Real estate debt is fast becoming an established asset class, but it remains challenging. Rachel Fixsen speaks to six investors and advisers

Benny Buchardt Andersen
• Pioneered real estate debt while rescuing near-bankrupt projects
• Now in talks to offer new incentivised property loans

PenSam, the Danish labour-market pensions provider that manages around DKK110bn in total assets, is something of a pioneer in real estate debt. It now has around DKK1bn of holdings in property debt, a figure that is growing, according to investment director Benny Buchardt Andersen.

“Three and a half years ago, we were looking at real estate as an equity investor, and we thought it would be helpful if we could look at the capital structure,” Buchardt Andersen says. “There were some real estate projects that were close to bankruptcy. We told one developer we will not buy now, but when it’s finished. We said, we will offer you a loan and when it’s finished you can sell to a third-party investor at a profit and we’ll buy the other 50%.”

PenSam won the Nordic region award in the IP Real Estate Global Awards 2014 for its approach to property loan financing. Under its Blue Ocean model, PenSam demands that the developer invests equity in projects the pension fund lends to, and secures access to collateral allowing it to take full control should the developer have to withdraw for financial reasons.

The method means it invests in property at cost price, but could take over the project at below market value if the developer goes under — in other words, the developer loses equity without PenSam losing any.

Now PenSam says it is taking the real estate lending strategy one step further by creating a more attractive loan structure for developers, which includes incentives to create value in projects.

“We are now moving into the next stage of this and we are in negotiations right now,” Buchardt Andersen says. 

“What we are doing is giving the developer the opportunity to leverage their management fee.”

These new deals allow the developer to use half of its management fee to invest in the project itself, potentially receiving a return that is linked to the final sale price of the property.

Paul Richards
• Return of banks to real estate lending has compressed spreads of some funds
• European pension funds holding back from distressed commercial property debt

Over the past four years large volumes of money have been invested in real estate debt, observes Paul Richards, principal at consultancy Mercer. From the company’s pension fund client base alone, some £1bn (€1.26bn) has gone into the asset class, mostly from UK clients but also from Australian clients, he says.

The market has developed since it emerged in 2008. “From the beginning of this year, banks have come back in a big enough way that there’s been compression in the spreads of some real estate debt funds,” Richards notes.

Yields on mezzanine and senior have narrowed to the point where mezzanine now offers a similar return to core property. “A year ago, a borrower might have had one lender offering a loan, but now they would have two or three,” he says. “It’s not back to the way it was, but the balance has switched more in favour of the borrower.”

Until recently, the argument in favour of property debt as an investment was unequivocal — it offered a higher income return than underlying property as well as better security. “It’s become less automatic now,” he remarks.

Richards says real estate debt is now a relatively permanent part of the market. However, accessing the primary market is more difficult right now, because most of the funds were launched at the same time and are now investing. Very few funds are currently raising capital, he says.

Richards also finds it interesting that European pension funds have not invested significantly in distressed property debt. While their reluctance to buy into distressed residential would be understandable, he sees less reason for them to avoid distressed commercial debt.

Deals in distressed real estate debt, he explains, are usually about the gains that can be made through restructuring.

Rajesh Sukdeo
Syntrus Achmea RE & Finance
• Dutch commercial mortgage market now less risky
• Investors should align fixed-income, real estate teams to manage more equity-like property loans

Rajesh Sukdeo, fund manager at Syntrus Achmea Real Estate & Finance, sees some excellent investment opportunities in the real estate debt sector now. “Some parts of the Dutch commercial mortgage market have definitely bottomed, making investments in this sector less risky,” he says. “Although spreads have tightened, they still offer attractive value compared to other fixed-income asset classes.”

Syntrus Achmea manages an investment fund that invests in commercial mortgages, which the team originates in-house. The fund is 100% equity financed, and its investors are Dutch pension funds. It only finances Dutch commercial real estate.

“The Dutch landscape for commercial real estate financing is characterised by a small number of players,” says Sukdeo. “With the general economy improving, some sectors of the commercial real estate market having bottomed and others showing definite signs of improvement, there is room for new entrants in the market or for incumbent players to expand their portfolios.”

If real estate debt is a mix of property and fixed-income, how should investors manage it within their organisational structures? First and foremost, real estate debt is a fixed-income investment on a par with government bonds, credits, high-yield, emerging market debt and so on, Sukdeo says.

“However, if you move up the capital structure towards equity, the correlation with commercial real estate increases and thus you need to focus more on the real estate,” he says, adding that in this case, it is best to align the investment with both the fixed-income and real estate teams.”

As yet, he does not see the real estate debt market in the Netherlands as having matured. “I don’t think the market is more mature than it was a couple of years ago,” he says. “In the Dutch market there have been changes that have been more on the supply side concerning capital than concerning maturity of the market. Eventually more capital will come in as investors look for higher returns in this low-yielding environment, and other fixed-income assets become more expensive.”

Andrew MacDonald
• Lack of clarity around categorisation makes real estate debt problematic 
• Investors need greater degree of sophistication for success

The issue with real estate debt as an investment, according to Schroder Property Investment Management’s head of property finance Andrew MacDonald, is the question of whether it falls within a real estate or fixed-income profile. “It ends up being a bit in the middle and that’s the difficulty with it,” he says.

But interest in the property loans market is certainly increasing. “It’s clearly on a lot of investors’ radar as an alternative to traditional fixed-income products,” MacDonald observes. “If you’re a fixed-income investor and you’ve got corporate bonds and gilts, then real estate debt is potentially another piece of a fixed-income portfolio.”

If the pension fund or other institutional investor is comfortable owning property – as many are – they can further diversify their fixed-income portfolios by getting the different risk-return profile that property debt offers, MacDonald notes.

But although real estate debt does have fixed-income characteristics, it does not have the same tradability as corporate bonds. “The spread you can get on real estate debt can be more attractive than some corporate bonds but the downside is there’s less liquidity,” MacDonald says.

“If you compare it to real estate investment, however, one of the reasons you buy property is that you can potentially improve it – but you can’t do that with traditional real estate debt. If you lend against a building and it performs fantastically, you don’t benefit as a lender compared to if it just goes okay.”

On the other hand, if performance goes badly, a debt investor can expect to get their money back and interest paid — provided they have agreed the deal with a sensible degree of leverage, he says.

“In general, you need to be a slightly more active and sophisticated investment manager to be successful with real estate debt, because it won’t tick a lot of standard boxes,” he says. 

For example, good liquidity in an investment is a standard box for a manager to be able to tick – but one that would often have to be left blank on the checklist for property debt, he says.

Jacob Hübertz
• Joint investment team buys into senior, whole loans and mezzanine
• Banks still absent from secondary locations and more complex assets

Together, the Danish Pension Fund for Engineers (DIP) and the Pension Fund for Lawyers and Economists (JØP) invest in property debt via loans on commercial real estate, both in senior financing as well as whole loans and mezzanine. The two funds, which merged their investment operations last year, teamed up with AP Pension, Sampension and TDC Pension for a real estate debt club fund managed by AXA Real Estate.

Jacob Hübertz, investment director for DIP and deputy CIO for JØP, says: “We have committed approximately 3.5% of our balance sheets to real estate debt.”

The asset type pays an attractive premium over high-yield of approximately four to six percentage points for whole loans and mezzanine, depending on how DIP/JØP structures the deals, he says. Senior loans pay around 200-250bps above w, which is attractive versus Danish mortgage bonds.

“We are comfortable buying the senior loans at 60-65% loan-to-value, as we most likely would take on the property anyway if the borrower defaults,” says Hübertz. “With the combination of a pretty high cash coupon versus the high-yield space, the illiquidity of the investment, the risk that we would have to take on a property at a price we would be happy to buy it for anyway — all of this means real estate debt is a risk we are willing to take.”

But will the opportunity, which came about after the banking sector was forced to rein in lending following the financial crisis, become more limited in future? “Banks are coming back – and you can see that in the spreads – but within more high-quality assets,” Hübertz says. “In secondary locations or with more complicated assets, the banks are not back.” Non-performing real estate loans, for example, can still be attractive for pension funds, he says.

As for DIP/JØP, the merged investment operation will not rule out further investment in property debt, but it will need to be very selective — picking areas where the banks are not yet too active.

“There are opportunities especially in the UK and peripheral Europe, but in Germany and Scandinavia, where there are well established covered bond markets, it is more difficult to find them,” he says.

Peter Denton
Starwood Capital Group
• Market now at the point of increased loan provision, but also increased opportunities
• Loosening of covenants calls for vigilance

The real estate debt market may have emerged from the lending gap left by banks following the 2008 crisis but that gap has now largely been filled, according to Peter Denton, head of debt, Europe, at Starwood Capital Group.

“We’re at a point in the market where there is an increased provision of finance, but there is also an increased opportunity to lend,” he says. “There are areas of the market where there is a substantial excess of supply of debt compared to need. This is predominantly coming from low-risk institutions lending on plain vanilla situations.

“A consequence of that is that pricing has fallen dramatically, and to a degree there has been a loosening of covenants and the terms of lending.”

Market participants will have to watch this development over the coming years to make sure conditions do not loosen to the point where the market could crash. “It is inevitable that will happen at some point, but we don’t feel in immediate danger of that now,” Denton says.

It is important for pension funds and other institutional investors to work out what they want from real estate debt before taking the plunge in the asset class, according to Denton.

“Historically, the issue has been that real estate departments understood real estate and fixed-income departments understood fixed-income, but heads have now been gently knocked together and teams – while not merged – are being encouraged to work together to allow allocations to be made in this space,” he says.

“But I still think there’s often a lack of clarity. There’s a menu of managers with different strategies or specialisms who are having different levels of success,” Denton says, adding that an institutional investor needs to work out what it needs before finding the right manager.

Investors still focus on returns from real estate debt and perhaps not enough on the structure of the loan, he suggests, partly because they themselves are new to the market and can somewhat lack the expertise to judge that.