Property debt funds offer useful indirect exposure to real estate. But investors must choose the fund type carefully to get the right mix of real estate and interest rate risk, says Rob Bingen

In Europe a number of real estate related debt funds have emerged, seeking to provide the property market with debt capital as banks become more restrictive in their lending policies. This article seeks to describe why real estate debt related funds can be attractive and a useful addition to the toolkit available for indirect real estate investors.
Since late 2008 we have identified over 25 managers that have been marketing European unlisted real estate debt funds, many of them with a UK focus. A number of these funds have fallen victim to the challenging capital markets and abandoned further efforts. In aggregate we estimate the remaining funds are collectively seeking to raise over €6bn in equity, many of them still out in the market trying to achieve a first closing.

The strategies of these funds vary widely. We have identified three main types; senior mortgage loans, subordinated debt and commercial mortgage backed securities (CMBS). It is worth noting that the structured nature of most real estate debt investments can result in widely varying and overlapping risk profiles between strategies. For example an AAA CMBS may be less risky than a discounted senior loan at a high current loan to value (LTV). Disregarding specific structuring we would generally classify the profile of each strategy as shown in table 1.

Understanding the risk exposure is in our view a key assessment that investors should make when considering the suitability of the various strategies within their overall real estate strategy. Our thesis is that real estate investors should seek to have their risk exposure fundamentally linked to real estate but accepting a moderate level of interest rate risk. The latter is based on the experience that many unlisted real estate funds have historically used a reasonable amount of leverage, typically in the range of 50-65%.

Using these risk criteria, we have concluded that both senior loans and CMBS may not be a natural fit for all indirect real estate investors. This does not mean we believe they cannot provide compelling risk-adjusted returns, but merely that the source of risk can deviate substantially from real estate exposure. For CMBS, this is evidenced by the low correlations witnessed between property and CMBS returns in the US.

Senior mortgage loans are in our view less natural investments for European indirect real estate investors due to their sensitivity to interest rate movements and inability to capture potential property upside. Moreover the return expectation on new mortgage loans (up to a moderate 60% LTV) is between 5-6%, which we expect is insufficient for many real estate investors. An alternative higher-return strategy for senior loans is achievable through discounted secondary purchases, benefiting from the repayment of the notional amount at maturity. Rumours circulate about banks shedding their non-domestic real estate loan books, but to date we have not seen a very active market in Europe develop in commercial assets. So we question whether a secondary market will materialise for anything other than the most problematic loans.

By contrast a subordinated debt strategy has risk characteristics linked to property returns, both upside and downside. We are mainly focusing on mezzanine and convertible debt in unlisted funds. Convertible debt typically combines a high coupon with an option to convert at a pre-agreed price into new units of the fund, capturing future upside. The typical mezzanine loan will have a high coupon and a profit participation that is associated with the equity return. In some cases a minimum internal rate of return (IRR) exit fee may be included. Mezzanine is positioned between senior debt and equity in the capital structure and generally considered to be anything in excess of 65-70% of the value of the underlying assets. The equity and mezzanine provider could be seen as partners providing all the capital above the senior loan, whereby the mezzanine lender forgoes part of the property upside in exchange for a more secure coupon. Coupons can easily reach 8-10% and arrangement fees are usually payable.

Let us now investigate how subordinated debt can help optimise returns for real estate investors. There are no historical data to analyse correlations between subordinated debt and property equity, but the correlations and diversification benefits can be illustrated in an example. Critical hereby is the investor's property market outlook.

Using Schroders' expected total returns in continental Europe through 2013 as the basis (figure 1), we can project the returns for a mezzanine debt and a moderately (50% LTV) levered equity investment. The IRR expectations in our example are 9.9% per annum for mezzanine and 9.4% per annum for equity, despite the volatility of the latter being much higher. On a risk-adjusted basis we would therefore consider the mezzanine investment superior. An alternative scenario is for the moderately leveraged investor to wait until 2011 before making an investment and hold their cash. Although the expected performance would be slightly better than mezzanine debt, volatility would still be higher.

A similar example for the UK demonstrates the importance of the market outlook. Property Market Analysis (PMA) expects the UK market to recover from 2010 onwards. Return expectations therefore suggest that leveraged equity should be preferred over mezzanine debt as it outperforms. Nevertheless an investor that may have a more bearish view or is concerned about the volatility of the return outlook may still be attracted to mezzanine debt.

For an investor who manages a portfolio of indirect real estate funds the use of mezzanine debt, although still real estate exposure, allows for another investment tool to position the overall portfolio on a risk-adjusted basis. Moreover the use of mezzanine debt can be valuable in reducing interest rate risk on the overall portfolio. Almost all funds use leverage and will report on International Financial Reporting Standards (IFRS) necessitating the marking to market of their financial instruments. Falling interest rates thereby reduce the IFRS net asset value (NAV) and vice versa. The real estate debt funds are actually assets on the balance sheet; hence the interest rate sensitivity is the opposite to that of the debt liabilities held in other funds, thereby reducing overall interest rate volatility. Albeit ultimately a valuation issue and not cash-flow related, for this may be an important consideration for investors.

The above demonstrates that subordinated debt has sufficient real estate risk characteristics to justify a place within a real estate equity portfolio. It is a useful tool for investors seeking to position their real estate allocation on the risk and return curve and in fact allows the mitigation of interest rate risk within a portfolio of leveraged indirect real estate investments.

There are several points of consideration when investing in real estate related debt funds, including credit risk and default, intercreditor arrangements, foreclosure legislation, prepayments and time needed to deploy capital. But we believe that during a property cycle there may be ‘windows of opportunity' where the inclusion of a debt fund may be attractive for real estate equity investors. Certainly at the moment there seems to be a scarcity of debt and this market inefficiency allows for even better risk-adjusted returns.

Rob Bingen is head of European property multi-manager at Schroders