The debt fund market in Europe is beginning to gain critical mass. Maha Khan Phillips and Richard Lowe explore an increasingly diverse sector

Senior debt in European commercial real estate has had a complicated recent history. The withdrawal of bank lending after the financial crisis left the market open to new, third-party alternative lenders. Insurance companies were the first to move in, while various asset managers started to develop investment products for other institutional investors. New banks have also entered the fray and some old ones have returned, all making for an interesting, dynamic market place.

During that time, institutional investors, for whom senior debt is new, have taken some time to warm to the idea of making allocations, whether through their real estate or their fixed-income teams.

“Interest in debt products is quite selective for pan-European investors,” says Peter de Haas, head of business development in Europe at Cornerstone Real Estate Advisers.
“There is a selective demand for just a few players here on the continent. There is also a split between pension funds and life insurance companies. Life insurance companies are more interested in senior real estate debt because it is a good match for liabilities. For pension funds, it depends on what kind of risk appetite they have, and where senior debt sits in the portfolio and organisation. Senior debt products are often dealt with by the fixed-income department, where they see it more as a credit. If you scale it up, then it is considered more real estate.”

Consultants admit that, even now, understanding senior debt is a process of education and evolution with their clients. “For traditional pension funds, this is still a learning curve,” says Paul Jayasingha, global head of real estate at Towers Watson. “It is an area of the market that they feel less knowledgeable about. It’s got connotations with things that went wrong in 2008, even though it is a non-securitised, senior asset-backed position, and lending on a specific piece of real estate, giving you a very well collateralised position.”

The market has a lot of potential, though. There has been plenty of discussion about the funding gap in commercial real estate. An estimated $2.6trn in commercial real estate loans were due for refinancing between 2012 and 2015, representing 38% of all outstanding commercial debt globally. Banks are still deleveraging, with balance sheets expected to shrink by £250bn to £500bn over three to five years. In a 2013 briefing note entitled Senior Commercial Real Estate Debt, KPMG estimates that there is a funding gap of €500bn in the market.

Institutional investors are slowly embracing the asset class. “What we found was that, at the start of 2013, there were a number of institutions that were looking at real estate debt, particularly senior debt, as a way of getting better returns on their bond portfolios,” Jayasingha says. “They were taking on more illiquidity risk in doing so, but they could get better asset backing and Libor-plus coupons which, in a rising-interest-rate environment is more attractive than investment-grade corporate bonds.”

Renè Kassis, managing director and head of the European Infrastructure and Real Estate Debt Fund at La Banque Postale Asset Management, which launched its senior debt initiative in 2012 and raised approximately €500m last year for senior and infrastructure debt, says the fund has seven institutional investors. It chose to focus on senior debt because it was an easier concept for institutions. “The theme of real estate debt is still quite new for investors. We wanted to start with something which is homogenous, and investment grade, in terms of the risk profile,” Kassis explains.

However, he believes that institutional appetite is increasing. “Debt is attractive for institutional investors as part of a diversification play. It is part of their fixed-income strategy. These assets are certainly not as liquid as what you would find in traditional fixed income assets, but there is an illiquidity premium, so by investing in these asset classes, they can capture this illiquidity premium without forgoing on the risk profile.”

An attractive, but not static, spread
There are plenty of reasons why senior debt is of interest. Premiums are above similar quality corporate bonds, by 1% or 1.5%, according to KPMG. It provides better capital protection than equity, and similarly rated corporate bonds. Debt also has lower volatility than equity and balanced property, and higher certainty of return than equity and balanced property, according to KPMG.

KPMG also pointed out that senior loans are at the top of the capital structure and in the event of default, the invested capital is protected by the resale value of the property. In addition, unlike investors in commercial mortgage-backed securities (CMBS), private debt managers will typically be the only investors at the senior level, and will thus retain control over the restructuring process.

Prior to the financial crisis, senior loans typically funded 75-80% of the purchase price, or loan-to-value (LTV). Current senior loans are made at 50-65% LTV, which provides investors with a 35-50% fall in value cushion before some of the capital might be impaired, according to the firm.

KPMG also points out that the lack of lending sources has increased the premium that borrowers are willing to pay for commercial real estate loans. Before the crisis, senior loans paid in the range of 50-80bps above the benchmark. “Comparing the opportunity to other asset classes, the average spreads of 300bps are currently significantly higher than those offered by fixed-income asset classes of similar credit quality, such as investment-grade corporate bonds and more liquid asset-backed securities,” said the firm. It also argues that while a portion of the spread can be attributed to significantly lower liquidity of CRE debt, the current spreads are above those justified by an illiquidity premium alone.

However, Paul Richards, principal at Mercer, says there is now a 200bps spread between senior premium and corporate bonds. “There will be a point in the future when senior spreads narrow but, for now, the spread is still there, and you have high capital security as well.”

Jayasingha suggests an even lower spread. “Pricing has shifted a lot. You could get senior real estate debt on prime properties at Libor plus 300bps at the start of [2013]. That’s down to around Libor plus 150 now. Banks have become more willing to lend in the prime property space.”

A new fund sector is born
As institutional interest in senior debt products grows, so does the number of providers launching new funds. It makes sense to start with insurance companies (and their asset management businesses) as they were the first to move into the market after the crisis, while some were already active.

Standard Life moved into senior debt in 2013 – effectively joining other UK insurance giants Aviva, Legal & General and Prudential – when its asset management arm, Standard Life Investments (SLI), announced it would invest £250m on its behalf. It has yet to launch a fund for third-party investors but the company has intimated that this is a logical progression. Prudential has already made a significant move into senior debt in recent years through its own asset management firm M&G, which has been talking to investors for some time about a third-party senior debt product.

Aviva has been a senior lender in the UK since 1984 through its subsidiary Aviva Commercial Finance. The insurer plans to merge the entity with its asset management arm, Aviva Investors, which last year launched a third-party senior debt fund, attracting £288m from UK pension funds. Only Legal & General has set up a senior debt business without talking publicly about the possibility of offering a third-party product to the wider market.

Other asset managers in the UK have sought to launch senior debt funds. Henderson Global Investors was one of the first, but never managed to get its fund off the ground. It has since entered into a merger agreement with US financial group TIAA-CREF, which should enable it to launch a lending programme based on US capital. Hermes Real Estate Investment Management has managed to launch a senior debt fund. The cornerstone capital is believed to come from the BT Pension Scheme, which owns Hermes.

Senior debt funds have also gained traction in France, which is perhaps not surprising, given the number of insurance companies in the country. ACOFI Loan Management Services, AEW Europe, La Française Real Estate Managers and La Banque Postale Asset Management have all launched senior debt funds for French insurers.

By far the biggest player in France is AXA Real Estate, which now manages some €4.6bn in debt investments. France’s biggest real estate fund manager says it has €7.9bn of capital committed to debt strategies (both senior and whole-loan). A large portion of this capital is derived from insurance companies from within the AXA group, but AXA Real Estate has also been bringing in third-party investors.

The most obvious example came in October last year, when AXA Real Estate was given a mandate by Norges Bank Investment Management (NBIM), the manager of the Norwegian Government Pension Fund Global, to build a co-investment loan programme. Together, they will target investments in large senior loans of up to €600m, focusing on the UK, France, and Germany. The deal is significant for the senior property debt sector as it seeks to become a mainstream institutional asset class.

AXA Real Estate has the benefit of scale, which has only been enhanced by the NBIM mandate. Isabelle Scemama, head of real asset finance at AXA Real Estate, says the co-investment programme was a no-brainer. “For AXA, being capable of doing larger loans will help us to get access to larger deals,” she says.

With new managers launching in the market, Scemama sees scale as an important differentiating factor. “You need significant seed capital to operate in this market. If you come with a debt fund of only €300m, then it is almost impossible to operate in this market,” she says. “You have to provide €50m [per loan], and you have to have diversification. Even if you consider that a portfolio of 10 loans is sufficient, that means €30m per loan, and that won’t generate a lot of excitement.”

Jayasingha says: “There are very few parties out there in Europe that have the scale that Norges/AXA have. There can be an advantage to scale. If you have the ability to write large cheques when there are very few people in the market who can do that, then you are in a good position. The downside is that the smaller deals won’t move the needle as much.”

Others are finding niche areas to operate in, including financing for residential developments in the UK. Steven Cowins, partner in the funds and indirect real estate practice at King & Wood Mallesons SJ Berwin, says: “You could see a clear bifurcation in the debt market with a small number of mega debt funds taking a lot of prime debt on prime assets at one end of the spectrum and a number of smaller pools of managed capital targeting niche strategies such as residential development, infrastructure and renewables and assets with operational risks, such as hotels.”

Cordea Savills and LaSalle Investment Management have launched respective funds with strategies to finance residential developments in London. LaSalle’s fund, backed by Dutch pensions group APG, will also lend against student accommodation developments. Amy Aznar, head of debt investments and special situations at LaSalle, says the fund is “significantly invested” but she is still seeing plenty of opportunities in the market.

Kiran Patel, CIO at Cordea Savills believes it is an untapped market. “Most of the lending today is on commercial property,” says CIO Kiran Patel. “There is very little going on in the residential market. We’re looking to launch on the residential side, to house builders. We see them as the ones who are really struggling. We give them up to 70% on loan-to-cost and 60% on loan-to-value and that gets us returns of 10% to 13% because these guys can’t get any formal lending.”

Whole-loans and hybrids
Those returns show that these residential finance funds are a very different prospect to the pure senior debt funds that are, in effect, looking to outperform government bonds. In fact, they are more comparable to the returns traditionally offered by mezzanine debt funds and so are more likely to appeal to traditional real estate investors than fixed-income investors.

“Senior debt is a different risk and return,” says Andrew Radkiewicz, managing director of Pramerica Real Estate Investors, a company that has raised more than €800m for its latest mezzanine fund. “It is a return of 3% to 4%. “It doesn’t suit real estate investors.”

Pramerica was among a number of investment managers to launch mezzanine funds in 2010, which proved popular with investors, offering returns of 15-19% for a relatively low level of risk, at least in comparison to equity, and comparative to traditional core or core-plus real estate investments.

Mezzanine investors were taking advantage of the drop in appetite among traditional bank lenders for higher LTV loans and refinancings. However, a mezzanine strategy is very dependent on an active senior debt market, since it is effectively supplementing it. So when, in 2012, banks started to withdraw more comprehensively from the market, questions were raised over the sustainability of pure mezzanine strategies. Some managers reportedly had to go back to investors to ask to widen their remit to include more conservative deals often without senior lenders.

This development also acted as a catalyst for the rise of ‘whole loan’ strategies, where the lender provides both the senior and mezzanine pieces in one. In many cases, the whole-loan lender would syndicate the senior piece, leaving it holding the mezzanine part of the loan. Whole loans offer both flexibility and provide a one-stop shop for investors who want to deal with a single vendor, rather than a host of credit providers. Many providers see it as an untapped part of the market, with plenty of potential for growth.

“Flexibility of strategy is key for debt funds,” says Cowins. “This is why whole-loan was the most popular strategy in 2013, especially where there is the flexibility to do some senior or mezzanine if the underlying economics made sense.”

Ravi Stickney, co-head of Cheyne Capital’s debt team, says whole-loan providers can give borrowers a “certainty of execution” if they need to make a transaction by a certain date.
He cites the £260m acquisition by Queensgate Investments of Executive Offices Group and its 28 central London assets, a deal that was financed with a four-year whole loan from Cheyne and DRC Capital. “The sponsor was in a competitive auction and had a very short time to complete, and senior lenders just weren’t able to get the credit transacted in the time he desired. So we funded the entire debt in the space of three to four weeks, which gave him time to source the senior debt thereafter.

Arnaud Plat, head of business development for real estate investment manager Aerium, says: “One of the funds which we are working towards launching is a whole loan fund. “We see very interesting opportunities there. A number of our competitors are focusing purely on the mezzanine space or on the senior debt space, but very few players are capable of providing whole loans. From a borrower perspective, it makes it much simpler to have just one counterparty.”

Aerium manages in excess of €6bn of real estate assets across of a number of investment vehicles, but has a dedicated real estate debt and mezzanine platform called Aeriance, which has deployed €1.4bn of capital in the UK and continental Europe since 2008.

Plat suggests that there is plenty of room for new managers in this space. “Traditional commercial lenders do not want to go above 65% loan-to-value, because it starts getting very expensive in terms of equity requirements. Many insurers are new to the lending space in Europe. They want to stick to very conservative underwritings, and so they stick to mezzanine or senior debt, and don’t do both.”

UBS Global Asset Management and Mitsubishi Corporation have also launched a whole-loan fund and raised £140m in a first close. It is a very specific strategy – participating mortgages, which give the lender a share of rental growth and capital appreciation – that UBS GAM has been carrying out in the US for a number of years.

Others have launched funds that will invest in a combination of whole loans and mezzanine and/or senior. Cheyne Capital, DRC Capital, Renshaw Bay, Caerus (formerly part of Signa), BNP Paribas REIM (which recently acquired iii-investments), GreenOak Real Estate Advisors, LaSalle Investment Management and ICG-Longbow are all pursuing hybrid strategies for the latest fund ventures.

ICG-Longbow has taken this approach for two consecutive funds: the Longbow UK Real Estate Debt Investment II, which had a final close for £242m in September 2011, and ICG-Longbow UK Real Estate Debt Investment III, which raised significantly more, at £700m by May 2013. The former focused on newly originated mezzanine and whole loans, with target returns of 14% per annum and an annual income of 8%. The more recent fund is targeting returns of 11% and a net cash yield of 8%.

“Whole loans are popular with investors, but deployment is a concern,” says joint managing partner Martin Wheeler. “They worry about whether you can hit return targets, whether you can put the money out, and the quality of the real estate they are dealing with.

Last year, ICG-Longbow provided Shiva Hotels with a £74.5m whole loan to purchase Millennium Bridge House. It also funded an industrial estate to the east of London.
Wheeler says that borrowers like the prospect of whole loans because they deal with only one funding partner, and aren’t tied up with inter-creditor agreements that are required when there is more than one lender involved in a deal.

Mezzanine 2.0?
But not all investors are attracted to the strategy. “For some people, whole loans don’t make sense,” says Paul Richards, principal at Mercer. “They are seeking great capital security, so whole loans just don’t fit with what they want. Equally, some people want to go for higher risk and higher return. Whole loans aren’t for everybody.”

Pramerica Real Estate Investors has shown that there is still interest in pure mezzanine strategies, having raised more than €800m for its fund (which also invests in preferred equity).

As mentioned at the start of the article, the senior debt market in Europe has recovered, helped by the return of some established banks and by an influx of new non-European lenders and insurance companies. This will support mezzanine transactions.

“Two years ago we were all talking about the dearth of senior debt in the marketplace,” says Dale Lattanzio, managing partner of DRC Capital. “That has reversed quite dramatically, for a couple of reasons. Banks have been quite active again, as they begin the healing process and they look at commercial property lending spreads which, relative to other assets, are quite attractive.

“We are also seeing the impact of the new non-bank lenders entering the senior space, most particularly insurance companies. As a result, spreads that were once 275-375bps are now anywhere from 175bps to 275bps.”

Lattanzio points out that leverage has also increased. “There is a substantial increase of debt available, not just in London and Munich, but other cities as well. We also have a lot more activity in the non-bank lending space, with both European and North American insurance companies making deals.”

“What we find interesting is that the lowering cost of senior debt has made some of the higher leveraged refinancing more cost-effective,” he adds. “So you can combine bank and insurance company senior with a mezzanine provider to effect higher leveraged refinancing without the existing lender having to take a loss on their position.”

LaSalle Investment Management’s new fund, which was oversubscribed and closed at £600m, will invest in mezzanine alongside whole loans. “We are seeing more liquidity, particularly in the senior side of the market, than we did six months ago, which means that, in a lot of cases, mezzanine could be a very interesting way to team up with some of those aggressive senior banks,” says Aznar. “It also feeds into the whole-loan opportunity for us and gives us more confidence to invest in a whole loan where, ultimately, we would have a syndication strategy for the senior, keeping the mezz.”

As Richards points out, investors have more choice available to them than ever before in the real estate debt asset class, which can only be a good thing. “Senior debt is in the low-risk category,” he says. “As long as senior debt performs, there isn’t any volatility – you just hold it. And default rates are in the low single-percentage points, so it sits in a very secure basket. Mezzanine is different. It is obviously higher risk, but it still sits at lower risk than just investing in property, although obviously at a much higher risk than senior, because you would lose your capital before senior debt would.”

He adds: “People have a choice now, because in the first half of 2013, there were a number of funds raising capital. You can get into a whole-loan fund which is mezzanine or senior, or you could do one or the other.”

Cowins offers a note of caution regarding return expectations, which will always be subject to the vagaries of what is a changeable market undergoing structural shifts. “There is no doubt that debt as an asset class is better understood by investors than it was in previous years, but there are still several issues facing investors and fund managers,” he says. “One issue is where to set the hurdle for new debt funds. It is a fine balancing act to ensure that the hurdle is commensurate with the relevant risks and is attractive to investors – but that the hurdle is not so high that, with banks returning to the market and margins tightening, debt funds don’t find themselves priced out of the market or having to move too high up the risk curve by having too high a hurdle.”

Market participants broadly agree that the withdrawal of banks has changed the landscape of the business permanently, with a 50/50 split between banks and non-banks, closer to the US model a likely reality in the future. “Alternative non-bank lending is not a flash in the pan,” says Radkiewicz. “It makes sense for a lot of people. It has become part of the mainstream. Three years ago very few people would consider an alternative non-bank lender. It is now part of the equation.”