Pension funds and insurance companies are finally committing capital to vanilla senior debt in one of the most significant developments in property finance in 2013.
Tucking away billions of pounds of secured private debt, including commercial mortgages, was once the preserve of banks. But since the financial crisis, it is institutions, governed by Solvency 2 rules, not banks, that get the more beneficial capital treatment for holding secured loans.
Add to that big investors’ search for higher-yielding but low-risk alternatives to supplement fixed-income portfolios, plus the chance to step into the shoes of banks that now do less senior lending, and there is clearly a case for investing.
But while the opportunity was recognised three or four years ago, action has been a long time coming. It is new ground for most of these investors; even US insurance giants like Prudential and MassMutual, which set up businesses in London last year, are new to the European lending market.
Property debt is illiquid compared to the corporate bonds that make up most of institutions’ fixed-income portfolios; few of the managers competing to advise this new capital have a track record in this field; and many would-be new lenders need to invest via fund structures, which can be complicated to set up.
AXA REIM, which has invested about €7bn in European senior loans, was the first mover, followed by M&G Investments. European insurance giant Allianz started investing in senior debt last year. But one experienced sponsor who has raised capital for a senior debt fund says the pace really picked up “from around May this year, with mandates being awarded and more in the wings.”
These included third-party commitments such as Friends Life’s to Prudential Financial’s European subsidiary Pricoa Mortgage Capital; Guardian Financial Services’ to new debt investment manager Renshaw Bay; and the Norwegian sovereign wealth fund’s mandate to AXA Real Estate.
Since the summer, in-house clients have made allocations too, among them Standard Life Assurance to Standard Life Investments, and the BT Pension Fund to Hermes REIM. Aviva, a long-maturity, fixed-rate property lender for 29 years from annuity funding, launched a shorter-term, floating rate senior lending product for internal and external investors (see table).
“Institutions have a lot of requirements, unlike retail investors who are not so fussy,” says the senior debt fund sponsor of the time it has taken and the requests for proposals and subsequent selection process. “Some small managers couldn’t deliver what big investors want. You get an incredible range of questions on your policies and how you monitor compliance, and third-party managers must have proper risk manage-ment, with separate investment committees.”
Investors also question managers’ origination capability – “they are going into an illiquid asset and don’t want to wait two years before their money is invested” – and whether the team has a track record of performance. “They want to know if you’ve invested in a bunch of loans before and did they all repay.” Some also want to co-invest alongside manager capital to access the widest pool of deals and align their interests.
For investment managers, this business needs scale to be profitable, as management fees are low, commensurate with relatively low returns to investors of 4-6%.
Falling margins put pressure on returns
One key question is whether even these returns will be under pressure, because senior lending margins have fallen this year and are likely to come under further pressure in the next 12 months. Neil Odom-Haslett, head of commercial real estate lending at Standard Life Invest-ments, says some investors may go up the risk curve, “which is fine, where they have excellent teams who can manage that”.
Margins have fallen below 200bps for low leverage on the best buildings and sponsors in central London, but are higher elsewhere. For shopping centres in good regional towns, for example, they are at least 300bps.
“We are looking to build a balanced portfolio lending on a floating rate basis at Libor plus 250-350bps,” says Ben Sander-son, director of international investment at Hermes Real Estate Investment Manage-ment. Hermes structured a senior debt fund in November, seeded with £400m of in-house capital and hired Marcus Palmer, formerly of Barclays Capital, RBS and NAMA as head of debt. “On an absolute return basis, assuming some normalisation of Libor, to 2-3%, that gives a 4-6% return.”
Palmer’s six-strong debt team sits within real estate. “We can apply our property skills with these new skills and add an edge by knowing the assets,” Sanderson says. “There’s a perception that senior lending at 60-65% LTV is easy to do, but you have to be risk- aware enough to underwrite well.”
Odom-Haslett, who joined Standard Life in August from pbb Deutsche Pfandbrief-bank, says the response to its launch “has been overwhelming”. He adds: “We have a huge direct and indirect real estate book, so we understand property. We can accommo-date holes in cashflow and understand business plans because we look at whether we’d do the same if we owned the property. We want to be competitively in the market.”
His team has one retail and one office loan at the credit committee stage. The initial £250m allocation from Standard Life Assurance’s balance sheet is likely to grow quite rapidly. Next year, he says, this will be supplemented by annuity money and a pooled vehicle of fixed-income money from investors from Europe and Asia “who like this risk profile”. Hermes is also out raising more capital, Sanderson says, and expects to invest at least £750m per year in the next 12-24 months.
More money waiting in the wings
Even more capital is waiting in the wings. Consultants bfinance, Oliver Wyman and Towers Watson have clients with senior debt requirements and in the summer, enhanced life insurer Partnership Life brought out a mandate worth around £125m. Credit specialist Agfe and TIAA Henderson Real Estate are likely to launch funds next year.
It’s hard to be definitive about the quantum of new capital, but Real Estate Capital estimates at least £3.5bn this year, based on the conservative assumption that Norges has allocated €1bn; it hasn’t announced a figure. At least four French investment managers also began investing for European senior debt this year, including Acofi/French insurer Groupama, AEW/Natixis, La Banque Postale and La Francaise.
As Sanderson says: “The senior space is where the largest, sustainable opportunities are. For us it’s a strategic, long-term decision.”