continue with the mezzanine strategy because we think it is a good one and an appropriate one in the market," he says. "I expect us to do other things in the debt space as well, and that might include senior or other parts of the capital structure."

He adds: "I continue to see a paucity of senior debt and in those situations where there is senior available it certainly has tended closer to 50-55% LTV, so the width of the mezzanine is bigger," he says. "That is a good thing and a bad thing. The good thing is there is a continued need for our kind of capital. The difficult thing is you still need a senior lender to remain in place, in the case of a refinancing, in order to find investable situations. But when the market is at the stage that it is right now, given the retrenchment, it is difficult."

Forum Partners was an anchor investor, co-sponsor and co-general partner in the first Duet fund. The global fund manager, which has also been active in the non-performing loan market in Europe through its acquisition of loan servicing company Crown, hopes to continue to work the DRC Capital team.

"We hope we'll have a second fund and will be participating in that as well in some fashion," says Russell Platt, CEO at Forum Partners.

"That's given us access to a very strong team and we've been able to participate in the origination of mezzanine debt investments in a number of countries across Europe."

Platt says Forum Partners is beginning to turn its "attention to the senior debt market". He adds: "Two years ago we thought equity was not being well rewarded, but mezzanine was quite attractive; risk-adjusted returns allowed you to get as good if not better returns for what we thought was less risk. Now what's happened is that the senior debt market is in real crisis."

Lattanzio says the situation "certainly points us in the direction that at some point a senior product could very well make sense", but he has concerns about its viability in terms of asset allocation. "The question is where does that allocation flow from? Does it flow from real estate investment allocation or does it more naturally belong in a fixed income portfolio?"

Radkiewicz is also sceptical. "A senior debt fund is incredibly difficult as a standalone business case. It's focused on fixed income investors who don't necessarily do discretionary capital," he says.

That said, AEW Europe successfully raised €240m from French insurers this summer for its senior debt fund, which is being managed in conjunction with Natixis Asset Management and will invest in the UK, France and Germany.

But it should be noted that the French insurance companies in question have not been disclosed and it is uncertain whether the seed capital for the fund's first close is from ‘true' third-party investors or from its parent group Natixis. If the latter is true, it is arguably more comparable to AXA Real Estate's European senior debt programme, which is understood to be largely based on capital from AXA insurance group companies, although AXA Real Estate says it has raised capital from "European insurance companies".

"In reality, pure third-party platforms - raising third-party money for senior debt funds - have yet to materialise," says Giostra. "They are out there with their strategy, marketing the funds, but so far they haven't raised the money."

Christian Delaire, CEO at AEW Europe, told IP Real Estate there had been a lot of interest from German insurance companies, as well as French institutions, and that he is hopeful of raising €500m for the fund eventually, with a longer-term ambition of launching a series of funds. "Considering the appetite we see and considering the size of the market, we may want to have another fund operating in the senior field," he says. "I think there is room to do that."

AEW Europe is also looking at mezzanine strategies, although it has no plans as yet to launch a specific fund. Instead it will invest in mezzanine debt through its European opportunistic real estate fund. "If the market evolves and there is higher demand in terms of mezzanine financing, we may consider launching a mezzanine fund. But we think today it is premature," Delaire says.

Giostra says anecdotal evidence suggests that capital raising for senior debt funds is more challenging. "What I hear from talking to fund managers it seems that they are getting much more traction with the stretched-senior/junior type of product," he says.

Neil Lawson-May, joint CEO at Palatium Investment Management, says there are some potentially "terrific" risk-adjusted returns to be had in senior debt, but it is an "awkward" investment proposal. "Why aren't people storming down the walls to do it? The pace of money is much slower than you might think, because first of all the delivery mechanism is illiquid," he says.

Like Radkiewicz, he is sceptical about the propensity for traditional fixed income investors to commit capital to illiquid, discretionary funds. Fixed income investors "don't really want funds, they want bonds", Lawson-May says.

Mezzanine, meanwhile, is looking like a "slightly more limited market", especially now return expectations have moderated from 15% to 8-10%. "That's quite a big fall-off in return. If you can earn 5-6% on the safe bit, is there enough additional margin on the not-so-safe bit?"

Fixed income collaboration
Lawson-May therefore believes that senior debt is an opportunity institutional investors should be looking at, despite its illiquid nature. "This new product comes along which is clearly not liquid and tradable but looks in every other respect like fixed income," he says. "The property people say it isn't property and the fixed income people says it's not fixed income, and that is one of the reasons why it is slower to develop than you might expect."

An alternative solution would be to set up a mortgage REIT, but for the time being "we are in fund world", Lawson-May says. "I think people are gradually come round to saying, ‘all right, the returns are high enough to justify the inconvenience'."

Giostra agrees that institutions need to organise themselves to take advantage of what is a "hybrid" asset class. "It's not pure fixed income, because you still have to take a view on the real estate, but it's not pure real estate because you don't have upside," he says.

A number of debt fund managers report that real estate and fixed income teams at large institutions are beginning to collaborate more. "There needs to be more collaboration between these departments in the future in order to reach all the opportunities," says Morgenroth. "That is what we experience from investors; we often have both teams at the table. That is probably a development that will change organisations slowly but steadily."

Platt says "some of the most forward-thinking pension funds" are discussing putting together what he terms "multi-disciplinary taskforces". He cites a recent RFP from an existing client calling for a "holistic response to the European crisis", a strategy that had the flexibility to invest across assets classes and parts of the capital stack depending on where the best opportunities arise at any one time.

"It represents a challenge, frankly, to the investment management industry," Platt says. "We need to think in a multi-dimensional way; we need to think laterally. We cannot believe that real estate exists in some kind of vacuum where capital gets provided to us irrespective what is happening in the wider world."

But there is still a general consensus among fund managers that real estate debt is first and foremost a real estate investment. Reinhard Mattern, managing director at iii-investments in Germany, is currently discussing real estate debt strategies with German institutional investors, looking at both senior and mezzanine depending on their risk appetite. Mattern says the question about whether it is real estate or fixed income is the question they are currently discussing.

"Sometimes we are talking to the real estate guys, sometimes we are talking to the fixed income guys," he says. But Mattern believes that "first of all" it is a real estate product. "I would recommend that the decision has to be made by the real estate guys, because for us it is very important to have a look at the underlying real estate," he says.

The real estate debt team at LaSalle Investment Management has also noticed this emerging trend. "We have seen a few of our investors doing a sort of joint venture approach between their real estate and fixed income desks, where they have representatives of both groups considering and overseeing the product," says Amy Aznar, head of debt and special situations at LaSalle.

"Almost all of our investors are considering it as real estate investments as a nice complement to their core property strategies."

LaSalle has been investing in mezzanine debt and preferred equity through its debt fund and also its special situations strategy, which can invest across the capital stack. But the changing market - lower LTVs, less senior debt as a whole - has prompted the fund manager to look at providing all the debt in deals.

"With traditional debt providers in today's market focusing solely on prime, and mezzanine becoming a much bigger component of the capital structure, we're actually finding situations now where our product is suitable to borrowers on a whole-loan basis," says Michael Zerda, director of special situations at LaSalle.

"We're seeing no signs of that opportunity dissipating, especially as you read the headlines of major lending institutions pulling out of the market in their entirety. It actually opens up for dual-pronged strategy that we're currently deploying capital into."

ICG Longbow is also likely to move into the whole loans market when it raises capital for its next fund. Its predecessor, capped at £242m, is very close to being fully invested and operated mainly in the mezzanine and stretched-senior parts of the market.

IP Real Estate is aware of another global real estate investment manager talking to investors about its own whole-loan strategy, which it claims is unique to the market place, but is unable to speak about on the record.

Starwood is already active in the whole loans market on behalf of US mortgage REIT Starwood Property Trust and the plan is to employ a similar strategy directly for third-party investors. "What we're trying to do is blend across mezzanine and senior," says Denton. "We just see more value in whole loans."

"There is a score of people looking to take more passive mezzanine positions in deals, and often you can end up in an auction process where it is the weakest structure and weakest pricing that wins," he says. "We are looking to be more focused on lending per se and finding the best risk-return in any debt deal. So we believe in a hybrid strategy, not being a pure mezz player."

Denton says it is wrong to approach real estate debt purely from an absolute return perspective. "It is often a relative analysis," he says. "It is the most profound risk-return position of anything at the moment. You can earn attractive returns for all types of risk, whether you are doing really straightforward, plain vanilla 50% LTV business or whether you are undertaking more aggressive lending strategies."