This article is sponsored by PIMCO.
PIMCO was one of the earliest alternative investors in the private real estate debt space, setting up its private and alternatives platform over a decade ago. More recently, it has established a direct, primary loan origination platform, and in 2020 PIMCO assumed oversight of Allianz Real Estate (recently rebranded as PIMCO Prime Real Estate) to become one of the world’s largest real estate investors. PIMCO’s real estate team consists of over 300 dedicated investment professionals across 19 countries, with $195 billion of assets under management, including $17.1 billion of European debt.
Roman Kogan was recruited by PIMCO in 2020 to lead a standalone European unit dealing with everything from deal origination to execution. “What really makes us different,” Kogan explains, “is the diversity of our capital. We invest on behalf of a wide array of strategies with return targets ranging from core-plus all the way to highly opportunistic. With the addition of PIMCO Prime into our broader organisation, PIMCO as a group has added unparalleled capabilities and expertise in the core space. We believe this unique offering allows us to provide a broader set of financing solutions to the market and offers us the freedom to be more selective with the investments we make.”
Whereas traditional debt funds may typically achieve their target returns through taking some form of repo leverage, PIMCO’s more recent strategies operate on an unleveraged basis. Kogan adds: “Our unlevered strategies have been well received by the market. Our ability to hold large positions, without the need to syndicate or introduce a back leverage provider increases execution certainty, and mitigates borrowers concerns around other lenders coming into a bilateral relationship.”
Alongside the growth of the alternative lending market, Kogan elaborates on the tension between banks and private debt funds and the opportunities provided by transitional lending.
Why do you believe there will be growth in alternative lending?
There are ongoing secular trends that are creating a long-term imbalance between supply and demand in the debt market.
On the demand side, there is a growing need to upgrade or develop certain types of real estate. This is most notable in the office sector, as in the post-covid environment occupiers have reassessed how much and what type of office space they require. But even outside of the office market, Europe is grappling with a structural undersupply of affordable rental housing as well as a shortage of the logistics space needed to support the ballooning growth in e-commerce. To satisfy all these needs requires a significant amount of debt capital.
Historically, European lending was dominated by banks, which just several years ago would have provided approximately 95 percent of debt in the market compared to just 50 percent in the US (estimates point to bank lending accounting for 70-80 percent of the European market today).
However, as regulatory momentum is moving towards standardised methods for calculating bank capital reserve requirements – and thus reducing many of the benefits European banks gained from internal models – it is expected that commercial real estate lending will become less economically attractive for the traditional bank lending model. This will put pressure on banks to reduce their risk appetite for all types of lending, especially on transitional risk profiles.
What makes the transitional lending space so attractive?
Two characteristics stand out. Firstly, transitional lending can offer lenders the opportunity to take exposure on a property at an early stage in its revaluation. The property may be empty or about to be empty and thus you are taking execution risk on your borrower and market risk on the property, but you are investing in the asset at a crucial inflection point where fresh capital is coming in to fund improvements and create value, thus creating a natural deleveraging of the debt exposure.
Whereas an investment loan on a fully occupied property may not have the same sort of execution and market risks, I would argue that this type of lending can itself be high risk, particularly in the current market with significant macroeconomic disruption and worrying secular headwinds. Income will get shorter as the asset base becomes increasingly out of date.
Secondly, transitional lending offers an attractive alignment of interests for a lender. Our debt comes in alongside fresh borrower equity. That equity not only supports the acquisition, but the borrower will guarantee that further equity is invested to improve or develop the collateral. Most importantly, the borrower will not see any of that equity redistributed to them until the business plan is realised and the debt exposure is significantly de-risked.
Can you give us any examples that prove the effectiveness of transitional lending?
We recently completed a transaction that involved the refinancing of a construction loan along with the provision of further debt capital to fund the development of an additional asset. This deal was in the multifamily sector within the UK, and the financing structure offered the sponsor time to lease up the standing assets and of course execute the construction of the remaining property. The sponsor not only had significant equity still at risk in the project, but invested additional equity to fund the development.
We’re currently also working on another project that involves the construction of a prime logistics facility located next to an airport in one of Europe’s major gateway markets. Interestingly, the design and development of the asset benefits from the latest technology which will significantly reduce its carbon footprint. We believe the strength of the sponsorship, the alignment of interest and the quality of the property greatly mitigates the risk of the transaction and offers our investors very attractive returns.
What is your sector strategy in this challenging economic climate?
It is important to be realistic towards the current circumstances. We are operating in challenging economic environment, moving from an extended period of zero – or even negative – interest rates, to one in which rates have risen 300-400 basis points in the span of 12-18 months. Obviously, real estate valuations are correlated to both interest rates and broader macro sentiment, so it is unsurprising that there have been significant market adjustments.
However, we are a lender and as with any lender, our first priority is downside protection. We therefore need to separate the normal valuation cycle, for which a lender can structure protections, from secular trends which may result in obsolescence – the latter being permanent and must be avoided.
We are focusing on sectors where we see long-term secular fundamentals that support the ideal combination of strong demand and limited supply. This is currently the situation in the following sectors: logistics, multifamily residential, student housing, prime Grade A offices in major gateway central business districts, and life sciences. We also are seeing good performance in our hospitality portfolio, where we expect operating performance to return to pre-pandemic levels well ahead of plan.
Which sectors are you avoiding in the current market conditions?
As I mentioned previously, valuation is cyclical, but obsolescence is permanent. And in real estate undoubtedly the area of our market that is experiencing a heightened degree of obsolescence risk is the office market. This is particularly notable for older secondary quality stock in secondary locations, and we certainly have no strategic plans to increase exposure in this area.
It is important to note, however, that the entire office market should not be painted with the same broad brush. Yes, the evidence does point to offices suffering from a significant reduction in demand as occupiers conclude they require less office space in the post-covid, hybrid work environment.
However, the evidence also points to occupiers assessing that such reduced office footprint be in the best-quality, best-located buildings, and they are rather insensitive to how much this may cost. They view their office space as a retention tool, a recruitment tool and a medium through which they can advertise their brand – an office has essentially become an extension of a company’s values as an organisation.
This is leading to rising rents for prime, Grade A, environmentally-sustainable buildings in major gateway market CBDs, most notably London’s West End.
As a lender, how are you mitigating risk in the transactions you undertake?
It is certainly an environment where caution and selectivity are key. We want to focus on asset classes that have strong long-term fundamentals, lending with considerable downside cushion to our basis, and with loan structures that offer lenders protections against underperformance. We also tend to focus on larger loans, as we feel these are typically secured on better-quality properties, and are typically backed by larger sponsors who not only have more meaningful absolute quantities of equity at risk, but also the financial means to provide further capital into an investment should the business plan be delayed.
I also think our diversified capital, with a broad spectrum of return targets, does help mitigate certain downside risk. We are not beholden to one particular strategy that has a specific geographic scope or return hurdle. Such restrictions can lead to an imprudent chase for higher yields or higher volumes. The fact that we have this flexibility gives us the opportunity to pursue a wide variety of profiles. A lot of it does fall in to the delayed draw transitional loans, but we probably do an equal amount of fully funded investment loans that provide balance to our portfolio and enables us to more efficiently deploy our investors’ capital.
How do you factor ESG requirements into your thinking?
It’s right up there as one of the primary factors we consider for any investment. Five years ago, you would get an information memorandum from a sponsor with a cover page, a table of contents and an executive summary. Then it would dive into the details of the opportunity and, finally, buried somewhere near the appendices was a page on ESG credentials. Today, the ESG strategy and business plan is often front and centre and is a fundamental part of underwriting.
ESG will continue to be an important input into real estate investment. Certain strategies invest in assets that meet future ESG requirements and the prospective raised EPC ratings, or which have a business plan in place to reach these higher and more sustainable levels of energy efficiency.