2021 outlook: Why RE debt will appeal to investors in the coming year

With government bonds offering low yields in the US, and even negative yields in some cases in Europe, private real estate debt is likely to produce attractive risk-adjusted returns, according to a new outlook report by the real estate investment arm of the asset management company DWS.

Although the investment manager expects European direct property returns for the best-performing parts of the market to have compressed markedly during 2020, it said the return on offer from private real estate debt has increased.

However, the firm warned a careful selection of assets will be crucial in the coming months, as covid-19 has increased the risk attached to real estate lending and led to a widening differential between sectors.

Here is a rundown of some of the report’s other findings.

A rebound in financing activity is expected: After a significant fall in transactional volumes and lending activity during the second and third quarters of 2020, activity is expected to pick up from next year, due in part to outstanding refinancing requirements.

A further increase in real estate debt returns is likely: While there is an expectation that fixed income yields may remain low in the short term, DWS said we could see a gradual upward trend in yields, which would start to push real estate debt returns higher beyond 2021, towards the middle of the decade.

Homes and sheds will remain a strong prospect for lenders: From a pure risk perspective, the investment manager said logistics and residential will offer the most attractive risk-adjusted returns, as they are likely to have suffered less of a market correction in 2020 and are backed by positive long-term trends. As such, DWS predicted risk-adjusted returns for both senior and junior lending in these sectors to remain attractive.

Student housing and some hotels could also be attractive: Although the two sectors will continue to face challenges related to covid-19, the investment manager said longer-terms trends remain favourable for them. DWS therefore predicted good senior lending opportunities, albeit at the prime end of the spectrum, and dependent on the quality of the operator. It warned that caution is required at the junior end of the capital stack, but that, with sufficient allowance for short-term volatility, lending to subsectors such as budget hotels could still prove attractive.

Careful retail lending could be lucrative: With many lenders pulling back from retail, a sizeable rise in margins is expected, meaning there could be room for retail within diversified debt portfolios. However, DWS warned that cautious asset selection and lending at lower loan-to-values will be important. It used the example of a German shopping centre, where it predicted prime capital values could fall by 30 percent over the two years from mid-2020, meaning a 60 percent LTV loan would increase to around 85 percent.

A widening in spreads between core and core-plus assets is likely: As more lenders focus on the lowest-risk opportunities, returns for well-located assets with an additional risk factor, such as a need for refurbishment, could increase. DWS added that, in an environment of reduced risk appetite, some of these risks could be mispriced.