Mezzanine debt investments theoretically offer better risk-adjusted returns than direct equity investing. But are return expectations really in line with market opportunities? Shayla Walmsley investigates

There is too much hype surrounding forecast returns for real estate debt funds, according to Ari Danielsson, managing director of Reviva Capital. He describes return targets of 15-20% as “belonging more in marketing than in reality”, and says mezzanine funds should be looking at 11-14% at best.

Claude Angeloz, a partner in private markets specialist Partners Group, which is active in mezzanine finance, has likewise expressed scepticism about junior debt opportunities in prime, pointing out that mezzanine lenders in the City of London should expect a margin of no more than 600 basis points over LIBOR.

That is not to say that pension funds will not be investing in mezzanine debt. Take, for example, Dutch pension fund asset manager APG’s investment in Pramerica Real Estate Investor’s property debt platform, which provided mezzanine finance, inter alia, for the acquisition of Drapers Gardens in the City of London. Pramerica’s strategy includes investment in directly originated mezzanine finance and preferred equity, but it will not invest in distressed or securitised debt.

Another example is private equity firm Duet’s €300m European mezzanine debt fund, which now includes €80m financing for Blackstone in the largest European deal of its kind to date. The fund has some 20 investors, most of which are pension funds and insurers. What is important to pension funds, according to managing director Dale Lattanzio, is to understand the position they have taken within the capital structure. He says the reason his team had been able to raise capital for the fund is because it was clear where the risk started and stopped.

Another problem for investors is that it is impossible to separate out junior from senior debt. Senior debt has to be in place for mezzanine funds to deliver. If senior lenders (and borrowers) are struggling, pari passu so will their junior counterparts.

This does not necessarily mean that without the banks there will be no borrowing. In fact, it could mean that junior debt funds with sufficient flexibility opt to make modest senior debt deals themselves. Is this likely? Yes and no. It depends on a specific fund’s investors. If they accept the principle of debt investment, most institutional investors still want to lend against high-quality real estate. In a mezzanine fund, for example, investors will opt for the same kind of assets as they would were they acquiring real estate equity; the important factor is the quality of the underlying assets.

Andrew Radkiewicz, managing director of Pramerica’s global high yield debt group, claims most investors in debt are using it simply as an instrument - they see it as fundamentally no different than real estate equity.

“Debt and equity refer to the same real estate,” he says. “You can structure an investment in a property to give a certain return for the risk you’re taking. Generically, you’re investing in their debt whether you’re buying securities in debt or large portfolios of debt. You have CMBS and public debt, and behind those, loans and pools of loans.”
Radkiewicz adds: “It’s just a different type of return on equity - and you get your money before equity investors when it’s sold.”

Yet investing in debt - senior or junior - is effectively investing in an asset that the investor will not end up owning unless it is a development deal. “When we approach investors about investing in real estate debt, most have a perception that it’s esoteric and difficult because it isn’t investing in a property. But there’s a light-bulb moment when they decide to invest after they’ve understood the risk and return,” says Radkiewicz.

“Apart from the risk and return element, they’re putting their allocation in a property they can’t buy. Here’s a route for investors where they can deploy their allocation to property they don’t own and get good diversification.”

The mezzanine piece comes with a different style of return, with a more stable income element and less capital upside, and it’s being deployed more at the lower than at the higher levels. Natale Giostra, head of UK and EMEA debt advisory at CBRE, believes that since it is now impossible to generate returns above 10% on core and core-plus assets, managers must either shift towards riskier assets or accept lower returns. It is most likely they will have to do both.

“What counts as core or core-plus in times like these has changed dramatically,” he says. “Now it means a few blocks or, at most, a few streets. There are more investors fighting over fewer safe havens. Investors are staying far away from anything else.”

At the other end, there are limited low-risk opportunities in debt. Private equity firm Corestate estimates that €1.2trn commercial real estate mortgages are due to mature over the next four years. Banks preoccupied with coming up with the tier-one capital demanded by Basel III are at best upping premiums, or even avoiding loan extensions altogether. The assets needing refinancing tend to be non-performing assets that have stopped generating stable payments. According to a research project involving cooperation between Corestate and Nico Rottke, head of the Real Estate Management Institute at EBS University of Economics and Law in Wiesbaden, most are opaque, with complex structures, and exposed to economic and legal risk.

At the esoteric end of lending, there is activity and imagination, even if there is no broad appetite for it. The Intermediate Capital Group, for instance, reportedly plans to raise senior European debt funds for real estate after focusing on providing debt to private equity players in need of capital to refinance existing debts. Private equity firm Blackstone’s €4bn debt strategy includes multiple options, including not only mezzanine debt and recapitalisation of over-leveraged assets but distressed assets and debt/equity combinations via preferred equity.

Incidentally, in Europe, private equity is providing much less capital than it has traditionally. As the cost of capital goes down, the buyer pays a higher price, says Danielsson. So one option for borrowers whose time is up is not to do a direct sale but to create a hope-note and become a partner in a joint venture, even though from a regulatory point of view it’s more difficult to do a because the property needs to be de-recognised from the balance sheet. Otherwise, if the bank holds too much property, it will remain on the balance sheet and will still be classified as a loan.

There are relatively few investors able to provide financing across the entire capital stack. M&G Investments is one of the few exceptions. In October it arranged senior, mezzanine and preferred equity financing for two London shopping centres, sourcing the senior debt from separate account clients, including Prudential, and the mezzanine debt from its €343m M&G Real Estate Debt Fund.

Even for more cautious mezzanine investors, there is significantly more capital being raised than deployed in the market. There are several reasons why that is the case. One, as Danielsson points out, is that it is expensive and borrowers will see it as a last resort. “You are seeing a few big deals, such as RBS and Blackstone, but you can’t say there’s a market,” he says. “In the US, private equity players were first in the loan services market. In any case, European banks haven’t made promises to meet demands of investors. US banks have.”

Duet says a requirement for investors in its European mezzanine fund is to show evidence that their capital is being invested. They want to see the deal flow, but deals are still scarce. “There’s huge interest from institutional investors in the debt space but there’s a disconnect between wanting to invest in it and being able to,” says Rob Clayton, director at Duet. “You need to be able to source the stuff.”

Does that not present a mezzanine fund manager such as Duet with an opportunity? “I’d like to think so,” he says.

Although he believes the senior lending market “has been more constipated in the past few months than it’s ever been”, Clayton says he is seeing banks trail-marketing loan portfolios with a view to bringing them to the market next year. “I’m not sure how many will trade, though,” he adds. “There’s still a disconnect between what banks are demanding and what buyers are willing to pay.”

In the meantime, the European Association of Investors in Non-listed Real Estate Vehicles (INREV) has been sceptical about the ability of new lenders to close the lending gap left by banks. In its December report on capital sources, INREV claimed that despite an estimated shortfall of €398bn in debt capital, banks would continue to be the primary lenders of core assets, with alternative lenders such as debt funds unlikely to provide much more than €110bn.

The report suggested the increased cost of debt and more selective lending had compounded the impact of 42 lenders disappearing from the European market as a result of either collapse or parent company withdrawal. According to the survey, 10% of fund managers had failed to refinance at least one asset after a bank lender pulled out of the market.

The debt gap undoubtedly presented an opportunity for alternative providers - but not necessarily the ones that have taken it. Danielsson believes the problem with institutional investors and insurers is that they have no channels of origination and no experience in that area.

Danielsson expects to see a new breed of CMBS with a simple, more transparent
structure than the vintage variety. Yet the European CMBS market looks pretty anaemic next to its US counterpart, which is worth around US$600bn (€454.7bn) with junior and senior yields at last count of 8% and 5.3%, respectively.

But Danielsson also reckons that in a couple of years the notion of junior bank loans will no longer exist, and their place will be taken by expensive mezzanine debt or equity. Certainly, debt funds’ initial expectation of returns above 20% had been predicated on “a market flood of distressed assets and debts, which failed to materialise”.

Subsequent market rationalisation and the setting of more realistic return expectations have resulted in alternative providers narrowing their focus to either senior or mezzanine debt, but that divergence itself is probably unsustainable in the long term because one is predicated on the other.

“Over the past few years we’ve seen several mezzanine funds and lately we’ve also seen investors thinking about raising senior debt funds as banks and traditional lenders retrench,” says Giostra. “Liquidity is scarce, margins are going up - and will continue to do so - and investors are looking for conservative but good returns.”

Without senior debt providers, junior debt opportunities won’t emerge and that’s where pension funds looking for debt will invest - but like, well, pension funds - cautiously, even conservatively, with an eye on liabilities and a taste for prime.