Capital flows 3: Investors shift to debt

In the final part of REC's series on capital flows, Lauren Parr examines how real estate credit vehicles are being boosted by the rise of private debt.

Against a backdrop of low global interest rates and bond yields, private debt is one of the hottest alternative asset classes and real estate debt funds are prime recipients.

Capital raised by private debt funds with a Europe-focus reached $47.5 billion in 2017, according to Real Estate Capital data. Of that, just over $10 billion went into real estate debt vehicles.

Will Rowson, partner at Hodes Weill & Associates, which advises clients on fund investments, sees growing interest in European real estate debt funds, particularly from US and South Korean investors. “US investors are looking at growth in Europe, and are used to investing in debt funds in the US, with a sense that the US is late in the cycle. They’re wondering if they can get into Europe in a defensive way, since the EU market still contains late cycle risk. It’s not a flood but it is a market,” he says.


1. Global capital is targeting Europe

2. The feast from the East

US capital typically chases higher returns, so when it targets Europe it leans towards mezzanine and whole loan strategies, of which there are few, by US standards. US public pension plans and insurers are looking for high single digit/low double digit returns on a net basis. Senior property debt strategies in their domestic market usually generate in the region of 3 percent returns, notes one European manager.

South Korean firms are big investors in the US, and so Europe – with its lower interest rate environment – only makes sense when higher returns can be identified. “When investing in Europe, investors need to hedge back in their local currency so they also need to compensate for that,” says John Barakat, head of real estate finance at M&G Investments, which manages both senior and mezzanine debt funds.

Korean investors have gradually turned to debt in Europe, due to concerns that the European markets they have been investing in are late into the cycle. “Korean investors have been buying core property in Europe for the last six or seven years, starting with London, hence why debt became a good, defensive play. They get high single digit returns with a 30-40 percent equity cushion above them,” says Rowson.

Real estate and real estate debt suits the investment need of many Asian investors, notes Christoph Wagner, director of debt strategies at TH Real Estate. “There are defined contribution schemes and often asset-backed defined benefit schemes in Asian countries which have a requirement for investments that yield cash returns,” he says. TH Real Estate has a mandate to invest in UK whole loans on behalf of two Korean investors – Dongbu Insurance Company and Dongbu Life Insurance Company.

Life insurers and pension funds are a dominant source of capital coming out of Korea. “For them, going offshore tends to be about finding more attractive returns. Whereas very large sovereign wealth funds need to diversify and either find their domestic market is too small or are chasing returns they can’t find at home,” says Barakat.

Even smaller and mid-sized Korean investors have been internationally focused for some time as they struggle to source opportunities in their home market. “Many have made investments directly and over time have realised it’s hard for a small investment team sat in Seoul to make direct investments in individual mortgage loans. They like the asset class and some are now approaching investment managers with on-the-ground presence in order to unlock more volume,” Barakat adds.



Asian capital looks increasingly likely to find its way into European debt strategies. Some 29 percent of the 170 delegates surveyed at a conference held by the Asian Association for Investors in Non-Listed Real Estate Vehicles in Seoul in February said they plan to deploy the most capital in the European real estate market this year, with 80 percent planning to invest in debt deals generally.

“Most Asian investors are still learning about the market and do not have a deep understanding of the risks associated with investing in European private loans. The education process suggests it is early days for raising capital in the region for commercial real estate loans,” says Jon Rickert, an investment director within GAM’s Real Estate Finance Team, which is targeting Asian capital.

Japan could become a source of capital for real estate debt, some suggest. “Many Japanese institutions have historically been focused on investing in their local market, but with negative interest rates, are now looking to diversify their portfolios. We’ve seen large pension funds starting to mandate gatekeepers to find them exposure to international direct real estate. Investment in real estate debt could follow at a second stage,” says Antonio de Laurentiis, head of commercial real estate private debt at AXA Investment Managers – Real Assets.


European institutions represent a significant proportion of AXA IM – Real Assets’ debt platform investor base, the biggest manager of real estate debt assets in Europe. “Look at which countries have the largest insurance companies or pension funds; insurers in France are very big; the Netherlands has some very large pension funds; and in the UK there are more pension funds looking for long term debt,” notes de Laurentiis.

Rowson adds: “There now seems to be pockets of interest from German investors, mainly sophisticated ones that have consistently invested in low yielding debt but are now looking at higher yielding debt that finances value-add strategies. They are looking at the asset class as a way of getting real estate exposure whilst reducing risk this late in the cycle.”

Insurance companies were among the first movers in real estate debt, post-crisis, as capital requirements under Solvency II regulation made it an efficient asset class to invest in. The capital charge associated with a five-year, AAA-rated commercial real estate loan is just 4.5 percent for European insurers.

“In the last few years we’ve seen more interest from pension funds than we did five years ago. The continuing withdrawal of bank capital from certain parts of the market is providing good opportunities,” says Emma Huepfl, co-founder of Laxfield Capital, which recently launched a UK debt fund with £500 million (€560 million) of commitments.



Pension funds are looking for predictability of cashflow to match their annuities and real estate debt offers security through exposure to buildings with regular, easy-to-project cashflows. “Less likely risk-takers in the market are beginning to understand the asset class slowly but surely, as debt funds have got bigger,” says Rowson.

Investing in real estate debt looks as good value today as it ever has. “What first created appetite was investor demand for attractive yield and relative value in a 10-year low interest rate environment. As money continued to flow into credit markets generally, and particularly public markets, the spread between private and public debt accelerated, thus making a private asset class like real estate debt appear interesting in terms of absolute and relative returns for a comparable level of risk. This trend has remained fairly robust,” says Barakat.


The absolute level of return generated by all credit is lower today than it was in 2011-13, but the relative attractiveness of real estate debt remains high. “Public credit margins have compressed even more significantly than for real estate debt so the relative return on an investment grade basis remains interesting,” explains Barakat.

Fixed income investors are drawn to an illiquidity premium of at least 100 basis points compared with corporate bonds, which yield 50-100 bps compared with 150-300 bps for private debt in Europe, according to de Laurentiis.

“Insurance companies and pension funds are also looking to diversify their portfolios with exposure to alternative asset classes, including real estate debt as well as other types of private debt. Such alternative assets tend to be less correlated to their more traditional investments such as bonds or equities,” he says.

Compared with direct property, real estate debt looks undoubtedly more attractive in the view of Dominic Smith, senior director within investment and capital advisors research at CBRE. “In the UK, the forecast for real estate market performance is essentially an income return of 4-5 percent and little capital growth. Getting 2-4 percent just from senior debt, which is much lower risk than equity as it is not exposed to risk of capital decline – which will be a concern late in the cycle – therefore makes great sense on a risk-adjusted returns basis,” he says.

The defensive nature of debt investing is the main benefit of investing in debt funds, Rowson believes. “This has become more relevant over the last three years as core pricing has become very hot and investors are starting to get cautious,” he says.

“As economies grow and tenant demand for space in some of the stronger markets in Europe allows value-add investors to refurbish assets, rents and values go up and therefore your debt becomes less risky over time as loan-to-values fall.”

European real estate debt continues to attract investors from across the world and mezzanine and whole loan strategies, in particular, look likely to keep drawing investors’ capital, as long as returns stay strong and European economies continue to grow.