GLOBAL - Debt may be the newer, safer equity, according to Mercer.
Because maximum loan-to-values (LTVs) for senior debt on core real estate are lower today than they were at the peak of the market, approximately 35-40% of the reduced capital value must be financed by the borrower, in addition to the original loan.
In a recent survey looking into the topic of real estate debt as an alternative to equity, Mercer analysed the opportunities for non-bank lenders such as institutional investors, as borrowers face this 'funding gap' when it comes time to refinance.
Mercer said: "Estimates of the gap in Europe for 2010-11 are over $195bn (€142bn) if senior LTVs stay below 60%. Over a third of this is in the UK, with another fifth in Spain."
In the US, the study estimates the gap at $1.1trn if senior LTVs stay below 70%.
In addition, the survey calculates that funding gaps will persist into 2012-14. This calculation is based on an average loan life of five years for those loans made at the market's peak in 2007, plus two years' extension.
The study does not address distressed loans, which have a different profile, Mercer said. Instead, it considers "un-distressed debt with a distressed borrower" - performing loans that need a source of capital when it is time to refinance.
Thus, it represents a low-risk investment opportunity, as long as there is sound property and tenant underwriting, the consultancy said. Sources of return include coupon, arrangement fees and early repayment penalties.
There are numerous reasons why, in the current economic climate, real estate debt may be a better option than traditional real estate equity, according to Mercer.
The survey states: "Return expectations along all points on the risk/return spectrum indicate debt is expected to perform in-line with equity, but with a higher income component and capital cushion generated from the borrower's equity."
In addition, while debt is firmly tied to real estate, it is less correlated with underlying economic conditions, mitigating the current economic uncertainty, Mercer said.