In debt strategies, go short

Following the global financial crash, real estate debt and credit strategies were seen as a niche alternative to core investing.

Today, a growing number of investors are shifting their real estate allocations into real estate debt investments. As we approach the late stages of the economic cycle in both the UK and Continental Europe, this rebalancing can be viewed as a defensive measure by investors. However, successfully executing property debt strategies remains challenging in what is a relatively shallow European market for real estate debt funds.

Across the US, the market has become more homogenised and is easier to operate due to the simplicity of working under one federal law. Europe is less straightforward, as managers must operate across countries with differing laws. Despite this, more investors are shifting resources into real estate debt in Europe.

CHALLENGE

While complexity across multiple jurisdictions is not dissuading the big institutional players from investing, it remains a challenging backdrop. For example, in mezzanine debt, while some funds have been lending in this space for more than a decade the European market still only boasts a handful of serious providers, in comparison with the larger numbers we are seeing in the US.

The 2017 Hodes Weill Allocations Monitor, an annual survey of investor sentiment, highlighted demand for real estate debt had increased year-on-year with 60 percent of all institutions intending to invest in 2017, compared with 52 percent in 2016. As one survey participant said, they are focused on commercial real estate debt “due to the current valuation level of commercial real estate in most of the developed markets”; a consistent feedback theme from many institutions.

At this point in the cycle, the most obvious attractions of a real estate debt strategy are durable income and downside protection given the subordination of sponsor equity. Managing the duration element also allows investors to risk adjust and benefit from further defensive protections. For example, extensions beyond three years generally require collateral meets certain performance criteria such as a minimum debt yield or debt service coverage.

Debt strategies are being applied on both prime and transitional real estate, even though the availability of the latter is far thinner. Loans on transitional real estate are commonly structured with an initial maturity of three years, with typical pay-offs occurring within 18-24 months as the borrower can pay back loans in a shorter timescale as assets are refurbished, re-let and then re-sold.

Building in those shorter duration loans to a debt portfolio allows investors further balance, compared with the typical seven to 10-year term debt on stabilised prime assets. Such a strategy minimises investors’ exposure to a hazier future. Additionally, since these loans are most often based on a floating rate such as Libor with a floor, moderately rising interest rates can be beneficial to returns.

While the European market for real estate debt still has its challenges, positive sentiment towards it continues to grow, with more investors placing elements of their capital allocation into debt at this later stage of the overall market cycle.

Hodes Weill is a global real estate advisory firm focused on the investment and funds management industry.