Investor demand and large reserves of committed capital are forcing European real estate debt fund managers to become innovative. Jennifer Bollen and Christopher O’Dea report

The latest figures from Preqin suggest a slight slowdown in fundraising for real estate debt funds in Europe. As of August, just two Europe-based real estate debt funds had held a final close, raising a combined $3.9bn (€3.5bn)this year. This is down from $4bn raised by nine funds in the same period last year, and $6.9bn raised by 10 funds in the same period of 2017. 

But dry powder – that is, capital committed but uncalled – held by European-based real estate debt funds has risen by 7,000% since the end of 2009. By August, the total stood at $14.5bn, down from the record $17.2bn recorded in December 2018. In December 2009, it was $200m. Meanwhile, the unrealised value held by these funds stood at $37.1bn at the end of last year – about a third of the global total.

More cash looks set to flow into the sector – the 2019 investment intentions survey from European real estate association INREV shows 22% of investors expected to increase their allocations to non-listed real estate debt in the next two years.

Antonio de Laurentiis, head of private commercial real estate debt at AXA Investment Managers-Real Assets, which leads the European market with more than €10bn under management, says the main attraction for institutional investors is the ability to “benefit from a mortgage security on the financed properties and offer stable and predictable cash flows”.

He says the returns offer a premium compared with other liquid fixed-income products owing to their complexity. “That’s the illiquidity premium and that’s really what we are targeting.”

At the mid-point of the year, the premium for investing in private property debt in Europe was between 80bps and 120bps over bonds of similar maturity and risk profile. “That’s very attractive because you diversify your fixed-income allocation through a highly-secured asset class, which offers a pick-up in terms of pricing,” de Laurentiis says. Being a private-market obligation, property debt is not marked to market. “On the pension fund’s balance sheet, it’s very stable in terms of value, provided there are no massive impairments,” he adds.

But Preqin figures show that across Europe there were 1,435 real estate transactions worth a combined $55.7bn between January and August, down from 1,537 worth $92.3bn in the same period last year. Is there already too much capital in the market for current deal activity?

“There’s more capital than there are good transactions,” says David Sarfas, global head of private equity and real assets at MUFG Investor Services. “It’s a hurdle-rate issue. Today the [internal rates of return] are slightly decreasing – that’s because of the rarity of the good deals, if you will, and the vintages.”

He adds: “The fact there’s a lot of capital to deploy creates tension on prices. The fact you have uncertainty around the price environment, which is due to all these different factors, has created lower LTV [loan to value] constraints. And then the issue becomes do you deploy? Do you not deploy? You have to become creative.”

Fund managers say speed and differentiation are among the most important factors to be competitive at this point in the cycle. “We are seeing competition in terms of efficiency of execution of deals,” says Andrew MacDonald, head of real estate finance at Schroders. “If you can move quickly and efficiently, both at the front end of the process in terms of delivering terms for the borrower and getting credit approval to the borrower quickly and executing the documentation quickly, that is a competitive advantage.”

In May, Schroder Real Estate launched its first, £200m (€223m) real estate debt fund, aimed at “under-banked parts of the UK commercial real estate market”, says MacDonald. These include asset management-led and alternative property such as student housing, care homes and self-storage. The fund targets whole loans in the £10m to £25m range, returns of 4% to 7%, and lends up to 75% LTV.

LTV is one area where borrowers are pushing on terms, say market participants, with some customers aiming for an 85% LTV – and successfully negotiating for 80%. LTVs vary across sectors. For instance, CBRE’s 2019 debt funds map of the region shows that in the UK office market, senior debt LTVs typically stand at 60%, with mezzanine and whole loan LTVs each hovering around 75%.

Look higher up the risk curve – at office development in the UK – and typical senior debt LTVs fall to just 50%, with mezzanine and whole loans each available for 70%. There is a similar picture in retail and logistics.

Typical senior debt LTVs for office investment – one of the biggest sectors for real estate funds – are similar across Europe. They stand at 60% in France, Germany, Italy, and up to 65% in the Netherlands and Belgium, according to CBRE. They compare with LTVs of more than 70% in Poland, the Czech Republic and Slovakia, and75% in Austria.

Stretched senior debt, mezzanine and preferred equity are all responding to demand for higher overall LTVs, giving borrowers more freedom and lenders enhanced returns. “We’re going to see different risk profiles and there’s going to be a shift in how these funds are going to deploy,” says Sarfas. “You’re seeing more and more going towards more niche markets, which are small but end up being the future of the market.”

Niche going mainstream
Recent examples include the mezzanine finance supplied by PGIM Real Estate to Cording Real Estate Group’s €225m acquisition of an office in Berlin for a separate account client in June. 

Empira Group, a real estate manager based in Switzerland, is marketing a particularly niche strategy. In March it launched its fourth debt fund, raising €500m. Empira said the offering combined mezzanine with relatively low interest rates and a share in the underlying property. The fund plans to buy a 50% share in financed developments with a minimum total investment volume of €150m.

Law firm White & Case said in a report about debt trends in Germany in July that more lenders had sought to provide junior debt to sub-investment grade and unrated property companies in the past two years.

Meanwhile, lenders including DRC, M&G and LaSalle Investment Management are among firms offering whole loans for greater convenience at a time when borrowers are struggling to secure enough senior leverage.

LaSalle is a mainstay of the market, having provided about £3.4bn of debt financing secured against £13bn of property across Europe since 2010. It is currently investing its £804m LaSalle Real Estate Debt & Special Situations Fund III, the recently expanded £845m LaSalle Residential Finance programme, and the new €600m LaSalle Whole Loan Strategies platform. Together, the funds target lending opportunities across whole loans, mezzanine, development finance, stretched senior loans, and preferred and joint venture equity.

In May, Ali Imraan, managing director, debt and special situations at LaSalle, said: “We have seen an increasing number of borrowers seeking flexible financing solutions for assets by combing senior and mezzanine loans through the efficiency of whole loans.”

Real estate debt funds are enjoying a wave of capital in a market inching closer to the mainstream. With growing competition from their peers and traditional lenders, is there enough business to go round?

“As more of the conventional lenders returned, albeit constrained by regulatory capital… in some sectors [they have] probably eaten up some of the natural territory of real estate debt funds in Europe,” says Lyons. “But it’s not a completely overlapping set of fund resources.”

Roland Fuchs, head of European debt at Allianz Real Estate, says: “There is significant space for alternative lenders and debt funds, but they have to be realistic and reasonable in terms of expected returns. Interest rates have come down significantly in the past 12 months. If the business plans have been based on an assumption of 2.5%, there is big potential in the market. That’s the kind of product we’re offering. But if you would expect returns in the range of 6%, 7%, you have to invest in top-risk loans.”

roland fuchs

The real estate arm of insurer Allianz launched its Pan-European Debt Fund in July 2018 to meet demand from companies within the Allianz Group to increase their exposure to real estate debt – and, for the first time, other third-party investors. In under a year the fund had grown its deployed capital to €1.5bn, having targeted prime assets in Europe.

“Now most Allianz insurance entities, being limited partners in this investment platform, have invested via this debt fund structure,” Fuchs says. “We decided last year we would open this platform also for a selected amount to third-party investors with the idea to let them invest alongside Allianz on a pro-rata basis. We’re in the process of marketing this product with what we would call like-minded investors in Europe and selectively in Asia.”

At the same time, more investors are expected to instruct their fund managers to run separate accounts rather than commit to commingled funds. Paul Lyons, a partner in the real estate practice at Goodwin Procter, say this is a principal talking point in the European fund management circles.

Fund managers already running separate accounts, which give investors greater control over their underlying investments, include Ares Management Corporation and BNP Paribas Real Estate Investment Management.

MacDonald says Schroders is “talking to a number of different investors about the potential for some separate account-type mandates. Those vary in terms of the part of the market they might be looking at or focused on.” 

The “paradox” for AXA IM–Real Assets, says De Laurentiis, is “to be very selective in the type of new mandates or funds we take on, while preserving flexibility. We want to be flexible in terms of the asset classes we invest in. We don’t want to just do office buildings, but to leverage the in-house expertise we have to move into alternative sectors such as hotels, logistics, and residential or student accommodation. They are more protected because they are less exposed to the economy and more geared to other factors like demography or life-cycle trends.”