Pension funds in Europe are moving deeper into a lending  territory once dominated by banks and insurers, find Lauren Parr and Rachel Fixsen

European pension funds have demonstrated their commitment to investment in commercial real estate debt across Europe, with mixed success in deploying capital so far. 

Some have trumped banks in offering cheaper financing, others would like to have taken bigger participations, while one or two have been slower to put capital to work, partly as a result of an increasingly competitive market for senior debt lending.

Few pension funds invest directly; only the largest institutions have the resources to set up their own platforms. German pension fund BVK is one of these, having hired two former commercial real estate bankers and with real estate expertise within the group on the equity side.

It has progressed in making loans since its first deal in 2011 when it jointly provided €190m of finance against the Silver Tower in Frankfurt alongside Deutsche Hypo. Most recently, in August 2014, it was the largest lender in a consortium that financed the Berlin Mall. It contributed the €450m senior portion of a total €600m refinancing of the new shopping centre. Deutsche Hypo provided €80m of subordinate debt and two credit funds of BNP Paribas REIM Germany took the €70m most junior piece.

The debt package replaced four-year-old club financing from Helaba, Eurohypo, UniCredit, DG Hyp and Landesbank Berlin, which (excluding Eurohypo) had tried to put in place a new investment loan but could not compete with the sub-100bps margin over Euribor on the senior debt. 

BVK fulfilled its minimum €500m financing target per calendar year in 2014 even though “market conditions are becoming worse, especially when you look at spreads, particularly for core, stabilised real estate assets with strong cash flows”, says Constantin Echter, head of fixed income investments at BVK. “Documentation is also becoming more borrower-friendly but we still feel very comfortable with the seven main German cities and the office and retail sectors we consider.”

Now it has invested in the asset class, BVK won’t be backing away. “Banks say ‘you’re only interested in real estate loans because of the low-interest-rate environment’, but for us it’s not true. When the 10-year swap rate is at 4% in future we will still lend; it will always be part of our portfolio,” says Echter.

Constantin Echter - head of fixed income investments at BVK

“Banks say ‘you’re only interested in real estate loans because of the low-interest-rate environment’, but for us it’s not true. When the 10-year swap rate is at 4% in future we will still lend; it will always be part of our portfolio”
Constantin Echter, head of fixed income investments at BVK

Europe’s largest non-bank lender, AXA, has been prolific in deploying capital. A major part of the group’s business being underwriting syndicated pieces of loans. It had invested €7.5bn of the €10bn of commitments it has for senior commercial real estate debt by the end of the last fiscal year. 

The French company has practically led the surge by European insurers into the real estate debt market, investing its internal insurance money before taking on capital from third-party institutions four years ago. But Charles Daulon du Laurens, head of European sales at AXA Real Estate , notes that, in terms of allocations, pension funds are catching up with insurance companies. 

Charles Daulon du Laurens - head of European sales at AXA Real Estate

“Pension funds have not only caught up but are now above insurers”
Charles Daulon du Laurens, head of European sales at AXA Real Estate

In April last year, AXA Real Estate won a €485m mandate for senior debt lending in the UK, France and Germany from five Danish pension funds. “When we first opened up activity to third parties in 2010, our client base was dominated by insurers,” he says. “Pension funds have not only caught up but are now above insurers, accounting for slightly more than 50% of commitments.” 

Danish pension fund PenSam was not involved in the club fund set up by AXA Real Estate but it too is seeking to grasp debt-investment opportunities. It is positive on the sector because of past experience and its allocation to property debt is still increasing, says Benny Buchardt Andersen, chief investment officer. “There is a fundamental change where pension funds are taking over the financing during the building period, and financing the payment guarantees,” he says.

For some time, PenSam has been using its innovative ‘Blue Ocean’ model of real estate lending, whereby it takes an equity stake in projects on which it lends, allowing it to take full control should the developer have to withdraw for financial reasons. This strategy works, says Buchardt Andersen. It allows the pension fund to use real estate debt to have running yield as well as access to cheap real estate capital.

Looking ahead, he says the pension fund is currently close to finalising an OTC real estate lending deal where private development companies prefer direct lending to blind lending. “They find a tailor-made financing agreement more attractive than a listed bond, and so do we,” he says.

Austria’s APK Pensionskasse is an experienced investor in real estate debt. Rather than investing in the asset class within its fixed-income allocation, the fund’s property debt investments are on the alternatives side, explains portfolio manager Michael Bujatti.

The pension fund is currently invested in one European real estate debt fund, with which it is aiming for a target return of 10%. “What we are doing is more on the opportunistic side,” he says, adding that the fund falls within its hedge fund exposure, since the structure is relatively complex.

Looking ahead, the Austrian pension fund is aiming to invest in US real estate debt funds. Once the due diligence is completed, the investment would fit in the pension fund’s real estate pocket, he says.

Bujatti describes the benefits of property debt as the income stream, the attractive yield, stable valuation, floating rate, alongside the fact that investors have good downside protection because there is – after all – a real asset behind the loan. “I think there are still good opportunities in the real estate market in Europe, where the market is not so mature, as opposed to the US,” he says.

In the UK, the Nationwide Pension Fund’s approach to real estate debt has tended – since the fund first started investing in the asset class in 2011 – to be opportunistic rather than having a set limit, according to Mark Hedges, chief investment officer at the fund. This means the current appetite for property debt depends on the overall illiquid asset opportunity set that the pension fund sees, he says.

Since existing holdings are in illiquid funds, Hedges says the allocation is unlikely to change.

Whether real estate debt becomes a permanent feature of the pension fund’s investment depends on the opportunities and the pace at which the deficit recovers, says Hedges.

“As we de-risk and move into matching assets, the need for shorter-dated cashflows – five to seven-year real estate debt – diminishes,” he says. “Obviously, if an open-ended, larger, more granular pool that recycles amortising debt into new loans were to morph out of the nascent private debt providers, then that might become a different story.”

Deploying the capital
Although AXA has managed to become Europe’s largest non-bank lender, Daulon du Laurens admits it would like to have taken a more substantial piece of the pie. “It happens sometimes that we want to take a bigger share than we get in the end,” he says. The trade off is access to certain transactions – for example, its participation in a Parisian office financing in which only one non-banking player was permitted alongside three banks. 

In addition, AXA, like any other lender, naturally finds that “sometimes people pay more or require lower spreads than we do”, du Laurens notes.  

Smaller institutions tend to outsource their allocation, selecting either a big manager to run things for them or a series of specialist managers.

Debt asset manager AgFe is an example of another success story. It has found no shortage of opportunities on which to provide long-term fixed-rate loans for its first UK real estate debt fund. It has £1bn of capital from retirement specialist LV= and by the end of 2014 had invested £150m, with a focus on £10-50m loans against regional properties. 

Other lenders have been slower to deploy their available capital, for various reasons. “It’s a fact that there are investors who have allocated money to managers that are not seeing investment at the rate they would like,” says the debt fund manager. “Part of that could be down to the origination team in place.” 

Hermes Real Estate Investment Management’s UK senior debt fund has yet to make its first loan since it launched in October 2013, seeded with a £400m Cornerstone investment, owing to a change in personnel. The BT  pension scheme’s manager recently hired  Victor Nobel from M&G Investments to take  the fund forward.

Survey: RE debt becoming an established allocation

A small majority (53%) of predominantly European institutional investors surveyed by IP Real Estate invest in real estate debt (figure 1). The finding shows that the sector has become an established asset class for pension funds.

This contrasts with last year’s survey that found that investors active in real estate debt market were in the minority, at 43%. But last year’s report also found that a greater proportion of investors planned to invest in real estate debt over the subsequent 18 months, which supports this year’s finding.

Survey - RE debt becoming an established allocation

But it should also be noted that this year’s survey shows that a significant proportion of investors have no plans to move into real estate debt: only a  fifth of respondents that  are not already invested  in the asset class plans  to allocate capital in the  next 18 months (figure 2). This suggests that the growth in first-time real estate debt allocations is likely to slow in the short term.

A small majority (54%) of investors surveyed favour pooled funds to gain exposure. Almost half of this proportion are investing directly in-house (29%), while 25% are using separate accounts, and 7% are investing through ‘other’ means (note: respondents could select more than one answer).

The majority (61%) of investors place real estate debt within their real estate allocations, while 29% classify it as a fixed-income allocation. Only 11% allocate it elsewhere, which could include ‘alternatives’, ‘real assets’ or more ad-hoc, tactical parts of the portfolio. This tallies broadly with last year’s survey.

More than 50 pension funds and other institutional investors were surveyed in the third quarter of 2014. Respondents were predominantly based in Europe (including Austria, Belgium, Denmark, Finland, Germany, Iceland, Italy, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland and the UK), as well as a small proportion from North America and the Middle East.

“There is more competition today than when we launched but target returns of 4-5% on a nominal basis remain an attractive place to be,” says Ben Sanderson, director of fund management at Hermes Real Estate. “Our angle is to lend against attractively mispriced assets using our real estate knowledge. We’re not scared of short leases or assets that don’t look amazing in the brochures; our priority is rents that are affordable, so the space can be let.”

The closed-end fund’s sweet spot is loans of £40-60m at loan-to-value ratios of 55-60%. It has an eight-year life plus a two-year extension, so it can afford to “be patient and not force pricing”, says Sanderson. 

“It’s a very different mentality if you’re a pension fund investing in debt as opposed to a bank seeking market share. It’s about  long-term stability, security of cash flows and getting capital back at the end of the term,”  he explains. 

Ben Sanderson - director of fund management at Hermes Real Estate

“There is more competition today than when we launched but target returns of 4-5% on a nominal basis remain an attractive place to be”
Ben Sanderson, director of fund management at Hermes Real Estate

Irrespective of the conduit, allocations by pension funds to senior commercial real estate debt have been growing over the past nine months – a function of the search for yield. The lending landscape might be getting more competitive, with capital at the ready from both alternative lenders and banks, but “if you look hard enough and are patient there are deals to be had”, believes Sanderson.  

Annual new origination volumes in the UK are roughly half what they were at the  peak of the market. This means there is still a lot of real estate to be financed. “If you think about the likely allocation numbers to this space by pension funds, there are enough opportunities to go round and not to have to deploy capital within the space of one or two months,” he says.   

Whether a pension fund or an insurer, new entrants are attracted by the returns on offer, set within context of the constraints traditional lenders remain under. “The real estate debt space has evolved from a market that, back in 2010, made it possible to lend at coupons historically unheard of at 5-6% spreads over LIBOR for senior risk on all sorts of corporate credit,” says Sanderson. “It’s now a more normalised environment where real estate lending is an interesting place to play owing to persistently low yields available through traditional credit investments such as government debt.” 

From BVK’s perspective, the very high spread (100 basis points above mid swap) available from German real estate debt makes it an interesting asset class. “In the past, investment in German covered bonds were very safe but expensive [5-10bps] whereas German real estate debt spreads are much higher,” says Echter.

Banks are equally attracted to senior debt partly because capital adequacy requirements make riskier lending more costly for them, which in turn places pressure on spreads. Ultimately though, banks remain constrained in the volumes they are able to lend. 

Notes Sanderson: “There is not a frenzy of behaviour causing banks to be aggressive in seeking market share; they are also keeping less on balance sheet. Therefore, the long-term prospects for private lending including real estate remain attractive.”

“It has reached a plateau,” says Paul Richards, principal at consultancy Mercer. “I thought this would be a five-year phenomenon, which would then tail off, but I don’t think that’s going to happen for all sorts of reasons.”

The main reason is that the Basel II and Basel III standards on bank capital adequacy have curbed the longer-term ability of banks to take on property debt. 

New debt funds target Europe - Preqin

Private real estate debt funds continued to demonstrate considerable growth over the course of 2014, with funds primarily focusing on debt investments raising a record amount of capital. 

As shown in figure 1, an aggregate $20.4bn was raised by debt funds closed in 2014, compared with $15.7bn in 2013 and just $6.1bn in 2012. However, the number of funds closed declined from 29 in 2014 to 26 in 2014, demonstrating the increasing concentration of capital among fewer managers. As a result, the average fund size of primarily debt-focused funds increased from $541m to $887m for funds closed in 2013 and 2014 respectively. 

Annual primarily debt-focused closed-end private real estate fundraising 2008-14

Breakdown of agregate capital raised by closed-end private real estate funds 2008-14 equity vs debt

Encouragingly for managers bringing debt funds to market, these funds appear to increasingly be reaching or exceeding their target sizes, with funds closed in 2014 raising, on average, 111% of their initial target size. In contrast, funds that closed in 2012 raised an average of just 89% of their initial targets. A sizeable proportion of capital raised came from first-time funds, with these accounting for 38% of aggregate debt-focused capital raised in 2014.

Debt is increasingly targeted by a large proportion of fund managers, including both debt specialists and those that target a combination of debt and equity investments. In 2008, the vast majority of funds focused solely on equity investments, with 79% of capital raised accounted for by solely equity-focused funds. By 2014, this had decreased to 52%, with 25% accounted for by funds making debt and equity investments, and 24% by funds making solely debt-focused investments. 

Regionally, Europe is attracting increasing amounts of capital for debt investments (figure 3). In 2014, Europe accounted for 41% of debt-focused capital raised by private real estate funds, compared with just 6% in 2012. In terms of capital, $8bn was raised by eight Europe-focused debt funds reaching a final close in 2014, compared with $6.5bn raised in 2013 and just $0.4bn in 2012. The largest Europe-focused debt fund to close in 2014 was Kildare European Partners I, the first fund raised by Kildare Partners. The fund closed on $1bn in April 2014, having exceeded its $1.5bn target. AgFe Senior Debt Fixed Rate Fund also reached a final close in 2014, after attracting £1bn in institutional capital.

Breakdown of aggregate capital raised by primarily debt-focused closed-ended provate real estate funds by region

Primarily debt-focused closed-ended private real estate funds in market Jan 2010-Jan 2015

In comparison, North America has declined from accounting for 72% of aggregate capital raised in 2010 to 55% for funds closed in 2014. However, these funds still garnered $10.7bn in 2014, more than the $8.5bn raised by North America-focused debt funds in 2013. This includes the largest debt fund to close in 2014 – PIMCO Bravo Fund II – managed by US-based PIMCO, which raised $5.5bn. 

Despite the capital raised by debt funds growing in recent years, the market is increasingly competitive, with a record number of debt funds being marketed. As of January 2015, there are 61 primarily debt-  focused funds, targeting aggregate capital commitments of $24bn. The number of debt funds in the market has increased year-on-year since 2012, when 33 debt funds were on the road, seeking capital commitments of $9.9bn. A notable 39% of aggregate targeted capital primarily focuses on European investments, with 56% focused on North America. First-time managers are widespread within the debt market, with 58% of aggregate target capital sought by teams raising their first debt-focused fund.

The largest debt fund currently in the market is Hermes Real Estate Senior Debt Fund, managed by Hermes Real Estate. The fund is seeking £1.5bn to invest in senior loans against existing core assets in London and select regional UK markets. The second-largest debt-focused fund is AgFe Real Estate Senior Debt Floating Rate Fund, targeting £1.2bn to originate commercial mortgages secured on UK commercial property.

Debt vehicles are likely to continue to be targeted by real estate investors in 2015, with 15% of institutions with active fund searches seeking on the strategy. This remains similar to the level of investor interest in this strategy 12 months ago and indicates that appetite for debt-focused funds is likely to remain stable in 2015. However, institutional appetite for debt does not match the interest in equity strategies, with 47% of active investors targeting opportunistic funds and 51% targeting core offerings. This demonstrates that debt as a strategy is still likely to remain a relatively small part of the overall real estate fund market.

As the demand for debt is still there, supply has to be met from sources besides banks, Richards says. And demand is continuing, despite the fact that economic growth is still relatively slow, not least because there has been a lot more value-add activity – such as refurbishments – for lenders to finance,  he says.

However, Richards notes that returns for both senior and mezzanine have shrunk over the past year, he says. “In those simple terms, the attraction is lower, but it is still attractive, particularly to insurance companies because they use it to match their long-term liabilities. Some of those insurance companies are bringing along pension funds with them; people are coming to the party from all different directions,” says Richards.

One of the issues that is particularly affecting the real estate debt market right now is that many pension funds are deciding to position themselves to be able to pay benefits over the long term.

The funds have realised that their contin-uing funding shortfalls mean they will not be able to offload their assets and liabilities into a buyout arrangement. “Now they’re realising they’re going to have to do it themselves, and that they will need assets to provide income,” he says, adding that this is the reason the incentive to invest in infrastructure and real estate debt has increased.

The wave of old property loans coming on to the market as a result of banks offloading items from their balance sheets seems mostly  to have worked its way through by now,  Richards observes.

“Banks have returned to lending, but not in as big a way as before, and they are mostly doing it through syndications,” he says.

Paul Richards

“The attraction is lower, but it is still attractive”
Paul Richards, principal at consultancy Mercer

Paul Jayasingha, senior investment at Towers Watson, also reports a continuing level of investment in real estate debt, with the consultancy having put $500m to $750m into the asset class since 2010. “This has largely come from European pension funds and Asian insurance clients,” he says.

Most of the volume has been channelled into senior property debt strategies, he says, with the firm’s clients having done very little in junior or mezzanine. “Our view is you can get quite binary outcomes in junior debt,” says Jayasingha, explaining that the subordinate position an investor has with junior debt means it stands to lose everything if the underlying property falls by 20% in value, whereas a 60% fall in value is usually necessary before senior debt holders lose any of their money. 

“The risk-return metric is less attractive for junior or mezzanine,” he says.

It is important for investors going into the real estate debt to be conscious of where the property market is in the cycle, Jayasingha

says, as prime markets are now almost fully valued – in the UK at least. Even so, he believes there is probably still more potential to be had in regional markets. Since the flurry of real estate debt market activity that took place in 2012 and 2013, the interest-rate margin on senior debt has shrunk to 2% or less, from around 3%, he says.

“We are more cautious on senior debt than we were 18 months ago, but there are opportunities outside London. In those  markets you can still get a reasonably attractive return compared to investment-grade credit, with an additional return of 0.75% net of fees,” says Jayasingha.

One thing that has changed dramatically in the real estate debt sector is the increase in the number of managers entering the arena, he says. “Investors now just need to be careful in terms of the return they’re getting,” he says.

Margins on mezzanine debt are also narrowing. Oliver Schebela, director of private equity at consultancy Feri, says this can be interpreted as a sign that banks are increasing their lending. Rather than being big investors in mainstream property debt, clients of the German consultancy have mostly been allocating to real estate equity and to some extent distressed real estate debt.

Schebela says these opportunities are seen as ways of accessing real estate by, for example, taking on a distressed loan and then getting hold of the equity. “Definitely, there are opportunities but it depends what kind of projects you are looking for,” he says.