Interest is building among investors, but challenges must be overcome before debt funds can access a deep pool of capital. Richard Lowe reports

More often than not, the best investment opportunities can be found where others are not looking. It is much harder to unearth value when everyone else is digging the same patch.
This simple notion can be applied to institutional-grade real estate in Europe. You could buy shiny, secure, commercial properties in London, Frankfurt and Paris. But, with so much competition for core real estate, are you really getting the best value for your capital?

Some would argue you would be looking in the wrong place. True value exists where competition is low: not in property equity but in property debt. Prospective buyers of real estate – from pension funds to private investors – can be found in great numbers throughout the world; active property lenders are in short supply.

It is argued that real estate debt investments can provide returns higher than traditional core real estate while taking a comparable level of risk. Such a ‘free lunch’ should always be viewed with scepticism. But the sorts of returns being projected are compelling when taking into consideration the downside protection offered by being a lender rather than an equity investor.

And there is evidence that investors are taking notice. INREV’s Investment Intentions Survey 2013 showed that 35.1% of investors expected to increase allocations to real estate debt funds. It should be noted, however, that 50.9% of respondents did not invest in real estate debt, or it didn’t form part of their property portfolios. Of those that do invest, 71.5% expected to increase their allocations.

IP Real Estate’s own survey of pension funds and institutional investors shows that 38% of respondents are invested in real estate debt (figure 1), significantly higher than the 27% recorded 12 months ago. The proportion of investors intending to invest in real estate debt over the next 18 months is also up from 33% at the end of 2011 to 42% at the end of 2012.

Despite the above findings and a number of announcements and headlines about real estate debt funds in 2012, very little capital was actually committed to these vehicles by investors. One possible explanation is that the process to get investors signed up and funds off the ground has taken a lot longer than anticipated.

The main reason could be that debt investment strategies pose an awkward challenge for institutional investors. As a hybrid investment – not quite real estate, not quite fixed income – it is always in danger of falling between two stalls when it comes to traditional asset allocation approaches.

In addition, real estate debt fund managers lack the long track records (in Europe) of their traditional property counterparts (although individual staff may have years of experience in the banking industry) making it more difficult for investors to undertake due diligence to a satisfactory level.

Unless these challenges are overcome on a broad basis, it could mean that real estate debt investments remain ultimately a niche activity pursued only by the most adventurous of institutional investors. Perhaps this is not the end of the world. But is there a danger that institutional investors are missing a prime opportunity?

New investment styles require first movers and Dutch pension funds have often obliged. APG, which manages pension funds including the Netherlands’ largest, ABP, was one of the first European institutions to back publicly a European debt fund in 2010. APG followed this up with a separate account mandate with the fund’s manager Pramerica Real Estate Investors but, since then, it has taken some time to analyse the way in which the market has been developing. The approach mirrors that of other investors that committed capital to the first wave of European debt funds in 2010 and 2011.

“At first we thought this window of opportunity would be open only for a short period,” says Robert-Jan Foortse, head of European property investments at APG. “But the more we look at the current economic climate, the more we feel that this opportunity might be around a bit longer. With the banks still withdrawing and lowering loan-to-value ratios, we see there is a gap in the capital stack and we sense that might be around for a couple of years.”

APG has also identified real estate debt investments as a means of gaining access to core real estate at a time when it is difficult to acquire them with equity. “There are instances where, even in these market circumstances, it is hard to get equity exposure to high-quality assets,” Foortse says. “In order to get exposure to those high-quality assets, this might well be an opportunity.”

To a certain extent, therefore, APG is looking to divert capital it has allocated to core real estate into debt strategies, although Foortse stresses the institution may continue to make traditional property equity investments as well.

If real estate debt can be categorised as a substitute for core real estate equity investments – rather than a niche, opportunistic-type of investment – it could unlock a large amount of institutional capital. Andrew Radkiewicz, managing director at Pramerica, says if real estate debt (certainly, low-risk junior debt, increasingly called ‘stretched-senior’) could be “quasi-classified as core property, because the underlying property is core and you are taking a lower risk against it”, it could represent a “huge door opening for capital”.
Radkiewicz says Pramerica presents real estate debt investments to investors as “an alternative form of equity rather than debt”. He adds: “I think more capital will come from very deep real estate pockets once people increasingly get their heads around the idea that it’s actually equity.”

Research by IP Real Estate suggests that most investors are looking to allocate capital to debt investments from their real estate buckets: 58% of survey respondents said real estate debt forms part of the real estate allocation, while 31% said fixed income and 11% said ‘other’ (figure 3). This is much different to figures from 12 months ago, which found a more even split: 28% real estate; 28% ‘other’; 24% fixed income.

Foortse admits that investors are still grappling with the concept. “The key question many investors face, and we have faced as well is, is this property or fixed income, or is it hybrid? And if it’s hybrid, where do you put it?”

An added issue for investors is the lack of a track record for debt funds. “That is indeed the major issue when underwriting a new fund and arguably a new manager,” Foortse says. “It’s a new strategy and a new manager without a track record, and that is in addition to whether it’s property or fixed income and that makes it a harder sell internally.”

Foortse says these are challenges worth overcoming because of the investment opportunity, but he warns that some investors might think it is too awkward a fit and so easier just to pass up. “We truly believe this is a very interesting opportunity, especially in this market. That is our conviction,” he says. “If others do not get their heads around it or are unable to allocate resources internally, they might miss out on the strategy.”

Peter de Haas, head of business development for continental Europe at Cornerstone Real Estate Advisers and former PGGM portfolio strategist, says a number of Dutch pension funds “see the benefits of investing in debt and the favourable risk-return profile” but are finding it difficult to accommodate or to obtain board approval. “Some pension funds are reluctant to make it part of the investment strategy because they don’t know where it sits,” he says.

One option would be to organise the overall investment policy and internal resources in such a way to make it easier to deal with hybrid investments, such as real estate debt. “If I worked for a pension fund now, I think I would consider reorganising myself in a way that I can facilitate these hybrid investments in a better way,” he says. The debate over whether it is fixed income or real estate “is not important in the end”. De Haas adds: “It is all about what kind of risk-adjusted returns new investments give the pension fund or the member of the fund. It’s not important where it sits [within a portfolio].”

Some UK institutions have backed debt strategies, including the Nationwide Pension Fund, which committed €25m to a fund managed by Duet (now DRC Capital) and plans to allocate capital to a follow-up vehicle.

Mark Hedges, CIO at the pension fund, says in terms of risk-adjusted returns, real estate debt looks more attractive, especially if you can achieve 8% returns with downside protection, and possibly as much as 12% through mezzanine investments. “That represents a much better return than potential equity positions for the next couple of years, whilst we see low growth in Europe and therefore low potential for property price inflation,” he says.

The debt investments sit within the property allocation, and so, in a similar way to APG, the pension fund is effectively diverting capital normally destined to traditional real estate investments. “We’ve allocated it from our real estate bucket,” Hedges says. “Whilst they are credit-related debt terms, we are looking at yields here that are commensurate with what we would have seen typically – or probably beyond what we would have seen typically – from real estate equity. And fundamentally the return comes from rental on property, it’s just you’re at the more senior position in that structure.”

Hedges does not expect real estate debt to necessarily become a long-term feature of the Nationwide Pension Fund’s portfolio – only if it continues to offer attractive returns relative to other opportunities in the wider investment markets. “It really does depend on where it sits at any time in the relative risk-reward of your whole assets,” he explains. “I’m really looking at the dividend yield from equities as the real driver. There are a lot of credit-lending opportunities where I can generate a better return than a 3% dividend yield, and I’m at the top of the capital structure and not at the bottom.”

The real estate debt investment market has yet to see significant traction from Nordic investors. For instance, regulations affecting AP1, Sweden’s first national pension fund, render real estate debt unattractive from an asset allocation point of view, partly because it is unable to classify it as real estate debt.

Finland’s State Pension Fund (VER), meanwhile, has been speaking to a number of real estate debt fund managers and is at what portfolio manager Johannes Edgren describes as “a fact-finding stage”.

He adds: “I think the real estate debt funds as an investment class have made their case. It is maybe more a case of finding the right funds, as many are first-time funds and there isn’t necessarily such a proven track record.”

Like many investors coming to real estate debt from a real estate perspective, VER is more likely than not to opt for mezzanine or stretched-senior strategies, rather than core senior strategies, which is arguably more akin to traditional fixed income.

“I think senior debt is closer to fixed income and maybe would therefore not sit so well in the real estate allocation, whereas stretched/mezzanine is close to real estate and could fit into that allocation,” Edgren says.

A number of fund managers are raising capital for ‘pure’ senior debt funds, which promise returns more in line with fixed income, invariably below the hurdle for most real estate investors. The market opportunity to provide senior debt is likely to be larger in terms of volume, but it is possibly a harder sell since the first port of call will be fixed-income desks.
AXA Real Estate is investing €6.7bn in the senior debt markets in Europe, mainly on behalf of AXA insurance group companies, but also other third-party investors, including insurers and pension funds. Isabelle Scemama, head of commercial real estate finance at AXA Real Estate, says this “shows that several of them have found a way to consider it”. But she admits it can be difficult for investors that are not equipped to manage such a hybrid investment.

La Française Real Estate Managers is raising capital for senior debt fund (although it may look to launch funds targeting other strategies in the future), having secured approximately €300m in internal seed capital. Bertrand Carrez, head of structured financing at La Française, says it is a hybrid product, “probably as much fixed income as real estate”. He adds: “The product in its current form is being shaped according to exchanges with potential investors”.

Carrez says the fund manager is speaking to fixed income investors, although they invariably seek to get “comfort from their real estate experts internally”. For that reason, it is more difficult to present the opportunity to investors without real estate expertise.
“Probably the potential of this product for investors not being players in the real estate equity field is more limited than for the ones who are more diversified and who are real estate investors,” he says.

A recent survey by Schroders Property suggested that German institutional investors have a preference for senior debt rather than mezzanine: 68% of respondents favoured senior debt strategies, 23% preferred junior or subordinated debt, and 10% were focused on mezzanine. The low-risk approach seemed to extend to the risk profile of the underlying assets: 76% wanted exposure to core or core-plus properties, 15% value-add and 10% opportunistic.

Ingo Bofinger, head of real estate at the asset management of German insurer Gothaer, says senior debt is interesting, but the German institution is focusing on higher-returning strategies to meet its real estate hurdle of around 4%. “We also have to fulfil our target-return requirements and so I think, as of today, it is more the stretched-senior or whole-loan strategies, which go up to LTV levels of 60-70%, because this really provides our target-return requirements,” he says. “If you target only on the core senior lending, you are quite often below this 4%.”

Bofinger is overseeing a real estate debt investment programme that began in 2010 when commitments were made to debt funds targeting mainly the UK. “The real estate debt funds started in the UK and now we see increased demand from other investors, like insurance companies, in Germany,” he says. “We are looking for more German-oriented investments.”

Gothaer is another investor treating real estate debt effectively as a substitute for traditional real estate investments, although it is still open to the latter in markets where debt products are not available – in other words, outside Germany, the UK and possibly France.

“We want to invest in debt where we see there is no huge capital appreciation on the equity side,” Bofinger says, adding that they can also provide an effective portfolio hedge.
But he says it is a challenging area of investment because it is so new. “You see a lot of new fund managers in the market and you have to understand what their strengths are, the team and their investment approach,” he says. “Some of them are coming from the equity side where they have a long track record, but quite a short track – or no track record – on the lending side.

Bofinger does believe that the structural shifts taking place in the lending market in Europe – driven most notably by banks retrenching due to Basel III regulations – could bring about long-term allocations to the sector from institutional investors.

“If the trend continues,” he says, “I think we will assume it will be a long-term trend that other investors and organisations will replace the banks in long-term commercial real estate lending.”