According to a September 2020 research report, Europe’s real estate sector will need a significant injection of debt capital to meet property owners’ financing needs in the coming years.
The report, by investment manager AEW, predicted a £30 billion (€32.7 billion) refinancing gap in the UK for the 2020-23 period, as traditional lenders reduce their appetites for risk. In Germany, it added, the gap will be in the order of €54 billion, or 10.5 percent of outstanding loans.
The good news for borrowers is that asset managers are increasingly eager to take advantage of the widening lending void. Among them is Schroders. The £574 billion asset manager, headquartered in London, launched a pan-European real estate credit platform in January, designed to expand its existing property investment management functions by, to quote its announcement, “offering clients the complete range of risk and return investment throughout the real estate debt spectrum”.
To lead the strategy, the manager hired Natalie Howard, a property finance veteran who, for the past decade, has worked in the alternative lending industry for debt fund managers including DRC Capital and AgFe. Before 2010, she led real estate lending and securitisation businesses in the investment banking world.
Howard’s track record
1989-2000 Worked as a real estate loan originator for Paribas and for Charterhouse Bank from 1997
2000 Joined Morgan Stanley to launch its European CMBS business
2004-07 Led Barclays Capital’s real estate balance sheet and CMBS business
2007-09 Private equity fund manager for real estate debt at Lehman Brothers
2010 Joined UK non-bank lender AgFe to run its real estate division
2018 Became a partner at debt fund manager DRC Capital
2020 Joined Schroders as head of real estate debt in Europe
Howard was hired by Sophie van Oosterom, the former CBRE Global Investors chief, who also joined Schroders in January as global head of real estate. The two had worked together at Lehman Brothers in the late 2000s.
Howard’s task now is to add to Schroders’ real estate equity and private debt businesses, by building a dedicated pan-European property credit platform.
She believes it is eminently achievable. Howard tells Real Estate Capital that the potential size of the funding gap in Europe could be “so enormous that, even if 20 Schroders’ platforms were created, that gap would still not be filled”.
“People are simply looking for more sources of funding”
She explains that, while quietly setting up the business without yet reaching out to borrowers, €7 billion of unsolicited transactions were put in front of her team. “People are simply looking for more sources of funding,” she says. “When you look at the European market, you have over €1 trillion of real estate debt. That churns at 20 percent per annum because most of it is five-year lending. In Europe, bank lenders represent around 90 percent of the market, while in the UK and the US, they are around 60 and 40 percent, respectively. The direction of travel is almost certainly downwards: tougher regulation combined with banks’ balance sheet issues, will likely result in an increased withdrawal of banks from the market.
“The natural fillers of the funding gap are the insurance companies and pension funds. It provides them with an opportunity to access a readily and easily accessible market, where there is plenty of product, with risk-return profiles for every investment appetite.”
For all tastes
Schroders’ plan is to operate three distinct strategies: investment-grade debt for core and core-plus property, priced around 150-300 basis points, aimed towards insurance investors; stretch senior and whole loans aimed towards pension fund investors with a 6 percent return target; and a higher-yielding product targeting 10 percent returns, for private equity-type investors.
Schroders’ European real estate debt strategies
Investment-grade loans priced between 150-300bps, secured against core and core-plus property, to appeal to insurance investors
Senior loans strategy targeting 4-8 percent investment returns, focused on stretched senior and whole loans secured against value-add and transitional property, plus pre-let development loans. Strategy designed for pension fund investors
High-yield loans strategy targeting 10 percent for investors looking for higher investment returns with a focus on opportunistic/ speculative whole loans, mezzanine facilities and speculative development loans, targeted towards private equity-style investors
According to Howard, this is the optimum way for an asset manager to take full advantage of investors’ growing demand for debt. “We see a massive opportunity to feed this appetite, so we need to offer the full risk-return range to enable investors to select the most appropriate strategy for them.”
Investments will be made through an open-ended vehicle designed, explains Howard, to offer investors the greatest flexibility. “Within this structure, we can provide both commingled funds and separate accounts, for the investment-grade and senior loan strategies.”
Howard is confident the debt strategy will grow to a similar scale to some of its more established lending market competitors. “AXA entered the European lending market in 2005 and, by 2016, it had more than €10 billion in AUM just by pursuing an investment-grade strategy. Allianz have a book of around €10.6 billion. There is no reason to think Schroders’ platform should not scale up similarly.”
One chief executive of a UK-focused real estate manager, speaking off the record, says the prospect of Schroders, one of the asset management market’s biggest names, as an active European property lender does not come as a surprise in the current environment. “I think every major real estate manager wants to have this capability as it is in demand from most investors looking for lower-risk real asset strategies.
“Natalie is great. She is highly experienced and has good connections, so her hire is a good and safe choice by Schroders.”
The source adds that, although the manager has the capabilities to raise money from third-party investors, it faces the challenge of entering a very competitive space. “Schroders has a real estate sales team that can do this but will be up against some more established players in the market today, so it won’t be easy.”
The trend of asset managers with track records in real estate equity turning their focus to Europe’s real estate credit market pre-dates covid-19. In recent years, faced with increasing property prices and in anticipation of an overdue market correction, a growing number of managers have been choosing to deploy capital by lending it against properties. Brookfield, Carlyle, Corestate Capital, and Tristan Capital are among the equity-focused managers that have made similar moves into European real estate debt since the onset of the pandemic.
Howard believes Schroders’ business was launched at the perfect time, as investor interest in defensive credit strategies is growing due to the uncertainty created by covid-19. “Amid the pandemic, a lot of banks are inwardly focused and are further retrenching from the market, particularly in France, Germany and the Netherlands. We have seen a continued retrenchment of the UK banks which I think are a cycle ahead of the Europeans,” she says. “We see this funding gap opening ever wider across Europe.”
The opportunity to step in and fill the gap is even greater for big managers like Schroders, she says. “Bigger asset managers will benefit from the move of investors away from smaller managers. During crisis periods, borrowers tend to favour managers with bigger resources and capabilities, which they perceive as more secure funding sources.”
On a personal level, Howard says this influenced her decision to take on the new challenge. “After 10 years working for smaller firms, it felt like the right time to move to a bigger institution.
“There were a number of factors involved in making the move, but the biggest was the opportunity to create a business from scratch and run it based on my 30 years’ experience of creating big real estate lending franchises across Europe.”
Howard argues that real estate debt is a relatively easy sell to institutional investors. Its risk-return profile meets investors’ needs for returns in line with their liability structures and offers them the benefit of portfolio diversification.
Property debt’s relative “simplicity” is, according to her, also of appeal to institutions.
“If you are going to enter a new asset class, you want the investment to be relatively straightforward,” Howard says. “Everyone understands some element of real estate because people live in a house or flat, some have mortgages, some rent. It is not a big step to understand commercial real estate in its basic form.”
It also offers pension funds and insurance firms immediate access to a substantial number of investments, she says. “Investors do not want to allocate their capital into an asset class that is too competitive or where spreads are likely to reduce. Investors like the premium that illiquid credit or private debt provides over and above liquid credit.”
To generate the target returns, Schroders is aiming to provide facilities from €15 million to €100 million, targeting the UK and European mid-market, which, Howard argues, is underserved by lenders and is the “most interesting” part of the market.
According to Howard, there is hot competition for bigger ticket debt deals, meaning the spreads of such transactions are thinner. “The mid-market is a good place for us to play.”
One of the reasons behind the particularly acute funding shortfall this market segment suffers from is, according to Howard, that ‘small’ transactions do not move the deployment needle, despite taking a similar amount of internal resource and time to complete from lenders.
“Many lenders have relatively small teams, of five to 12 people so, for a €20 million transaction, they need to put in the same amount of work as for a €150 million deal, which leads most of them to favour the bigger ticket transactions,” she says.
However, although the mid-market is an attractive playing field, it requires lenders to have in-house origination teams to cover different jurisdictions and interact directly with local players.
According to Howard, by focusing on this market segment, the firm has the chance to take advantage of its European real estate equity expertise.
“We are currently four people working on the platform and six more will be joining between now and October,” she says. “We will have people based across our European offices, working alongside the firm’s private assets team and the real estate unit to ensure we have local knowledge.”
She adds that this size band contains a broad profile of borrowers: “Everybody loves real estate. Everybody has exposure to it. What is important to us is that we are lending to experts in the strategy they are pursuing. It is also important that they have money because if things go wrong, and the sponsor has no money, you have a problem.”
The lending strategy is relatively sector-agnostic as “it follows the equity”, according to Howard. When considering financing any property transaction, Howard explains, the manager will make its decision based on the likelihood of protecting its capital, rather than following any macroeconomic views on property sectors.
“We are not interested in the upside because that’s for the equity”
“We are not interested in the upside because that’s for the equity,” she says. “We are just focused on what’s the downside, so we have a half-glass empty, broken on the floor, type of mentality.
“This is why we don’t necessarily favour specific jurisdictions or ‘winning’ cities or sectors. We are just looking at the borrower’s strategy and the amount of debt we are comfortable to provide, while we consider if we like a particular asset in a specific location.”
No game changer
Howard says the covid crisis has led to a widening of senior loan pricing, meaning managers can source less risky deals which generate similar returns to before the pandemic. However, overall, she does not believe covid-19 will be a gamechanger for real estate.
“The industry has an unending ability to carry on irrespective of what happens to it, including stamp duty changes, changes in lease liabilities, or the trend towards shorter lease lengths,” she says. “There have been so many changes over the past 20 years, they don’t seem to affect real estate values or the industry over the long term.”
What has changed over time, she adds, is the way real estate financiers underwrite the sector. “We have been constantly amending the way we look at real estate and what we are prepared to finance. I do not feel the way the world is coming out of covid is anything more than simply another evolution of the market that we need to consider when financing it.”
Although she argues that covid-19 has not fundamentally changed underwriting assumptions, Howard says it has led the industry to increasingly focus on those sectors that are emerging stronger from the crisis, such as healthcare-related and senior living assets, “as equity moves to provide the ‘baby boomer generation’ with the properties its evolving needs demand”.
She adds: “For us it’s more about individual deals than necessarily about new trends or ideas.”
Howard says that longstanding connections in the industry also help managers to make the right deal choices. “The key to any successful real estate lending business, or equity business, is you need to look at hundreds and hundreds of transactions to select the one you want to do.”
Despite her belief that core lending principles remain valid, Howard does recognise significant change in the real estate industry since she launched her career in 1989 at the bank formerly known as Paribas, now BNP Paribas.
“There is much greater transparency, and a lot more information available,” she says. “Technology has also made a huge difference to how people use property. Overall, the real estate lending market has become more sophisticated.”
Schroders’ global real estate business
Launched in 1971
Focused on active management of core-plus real estate
£16.9 billion (€18.6 billion) of gross assets under management
Led globally by Sophie van Oosterom since January 2021
Pension funds and insurance companies represent more than 60 percent of client base
Clients can invest in real estate through open-end funds, listed REITs, specialist funds, joint ventures, separate accounts and global real estate securities
More than 220 people in the business, including over 100 in London