With banks pulling out and few other alternative sources of capital, will more insurers follow the US lead and invest in debt? Shayla Walmsley reports

There is currently almost as much optimism about insurers stepping into the real estate lending market as pessimism about banks pulling out of it. While insurers increase their share of the debt market to 14%, Société Générale and Commerzbank's Eurohypo in recent months radically reduced the finance they make available to property or suspended their property lending altogether. Société Générale is looking to sell a €500m portfolio of non-performing loans and holding on to another €4bn portfolio of performing ones - for the moment.

A CBRE report on the senior debt market claimed insurers could eventually make up 15-20% of lenders in a market still dominated by European banks - with the financial institutions claiming a 17% share - not least because insurers' loan-to-value (LTV) ratios of 69% compare favourably with 66.2% in the overall market.

Some forecasts are suggesting that not only is there less need for debt than had previously been supposed but that insurers are more than capable of providing it.Towards the end of 2011, a DTZ report claimed the availability of nearly $156bn (€118bn) in European finance would be more than sufficient to close the gap in regional debt funding, despite a 4% increase to $122bn in Europe over the previous six months. The firm also forecast that participation in the market by insurers and sovereign wealth funds could lower the discounts on loan portfolios put onto the market.

Yet even this perhaps surprisingly optimistic report estimated the global debt funding gap at $142bn over the three years to 2014 (though it noted that this represented a 27% drop from May's estimate and a 50% drop from that of a year earlier).

So much for the vagaries of demand forecasts. While the reports must wait to be proved right or wrong, there are a couple of reasons why real estate debt is attractive to insurers: it offers both a diversification benefit and a secured form of lending against an underlying asset - assuming it offers a fairly safe and regular yield.

"Debt is a nice thing to have because you don't have management costs, you have nice returns, and you have the assets as security," says Matthew Cutts, head of lenders and investors at EC Harris.

This prompts the question: why have insurers not taken on banks as potential lenders before? In fact, they were among primary long-term lenders before cheap credit effectively squeezed them out of the market. That said, historical proof-of-concept is not quite the same as ready expertise.

AXA Real Estate has been in the European debt business since 2005, although by its own admission more as a watchful spectator than as a particularly active participant. "We started to invest in 2005 in order to diversify and because we found attractive spreads on the exposure," says Isabelle Scemama, head of corporate real estate finance at AXA Real Estate. "Now the driver is the risk-return ratio compared with, for example, an equity allocation."

Like AXA Real Estate, other major European insurers are becoming more interested in providing debt, because the return is now sufficiently strong to make it worth their while. "Appetite is increasing among pension funds and insurers as the appetite among bank lenders declines," says Cutts.

Solvency II: the principal driver?
How instrumental Solvency II has been and will prove to be in driving insurers back into the debt funding market after all this time is moot. German insurer Allianz, for one, claims to be increasing its activity in real estate debt because it makes sense in terms of the risk-return profile, rather than because Solvency II capital requirements would effectively penalise it out of equities.

Yet at the end of 2011, AXA Real Estate announced it had raised €2bn in capital commitments for its debt programme, including its eight-year CRE Senior One Fund, launched in 2006, largely as a result of insurers reacting to Solvency II's 25% capital charge on real estate equity investments.

So far, only the larger insurance companies in Europe have got in on the act - both long-established ones, such as Aviva, Prudential and AXA, and relatively recent entry entrants such as Legal & General. There has been some US interest and activity in the European market as well, most notably MetLife, which has been working with arranger Laxfield Capital on a number of deals.

Scemama believes particularly insurers requiring a regional reach will be attracted to lending markets. "I anticipate that, as in the US, more insurance companies will be doing more in the lending market," she says. "It will be good to see some competition, but entering the market is not so easy. I haven't seen another platform capable of operating in a pan-European market. You need to have pan-European coverage."

She adds: "It's a highly regulated and complex market, and there are differences between European markets. You need to build a platform with the credit, fixed income and real estate skills to analyse and assess the quality of a loan in each market. Because of the differences between tax and regulatory regimes, it isn't so easy for an insurance company from outside that country to buy a loan in France, Belgium or the UK."

The European Commission's recent tweaks to Solvency II regulations will likely exacerbate the built-in bias towards larger insurers. Previous guidelines on mortgage debt - another reason why property debt could be appealing to insurers - have changed. The old ‘standard model' referred to mortgages in toto; that has now been amended to residential mortgages. Although the definitive wording may offer more clarity, in the meantime commercial mortgages, in contrast, are now seemingly in the same category as corporate bonds.

Rob Martin, head of research and strategy at Legal & General, points out that smaller insurers are more likely to be reliant on the standard model because they have fewer data and resources to develop their own in-house versions. Larger, more complex insurers are more likely to use models that better reflect the risks in the business.
"I wouldn't rule out smaller insurers using their own models but it will be more challenging," he says. "Larger insurers are just better positioned."

If the size of the insurer is one caveat, there is another. Those who believe the lending future belongs to insurers - even if only the large ones - tend to base their arguments on the participation of insurers in the US real estate lending market. But, as is usually the case, it is different over there. Unlike their US counterparts, European insurers are competing with banks, which have no need to syndicate or distribute their exposure.

Still in their prime
If it is assumed that the large European insurers are the ones most likely to participate in the real estate lending market, the question remains as to how they will invest. While they are investing in funds and joint ventures, what insurers are not doing is originating debt deals, although AXA Real Estate's debt programme shares participation with bank originators of commercial real estate loans secured by mortgages.

A wholesale move into origination is not likely; a move into senior debt is slightly more so. Scemama says AXA Real Estate will likely originate more loans next year because banks will be less active, "but the lack of senior lending is currently of more value to us," she says. "There is an imbalance between demand and supply, which makes this part of the capital structure more interesting. We'd like to be active in junior loans but the risk-return ratio is less attractive and it's a tighter market. In any case, the rules are made by the senior lenders."

Similarly, Martin says he is not looking at mezzanine debt. "I would approach assets as banks would in Basel III. As the default risk becomes higher, pricing needs to take account of it. We don't rule anything out but pricing would have to reflect the risk," he says.

Speaking at European Real Estate Opportunity and Private Fund Investing Forum in October, LaSalle Investment Management director Michael Zerda anticipated pension funds would either provide senior debt directly or by investing funds set up for the purpose.

Peter Cosmetatos, director of policy at the British Property Federation, agrees that more pension funds will operate in lending markets, not only as a result of banks vacating the market and the impact of capital requirements and euro-zone risk (nor even because property debt and long-term liabilities are a good match), but because he believes pension funds will face their own version of Solvency II within the next year. The effect will be to make lending to property more attractive to pension funds than property per se.

In the meantime, even if the appetite were there among insurers, what exactly would they provide senior debt for? According to Natale Giostra, head of UK and EMEA debt advisory at CBRE, real estate investors' focus will expand into development and secondary locations as they become more confident and chase higher returns for limited risk-taking. "A low-risk high-return product doesn't exist anywhere in the world," he says.

Such a shift also points to what could go wrong. Giostra does not specifically refer to the potential to make bad lending deals against bad assets, but he points out that real estate debt, even if less risky than equity, is still vulnerable to market risk.

Cutts goes further. Success, he argues, might encourage insurers to invest in debt underpinned by assets of arguable quality. "They're risk-averse and if they stay true to their values, it's unlikely. Logically, they're better placed than anyone to analyse and price in risk," he says. "It's a great opportunity for investors with regular cash and a low cost of capital - as long as they don't go too far and make a bad deal."

The most likely ‘what-could-go-wrong' scenario would be negative publicity over a poor investment. "Insurers are trusted to make the right investment. If they were to cut corners or fail to do their due diligence properly, they wouldn't be pricing in risk correctly and that would come as a shock," says Cutts. "The temptation would be to take too much of the market quickly."

Presumably the temptation will be greater because prime assets tend to attract financing or do not need it. Core funds have low gearing or are ungeared. Even the average gearing in a real estate investment trust is, percentage-wise, in the relatively modest high thirties.

The distress, and the demand for refinancing, will more likely be in secondary and tertiary assets. "Investors can move up the risk curve from, say, trophy assets to long-lease good secondary but there's a need in the property finance sector for funding for conversion and refurbishment with a heavily geared return," says Cosmetatos. "I wouldn't want to see insurers and pension funds lending against risky assets. You need a combination of core investors and those with a higher appetite for risk."

The appetite will not be coming from banks, of course, though Cosmetatos argues that is the real issue. He points out that some in the industry believe the involvement of insurers could, in fact, slow down the resolution of the fundamental problem: that banks have not written down assets when they should have.

"I suspect the thing that might cause it to happen quicker will be pressure from the capital requirements both from Basel III and from crisis regulation," he says. "If banks are forced to assess risk in a conservative way, it will be natural to get rid of more assets, especially dodgy, weaker real estate loans."

In the meantime, insurers should avoid getting too comfortable. Up to now, regulation (both banking and insurance) has been one of the motivations for insurers to provide real estate debt. But what would happen if insurers were to become the biggest lenders in the market? According to Cutts, the regulation would catch up with them in no time at all.