Property manager PGIM Real Estate, which operates a range of lending strategies, argues that debt is an attractive entry point to the sector for investors amid current conditions.
In a May research paper, it argued that investors in credit can take advantage of the recovery in sectors including offices, while benefitting from the range of risk profiles on offer in the debt market.
Real Estate Capital caught up with Henri Vuong, who previously worked as head of research at industry body INREV and joined PGIM last November as executive director and head of real estate debt investment research, to discuss the outlook for real estate debt.
Is the pandemic creating distressed lending opportunities in Europe?
There has been an increase in investor demand for real estate debt and, as was the case following the 2007-08 global financial crisis, it is partly driven by an expectation of distress. However, we do not anticipate a large amount of distress in the market. That is largely because of the extent of government support packages for business, globally. Also, going into the pandemic, we did not see the overleveraging evident in the run-up to 2007. It was a far more disciplined market.
There will be some distressed debt opportunities as stimulus packages are removed – in retail, which was already stressed pre-covid, and hotels, which few would have expected. But it will not be the huge wave of distress we saw after the global financial crisis, as it will depend on where the distress is and the asset class. We have seen non-performing loan portfolios trade out of Ireland – but driven more by banks exiting that market altogether, or large UK banks selling out of retail exposure where the ownership structure is fragmented. So, it is nothing like the extent seen post-GFC, and we have seen very little in continental Europe, with the exception of southern Europe.
We would expect to see more in the retail sector, particularly regional shopping centres, which one would expect to be higher-returning strategies for new lenders/buyers, reflecting the repositioning risk.
What impact has covid had on demand for debt strategies?
Investors have become increasingly interested in real estate debt because of the opportunities for non-bank lenders, driven by tighter financial regulation on banks. Covid has played a role in that it created the potential for a downturn. Pre-pandemic, we were late cycle. Investors had expected a downturn for two or three years, although they did not know what the trigger would be. Debt becomes more attractive to investors when they expect capital values to fall because it, among other things, offers downside protection. The pandemic accentuated the existing argument for debt.
How will financial regulation shape the industry?
It is playing more of a role in Europe than anywhere else in the world because banks are so dominant in the European lending market. They still hold around 90 percent of overall European real estate debt. In the UK, after 2007-08, slotting regulation led to non-bank lenders growing their market share from 9.5 percent in 2012 to almost 30 percent by 2020. We are now seeing the finalisation of Basel III regulation, which means the big banks will need to hold more capital against their assets. After the last crisis, non-bank lenders came into the market to seek high returns. This time, they will come into the lower credit risk end of the market.
One aspect of the finalisation of Basel III is that it introduces a minimum output floor, which essentially means it places a minimum floor on the required regulatory capital. Banks may need to hold more regulatory capital against certain assets. This is expected to affect lower credit risk exposures more. Therefore, the increase in bank regulatory capital will increase the cost of capital for banks, which will open a window of opportunity for non-bank lenders to lend across the spectrum of debt strategies.
Where will managers of core debt strategies deploy their capital?
When designing a core lending strategy, managers will be focused on finding stabilised income with low credit risk exposures, rather than focusing only on specific sectors or markets. However, logistics and residential do tend to feature strong, steady income, so are favoured by senior debt strategies. But, within the office sector and others, lenders will focus on individual assets that can deliver stabilised income.
How important will value-add strategies be?
Value-add strategies are important for delivering higher yield returns. For sectors that are poised for a rebound or recovery after a correction – such as offices and, more selectively, retail and hotels – debt offers an attractive entry point because it features value preservation: downside protection against further capital falls. Flexible shorter-term lending, as is common in Europe, provides opportunities to capitalise on improving market conditions. Real estate debt can provide opportunities to capture the benefits of value appreciation as assets move through their recovery cycles.
Furthermore, value-add debt strategies can provide an enhanced source of return, while also having the opportunity to manage risk. Financing properties with an asset management plan potentially mitigates exit risk, as the repositioning and subsequent improvement in rental income profile protect and enhance the value of the underlying real estate. The risk lies in the ability to underwrite the real estate on a granular basis and focusing on highly experienced borrowers. Returns can be high single- or even double-digit, and in some cases, [deals feature] structured participation in capital upside, whilst maintaining downside protection through the credit structure.