Why buy a property when you can purchase the debt behind it? Institutional investors are grappling with this very question and, as Richard Lowe discovers, for many it might pose a real challenge

The growing appeal of investing in real estate debt was demonstrated clearly by a recent u-turn on the part of the New Jersey Division of Investment in the US, which opted not to follow through with a $250m (€194m) investment into two direct property funds, but instead decided to direct the capital towards debt strategies.

IPE Real Estate reported in January that the US institution was concerned about investing capital into commingled funds where the underlying assets were expected to fall further in value. Real estate debt, in contrast, looks attractive relative to property, with yields at historical highs.

A number of other US pension funds have either made the decision to increase their exposure to real estate debt or are investing in the sector for the first time. There is less evidence of European pension funds investing in the sector. Some of the continent's largest pension funds, like ATP in Denmark or the Universities Superannuation Scheme in the UK, for example, do not invest in real estate debt.

However, APG, the asset manager for the Netherlands' largest pension fund ABP, has invested in real estate debt funds in both the US and Europe for several years, targeting subordinated/mezzanine debt, convertible loans and junior loans.

Today, APG sees particularly compelling opportunities in the sector. "The dynamics of the subordinated commercial real estate debt market are becoming very attractive as pricing of subordinated debt is outnumbering value add equity returns," says Michel Meijs, spokesman for the fund. "Banks need to clear their books, have stopped lending and/or have strongly changed their lending standards."

Oliver Schebela, director of alternative investments at Feri Institutional Advisors in Germany, believes that the sorts of discounts currently available on senior debt - often in the region of 25-30% - provide "very attractive" cash yields and yields-to-maturity.

"A lot of the real estate debt is currently available with a quite attractive discount," he says. "If you look at the discount that is now in the market… you get an excellent risk-adjusted return. You are very senior in the debt structure, so the risk is limited due to the underlying asset. So, even if it declines in value there is still a quite sizeable buffer that needs to be absorbed before you are incurring a loss."

But Chris Milner, managing director at BlackRock in New York, thinks that while commercial debt yields are at historic highs, this is in part due to the opacity of the market, making investment decisions that much harder to make with conviction.

"You are seeing limited price transparency in the market, in terms of valuations of the underlying assets," he says. "Spreads or yields in the debt space are… you could call them compelling if you like. They certainly are, on a historical basis, dramatically wider than anything we have seen since the beginning of the CMBS market in the early 1990s.

"What remains to be seen is whether or not the pre-loss yields at which certain instruments are trading generates post-loss returns that are equally compelling. And I think as long as the market remains opaque with respect to valuations of properties it is going to be a difficult analysis to complete."

There certainly has been a raft of real estate debt funds launching during 2008, looking to raise substantial equity from institutional investors on the promise of double-digit returns. The likes of Apollo Real Estate, Blackstone, BlackRock, Lone Star and ING Clarion are active in the space.

A number of real estate investment managers have also shown intentions to move into the sector.But Paul Robinson and Tony Martin, senior directors in the investment department at CB Richard Ellis, are not seeing the interest on the part of fund managers being matched in any way by actual transactions. "There is quite a lot of interest, quite a lot of talk, but actually the number of people who have done it is not that high," Martin says.

The lack of transactions in the market seems to be down to a mismatch between buyers and sellers of debt. The lack of liquidity in the market means that investors are looking at debt investments with a good deal of caution.

"People are taking it cautiously, because the number of transactions that occur is not that great," Martin says. "It is not an overly liquid market. Once you buy it, to then get out of it and know what you can get out of it is not straightforward. So, inevitably, investors are looking at it as a relatively illiquid form of investment."

Milner describes BlackRock as "participating" in the market, but only on a "measured basis", because, as an investor, it is faced with a very opaque investment environment going into 2009.

He explains: "At the moment we are challenged by the tremendous uncertainty in the market. You look at the economic footprint in front of us; you look at the corporate instability that our financial institutions are demonstrating; you look at, in some ways, the myriad and, at times, inconsistent approaches that our global central banks are taking with respect to addressing the crisis."

Milner agrees there is a pricing mismatch between buyers and sellers of loans, but he argues this is amplified by the uncertainty in the market.

"There is no question that certainty reduces the variance of valuation perception," he continues. "What we are typically looking at in today's market is a wide variation between those investors who have substantial capital and those in need of substantial capital - in terms of the underlying value of the physical asset.

As the uncertainty declines - because we move through time and things become more clear - there is no question that the variance will diminish, and transaction volumes will increase."For these reasons Milner emphasises the importance of timing for debt investments.

"We are looking at our entry point - when do we actually invest the dollars - as being one of the most crucial elements of portfolio diversification in this particular environment," he says.

"When you spend your investment dollars is going to prove to be more important in this environment than whether you spend them on offices or retail or multi-family housing or even the geographic diversity that one brings. It is going to be critical how your entry point looks relative to what actually plays in terms of the economic environment."

If it is to be believed that there exists a real opportunity in real estate debt that investors are in danger of missing out on, pension funds may find, in any case, they are in a difficult position to capitalise on it. For some, real estate debt may be construed of as more of a fixed income or ‘alternatives' investment and not ‘pure' real estate.

For example, the real estate arm of Denmark's largest pension fund ATP focuses on "pure real estate investments", as Michael Nielsen, head of real estate, reveals. "We have some other colleagues in ATP dealing with general debt products. We are not engaged in any focused debt investments."

IPE Real Estate reported last November that AXA Real Estate Investment Management had made a tactical decision to refrain from investing directly in real estate while property prices are forecast to continue to fall. Instead it will look to purchase discounted real estate debt.

Alan Patterson, head of European research and strategy at AXA REIM, admits that the way pension funds are structured with rigid portfolio boundaries - and often legal restrictions, depending on the jurisdiction - can serve as an obstacle for these sorts of opportunities.

"In a way it is shame that institutions have to have those sorts of boundaries anyway, because they must miss opportunities where someone says, ‘it doesn't quite fall inside of my area', and somebody else says, ‘it doesn't fall inside my area either'. So nobody looks at it," he says.

Milner says it depends on how an individual pension fund is structured and where their expertise lies. "You have to disaggregate the strategy, look closely at the particular pension scheme you are talking about," he says. "It is our job to help clients match up their particular structure with the asset class."

Milner continues: "Is this business something that fits within the alternatives space? Is this business something that fits within the real estate equity space, or is it a fixed income product? I think those three sectors constitute the range into which this product falls."

The more secure end of the spectrum, which includes the likes of AAA-rated CMBS, represents more of a fixed income opportunity, Milner says, while further up the risk scale, such as the high-yielding mezzanine sector, "starts to feel more like it should be allocated to the real estate segment".

Patterson agrees, suggesting secure debt investments offering returns in the region of 6-7% would be more of interest to fixed income investors, while higher up the risk spectrum is where real estate investors should be at least assessing the opportunities.He outlines a potential scenario where an investor had originally structured a deal comprising 25% equity and 75% debt.

"If you had been structuring that a year ago then the equity has been reduced and it may even be negative now," he says."Originally, it was fixed income debt and clear equity; now the boundaries are much hazier. So the question is: where do you want to sit along that spectrum? Do you want to take a chunk of the equity, do you want to take the secure end of the debt, or do you want to be somewhere in the middle?"

Patterson believes real estate investors should be thinking along these lines today, but some in the industry may find this shift a difficult one to make. "Property people tend to be very vanilla by nature. They tend to say: ‘a property is a property; I understand about rents and yields and location'," he adds.

"That is still all very true and very important, but you also have to think about another thing: how you structure this deal, where you sit in the deal. This is a little bit more of a technical, mathematical approach." Patterson believes the current and coming period will entail a learning curve for many property investors.

Ethan Penner, executive managing director at CBRE Investors, echoes many of these sentiments, having met with a number of institutional investors who are struggling with real estate debt opportunities being pitched by various fund managers.

"I've seen many of these investment professionals having to look at debt for the first time in their careers, facing the challenge of finding a way to measure risk in this seemingly perplexing arena," he says. "What is helpful to remember is that the same calculus that governs real estate equity holds true for debt, be it mezzanine or first mortgage debt. To be a good deployer of capital, one must start with understanding the value of the underlying asset."

The second step, however, is to consider where in the capital structure the risk-adjusted return is the best. "It is only by looking agnostically at all of the choices - equity, mezzanine, and first mortgage - that one has a chance to arrive at the correct conclusion," Penner says.

"By taking some of those choices off of the table and not considering them, it is impossible to optimise one's exposure to the real estate investment sector. However, the institutional real estate community has for the most part never seen things that way before. There has always been a strict division between conventional property investments and anything considered ‘debt'," he adds.