Structural and cyclical factors are driving a new wave of interest in Asia-Pacific real estate debt.
The region’s largest markets have become more sophisticated, so a broader range of investment avenues is developing, while changes in several markets have affected the supply and demand for debt. There is also a perception that, with real estate deemed to be late in the cycle, debt offers extra security.
China and Australia are by far the preferred markets. Japan and Singapore remain well supplied with bank lending, while smaller South-East Asian markets are generally considered too risky. India has been a focus for non-bank real estate lending, but the market has come to a halt following the default of IL&FS’s non-bank finance company in October. Non-banking financial companies, including some backed by foreign private equity, have been major lenders in India, including to each other as well as to developers, but the market is currently frozen.
Fergal Harris, head of debt capital at JLL, says: “A lot of people are looking at Asia-Pacific debt at the moment, including US and European pension and insurance funds.”
Most commentators agree that China and Australia offer the biggest opportunities for real estate lending. Harris says: “We are seeing growing interest in China offshore lending; the government-driven deleveraging is making people rethink the opportunity there. There is also growing interest in non-performing real estate loans. The China NPL market is huge and there is a significant percentage of real estate loans.”
The China NPL market has acquired something of a Holy Grail status among investors, as it offers enormous potential in theory, but grasping it has been difficult. A number of private equity investors, such as Oaktree Capital, Lone Star, Bain Credit, PAG and Blackstone, have acquired China NPLs.
A recent report from PwC estimates foreign investors have spent around $1.5 billion on NPL portfolios, with 70-80 percent of the loans backed by real estate. However, this is tiny compared with the size of the market: as of June 2018, China’s banks reported 2 trillion yuan (€263 billion) of NPLs on their balance sheets and 3.4 trillion yuan of ‘special mention’ loans, stressed loans which are likely to end up as NPLs.
Harris says: “A lot of the loans are secured on assets in second- and third-tier cities which makes debt recovery, especially within a fund’s timeline, difficult.”
An NPL portfolio might include hundreds of loans on smaller assets, some of which will retain little value and others where lengthy, expensive and possibly fruitless legal action might be required. The right pricing is important in mitigating these risks, but so also is a large enough portfolio to offset the bad against the good.
Tom Moffat, head of capital markets, Asia, at CBRE, says: “Everyone is looking for the NPL market to develop but so far investors face challenges in the execution of deals, particularly in a scalable manner.”
The most popular China debt strategy with private equity investors in recent years has been short-term mezzanine lending to China developers. China is undergoing a program of deleveraging, which is causing a credit squeeze for developers. Previous sources of non-bank finance – the various ‘shadow banking’ options – are now largely ruled out for developers, which has put some in urgent need of finance.
However, this investment is perceived to have a limited window. Moffat says: “The China debt deals we tend to see involve mostly private equity investors targeting opportunistic returns, at least mid-teen IRRs. There is a feeling that there is a time limit to this opportunity, as a lot of groups believe the tighter domestic liquidity will ease later this year.”
Infrared NF has been an active mezzanine lender in China, placing a total of $650 million in 10 deals, seven of which have been fully repaid. In February, it announced the closing of a $92.2 million financing investment with Hong Kong-listed Fullsun International, a unit of China developer Fusheng Group. The lending is secured by two partially completed developments in Changsha.
Stuart Jackson, CEO of InfraRed NF, says: “A window of opportunity has arisen for InfraRed NF from the well-publicised contraction of available credit within China. China’s deleveraging is creating an attractive investment environment for us resulting in a healthy pipeline of mezzanine and value-add deals.”
Unlike private equity players, which have extended loans to credit-squeezed smaller developers as part of their opportunistic strategy, CapitaLand’s new China real estate debt fund is operating in a different strata of the market.
CREDO I China, the Singaporean group’s first discretionary real estate debt fund, has raised $556 million from its target of $750 million. It will provide offshore, dollar-denominated mezzanine loans for assets in China’s first- and second-tier cities and Hong Kong.
Credo offers “augmentation of the capital which is made available by senior lenders,” says James Lim, chief executive of CapitaLand Investment Management. Typical loan to value ratios for China senior real estate loans are 50-55 percent, while the new fund will lend in the 50-70 percent range. “We are providing added gearing to high-quality borrowers and assets,” he says.
The fund will lend from $25 million upwards for each deal. Most loans will be backed by stabilised assets but Lim says the fund will focus on lending to “value-add or transitional assets.” “With these projects, rising values will decrease the gearing of our loan, which can then be refinanced by bank debt,” he says.
Since joining CapitaLand from HSBC in 2017, Lim has recruited a team of former real estate bankers with “deep and wide” experience and great relationships with both borrowers and senior lenders in China.
He expects market conditions to support CapitaLand’s debt business in the longer term. “Real estate is cyclical,” he says, “however [banking regulatory initiatives] Basel III and IV will not be more lenient on banks and will support more opportunities for non-bank lenders.”
The fund has been supported by large institutions with experience of China real estate, although CapitaLand will not give further details about its investors. For investors, Lim says, the fund offers China real estate exposure without equity risk. Mezzanine funds of this type are common in the US and relatively widespread in Europe, but CREDO is unique in Asia, says Lim.
Australia’s A$30bn opportunity
A flurry of new non-bank lenders is emerging to fill the gap left by the country’s ‘big four’ banks
Fergal Harris, head of debt capital at JLL, says: “The biggest opportunity in Asia-Pacific debt may be in Australia, as the big four banks there pull back from real estate finance. Over the next three years we expect there will be A$30 billion (€19 billion) of loans on their balance sheets which they will sell or simply opt not to refinance.”
Australia’s banks are under fire from a Royal Commission and are becoming weighted down with regulation. However, the Australian commercial real estate market continues to perform and remains one of the world’s most transparent markets.
There are opportunities for senior lending and for shorter-term mezzanine loans, although participants say the latter opportunity has shrunk in recent months. Tom Moffat, head of capital markets, Asia, at CBRE says: “You can lend beyond three to five years, as there are long leases with indexed rental uplifts – there is a lot of certainty when you are underwriting these deals and in some cases we have seen groups interested to provide up to 10-year senior loans.
“Typical returns for good quality income producing assets in Australia would be low 4 percent for senior and into the high single digits for mezzanine. Rates in the construction finance space would be roughly double these levels.”
Most of the activity has come from private equity firms, such as Partners Group, Invesco Real Estate and PGIM Real Estate, while both Blackstone Group and KKR have invested in non-bank lending platforms.
Some large global investors are also participating: last year Canada Pension Plan Investment Board awarded a A$500 million ($351.6 billion) mandate to Challenger Financial Group.
Speaking at the PERE Asia conference in Hong Kong in March, François Trausch, chief executive of Allianz Real Estate, which has $20 billion of real estate debt investment in the US and Europe, said: “The obvious market for us [for real estate lending in Asia-Pacific] would be Australia.”