Debt funds: A market in flux

The debt fund market has been growing for many years, fuelled by increased demand from borrowers needing to finance new acquisitions, while concurrently bank regulations have tightened, restricting the supply of credit. This regulatory scrutiny has accelerated in recent times, going into overdrive thanks to the Silicon Valley Bank and Credit Suisse debacles.

While it is true that the then-smaller debt fund space was tested by the global financial crisis, Charles Allen, head of European real estate at London-based investment manager Fiera Real Estate, notes that “it was considerably less mature at that point. This will be the first real test since that expansion happened.”

Against this impending challenge, many practitioners are sanguine.

“I think there is obviously going to be some kind of test, but I do not think it is going to be a significant one,” says Christophe Montcerisier, head of real estate debt at BNP Paribas Asset Management. “Lenders have a lot to fall back on. For example, there are a lot of covenants… and the lender has access to cashflows; [they] benefit from an equity cushion. The question is, how thick is that cushion?”

Sources suggest senior debt funds are highly protected with a cushion of approximately 35-50 percent. It is only the junior debt funds, where the cushion is 15-25 percent, that might be more at risk, especially for the previous vintage funds. “Most are structured so that a minimum of 80 percent of the debt is hedged,” Montcerisier adds. “It is only that small minority that are not properly hedged that pose a risk, or when there is a need for refinancing.”

Chris Bates, head of Europe real estate debt origination at global investment manager Barings, agrees: “Borrowers have a greater proportion of equity in their investments and are therefore more motivated to work through loans facing possible distress.”

Extend and pretend

The question remains: have some funds lent too riskily?

Allen admits that “there will be some who have lent too freely and may well face significant loan-to-value (LTV) and income coverage ratio (ICR) breaches”, while Bates believes “borrowers who financed using high LTV or mezzanine loans could experience stress as floating interest payments rise and ICR covenants are tested. Furthermore, pressure could be applied from falling valuations potentially impacting LTV covenants”.

Valuations are certainly falling at an alarming rate in certain sectors. Jim Gott, head of asset surveillance at loan servicer Mount Street – which advises on €130 billion’s worth of assets under management across Europe – notes that “the fundamentals are deteriorating across the CRE debt market. Only something like 15 percent of loans reaching maturity have been successfully refinanced so far this year. The rest have been extended or defaulted. I am afraid ‘extend and pretend’ is a very real phenomenon among debt lenders.”

Most extensions that have taken place have been short-term, according to Gott, typically three months to one year. “I suspect a lot of encouraged divestiture is eventually going to happen. It is important to give time to sell assets rather than to default. The term ‘extend or enforce’ may be where we are heading. Debt funds are very busy currently, they are out there being very active, seeing assets a lot more than previously and trying to assess the risks, which are being actively managed.”

This high level of activity reflects the more hands-on approach that debt funds take in comparison with banks. “In a risk-free money approach, this means that they are not necessarily riskier,” Gott adds.

Bates agrees: “Generally, debt funds may be more likely to take a proactive approach in resolving issues that may arise across the portfolio given their single focus to manage a fund. This means their decision-making is not being affected by other relationships with the borrower that may exist for bank lenders.”

Client pressure may also be behind this. Paul Spendiff, head of business development, global funds at fund services and solutions provider Ocorian, suggests that managers should expect, and prepare for, increased scrutiny. “Debt managers can expect an increasing investor interest in their risk models, borrower engagement and quality of loan agency date being fed to the administrators,” Spendiff says.

“Investors will want comfort that the funds’ net asset value is an accurate reflection of the reality of the portfolio.”

Bates points to a wide variation across the market, and suggests the extent of the challenge depends on several factors, including a fund’s strategy and whether a fund was originated when property values and cap rates were at a peak.

Gregg Disdale, head of alternative credit at brokerage WTW, concurs: “There is likely to be quite some variation in performance across debt funds, with those lending deeper into the capital structure (mezzanine funds for example) and into sectors facing greater headwinds to face the biggest challenge.”

The new subprime

The problems identified are sector-specific. Aside from interest rate volatility, Gott notes additional factors that are impacting performance. “The two long-term secular trends of internet shopping undermining retail and the work-from-home phenomenon undermining offices are here to stay,” he says. “In fact, with offices, I sometimes question whether they are not the ‘new subprime?’”

Offices are additionally vulnerable given the question of energy performance and the risk of stranded assets. “This is a very considerable risk,” Gott adds. “We estimate that the amount of capital that is necessary to meet the regulatory requirements by 2030 is as much as £150 billion (€169 billion) in the UK alone. I would say debt funds are more on top of this than banks and understand that capital expenditure is neutral as to location, but tenants and rental value are not.”

Spendiff fears “a flight to quality”, particularly away “from the firms and funds that are overweight commercial in sectors such as city centre offices”.

Focusing on vacant office space in London, according to Gott there is currently approximately 5-6 percent in the West End, 7 percent in the City and 9-10 percent in Docklands. “These may be unsettling numbers, but frankly they are nothing compared to the 29.5 percent that the market is seeing in San Francisco,” Gott adds.

Alexander Oswatitsch, head of real estate debt, Europe, at Frankfurt-based asset manager DWS, adds that the latest figures for vacant office space in the US paints a difficult picture: “Clearly the US office sector is in very bad shape. It is likely some big sponsors will be handing back properties and overall market sentiment for offices is negative.

“It will be necessary for some players to have a strategy for any distress. We must be adult about this and, of course, extending arrangements are going to be a consideration if a loan becomes distressed.”

Other sectors are not being affected in the same way, according to Adam Buchler, managing director of real estate debt adviser BBS Capital. “The US office market is particularly challenging for debt funds at present and this affects how US funds feel about that sector in Europe as well,” Buchler says. “By contrast, beds and sheds are a lot easier; there is depth in the market.” There is also particularly strong demand for student accommodation and buy-to-rent.

In Germany, problems tend to be confined to the office and retail markets. Markus Königstein, global head of investment management at Switzerland-based investment manager Empira, admits some residential projects are being delayed. However, it “is not happening to a great extent because of the significant demand against a background of a supply shock as new construction falls dramatically, he adds.

A new beginning?

It is not all doom and gloom, however. Reflecting this differential sector performance, Montcerisier believes significant support is offered by the strong rental growth across the overall European market. Commercial property rent increases were recorded in all but one of 10 major markets measured by BNP Paribas Real Estate, with Central London and Warsaw recording the highest increases year-on-year, at 19 and 13 percent respectively. Rather than a crisis, Bates sees these challenging times “as more of an opportunity for debt funds as bank lenders continue to reduce their exposure”.

According to Charles Allen, approximately €200 billion of debt is due to mature in the UK, France and Germany during 2023 and 2024 alone. A large part of this is secured by mainstream bank lenders, who, Allen notes, “are likely to be much more demanding when they renegotiate loans, or indeed may not be there at all. This provides a huge opportunity for debt funds.” For example, Fiera Real Estate has launched a €500 million pan-European debt fund based around its new team.

There are further opportunities for debt funds. Banks may consider selling off a piece of a loan to investment vehicles such as debt funds, instead of extending a loan. For example, assuming a loan granted in 2020 at 65 percent LTV for five years now has property collateral value that has been reduced by 10 percent, the LTV is mechanically going up to 72 percent.

According to Montcerisier, “In order to avoid extra equity against the loan, [a] senior lender may be tempted to split the loan into two pieces: one up to say 55 percent LTV, which will be kept on bank’s books, and one from 55 percent LTV to 72 percent LTV that will be distributed, most likely to debt funds.”

Gott believes debt funds “are taking an increasingly larger share of the market, and this will accelerate”. He notes that, in the US, debt funds currently represent around 40-50 percent of the market, whereas in the UK it is more like 20 percent and in continental Europe it is closer to 10 percent. As banks increasingly withdraw, thanks to the Basel regulations and a more conservative outlook, Gott expects these UK and continental European numbers to double. “Debt funds will not be the cheapest money, but in many cases they may be the only money.”

As a consequence, there are “a lot of new funds being set up”, according to Gott. “We had three approaches in just one week. I think we will see a lot of value-add funds, and also a lot of funds looking to repurpose offices. We are also likely to see some specialist funds looking to make the capital expenditure necessary to meet ESG regulations.”
Montcerisier also expects “more diversification in strategies (by property type or by geography) and… that ESG will be incorporated more into the way in which capital is allocated”.

Disdale notes that the denominator effect has led to very subdued fundraising in recent months compared with prior years. Nevertheless, he also believes the economic environment should be supportive for new funds raised “given the likely challenges faced by traditional lenders and of course a less competitive debt fund environment, as fewer are able to raise funds at hoped-for targets”.

Avoiding denominator woes

There are ample opportunities, according to Oswatitsch, “that we would expect greater allocations to the private debt space, if it were not for the famous denominator effect”.
The fall in the value of equities and bonds means alternatives are breaching guidelines for some multi-asset funds. But there is hope, Oswatitsch says: “That is not necessarily the case for some US players, and we have seen them branching out and starting to be more active in European markets as they are not suffering from the denominator straitjacket. They are more flexible to shift funds to deploy into real estate debt within their existing illiquid allocations.”

Within alternatives assets, there is a difference between real estate debt and real estate equity, particularly thanks to rising rents across Europe. “Real estate debt appears very attractive compared to real estate equity at this level,” Montcerisier says. “Therefore, I believe there may be further allocations to this subsector.”

While Königstein agrees that the denominator factor remains an issue in the German market, he remains optimitic: “Fortunately, insurance companies are coming from such low allocations to real estate that there is significant headway for them to increase allocations in the medium term. Especially when debt funds are so attractive as banks withdraw from the market and margins rise.”