When Ares Management announced its move into the European real estate debt market in January, the explanation for this expansion had a familiar ring to it. The Los Angeles-based manager referred to a “natural evolution” of its equity investing here, as well as its long track record in US real estate debt.

This shift into European debt has been a well-rehearsed diversification play for at least a decade. But the disruption created by covid-19 has made traditional sources of finance harder to secure, resulting in greater opportunity, visibility, and relevance for alternative lenders generally, and for US players in particular.

Ares is just the latest in a series of US-headquartered managers to launch European property lending strategies over the past two years. Others include Invesco, AllianceBernstein, BlackRock and KKR.

Over the same period, other investment managers with an established presence in European real estate debt, notably Kennedy Wilson and Allianz Real Estate, have increased their activities significantly.

Last year, Allianz Real Estate delivered €2.2 billion in new real estate loan production across 12 European countries, the firm’s highest annual volume in Europe to date. Roland Fuchs, head of European real estate finance at Allianz Real Estate, expects continued demand in 2022, and not just for his firm. “We are doing almost 100 percent of our deals by direct lending and club deals. We hardly take any secondary positions, but we are not an exception anymore,” he says. “I would say 10 years ago, the market share of alternative lenders in Europe was 10 to 15 percent. Today, it would represent, my best guess, between 25 and 50 percent.”

With California-based manager PIMCO assuming oversight of Allianz Real Estate in 2020, Fuchs is well positioned to comment on the US perspective on Europe’s changing debt landscape. “You can still achieve spreads over benchmarks ranging between 150 and 250 basis points,” he says. “This is a very large number compared to US standards, where markets tend to be much more industrialised, much more broker-based, and spreads over benchmarks are traditionally much tighter than they are in Europe. But you need to be operationally present locally to grab the opportunity and get those attractive returns.”

Russia’s invasion of Ukraine has changed the geopolitical and economic backdrop, ramping up high inflation, keeping base rates on a rising trajectory, and stoking fears of stagflation in Europe. The question remains as to whether the economic fallout from Ukraine will dampen investor sentiment. Not so far, say market participants.

A compelling opportunity

According to consultancy JLL, real estate investment volumes rose 27 percent year-on-year, to €71.3 billion, across EMEA in Q1 – the largest Q1 total on record – with cross-border activity particularly strong.

The Q1 upturn in equity investment suggests that alternative lenders still have a strong flow of transactions to finance. The banks – risk-off during the pandemic – are also growing their loan books again, says Edward Daubeney, JLL’s co-head of debt and structured finance for EMEA. Last year, JLL advised on €9.6 billion of loan production, with debt funds accounting for 30 percent, insurers 11.25 percent and banks 58.75 percent.

“The momentum with the alternative lenders is still there,” he says. “However, we have noticed in the last month, lenders who are using back leverage are finding this more expensive with political uncertainty, which means their margins have increased. But for the alternative lenders not using back leverage, I think it is a good moment to grab market share.

“There still seems to be a tremendous amount of equity investing in real estate. But those investors will be looking very closely at their returns because of rising interest rates. If you are investing in a debt product, the returns are greater because the index has risen. With the appropriate risk-adjusted returns, it is still a very compelling opportunity to be investing in real estate debt.”

“Over the next 10 years, the leasing transformation needs of all real estate segments will be strongly covered by alternative lenders”

Roland Fuchs
Allianz Real Estate

This impact on returns has been borne out at London-based Starz Real Estate. In February, the pan-European debt platform secured funding from a Middle Eastern sovereign wealth fund with which it aims to originate €900 million of property loans over two years. Starz set loan pricing at 3.75 percent and target returns of 10 to 12 percent.

“Actually, they are slightly higher because interest rates have started to creep up,” says Starz chief executive David Arzi. “The spreads on the loans are more or less the same, but the all-in returns have gotten higher. As SONIA [the Sterling Overnight Index Average] has gone up, we have picked up that additional interest income.”

As Arzi points out, interest rates typically fall during times of financial stress. This time, however, central banks are all indicating higher rates. “That bodes well for credit,” he says.

Although he acknowledges that the Ukraine crisis has added “tremendous volatility” to all investment markets, Arzi argues: “In the credit space, we are pretty well protected just because of our loan-to-value cut-offs. But on the equity side, we have not really seen a big pricing change as a result of Ukraine, so equity is getting a little squeezed. And I think on a relative basis, debt is looking a little more attractive than equity today, especially if we are going to be in a much higher interest rate environment. We naturally write floating-rate loans, so our investors get the benefit of the rising yields.”

Against such competitive returns and limited downside, debt accounted for more than 34 percent of total global capital raised during the first quarter of 2022, according to affiliate title PERE’s latest fundraising report. It is easily the largest percentage for real estate debt over the past 12 years, and ahead of other investment strategies such as opportunistic and value-add investment.

A transformative role

Arzi suggests that there is still “a fair amount of room for alternative lenders” in Europe, especially for the US players to achieve higher yields than they would at home. “The difference between the States and Europe is each jurisdiction requires its own structuring from a tax and legal perspective, so there is a lot more friction and inefficiencies in making loans here.”

According to Fuchs at Allianz Real Estate, debt will continue to be an “attractive complementary product” in Europe for asset managers, including many US players, not least because “the nominal returns are back almost at the same level as prime equity returns”. But he believes there is a bigger draw that revolves around the ESG agenda as well as the “transformation needs and opportunities” in sectors such as retail, which the pandemic disrupted.

“You can expect that over the next 10 years, the leasing transformation needs of all real estate segments will be strongly covered by alternative lenders,” Fuchs says. “The banks will always have a decent stake in this market going forward, but many real estate asset management firms getting exposure to debt will benefit from this tremendous opportunity in the transformation part of real estate.”