Observers wondering just how widespread the appeal of European real estate debt is, need only look at the September announcement by AustralianSuper that it had entered the market.
The mammoth superannuation fund, into which about one-tenth of working Australians pay pension contributions, has given an investment mandate to TH Real Estate, which is headquartered in London – some 10,000 miles away from the Antipodean fund’s own head office in Melbourne. At the same time, it announced it had issued a £230 million (€262 million) facility to Malaysian developer MTD Group to bring forward its development of One Crown Place in Central London.
While Australian investment in European property debt is, so far, rare, Asia-Pacific investors have proved willing to allocate capital to such strategies, hinting at the global appeal of the asset class.
“Currently, Asian investors seem to be quite interested in increasing their exposure to Europe, in direct real estate and/or through debt funds,” says Bertrand Carrez (pictured), head of real estate debt at Amundi in Paris.
Carrez has recently been recruited from La Francaise Asset Management, a French investment manager, to run Amundi’s real estate debt strategies. He already manages €550 million of senior debt for entities within Credit Agricole Group, to which Amundi belongs, seeking loan-to-value ratios no higher than 60 percent against core properties with established sponsors. He hopes to raise between €400 million and €500 million for a second strategy, run for external investors, also targeting senior debt.
Although most of the interest for this so far has come from French investors, he says some has come from other continents, including Asia. “This is not surprising, because some Asian investors have already learnt about European real estate through direct investment, so it’s a natural evolution for them to look at real estate debt now, when it is unclear what stage we are at in the real estate cycle,” says Carrez.
Speaking more generally, “we are certainly seeing more investor demand than four or five years ago”, says Jon Rickert, investment director in real estate finance at GAM, the Swiss asset manager, based in London. He thinks this is largely because investors are becoming “better educated around the product”, though he also sees a defensive move, at this late stage of the real estate cycle, from direct investment to debt.
This global interest stands to reason because much of the demand, at least when it comes to senior debt, is driven by global regulations. For example, the Solvency II rules for insurers are specific to the European Union, but have parallels in all other major economies, following regulatory agreement. These regulations use capital weightings to reward diversification into new asset classes. They also charge insurers lower capital weightings for real estate loans than for direct investment in real estate; Anthony Shayle, head of real estate debt for EMEA at UBS in London, puts this, as an indicative rule of thumb, at between 20 percent and 25 percent for direct investment, compared with between 10 percent and 15 percent for debt.
But although Rickert of GAM sees strong demand from Asia-Pacific, he emphasises, like all other participants in the debt fund space, that the bulk of demand emanates from Europe. Market observers say most of this comes from pension funds and insurers, with significant participation from endowments and ultra-high-net-worth families.
There are, however, variations of interest within both Europe and Asia-Pacific. Interest from Japan is growing sufficiently, for example, for Rickert to have visited once or twice a year for the past five years or so, knocking on the doors of pension funds and insurers. Fund managers also point to interest from South Korean and Australian investors, though some say Korean interest has peaked.
Fund managers also agree it is currently hard to entice Chinese investors. “Hong Kong and China have been difficult, because they often want something in the double digits,” says Rickert, referring to annual internal rates of return. “In this environment the interest is there, but this interest is difficult to satisfy.”
Even within Europe, levels of investor interest differ from country to country. They are strong among UK pension funds, which were pioneers in European real estate investment, and among German pension funds and insurers. However, Dutch pension funds have shown much less interest. Considering Europe as a whole, Will Rowson, London-based partner at Hodes Weill, the placement agent, assesses overall interest as “rising slowly”, using a term reminiscent of BBC Radio Four’s iconic shipping forecast for the British Isles.
The region glaringly absent from this round-the-world tour of investor interest is the US. Observers say US investors have less need to go to Europe because their home real estate debt market is so broad and deep; they also currently have less opportunity to do so because euro-dollar hedging costs have risen to almost 300 basis points on renewed currency volatility, making senior debt investing prohibitive and even mezzanine investing hard. “If you invest in a debt fund returning 4 to 5 percent, and you take 300bps off, what’s the point?,” says Rowson.
Would-be investors in European debt must also consider that, even before considering hedging costs, returns have come down in absolute terms.
Shayle of UBS remembers the heady days of 2012 to 2014, when European banks faced a liquidity crisis because of the continent’s wider debt crisis, and debt funds were able to lend at rates that brought the IRR over the life of a senior debt loan to about 8 percent or 9 percent. He contrasts that with today, when bank liquidity has returned to the market, interest rates in the eurozone are lower, and IRRs have dropped to 3 to 5 percent for similar loans.
For highly defensive senior debt funds, returns are lower still. For example, fund managers for the Senior European Loan Fund II, which is expected to be fully invested by Q1 2019, aim for a yield to maturity above 230bps, compared with 300bps for SELF I, which was fully invested in 2015. The funds are managed by AEW Europe, a real estate investment manager, and Ostrum Asset Management, formerly Natixis Asset Management; both companies are part of France’s Natixis group.
Returns for value-add strategies, which lend much of their capital as mezzanine and finance the improvement of properties, have also come down. Many funds that targeted 12 percent-plus three to five years ago are unlikely to target much above 10 percent these days.
This decline in returns has led to some tough conversations with limited partners, admit fund managers. Shayle of UBS recalls the “watershed moment” of 2015, when greater competition and lower interest rates pushed down achievable returns abruptly, sometimes wrongfooting managers who had been seeking higher returns.
“In a low-interest-rate environment it’s very hard to make the same returns, unless you move up the risk curve,” Shayle says. Reluctant to do this, many fund managers were forced, as Shayle puts it, “to re-engage with investors and say: ‘Terribly sorry, the target’s wrong, we need to adjust it’.” This did not happen to UBS, however. He says he is aware of one or two instances when managers may have asked limited partners if they wanted their commitments back if they were not happy with the returns being achieved.
However, Shayle knows of no cases in which he can say with certainty that limited partners cancelled their commitments. This chimes with what both placement agents and fund managers say about the attitude of limited partners, though limited partners are reluctant to give their views on returns and other matters – Real Estate Capital contacted several, but none were available for comment.
Returns at their peak – with an absolute peak, say fund managers, in about 2010 – could never be sustained for the given level of risk, say agents and managers. “In the early days, you could make double-digit equity-like returns, but by providing loans,” says Anne Gales (pictured), co-founder of Threadmark, a placement agent specialising in real asset funds, in London. “These returns were outsized.”
Informed by this perspective, European limited partners have not stayed away or left just because returns have fallen. Even outside Europe, investors from some countries, notably the US, China and Korea, have stayed away or reduced exposure, but they have been more than replaced by other investors from outside the continent. Fund managers and other observers have, moreover, not noticed any general migration from senior debt to mezzanine. This is largely because of the high capital charges imposed by regulators for investing in mezzanine funds, and because of an aversion to risk at this late stage of the credit cycle.
But even if they have not rushed into the arms of mezzanine managers, why have investors not forsaken private real estate altogether?
This is mainly because in relative terms returns still look fine. Observers say the illiquidity premium relative to public bonds still exists, though even that has come down. One fund manager puts it at about 50bps to 70bps above equivalent corporate bonds, although Carrez of Amundi thinks it is still more than 100bps.
As he puts it: “Our clients do not just appreciate the return in the absolute; they are arbitrageurs within the fixed-income compartment. If you get around 50bps buying the bonds of BBB-rated REITS, and you can get 200bps investing in a private real estate debt fund presenting a similar risk profile [the target of Amundi’s external fund] then you are happy because you are still getting an attractive liquidity premium.”
Fund managers are, however, having to work hard to achieve even these lesser returns. Arnaud Heck, co-manager of the SELF funds, say they have managed to minimise the reduction in yield between succeeding funds through cost efficiencies, driven by operational innovations, and through operational gearing.
Another option is to seek new pastures – particularly those to the south. Investors frequently complain about low yields in Germany, for example. But Rowson of Hodes Weill, who is marketing a Spain fund for a client, draws a contrast between IRRs for value-added deals in Germany, which have fallen to 9 or 10 percent, and in Spain, where he says that IRRs of 12 to 14 percent are possible – far beyond what many value-added funds are now targeting. To achieve this, however, the fund is investing in relatively small deals of €20 million not just in Madrid, but also in the somewhat smaller cities of Valencia and Seville – and even in much smaller cities such as Vigo.
Carrez of Amundi does not put the premium for Southern European countries at quite this level, but he believes deals in Spain and Italy still offer another 50bps or so for the same level of risk, because local markets are a bit less competitive and offer a jurisdiction premium. Managers say competition from the banks remains relatively muted in both countries.
Another option is to consider investing in particular niches. Carrez thinks that hotel financings generate about 50bps of additional yield. “It pays quite well in comparison with other asset classes, and we have already done a few for our Credit Agricole Group fund,” he says. This makes sense, Carrez believes, “provided you are financing in a good location, because the asset value should be more resilient in stress scenarios, though there is more cash-flow risk and you have to be careful about how, and by whom, the hotel will be operated”.
He notes that in perpetually popular locations, such as Paris, the asset could always be sold if necessary. However, Carrez points out that a fund manager will need specific complementary expertise, which exists within Amundi.
Can expertise in niches be the way funds can differentiate themselves from each other, as the number of funds investing in Europe increases?
Single-country funds are common, and many observers say they can be attractive, though Gales of Threadmark prefers pan-European funds – she argues the investment window can change quickly, so to achieve the best risk-adjusted returns, it is good to have a wider investment mandate. However, it is hard to find anyone who sings the praises of funds that focus on a specific niche to the exclusion of other opportunities – though this may be because the managers of these funds are publicity-shy. This reflects the opportunistic nature of funds, which are ready to listen to all-comers even if they do not ultimately invest.
Carrez of Amundi says: “We can look at nearly anything for our external fund as long as it is senior debt, including alternative asset types such as healthcare and data centres.” However, “obviously we will try to do most of our financing on standard assets”.
Gales sees good investment opportunities at the moment in “transitional capital”: value-added investing that involves financing the upgrading of assets. An example she gives is improving residential units before renting them out again. For such investments, Gales notes: “Are groups still looking at high single digits? Absolutely, on a net basis. But to achieve this, they have to go quite far, and into more complex situations.”
Gales also warns against overplaying any sense that this is a highly crowded market, noting it remains less competitive than the US: “There is a big group of smaller funds, and that worries me because it is key to have scale in credit, so I don’t think they’re all going to survive.”
Andrew Macland, London-based head of European debt and portfolio manager at PGIM, one of the world’s largest managers, with AUM in debt of $90 billion, explains: “Senior debt fund managers require scale to originate and outperform because fee income as a percentage of assets under management is not as high as for other private market investments.” Or, as one fund manager puts it: “The fees have to reflect the margin, and this is a low-margin product.”
PGIM’s senior lending includes a €78 million refinancing of three residential portfolios in infill locations in Amsterdam and The Hague; its value-add funds have recently provided £48 million in funding, alongside £70 million of senior debt, for the refurbishment of an office, leisure and hotel development in central Manchester.
As for the total number of debt funds in Europe, Cyril Hoyaux, co-manager of the SELF funds, says research last year found about 35, after substantial growth over the previous two or three years; he thinks the number is still growing fast. However, they note the number is still small compared with the 350 to 400 private debt funds lending to corporates.
Both co-heads would actually like to see more funds rather than fewer. Their reasoning: the more there are, the more that real estate borrowers, and the banks that often partner debt funds, will naturally turn to debt funds’ standard loan terms. Heck concludes: “We don’t think that competition is a threat.”