Good theory, but in practice?

Will institutional investors embrace senior property debt as a viable alternative to fixed income? Shayla Walmsley reports

Can debt beat bonds? Yields on senior real estate lending, mooted as an alternative to low-yielding fixed income, are certainly too meagre at 4-6% to interest traditional, return-oriented real estate investors. That is why, according to INREV, pension funds are less likely than insurers to invest in it.

But compared with low bond yields? Two of the characteristics that make real estate senior debt a credible proxy are modest leverage – often at less than 60% loan-to-value – and the premium over corporate bonds. The problem with this premium is that it is effectively a premium for illiquidity.

Even given the illiquid nature of the investment, at 60% loan-to-value, even in the event of a forced sale, the discount would have to be more than 40% of the loan’s value for senior debt investors to take a hit.

Ben Stirling, managing director for Europe at Aviva Investors, does not expect institutions to be put off by investments that will, by definition, sit in the illiquid part of the portfolio. “Investors are taking account of the illiquidity, but I haven’t yet had a conversation where investors have said the investment is a non-starter because of it,” he says.

Preqin data suggest that, while appetite for other types of property fund remained constant, the percentage of investors looking to invest in real estate debt funds increased from 8% at the end of 2011 to 23% at the end of 2012.

IP Real Estate’s own survey of pension funds and institutional investors shows that 38% of respondents are invested in real estate debt, significantly higher than the 27% recorded 12 months ago. The proportion of investors intending to invest in real estate debt over the next 18 months is also up from 33% at the end of 2011 to 42% at the end of 2012.

The research also found that the majority (57%) of investors were placing real estate debt investments in their real estate allocation, compared with 31% placing it in their fixed income portfolios.

Yet, despite evidence of investor appetite, Towers Watson senior investment consultant Paul Jayasingha admits he has had to persuade his clients of the utility of senior debt vis-à-vis fixed income. If illiquidity is one obstacle, another is, quite simply, lack of awareness.

“Our clients aren’t necessarily aware of the opportunity,” he says. “We’ve had to be proactive about it.”

For Stirling, the fact that consultants are starting to research the idea is important because it marks a shift away from what had been an exclusive focus on mezzanine. “They rated mezzanine strategies for years and now they’re getting their clients comfortable with the idea [of senior debt],” he says.

But the problem for Jayasingha’s clients is that senior debt is not an obvious asset class. Neil Lawson-May, co-CEO at Palatium Investment Management, in similar terms recently pointed out that one reason for investor hesitation is the perception that senior real estate debt is not obviously one thing or the other – too much like real estate for fixed income portfolio managers and too much like fixed income for their real estate counterparts.
Regulators are arguably not helping. “When you speak to European German institutional investors, they’re often concerned with [their] regulator’s approach before appraising the merits of a new investment,” says John Feeney, head of commercial real estate debt at Henderson Global Investors. “US regulators tend to be more flexible and this allows institutional investors to allocate to non-traditional asset classes more quickly.”
In contrast, he says, US investors have already started to shift away from senior debt investments in their domestic market – where yields have dropped to as low as 3.5% – to those in the UK. “They have major capital to allocate and they can get a big premium in the UK compared with the US,” says Feeney. “Hence US pension money is making its way to the UK.”

Today’s European senior debt market is effectively a UK market, although Germany and to some extent France are catching up. “Big pension funds are following insurers, mostly in the UK but they’re beginning to be active in Germany and even France,” says Feeney.
What has held Germany back up to now has been, quite simply, the relative availability of senior debt. Returns are lower because there is still liquidity, for example from the Pfandbrief. Stirling says he has had interest from euro-denominated investors in the UK commercial mortgages fund he is currently seeking to raise capital for. Although some mainland European investors he has spoken to are reluctant to take on currency risk, larger ones with a balanced portfolio across different currencies already have hedging mechanisms in place. “They have to price it in, obviously,” he says.

For non-European investors, the UK market is easy to understand, liquid and transparent. US and Canadian investors “can get their heads around it quickly – especially its legal regime”, says Feeney. “For non-bank lenders, licensing is not an issue in the UK, whereas it is in Germany and other European markets. North American investors also have a cultural affinity for the UK.”

The trouble with funds
The attractiveness or otherwise of senior debt as an alternative to fixed income will depend to some large extent on how investors plan to gain exposure. Unless they are willing to invest directly in funds, it requires scale.

One of the reasons Cordea Savills has shifted its focus away from mezzanine to a more niche debt activity, for example, is that it is unable to compete with scale-endowed insurers in the senior debt market. “In contrast to corporate bonds, you can’t trade those debts; they’re held until maturity,” says CIO Kiran Patel. “So to make it work you need access to the big fixed-income investors – the kind of access enjoyed by debt managers currently at the senior end. It’s a volume business. It makes sense for the big insurance guys – not for us.”

Insurers are forecast to increase their share of the UK debt market from 15% to 30% within the next five years. If that forecast is correct, their participation will change the senior debt market. For insurers, these are longer-term loans – on average 10-15 years in line with their liabilities, compared with banks’ five to seven years.

“There has been a shift away from the short-dated facilities common when banks dominated senior debt towards exposure to the more long-term fixed-rate facilities insurers like,” says Feeney, who argues that the shift will result in a more stable market, because the loans will be more expensive to prepay, thus creating less incentive for institutional investors to flip assets precipitously.

“I consider the long-term provision of capital to be a positive development,” he says. “For agents looking for fees generated by lots of transaction volume, long-term debt is a bad thing. For bankers looking to rework a loan every couple of years, it’s a bad thing. But the market is dominated by assets needing long-term finance.”

Not least because of the entry of insurers into the market, senior debt has become safer. While the interest rate on loans has increased from 1% over LIBOR in 2008 to 350-400bps in 2012, the loan-to-value ratio on property has increased from 60-70% in 2007 to 60-65%. The result is higher margins and safer loans.

Still, a trade-off between different types of risk is not eradication of risk. In addition to illiquidity, senior debt comes with corporate exposure from an underlying exposure to tenant risk – but with specific collateral backing from the asset itself. With a corporate bond, in contrast, you get the corporate risk without the specific assets as collateral.
While insurers are likely to work with banks to invest directly, pension funds have little choice except to invest in debt funds.

Even for fund investors, these are not negligible commitments in a limited pool. Around seven European funds are dedicated exclusively to senior loans, providing loans of between €50m and €100m and with an average target fund size of €1bn. Any smaller, the reasoning goes, and they would be unable either to provide large loans or to achieve sufficient diversification.

The corollary of large funds, of course, is that they ask investors to allocate larger chunks of capital. “We’re talking about substantial investments,” says Feeney. “Across the UK, institutions are not investing in a small way.”  Allocation size is relative, of course. One argument against institutional investors migrating to senior debt is the unlikely prospect of their reallocating wholesale their often hefty fixed-income portfolios.

The fact that senior debt funds are complex closed-ended structures, where the manager draws down investors’ money as and when necessary, is a problem for some investors, according to Jayasingha.

“The potential barrier for investors is that they don’t want to lock their money up for six or seven years; they prefer the liquidity of an open-ended fund,” he says. “But in fact it makes sense for senior debt funds to be offered in closed-ended structures because it’s in an illiquid asset.”

Senior or otherwise, debt funds come with management and loan origination fees, although senior ones are unlikely to come with performance fees. Some investors are reportedly concerned that the structure of performance fees could encourage managers to take on more risk than they need to.

Fees have come in for criticism from Hans-Wilhelm Korfmacher, managing director of the €2bn German accountants’ pension fund WPV, who last year expressed scepticism about debt funds primarily because of manager fees.

Yet Jayasingha notes that few of his clients have asked about fee transparency – although they should, he says, because transparency is one of the main drivers. The caveat is that the loan origination fee, which incidentally reduces the J-curve effect, should go to investors, although it sometimes goes to the manager or is shared between the manager and investors.

“Senior debt funds have a much simpler fee structure,” he says. “In a traditional property fund you have multiple fees and costs, such as the property manager’s fee and charges for capex, for example. A debt fund has a final fee but you don’t typically see performance fee structures because they wouldn’t make sense.”

The banks are back in town
Assuming there is an a priori case for investors to target senior debt as an alternative, what might scupper it?

One variable would be changes in the senior debt market itself. Insurers may have entered the depleted senior debt market as providential providers but it turns out they are not the only ones. Despite INREV’s finding that most investors surveyed believe European banks (which hold up to 95% of all outstanding loans) would not return to the market in the medium term, there are indications that the bankers are back.

Two examples emerged in quick succession over a couple of weeks in January. First, former Citi head of European real estate Paul House set up Venn Partners to invest in mezzanine debt but also in senior loans secured against UK and German commercial real estate. Then it emerged that US bank Wells Fargo planned to lend £1bn to UK property companies in 2013, an expansion of its previous lending on UK assets (although in that case to US clients).

What this might mean for would-be senior debt investors is not that available opportunities will dwindle, but that there will be greater competition for them, potentially from the usual suspects.

Yields should be a concern, too. Compared with those on junior debt, they are already low (which is why senior debt is likely to appeal to fixed income investors and desks, and junior debt is more likely to appeal to traditional real estate investors).

To be sure, senior real estate debt as an alternative to fixed income – in fact any alternative to fixed income – is bound to have a certain appeal from a yield perspective.
But an improvement in bond yields, or, pari passu, a decline in yields on senior debt, could make it less attractive even as an alternative to fixed income.

As Feeney points out, one of the reasons US investors have targeted the UK senior debt is because yields on it in their domestic market hover not far above 3%. Yields on senior debt might need to not only be better than bonds, but significantly better.

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