Drawn into the unknown

Real estate debt has gained traction with institutional investors in recent years. But Rachel Fixsen finds that, for many, it is a new and uncertain asset class

Opportunities to invest in real estate debt have opened up for institutional investors, largely because banks have been forced to scale down, or withdraw, their property lending business due to the financial crisis and tighter regulation. Pension funds and other institutional investors around the world have been allocating to what is, for some, a new asset class.

For property investors, it offers an alternative to buying core real estate, a class that has become highly competitive and expensive. For generalists, including fixed-income investors, the returns are appealing at a time of low bond yields, despite the inconvenient illiquidity.

Only a small majority (57%) of European pension funds and similar institutional investors polled by IP Real Estate do not have exposure to real estate debt – including mezzanine, senior and distressed loans – either directly or through indirect funds. The research showed that a similar proportion (60%) of investors are planning to invest in real estate debt over the next 18 months.

In November, four UK defined benefit schemes took part in the second close of Aviva Investors UK commercial real estate senior debt fund, which aimed for a yield of between 2.5 and 3.5 percentage points above Gilts.

The fund’s manager James Tarry expects to see more interest from pension funds in real estate debt. He said they favoured these   investments as fixed-income diversifiers. “The fund provides them with a spread over the Gilt which looks attractive relative to the yield they could get from the equivalent rated corporate bond,” he says.

Also in November, Dutch pension fund manager APG once again backed Pramerica Real Estate Investors in raising equity for its fourth European debt vehicle, Pramerica Real Estate Capital IV. The Dutch firm had already invested in the manager’s earlier real estate debt funds. Pramerica raised €820m of new equity for the fourth fund, which is to focus on office, retail, industrial and residential properties in the UK and Germany, with deals of between €10m to €100m.

In the US, too, pension funds are turning toward real estate debt. The Orange County Employees Retirement System (OCERS) in California, recently put out a mandate for a real estate debt manager for a portfolio of up to $75m (€55m). The pension fund was undecided as to whether it would actually allocate but wanted to test the market as an alternative to core real estate.

“We’ve made a strategic decision to move away from core real estate because we think it’s overvalued,” says Girard Miller, chief investment officer at OCERS. The fund plans to shift around 10% of its $10m of property assets from core to non-core. “Real estate debt is one of the non-core real estate strategies we’re looking at,” he says.

The Canada Pension Plan Investment Board (CPPIB) has increased investments in its private real estate debt (PRED) programme in the last few years, with assets growing to CAD2.3bn (€1.5bn) by the end of March 2013 from about CAD600m in 2011. The fund says real estate debt is a growing area within its investment as the size of the overall CPP fund grows, and as the PRED team grows and gains expertise.

The PRED targets both real estate mortgage and mezzanine financing opportunities, but has not said publicly whether it is also active in other areas. All of PRED’s investments are made directly rather than through funds. “We target high-quality assets that are managed by strong operators investing primarily in countries and sectors where our real estate investments department is active,” a spokesperson for CPPIB says.

In the US and Canada, pension funds are eyeing the European property debt market as an opportunity to secure much higher returns than available domestically. In November, the Sacramento County Employees’ Retirement System invested in European real estate debt for the first time when it committed $50m to the DRC Capital European Real Estate Debt Fund II.

Explaining the move, the fund’s chief investment officer Scott Chan said there was a huge supply-demand imbalance for real estate debt in Europe, with $1trn of debt to become due in the region over the next three to five years. About 60% of the banks that had provided the original financing were no longer in the marketplace, Chan said.

For the Sacramento pension fund, turning to European property debt was a way to achieve high returns on core properties, with expected ungeared returns on the strategy in the range of 9-14% — much higher than the returns of between 6% and 7% expected for equivalent investments in the US. Chan estimated the European market was two to four years behind the US.

In Korea, too, institutional investors have sharpened their interest in real estate debt. The Korean Teachers’ Credit Union (KTCU) reports that part of its recent investment focus has been on real estate debt, including mezzanine and preferred equity. This focus has come about for two reasons: core assets have been identified as overpriced and the investor’s short-term liquidity has increased.

KTCU says it prefers to invest directly rather than in blind pooled funds, although it would consider using a blind fund when, for example, it has to make a quick decision. “We usually like to invest in direct assets,” explains Steve Park, assistant manager in KTCU’s alternative investment department. “After we learn how things are going on, we invest in funds, too.” The fund uses domestic funds as a vehicle whenever it invests in overseas deals, because this allows it to manage new investments abroad more effectively, he says.
In 2013, KTCU provided £68m (€82m) of senior debt for a portfolio of 61 UK hotels as well as $50m of junior mezzanine debt for the Seagram Building in New York.

Korean investors started taking an interest in property debt opportunities at the end of 2012, either directly or through debt funds, according to Samant Narula, real estate partner at Berwin Leighton Paisner in London. “Principally, they need a particular coupon, and they found that yields in the central London property market were getting quite tight,” he says, with prime central London city office yields being sub 5%.

This prompted investors to change their strategy, preferring debt – namely mezzanine, rather than plain-vanilla senior debt – Narula says. “The appetite is there and they are keen to do it,” he says. “To a large extent, it’s opportunity-driven.”

Elsewhere, Nordic pension funds, in particular, have shown themselves keen investors in property debt. “Towards the end of the summer of 2012, we were being told that all they were prepared to look at was real estate debt funds,” Narula says.

In October, Norway’s Government Pension Fund Global made its first investment in real estate debt, when its investment manager Norges Bank Investment Management (NBIM) signed a co-investment programme with AXA Real Estate. The joint venture is to target large senior loan investments totalling up to €600m.

Pension funds have been investing more in commercial real estate debt over the past few years, and that trend has intensified over the past 18 months, says Charles Daulon du Laurens, head of investor relations, real asset finance at AXA Real Estate. The retirement institutions are trying to diversify their fixed-income portfolios at the same time as increasing their overall return in a low-interest rate environment, he explains.

IP Real Estate’s recent poll of European pension funds shows that a fairly significant number of investors are allocating capital from their fixed-income buckets. Of those looking to invest in real estate debt over the next 18 months, 37.5% identify it as a fixed-income investment (58.3% consider it real estate, 4.2% label it ‘other’).

As with many investment trends, European insurers are behind their US counterparts. While US insurance companies have, on average, 25% of their balance sheet allocated to private debt, in Europe the figure is less than 10%, Daulon du Laurens says.

Another factor driving institutional investors towards European real estate debt is the fact that they cannot so readily diversify their corporate bond exposure as their US peers, because the European corporate bond market is far more financially weighted than the US equivalent. So real estate debt provides an opportunity for fixed-income portfolio diversification.

Also, pension funds and insurers have been traditional lenders in the property markets in the US but the situation has been completely different in Europe, says Daulon du Laurens.
“The European banks that were providing 95% of real estate lending have significantly reduced their allocation to property lending,” he says. “There is a huge empty space left for long-term investors who can replace them.”

The yields available on real estate debt are far outpacing those for corporate bonds, being in the region of LIBOR-plus 250-300bps, compared with spreads of between 70-100bps above LIBOR for investment grade corporate bonds, he says.

While interest in real estate debt investment has certainly intensified, there are signs that it could slip back. More supply is emerging for real estate debt financing in Europe – with those German banks that still have liquidity and big US banks that have identified the spreads in Europe – although Daulon du Laurens says the huge amount of debt coming up for refinancing will nevertheless keep demand strong.

“You do have more capital available from the banks on the supply side, but what is maintaining the spreads is the fact demand is still very high,” he says.

Short affair or lasting relationship?
Pensions provider Blue Sky Group in the Netherlands sees certain benefits in investing in real estate debt — good returns and preferential rights compared with equity real estate — but is not in any hurry to gain exposure.

A new investment case will be made for including the asset class in the near future, says Marleen Bosma-Verhaegh, senior fund manager, real estate. “In general, there is enough opportunity in the market space currently for real estate debt,” she says. “However, the preference of lower leverage levels and new initiatives and institutions offering loans could dampen the gap sooner than expected.”

Although, Blue Sky Group does not invest in debt as a specific asset class yet, it does have some indirect exposure to a small extent through individual loans through its existing non-listed real estate investments — mainly related to the US and Asia.

Since real estate debt would probably be part of the group’s fixed-income portfolio, investment in the asset class does carry some concerns about the diversification risk of portfolios, says Bosma-Verhaegh. “For these types of strategies, Blue Sky Group prefers to invest in separate accounts to be able to customise its specific mandates. Therefore, the question would be whether enough diversification would be obtained,” she says.
Some in the industry wonder if it is not too late for investors wanting to build up their RE debt exposure. Has the biggest opportunity passed institutions by?

Narula remarks that margins on property debt were slipping in 2013. “Given where margins are going, the question to the pension funds is — is the sector still appealing?” Banks are showing signs of recovery and coming back into the property lending market. While senior debt deals had been based on a loan-to-value ratio of 60%, some banks are now said to be happy to provide senior loans at 70%. Narula wonders if debt investments will “still provide the returns they were aiming for”.

Investor interest in real estate debt ebbs and flows, depending on how spreads change and how attractive the asset class is compared with other illiquid assets, according to Kate Mijakowska, associate in manager research at consultancy Redington. One thing that has changed, however, she says, is that clients are increasingly aware of the issues around direct property debt investment — primarily to do with the illiquidity of the asset class. Redington has been working to build frameworks for clients for investing in illiquid asset classes, helping them to look at the overall illiquidity budget, capital deployment time issues and so on.

Institutional investors are still interested in real estate debt funds, but the focus has altered, Mijakowska says. “As spreads on senior deals backed by core, prime London properties have compressed, we see the attention shifting towards stretch-senior and mezzanine financing,” she says.

Research by IP Real Estate shows that, of those investors planning to invest in real estate debt, the majority (61.9%) were interested in senior debt, while a large minority were interested in mezzanine (47.6%) and a smaller proportion (38.1%) were interested in stretched-senior (respondents were allowed to choose more than one category).

Whether or not the current wave of interest does turn into a longer-term trend for pension funds to get involved in real estate debt financing depends on pricing, according to Paul Jayasingha, senior investment consultant at Towers Watson.

He has observed a change in pricing on senior real estate debt this year. Whereas in late 2012 and early 2013, debt on high quality prime real estate was returning Libor plus 300bps, by the end of that year returns had dwindled to Libor plus 150-200bps. “That might look less attractive to pension funds,” he says.

Although, the higher returns available may draw pension funds towards mezzanine or junior debt in real estate financing deals, Jayasingha says Mercer has been cautious in recommending mezzanine to its clients. “If real estate values fall, then there’s the potential risk of being completely wiped out as a mezzanine-debt holder,” he says.

However, senior lending has been moving towards higher-yielding areas of the property market. “Investors will be far more cautious starting a mandate on senior debt lending on a prime area of market, because returns are not so attractive, but there are still opportunities to lend on less prime areas of the market,” Jayasingha says.

For example, lending on a property undergoing renovation can offer investors a higher return for taking on more risk. The type of managers able to offer this kind of financing differ from those managers operating in the prime space, Jayasingha says. Not least, they have a different network of contacts.

For pension funds seeking exposure to real estate debt, there are a variety of funds and strategies available. But, so far, the number of investment managers in the space is relatively small. The sector is populated by managers that have each established a certain niche on the back of their own particular set of skills, observes Paul Richards, head of the European real estate boutique at consultancy Mercer. “Competition is not as intense (as in other markets), but I suspect that’s going to change,” he says.

However, the entry of new providers will not create better value for pension funds clients, Richards points out. More competition is likely to reduce the returns available to investors, he suggests. While mezzanine funds have been popular with pension funds, Richards notes there is a current dearth of these funds in the UK, after a wave of them in 2010 to 2011 — which all opened and closed at the same time.

Mijakowska says the number of fund managers with strategies focusing on the safest super-senior deals backed by central London prime property is surprisingly high.
“Coincidentally, this is the area where banks are still willing to participate, which means that competition is strong and the pricing is relatively less attractive,” she says.

Because of this, it could be advantageous for managers to take part in deals that are more regional and more complex — or ones that might need a certain capital expenditure injection. “Some of the managers have an ability to make whole loans and then syndicate out the super-senior part, effectively choosing a desired slice of the capital structure to participate in, which is also an attractive way of achieving a desired risk-reward profile,” she says.

Many managers only focus on primary deals where they can influence the deal structuring and benefit from origination fees, which Mijakowska says is more attractive than buying existing loan books from banks.

Most other pros and cons of managers depend on the characteristics of the managers themselves rather than their strategy, she says. A few managers, for instance, are big enough to make large whole loans, which usually carry an attractive premium. Others have particularly good networks of contacts with borrowers.

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