Funding ratios in European real estate debt funds have increased from 47% in February 2014 to 86% in June 2015, according to research by Scope.

But this increased liquidity in Europe’s commercial real estate (CRE) lending markets will “intensify competition for assets, making it harder to source assets suitable for meeting investors’ risk/return profiles”, the researchers noted.

Scope sees two main drivers for the increase in interest in real estate debt apart from the obvious search for yield.

One is the ECB’s monetary policy, and the other is a “very supportive” regulatory framework, particularly in Germany.

Scope said the strong demand for debt funds among German insurance companies and pension funds could be explained by changes in the German insurance supervision law, or Versicherungsaufsichtsgesetz (VAG).

Harald Berlinicke, director at Scope and co-analyst for the report, told IPE it was “important that the legislator loosen regulations” around investments in alternatives such as real estate debt funds.

He said the new law brought “additional flexibility and new allocation spots”, and that this in turn made real estate or infrastructure debt investments “significantly easier”.

Under the new regulation, 30% (with optional expansion to 50%) can be allocated to transparent debt funds (with look-through reporting), while non-transparent funds can be allocated to the 7.5% alternative investment fund bucket, or the ABS bucket of same size.

However, alongside associate director Philipp Wass, Berlinicke told IPE about a “precarious situation” arising from increasing demand.

“The investment environment is relatively precarious for real estate debt fund as competition from other lenders like banks and mortgage banks that are strongly returning to the market is increasing,” Berlinicke said.

He pointed out there were isolated cooperations between debt funds and mortgage banks, but that competition was “the norm”.

In the long run, Scope even sees “risk of negative returns for investors” because of the difficult investment situation and future market downturns.

This means debt funds will have to increase leverage or find other “innovative solutions” to be able to achieve the promised returns.

Berlinicke stressed an increase in leverage could lead to problems under Solvency II as it would impact ratings and increase capital requirements.

The analyst also sees this new insurance supervisory framework as one of the drivers behind consolidation in the real estate debt fund sector.

“Not all providers will be able to afford to meet the reporting requirements under Solvency II,” he said.

In total, over the last five years, the number of real estate debt funds in Europe has increased from eight in August 2010 to 53 in June 2015.