Positioned for take-off
New entrants continue to join the roster of managers marketing real estate debt fund strategies in Europe. Lynn Strongin Dodds reports
During the past year, Europe has become awash with funds seeking to raise capital for real estate debt strategies. The coffers, though, are not filling as fast as expected, and deploying the funds may also prove difficult. Not only are the opportunities scarce in the much sought after prime locations, but the competition is intensifying with the banks remerging and alternative lenders, especially insurance companies, trying to make their mark.
This is not the first time Europe has witnessed the emergence of debt funds. The first wave came immediately after the 2008 financial crisis, focusing on mezzanine. However, enthusiasm waned as the returns did not, according to industry reports, live up to expectations. Instead of an attractive 15-19%, they came in at the low to mid teens. Many funds this time around do not want to make the same mistake and are taking a wider view, encompassing senior and stretched-senior, as well as whole loans.
Figures for the amount raised vary, but the latest report from data provider Preqin shows there has been a fourfold increase in the number of European focused debt funds. There are currently 19 looking for total commitments of €10bn, compared with seven funds aiming for €2.3bn 12 months prior.
Luca Giangolini, a partner in Cushman & Wakefield’s corporate finance team, believes the number is actually much bigger at 40 to 50, although this covers a comprehensive range of products, from dedicated new origination pooled funds and segregated accounts, to vehicles with a fairly broad real estate debt remit.
“Together they are targeting a total of $30bn, but I do not anticipate that amount will be raised,” he says. “I think it will be more in the $10-20bn range over the next two to three years. The market has huge potential and is growing but it’s not as mature or developed as in the US. As the supply of capital into real estate debt increases, fixed income investors may find better opportunities in other areas.”
Simon Dunne, consultant of Savills, agrees, adding: “In the current low-interest-rate environment, investors are looking at alternative investments, such as real estate debt funds. However, there is a finite number of institutional investors who will consider investment in such funds. This may partially explain why the pace of capital raising for such funds is slower than originally anticipated. Another factor is that real estate loans are inherently more illiquid and bespoke than corporate bonds, which are more liquid and homogenous.
“Real estate debt funds are also relatively new in Europe and European institutional investors may take more time to understand the real estate debt fund proposition. A key factor is the yield spread, which can be achieved on real estate loans versus comparably rated corporate bonds. It will be interesting to see if investor interest in real estate debt funds remains if this spread narrows in the future.”
The other issue is that the funding gap is closing. Estimates in June from property consultancy DTZ shows that it has shrunk 42% to $50bn during the past six months as alternative lenders have emerged and honed their own strategies. “We expect to see the gap reduce even more over the next two years,” says Nigel Almond, head of strategy research at property consultant DTZ. “There are several reasons; banks are deleveraging, leading to a reduction in the debt outstanding. Other factors, including bond issuance at record levels and an increasing influx of non-traditional lenders, are helping to shrink the gap in a number of core markets such as the UK, France, Germany and Sweden.”
Figures from DTZ show that bond issuance in the first half was €8.7bn, up from €5.7bn for the same period in 2012. It has surpassed the €8.2bn recorded in 2011 and it is predicted that the final tally for this year will be €17bn, overtaking 2012’s €15bn. As for alternative players, DTZ estimates that funds and insurers will contribute $181bn of new lending capacity across Europe between 2013-15, raising their market share to 7% from 2% over the period. The UK is out in front with non-bank share more than doubling to 15% from 7%.
Against this backdrop, Almond notes: “While some funds will not reach expected targets, others will, and new funds continue to enter the market. They may look at markets outside the core of UK, Germany, France and Sweden because of the overcapacity in these markets. There will be more opportunities in regions with less competition and better returns.”
The trend is already in motion. For example, Cornerstone Real Estate Advisers, a subsidiary of MassMutual, plans to raise third-party capital for further investments (around £1bn ) in the UK and Europe. The US-based group, which entered the UK real estate debt market last year through a joint venture with Laxfield Capital, completed its first deal with an £83m loan to Derwent last August. That 12-year refinancing is expected to set the tone for the types of senior loans the firm is looking to do.
“There is no doubt that Europe and especially the UK is becoming a more crowded marketplace,” says Nick Pink, chief investment officer and head of fund management in Europe. “Historically, there has been more focus on the mezzanine end, but success was mixed. Today there is clearly appetite among investors, including Cornerstone, for debt product right across the capital stack. We are also not limiting ourselves to London and will look at the regions and across all sectors – office, retail, industrial, residential and hotels.”
UBS Global Asset Management is also casting its net wider with plans to leverage its experience in the US and launch what it calls a “participating real estate mortgage fund” (PREMF) in the UK. Slated for October, the fund aims to raise £75m in its first close with £350m as its final target.
According to Anthony Shayle, head of global real estate UK debt at UBS, PREMF is modelled on the bank’s $2bn whole loan fund in the US, which has returned 9.5% per annum (at the portfolio level). The 10-year UK fund will provide five to seven-year loans of £10-35m and aims to generate returns of 9-11% by investing in loans for prime and secondary in cities such as Edinburgh, Birmingham and Glasgow. Office, retail and industrial are the main segments but it is also prepared to consider hotels, student accommodation, data centres and other alternatives.
“There are a surfeit of funds in central London looking for assets between £75m and £200m,” says Shayle. “We believe there are greater opportunities outside London and in the secondary markets. We will seek deals with profit-sharing arrangements and look to achieve returns from three sources – a coupon, front-end fee and share of surplus rent after the coupon is paid. We are also looking for a similar share of assets’ capital appreciation, although transaction specifics will change the mix.”
Europe is also in its sights but, as Shayle notes: “It is a difficult landscape because of the different regulations, taxes, banking regimes and clients.” He adds: “You need to have diverse local skills to approach each country’s idiosyncrasies. There is no one-size-fits-all across the continent which is why we may consider setting up another fund targeting perhaps two or three countries at a time.”
Other fund management groups are also veering off the beaten path. For example, ICG-Longbow’s recently floated ICG-Longbow Senior Secured UK Property Debt Investments fund made its first loan – £18m to subsidiaries of the Mansion Student Accommodation fund. Its latest fund, which closed at £700m, is looking to back smaller borrowers with strong property skills that may have been traditionally supported by RBS and Lloyds. It will invest in mezzanine debt as well as whole loans with a net internal rate of return target of 10-12%.
Aviva Investors is also looking outside the typical stomping grounds for its senior debt strategy. “Competition for prime has increased significantly with a whole range of new entries, such as US life insurers, existing players such as the German banks and the return of Wells Fargo and Lloyds,” says James Tarry, manager of its recently launched UK commercial real estate senior debt fund. “Once you move away from these properties, the competition falls away and there are attractive opportunities in the senior part of the capital structure, where the supply and demand imbalance is at its greatest. We think there is scope to deploy significant volumes of capital into good-quality loans, but we are not looking for prime, shiny new office buildings but cor e and core-plus UK property such as student housing.”
The fund, which has already raised £100m, aims to raise the same amount in the autumn. It will invest in fixed-rate, first-ranking mortgages of up to 65% loan to value with five to 10-year maturities. Target returns are between 2.5% and 3.5% above equivalent maturity government bonds.
Although commercial will be the main focus, some institutional investors are venturing into residential.
New players emerge
Looking ahead, new entrants are continuing to squeeze into the space. In June, Hermes Fund Managers appointed Marcus Palmer to manage its new debt programme, while Standard Life Investment hired Neil Odom-Haslett as head of commercial real estate lending. “We expect to enter the lending market by the end of this year,” says David Paine, head of real estate at Standard Life Investments. “We will focus initially on senior lending opportunities in the UK where we believe there remains an attractive risk-adjusted return on offer. The characteristics offered by commercial real estate debt relative to other asset classes are compelling.”
Meanwhile, US-based financial services giant TIAA-CREF and UK’s Henderson Global Investors, joined forces to launch a $63bn global real estate investment management company that will combine both funds’ European real estate businesses and Henderson’s Asia Pacific operation, focusing on office, retail, logistics, multifamily as well as senior debt and mezzanine.
“I expect we will see a stream of new entrants,” says Philip Cropper, managing director, Real Estate Finance at CBRE. “But, if margins are driven down too far, will people wish to continue investing. The alternative will be to lend on slightly riskier properties, so they can secure margins that will deliver the returns they want. I believe this will happen if they feel confident the economy is moving in the right direction. If not, they are more likely to stick with relatively core assets in good locations.”
Shamez Alibhai, partner of Cheyne Capital, which has £1.2bn invested in European real estate debt strategies, believes there is room for debt and alternative providers. “At the peak, European banks accounted for 85-90% of commercial real estate lending compared to the US where there is a more even distribution between banks, insurers and commercial mortgage-backed securities. Our view is that Europe is moving towards the US model, with banks no longer crowding out other providers.”
Charles Daulon Du Laurens, head of investor relations for CRE Finance at AXA Real Estate, which launched a real estate debt platform in 2005, also believes the UK will continue to be the main focus. “This is because of the efficiency and transparency of the UK market and the favourable legal framework from a lenders’ perspective. The spreads have tightened in some instances, but there are still better opportunities in the country than, say, France and Germany.
“Most of the capital is focused on super prime for obvious reasons, but at AXA Real Estate we have begun to move up the risk curve. The difference is that some of the properties outside of super prime may need asset management work, which is why it is important investors choose a manager who has the right skills to understand the underlying risk.”