Michael Morgenroth and Patrick Züchner have spearheaded Gothaer's move into junior debt and may replicate this at SIGNA. They speak to Richard Lowe about why mezzanine investment is so compelling

German insurance company Gothaer has close to €2bn in equity invested in real estate investments (€2.5bn if uncalled commitments are included). The institutional investor has employed a global indirect investments strategy since the middle of the previous decade, which has allowed it to build up a portfolio of investments in more than 60 real estate funds.

But in recent years a gradual shift has been taking place within the portfolio. The insurer has begun to act as a junior lender on core real estate assets, and these deals have effectively taken the place of new core real estate equity investments.

Michael Morgenroth joined Gothaer Asset Management, which oversees the insurer's investments, in 2004 as member of the board with responsibility for real estate and infrastructure investments. Along with his colleague Patrick Züchner, head of real estate at Gothaer, Morgenroth has spearheaded the insurer's move into the debt space.

Morgenroth says real estate debt investments will become a more "dominant allocation" as time goes on. "In our view, mezzanine is a substitute for [real estate] equity investments and is much more favourable under the Solvency II regime," he says. "For insurance companies it is really a sweet spot at the moment."

Such is the appeal of real estate debt investments that Austrian real estate investor SIGNA Group recently publicised its hiring of Morgenroth and Züchner - along with other real estate professionals from Gothaer - to help lead their planned entrance into the debt investment space. The transition will take place in March 2012.

The timing of the move is certainly not coincidental. At the time of the announcement, Morgenroth pointed to regulatory changes that would make "real estate debt, in particular" increasingly attractive to institutional investors, "presenting great opportunities for those teams that have the experience and capital backing to take advantage of them".

Morgenroth is also chairman of the European Association for Investors in Non-listed Real Estate Vehicles (INREV) and the chairman of the property commission of the German Insurance Association (GDV), and is consequently well versed in the details and implications of incoming European regulations, not least Solvency II.

Yet, despite Morgenroth's belief that Solvency II - which is likely to apply a 25% capital charge to real estate investments, while treating real estate debt in the same vein as fixed income - will drive insurers towards property lending, it is not the only factor.

Züchner likens Solvency II to an accelerator rather than the principal cause. "The business case is in existence, because the banks reduce their exposure to the real estate lending space. Solvency II is really the catalyst accelerating these types of strategies we see anyway."

Züchner says Gothaer would have moved into the space regardless of Solvency II. "The business case is really clear," he adds. "More or less the risk involved in these mezzanine transactions is some form of core/core-plus risk but with a value-added return."

In other words, junior debt strategies have the potential to provide superior risk-adjusted returns. "The risk profile is really similar to the profile of the underlying property, but the situation in the capital structure is much more favourable because of the additional equity within the structure," Züchner says. "So the risk-return profile is much more favourable for debt investments than core equity at the moment."

For some of the reasons outlined above, Gothaer positions such investments within its property allocation rather than treating it as a separate asset class. "In our institution it is really pure real estate," he says. "The reason is it's a real estate-related risk, and the real estate-related risk is not reduced by a significant amount of diversification."

He adds: "Not only in junior loans and mezzanine loans, but even in CMBS investments, the analysis is really a real estate-driven analysis. In CMBS this is a joint venture between real estate and fixed income, but on the loan side it is pure real estate. It is driven by the underlying risk and not by the structure around it."

The issue is not so clear cut when it comes to senior lending, Züchner admits. But then Gothaer has yet to move into this area of the lending market.

"The focus is on mezzanine debt. We are not doing senior debt so far," Morgenroth says.
Gothaer became active in junior real estate lending in 2009, initially through direct deals in Germany and the surrounding area. It also made commitments to two fund managers that could provide it with specialist exposure to other markets in Europe.

"We focused in the beginning on Germany and the surroundings," Züchner says. "But you can't do everything yourself. Therefore, we expanded the universe using two fund managers based in London for UK and pan-European exposure.

As evidenced by the upcoming move to SIGNA, both Morgenroth and Züchner believe the opportunity for institutional investors to move into the junior debt space will be a long-term one rather than a short-term window. They point to the €150-175bn of refinancing requirements in Europe over the next three years. If estimates are correct and only 25% of this can be met by traditional lenders, a near-€40bn financing gap should emerge annually during the three-year period.

Gothaer will not lend against developments, given the aim is to achieve stable cash flows. It is also maintaining a focus on Europe lending markets for the time being. Züchner says the insurer considered the US real estate markets but chose not to enter it.

The US lending market is also fundamentally different to Europe, with insurance company activity already well established and a far more dominant securitised debt market in place. In any case, Gothaer's domestic lending market - that is to say, Europe - looks certain to provide ample opportunities over the coming years.

"Given the refinancing issues we have in the markets for the next year, the whole financing world will change somehow," Morgenroth says.