ANALYSIS: Real estate debt funds need to change their strategy

Real estate debt funds were hailed as potential saviours in the wake of the global financial crisis as real estate lending ground to a complete halt. But many are facing tough competition from traditional lenders and insurers, PropertyEU has learned.

Many are finding it hard to find suitable assets to meet their investors' risk-return profiles, according to Philipp Wass, Senior Analyst at Berlin based rating agency Scope. He has crunched the latest numbers released by European real estate debt funds operators and the results do not look pretty.

So far the 54 real estate debt funds launched across Europe since 2010 have only been able to invest a mere 29% of the € 33.6 bn raised by institutional investors, he told PropertyEU. 'Debt funds managers are between a rock and a hard place.'

When traditional banks shut down on lending after the outbreak of the financial crisis in the fall of 2008, many investors could not even secure financing from banks for core properties in top locations rented out to tenants with perfect creditworthiness, Wass pointed out. 'Fund management companies and institutional investors alike saw a gap in the market begging to be filled.'

Situation has changed since 2009
Not surprisingly, the first debt funds set up in 2009 had no trouble raising capital and finding low-risk mortgage loans to invest in. However, the situation has changed since then. With the European Central Bank pumping cash into the markets in order to get the eurozone economy back on track, traditional lenders no longer face liquidity problems. Currently, banks can refinance their mortgage loans through real estate backed securities – or in the case of German lenders through Pfandbriefe – at close to 1%.

'This enables banks to offer interest rates of around 2% for low risk property financing thereby enabling them to undercut debt funds which need to charge higher interest rates in order to generate the proposed yields for their investors,' noted Bernhard Koehler, CEO of Swisslake Capital.

Paffikon-based Swisslake, a Swiss consultancy firm for institutional fund investors, has also conducted a study on real estate debt funds, with results similar to those compiled by Scope. 'Debt funds have passed their peak and are now on the decline,' Koehler said.

Indeed, prospects for real estate debt funds could worsen in 2016 with the ECB now ramping up its quantitative easing programme. 'Debt funds will likely face increased competition from commercial and mortgage banks as well as large insurers,' Wass predicted.

Increased competition from insurers
With government bonds near historic lows, large Insurance corporations are likely to increase their mortgage lending in a move to improve their yields. In mid-November, benchmark 10-year German government bonds yielded a mere 0.6%, thereby making a 2% yield on a mortgage loan look pretty attractive.

However, that does not necessarily mean that real estate debt funds will become a thing of the past. Maybe fund managers and their investors just need to change their strategy.

So far, debt funds have primarily targeted the same property financing deals as banks and insurers: mortgage loans with loan-to-value (LTV) ratios of up to 60%. 'Investments in these kinds of mortgage loans are no longer interesting for debt funds due to shrinking yields,' said Martina Hertwig, Partner at Hamburg/based auditing company TPW.

Instead, real estate debt funds should focus on upper credit tranches with LTV-ratios between 60 and 80%, Hertwig recommends in a new research report. 'Banks are very reluctant to provide property financing in this segment due to conditions imposed through Basel III.'

The third Basel accord is a global, regulatory framework set up by the Basel Committee on Banking Supervision after the financial crisis. It forces banks to significantly raise their buffers for mortgage loans exceeding LTV-ratios of 60%, making property loans in this range extremely unattractive.

'At the same time, investors demand for this kind of financing has increased drastically,' Hertwig said. Especially in countries like Germany where booming property markets are luring cash-strapped developers onto the scene. Most are willing to accept high interest rates on financing exceeding LTV-ratios of 60% in order to get their projects underway, Hertwig pointed out.

'By targeting those kinds of loans, debt funds could generate internal rates of return between 8 and 15%.'

The question is whether debt funds will and can change their strategy. Swisslake Capital CEO Koehler has his doubts: 'Most institutional investors engaged in debt funds are not willing to switch to riskier loans.'