Real estate debt is a new investment class for European institutions. Rachel Fixsen talks to six investors and advisers about their experiences so far

Roland Mangelmans
APG Asset Management
*Invests in junior and mezzanine debt, but no plans for senior
*Debt provides access to assets unavailable to equity investors

Having been one of the first big European investors to allocate to real estate debt, Dutch pensions provider and asset manager APG now invests in various debt strategies, focused on assets in core European countries.

“APG has committed over €1bn into these strategies and has further – yet selective – interest to expand its exposure to this sector,” says Roland Mangelmans, senior portfolio manager for real estate at APG Asset Management.

However, APG has not invested in senior debt or in non-performing loan opportunities and has, Mangelmans says, no intention of doing so at the moment.

Investing in real estate debt has the advantage for APG of providing access to certain assets and portfolios that are simply not investable from an equity perspective.

Added to this, from a risk-adjusted perspective, debt investments can offer an attractive return compared to equity, Mangelmans says.

“A generally shorter duration comparison to equity can in certain cases be considered as an advantage,” he says. “At the same time, being a long-term investor, this can be a drawback.”

Mangelmans sees real estate debt as a growing opportunity, because, over time, the proportion of non-banking lenders will increase.

“There is a large number of funds for which equity is currently being raised with numerous strategies,” he says. “However we believe only a limited number of managers will be able to successfully and sufficiently deploy capital in terms of execution of strategy.

“We consider the size and composition of the management team, track record and experience in sourcing and structuring attractive transactions with quality sponsors on quality assets as the key components in the successful execution of a debt strategy.”

When underwriting a real estate debt opportunity, the main factor for APG is the quality of the underlying real estate asset in terms of its location, tenancy, operational business plan and so on, Mangelmans explains.

Eliza Bailey
Partners Group
*Invested significant amounts in debt since mid-2008
*Looks for equity participation feature where there is potential upside

Partners Group has been an active investor in real estate debt since the middle of 2008
when the firm made an investment in a portfolio of non-performing loans.  

“Since then we have invested significant amounts in real estate debt,” says Eliza Bailey, senior vice-president in the private real estate team at Partners Group.

The company invests in mezzanine, participating mezzanine, preferred equity made through new loan originations, recapitalisations, and secondary purchases of loan portfolios.  

While property debt has the benefits of being defensive and having a high cash yield, there are downsides to watch out for as well. The upside of real estate debt can be capped, Bailey notes.

“Unless the debt includes an equity participation feature, it is unlikely to benefit from any upside achieved at the property,” she says. “This is why we look to include an equity participation feature in our debt investments if we believe in the upside potential of an investment.”

Also, some debt investments are made through intricate structures that might make it difficult to take control of the property if it underperforms, or may limit your rights compared to other positions in the capital stack. “It is important that you know what type of structure you are investing in and you have a structure that allows for a clear path to foreclosure or recourse,” she says.

Assessing this requires specialist legal and tax knowledge, she adds.

As real estate practitioners, Partners Group’s first consideration when investing in property debt is the fundamentals of the underlying property.

“If we like the real estate fundamentals and the business plan for the property and feel they compare favourably to the local market, then we review the business plan in close co-operation with the operating team,” Bailey says.

“If we get comfortable with the qualifications and experience of the operating team, then we determine where we think the best risk-adjusted return can be obtained within the capital stack and how best to structure our investment.”

Kate Mijakowska
*Tighter spreads and fewer opportunities in securitised products prompted interest in direct loans
*Manager numbers now high enough to run large segregated mandates

Consultancy Redington sees a significant number of pension funds and insurance companies seeking to make an allocation in the real estate debt market.

“Until recently, the main route into real estate debt investments for pension funds was through securitised products,” for example, commercial mortgage-backed securities (CMBS), says Kate Mijakowska, associate within manager research at Redington.

But spread-tightening and a decreasing number of opportunities in this area have led investors to explore other ways of accessing property debt. “Recently, we have observed particular interest in direct, commercial property loans,” she says. “Due to the retreat of banks from the space and an increased need for refinancing, the risk-return profile of these loans has increased considerably.”

Direct investment in commercial real estate loans is a relatively new opportunity for non-bank investors, and there have been many new entrants in the market in the last year or two.

“We believe there is a sufficient number of asset managers at the moment to run large segregated mandates,” Mijakowska says, but pooled funds are scarce.

The choice of asset manager is crucial. When investing in property debt directly, pension funds should consider factors including previous experience in originating and structuring such loans, network of contacts with borrowers and work-out experience, Mijakowska says.

“We currently advise our clients, who consider direct property debt investment, to focus on the senior and stretch-senior, UK, and to a lesser extent the core European,” she says.

“Stretch-senior debt can [offer] spreads of up to Libor plus 7.5% while still retaining a significant buffer in the form of equity and mezzanine debt, especially now that loan-to-value levels on senior debt have contracted significantly.

“Choice of geography is driven not only by the stability of the economy but also by the UK’s transparent and relatively straightforward legal system, which enables to foreclose quickly if we have to,” Mijakowska says.

Marcus Palmer
Hermes Real Estate Investment Management
*Expects the UK RE debt market to become less dominated by banks
*Loans of £50m-plus (€58.4bn) seen as particular investment opportunity

Opportunities for investors in real estate debt are emerging rapidly, according to Marcus Palmer, head of real estate debt at Hermes Real Estate Investment Management.

The Basel III capital-adequacy regulations and new rules governing how UK banks assess the risks of loans – known as slotting – have significantly reduced their appetite and ability to finance commercial real estate. “Lenders are now highly selective to whom, to what and how they will provide finance,” Palmer says.

But despite the structural deleveraging in the banking sector, it is still banks that dominate the landscape with a 90% market share, he points out, with the commercial mortgage-backed securities (CMBS) market remaining practically closed.

In the UK, £46bn of deal estate debt will mature in 2013, creating a need for refinancing, while between 2013 and 2016, £143bn will mature, Palmer notes.

“In comparison, banks have 57% market share in the US, with 22% taken by CMBS and 21% by alternative providers,” he says.

“We don’t expect the UK market to evolve this way, but certainly expect the landscape to be less dominated by banks in the long term.”

Healthy returns are on offer, with premium spreads for senior real estate debt currently 125-175bps above similarly rated corporate bonds.

“Capital structures in the property market have become more conservative, which is illustrated by falling loan-to-valuation ratios,” he says. “Using less leverage reduces risk, and lower LTVs mitigate the danger of large and unforeseen falls in property valuations.”

Given new regulations, few banks now have the appetite or capacity to lend more than £35m as a single loan to anyone outside their core clients, he says.

“Transactions above £50m now typically rely on club or syndicated lending structures and we therefore see loans of £50m-plus as a sweet-spot opportunity. This presents opportunities to providers of capital who can write large loans and have the skills to originate and execute,” he says. “We can originate on a bilateral basis as well as participate in club and syndicated structures.”

Claire Ballantyne
Hymans Robertson
*Client exposure to debt growing as familiarity with associated risks increases
*Limited secondary market and out-of-the-market risk are main drawbacks

Consultancy Hymans Robertson has a number of clients considering private debt opportunities, including real estate debt, according to Claire Ballantyne, research analyst at the firm.

“Real estate debt is a relatively new investment for UK pension funds to consider, as pre-financial crisis lending was dominated by the banks,” she says.

“We would expect client exposure to this market to grow as they become more familiar with the risks associated with investing in this market, including default, recovery and liquidity risk.”

Investors in real estate debt need to take a medium- to long-term investment view, as typically access is through a closed-ended fund with terms of 10 years or longer, she says.

But she cautions that the private nature of the market means there is a limited secondary market.

Another consideration is out-of-the-market risk, because managers of real estate debt can take time – often two to three years – to get capital raised and then invested, Ballantyne warns.

“That said, real estate debt can be an attractive investment for those pension funds who can withstand a level of illiquidity in return for a satisfactory excess return premium,” she says.

“An investment in private real estate debt could form part of a liability cash-flow matching solution for pension schemes.”

Conservative estimates suggest that €1trn of European real estate debt will need to be refinanced over the next three to five years, Ballantyne says.

At the moment, Hymans Robertson thinks there are only a handful of managers – mostly specialist ones – that can offer products to UK pension funds giving access to real estate debt as an investment.

“The lack of products is a function of barriers-to-entry for more traditional fixed income managers. There is a need for expertise in debt origination, workout in the event of default and a specialist understanding of property markets,” Ballantyne says.

“We expect manager offerings to increase as more traditional fixed income managers develop expertise in these areas, through hiring in or forming partnerships across specialist firms.”

Johannes Edgren
Valtion Eläkerahasto (VER) Finnish State Pension Fund
*Still looking at debt opportunities, but has yet to invest
*Focuses on manager track record, experience and alignment of interest

Finland’s State Pension Fund, Valtion Eläkerahasto (VER), has been busy looking at a number of real estate debt funds, but has yet to make any investment in the asset class.

“We are still looking at opportunities in this space,” says Johannes Edgren, portfolio manager at VER. “Real estate debt provides a stable and – depending on the strategy – high-income return,” he says.

The €15.8bn pension fund has the added security of being in a more favourable position in the capital stack compared to equity. “If you compare the income return on core real estate and the income return on a mezzanine loan on the same property, the income return on the mezzanine is likely to be higher even though it is in a more secure position,” says Edgren.

On the other hand, in many cases, the potential upside of the debt investment is capped.
“As banks have reduced their lending to real estate, there is a need for other parties to fill in the lending gap,” he says. “The opportunity seems to still be there and we have definitively seen more managers coming to the market and raising funds.”

He adds: “It seems that good managers do not have trouble raising capital as evidenced in the recent closings of some debt funds at their target levels.”

As with all its investments, VER focuses on the track record and experience of the manager when choosing a real estate debt investment, as well as the fund terms and alignment of interest. “We prefer managers with an existing track record,” Edgren says.
“But, as this is more of an emerging opportunity, the number of such managers are still limited.

He adds: “We also prefer countries within Europe where the legal framework is clear and supportive of this type of investment.”

So far in its real estate debt search, VER has looked mostly at the junior and mezzanine debt, as well as whole loans. “The returns for these strategies look attractive compared to the risks,” Edgren says. “Although the senior spreads can be attractive, the absolute return level can be quite low.”