During a recent discussion on fundraising in private real estate debt, one manager told us how covid had affected the dynamic between investors and those vying to be custodians of their capital: “It is taking longer to raise funds. It is more cumbersome. There is also a flight to quality among investors in terms of who they want to work with.”
However, the manager stressed covid had not dampened investor enthusiasm for real estate debt. In fact, it had bolstered it. “Investors see there are deals out there and the potential for managers to capture market positions.”
Real Estate Capital data show global real estate debt fundraising reached a peak in 2017. In 2020, the global total of around $21 billion was up from 2019’s almost $19 billion. In addition to those totals, managers also sourced confidential lending mandates from investors, captured in the individual manager figures of the Real Estate Capital Debt Fund 30 ranking.
More money is expected to flow into European property lending strategies. The latest Investor Intentions Survey, published in January by the European Association for Investors in Non-Listed Real Estate Vehicles, showed 35 percent of respondents, weighted by assets under management, intended to increase their allocation to the asset class in 2021 and 2022. No respondents planned to reduce allocations.
Steven Cowins, co-chair of law firm Greenberg Traurig’s global real estate funds practice based in London, says credit fund formation work has continued to come in. “I do not think covid alone is the driver of this activity,” he says. “Investors are looking at a market in which equity prices are heated, so they think it makes sense to invest further down the capital stack. Pension funds and insurers want stable fixed income with certainty of cashflow – so debt seems a sensible proposition.”
Levels of risk
Since Europe’s non-bank real estate lending industry emerged in the wake of the 2007-08 financial crisis, the risks and rewards it has offered have evolved. In its early years, the acute lack of finance in the market meant returns far outweighed risk. But as property markets recovered and became more liquid, returns compressed. In recent years, managers have offered investors access to strategies ranging from low-risk senior debt funds to mezzanine and preferred equity vehicles.
“People thought it was a post-credit crunch window of opportunity, but real estate debt has become a separate food group,” says Cowins. “It has continued to be driven by the effects of the financial crisis, including the regulation put on to the banks and investor demand for fixed income amid low bond yields and interest rates. It is, and will continue to be, an asset class in its own right.”
According to Cowins, the market offers investors returns of around 3-4 percent for senior lending strategies, between 5 percent and 8 percent for whole loans, and more than 8 percent for high-yield loan strategies. “Core debt and equity are similarly priced,” he says. “But core-plus equity, which would compare to whole loans, returns more like 8-10 percent. Value-add equity can be in the mid-teens.”
Heleri Hirsnik is an associate director in consultancy JLL’s funds placement division, having previously worked at capital advisory firm CAPRA Global Partners before JLL acquired it in March. She says the covid crisis has tempted some investors up the risk curve in debt strategies to capitalise on dislocation in Europe’s lending market.
“There is an opportunity now to take more risk, and it is covid-related”
Hirsnik explains that, in a bid to better understand the risk appetite of the limited partner investors it regularly worked with – which tended to seek higher-than-average yields – CAPRA surveyed 74 LPs in 2018. “These were not the type of investors to choose senior lending strategies, but investors hungry for yield, mainly looking for bond replacement strategies,” she says. “They felt the market was getting toppy and the clear winner for them was the whole loan space, which was delivering net returns of 5-7 percent, the majority derived from income.”
CAPRA noted an uptick in investor appetite for real estate debt in the second half of 2020 and so repeated its survey. “Out of the LPs that were actively investing or looking to invest in debt, more than half were interested in higher-risk, higher-yield returns, with mezzanine and preferred equity strategies popular,” Hirsnik says. “There is an opportunity now to take more risk, and it is covid-related.”
In the current environment, Hirsnik believes compelling, risk-adjusted returns can be found across sectors: from residential development to transitional office assets to student accommodation and hospitality in strong markets. “These are all themes traditional lenders have retreated from, creating an opportunity for mid-market alternative capital,” she says. “Current versus normalised net returns across the capital stack are 1-2 percent higher. This opportunity exists now but is likely to change in the coming 12-18 months when whole loans may again be the most attractive strategy for that type of investor.”
Although some investors see European real estate debt as a route to high returns, market sources say a wide profile of investors consider it a defensive strategy during a time of increased volatility in real estate equity markets. “The real estate debt fundraising market continues to be buoyant in both the US and Europe,” says James Jacobs, global head of real estate in the private capital advisory business of advisory firm Lazard. “Investors like the income component, the defensive nature of the asset class, and the predictability and visibility of the cashflows.
“An investor which wants exposure to core or core-plus real estate potentially could lose principal if it invests in equity and an event like covid results in a correction. But if they are invested in debt, they are unlikely to experience such losses. It is that defensive quality that is attracting investors.”
According to Jacobs, that caution is filtering through to a reticence among investors to allocate capital to managers that add leverage to their funds to enhance returns, particularly in the US market: “Some managers with warehousing facilities, rather than more conservative loan-on-loan financing, came unstuck in March and April 2020 when their lenders made margin calls. So, investors are more concerned about debt fund managers’ use of leverage.”
Jacobs says that whole loan funds are proving popular among risk-averse investors. “Investors can get outsized returns on whole loans of up to 60 percent LTV,” he adds.
The Real Estate Capital Debt Fund 30 shows that a handful of established managers dominate the market: $52 billion of the $71 billion raised was concentrated with the top 10 managers.
Cowins believes the debt market is mirroring the equity market, with the largest managers corralling the most capital – a trend he says is being exacerbated by the pandemic. However, he sees scope for smaller managers to gain a foothold in the European lending market, particularly by targeting niche lending strategies. He notes last year’s launch of UK residential lender Précis Capital Partners, on which Greenberg Traurig advised.
“Fundraising is never easy, even for the bigger houses, but we now see managers coming to the market with specialist debt strategies,” says Cowins. “Just as we have seen in the equity market, investors will be attracted to those with sector-specific strategies, which target hot parts of the market.”