Debt Funds: Bigger and better?
European real estate debt funds have matured over the past five years. They are getting bigger and more diverse
The landscape for European real estate debt funds has changed over the past five years as investors have sought to diversify. The top five private Europe-focused funds raised this year reflect what has become a substantially larger industry and suggest a broader range of target deals for debt funds (see European real estate debt funds).
Fuelling the growth are the need for higher returns in a low-interest-rate environment and disappointing fixed-income yields, and greater understanding of real estate as an asset class.
Following the 2008 crisis, the banks retrenched from the market. The opportunity was clear to investment managers: large numbers of property deals presented potentially lucrative transactions for alternative lenders. But the notion was difficult for some investors to get on board with. How would a debt fund work? Would allocations come from an investor’s real estate or fixed-income bucket?
Today “a huge education and understanding of investors” has made pitches easier, says Anthony Shayle, head of real estate debt in Europe, the Middle East and Africa at UBS Global Asset Management. “The understanding is there and it’s about how does your strategy work and what is your track record?”
Dan Pottorff, a director of debt investments and special situations at LaSalle Investment Management, said appetite for real estate debt funds was strong. “The number of investors – and from different geographies – who have for the first time considered this a strategy to get exposure to commercial real estate will increase a lot,” he says.
A key reason why investors are more keen to commit their money is that debt funds are becoming more sophisticated. Real estate debt has historically fallen through the cracks, Pottorff says, because limited partners have failed to identify it as either a property or fixed-income strategy. “As they start to develop track records, a lot of these institutions will consider it more carefully and pull together expertise on either side,” he says. “Real estate valuations have increased and people are seeing some markets getting close to the late stage… Real estate lending is an interesting way to have commercial real estate exposure but have downside protection.”
Andrew Radkiewicz, global head of debt strategies at PGIM Real Estate, says that during his team’s most recent fundraising he met with alternatives and fixed-income-focused investment executives at institutional investors as well as the usual real estate executives. “Investors are looking for income-style products with low volatility,” he says.
Creating further demand for the end product is a widespread move among commercial banks towards lower loan-to-value (LTV) ratios. A spring 2017 survey on European commercial real estate lending trends published by property consultant Cushman & Wakefield said LTVs remained low in most markets in the region by historical standards – about 60% in major cities – as banks stayed cautious amid increasing banking regulation.
As a result, debt funds are demonstrating more appetite for stretched senior loans – a senior and mezzanine finance hybrid. Cushman & Wakefield’s survey found a fifth of respondents preferred stretched senior as a strategy, up from 10% a year earlier. However, senior debt remains the most popular, cited by almost half of respondents.
Broadly speaking, the role of the debt fund has changed significantly in recent years. Following the crisis, they often focused on mezzanine finance – a layer of debt low in the capital structure that typically comes at a higher cost due to increased risk, says Radkiewicz.
Between 2012 and 2015, the market grew with more non-bank lenders providing whole loans as opposed to merely a portion of a deal’s finance, he says. Today more banks are operating with caution, and funds are increasingly offering senior debt or whole-loan packages to fill the gap.
Whole loans present potentially more income for fund managers, he says. For example, a mezzanine tranche could form £20m (€21.9m) of a £100m enterprise value, whereas a whole loan could account for £80m. “A senior deal can produce much more AUM – so more fees,” Radkiewicz says. “The whole market is getting bigger, so I’d say the total amount of capital available for value add – mezzanine and preferred equity – is still growing in absolute terms, but a lot of managers have gone from the more value end, which is more difficult to originate in, into the senior debt area.”
The European real estate lending market is dominated by banks but they are switching from an origination-and-hold strategy to origination-and-syndication, says Antonio de Laurentiis, head of private debt, commercial real estate finance at AXA Investment Managers–Real Assets. “They need to partner more and more with players like us.”
The growing trend towards diversity appears to be the result of larger pools of capital and the need for freedom to deploy. De Laurentiis, whose team - raised €1.4bn for a commercial real estate senior debt fund, says flexibility in terms of strategy is one of the firm’s strengths.
“In the real estate market the cycle is pretty advanced so you have to be cautious and able to choose,” he says. “With the funds we have and the flexibility we have we are not a forced buyer compared with a fund which would be only dedicated to a single country.”
The Europe-focused vehicle is the firm’s first debt fund to have an initial mandate to invest in the US, with an allocation of up to 25%, “as it looks to further capitalise on the continuing strength of the US economy”.
In April, PGIM held a more than £1bn final close on its sixth European real estate debt fund. The vehicle will provide debt, including whole loans, mezzanine finance and preferred equity, and will focus on investments from £10m-100m.
Radkiewicz describes the fund as a “value debt” vehicle targeting a double-digit return. “It is investing in the UK and western Europe, in a number of different sectors, looking to back strong operators and investors in real estate with good quality fundamentals,” he says. “We are taking some real estate risk combined with a preferred debt-style position.”
Orion’s €1.5bn fund, which held a final close in March, continues the firm’s strategy of investing “in a wide range of assets” in Europe. Aref Lahham, chief executive of Orion, said the firm was eager to capitalise on opportunities “generated by current political uncertainty across Europe”.
Shayle is using a £241m fund that closed in December 2015 to target a less competitive corner of the market. The UBS Participating Real Estate Mortgage Fund distinguishes itself from its competition by supplying senior and mezzanine debt in a single loan package. It targets an 8-10% internal rate of return each year, with returns driven by interest on the loans in addition to a share of rent and capital appreciation on the underlying assets.
“We don’t find ourselves to be competitive to lend on prime property,” says Shayle. “We are very comfortable in the right circumstances lending on development and refurbishment property and alternative asset classes.” Assets in his remit include hotels, student accommodation, care homes, cinemas and car parks.
Another fund providing whole loans is LaSalle’s £264m third UK residential finance fund, closed in May. The fund will focus on development or redevelopment assets in the student housing, residential, hotels or healthcare sectors.
The UK’s decision to leave the EU is concerning managers. “It will create certain issues for the UK but it will also create issues for Germany and other countries in the European market that so far seem to be not as concerned about the impact,” says Shawn Kaufman, director of the debt fund at TH Real Estate. “I could see a bigger impact on property as a result of Brexit.”
Returns are also raising concerns. Real estate debt funds globally delivered a median internal rate of return of 10.6% in 2014 – the most recent available figures, according to Preqin. This compares with 9% in 2013, 10.2% in 2012, 14.1% in 2011 and 15.1% in 2010. Such funds delivered their worst returns on record, -8%, in 2005. Can firms deliver the returns they have pitched to investors following increased competition and subsequent downward pressure on margins?
“It does go in cycles depending on how much volume people have been able to originate,” says Kaufman. “You can tailor the product to match the returns you’re trying to achieve. You have to take more risk. That’s one of the features of debt that we find attractive.”