Five years ago, they emerged to provide mezzanine loans. As the market has evolved, so have lenders aiming to provide high-yielding finance, writes Lauren Parr.
High-yield real estate lending has morphed several times during the five years since it took off.
Originally known in the market as ‘mezzanine lenders’, those pursuing high-yield strategies today are no longer simply topping up senior loans with subordinate strips. They are just as likely to write whole loans and then sell down the senior element to create a high-value junior debt piece that they can hold.
“A couple of things have changed,” says Dale Lattanzio, managing partner of property loan fund DRC Capital. “When we first started introducing alternative debt in the market back in 2009-10 the opportunity presented itself in the mezzanine space because banks wanted to get out of the piece that was causing them most difficulty in respect of regulatory capital. There was very little acquisition activity, most of what we did was refinancing.
“As the market moved on, borrowers sought capital to acquire assets and banks began lending again in earnest. Certain alternative lenders adapted their strategies towards business plans that required more asset management and lending risk, financing good quality core-plus and value-add properties, or repositioning transitional assets – areas of the market that banks were less keen on. We saw the opportunity to make whole loans as a one-stop solution for investors.”
Another early high-yield lender in Europe was PGIM Real Estate (formerly Pramerica). The firm has evolved how it structures deals – from mezzanine to preferred equity and senior bridge loans – and how it prices its lending, depending on the deal in front of it.
By 2015, the ‘funding gap’ thesis had become “a little long in the tooth”, according to Andrew Radkiewicz, global head of debt strategies at PGIM Real Estate. “At the same time we saw the division between high-yield lenders seeking high single digit/low teen returns by providing junior debt, preferred equity and taking property risk, and mid-single digit stretched senior/whole loan lenders, driven by investor demand. It’s easier to raise money for lower-returning strategies that investors can get their heads round, hence the start of diversification in what lenders were doing.”
There are just a fraction of managers operating in the high-yield space compared with three years ago, Radkiewicz says: “High yield seems to have got thin air now; there aren’t many around that have successfully delivered double-digit return-plus strategies.
“Investors seeking a 12 percent return from a fund are essentially seeking equity-style returns with the downside protection offered by debt structuring. This is achieved through combining mezzanine, preferred equity and senior underwriting structures across a range of property risks. Alternatively, investors seeking single digit income returns will favour whole loan strategies which blend 3-4 percent senior pricing with junior debt up to 75-80 percent LTV at 10 percent to achieve desired returns.”
Debt fund managers are taking on broader mandates with the capability to pursue more than one strategy. For instance, IGC-Longbow’s platform can provide whole loans, mezzanine, preferred equity and joint venture equity, promising investors 10 percent-plus returns. Under this programme it has invested £1.67 billion in first mortgages and £330 million in second mortgages since 2011.
Increasingly, investors consider real estate debt as another mainstream sector of the private debt market, opening up a wider investor base for fund managers. Investors seeking a stable, income-style return understand the relative reward for the risk. In addition, managers that have been active in the last five years can demonstrate their track record to investors.
Lower entry point
Macro-events affecting the wider lending market have created the conditions for high-yield lenders to hone their strategies. Creeping bank regulation, tighter restrictions on Pfandbrief lenders and the UK’s decision to leave the EU are all factors that are making traditional senior lenders more reticent.
Banks across Europe still generally have more real estate exposure than they want, meaning that liquidity is rolled back in difficult macroeconomic times. High-yield debt funds exist to fill gaps in the market, picking up slack when traditional financing retreats and moving fast when the market becomes more fluid.
“You can explain what funds are doing by looking at what banks are doing”, says Jon Rickert, investment director of GAM’s real estate finance team, which provides mezzanine and whole loans in the UK and Europe.
“During the period around the referendum lenders couldn’t get real valuations so we saw them knocking 5-10 percent off their underwriting so, in real terms, LTVs were probably even lower,” says Emma Huepfl, co-principal of debt broker Laxfield Capital.
This scenario has allowed high-yield lenders to step in at a lower entry point, some taking the opening to extend fatter loans, while charging higher margins. “There has been a step up in activity by alternative lenders,” Huepfl agrees. “They have been able to increase their relative pricing a bit above 60 percent LTV; to an even greater degree where leverage is higher.”
There was a period, pre-referendum, where returns had tightened significantly, typically on larger pre-packaged deals or those intermediated by third parties, in part driven by more awareness about cost of capital and due to more liquidity in the market. They have since stabilised at around 7 percent for mezzanine of up to 75 percent secured against reasonably
TH Real Estate’s head of debt, Christian Janssen, attributes this to “the triangulation of uncertainty in the system because of Brexit, the fact senior lending is wider, and property cap rates being slightly weaker”.
Higher coupons have become attainable since last year, explains Radkiewicz: “There were far lower transaction levels in Europe and people that decided not to sell had to refinance and were met with more conservative senior debt amounts at cheaper rates because the underlying swap rate had dropped. The mezzanine-style market can extract returns primarily out of coupons of 7-9 percent so it goes back into 10-12 percent territory of which there are fewer providers around.”
Some, including GAM, have become more inclined to co-lend in partnership with banks since the Brexit vote, as well as underwriting whole loans with a view to offloading part of the debt.
“Banks are taking a risk-off stance which means they are being careful about buying syndicated positions,” says Rickert. “There are still opportunities out there; it’s just less efficient because banks have marginally less risk appetite.”
However, some say that while banks are less fussed on origination, focussing instead on their relationship clients, there is an opportunity for agile funds to finance acquisitions and bring banks into deals later.
“The size might be too big for a bank, closing timetable too short, or an asset might be too operationally intensive at that point in time. The relationships we have fostered with various senior market players over time enables us to take medium-term financing risk,” explains Michael Zerda, managing director and head of Europe at Blackstone Real Estate Debt Strategies.
Expanding relationship base
Given the diverse mix of lenders in the senior debt space there remains an opportunity to team up with newer market participants like insurance companies.
GAM’s recent collaboration with a senior loan fund on a £130 million financing deal “worked very efficiently” as both parties could make decisions relatively quickly, Rickert says. The uncertainty in the market is a positive factor for high-yield lenders, as they capitalise on jittery banks’ reduced lending activity.
However, GAM’s Rickets admits that high-yield debt fund lenders also have to carefully assess risk. “Investment managers generally invest their own cash alongside investors in the funds they manage; that alignment provides a very different perspective on risk. The shifting geopolitical landscape and trade implications are what I’m thinking a lot about lately,” he says.
High-yield lending strategies may have changed but their rationale has not. “There remains a place for alternative capital to help borrowers solve problems; be they structural, issues relating to the underlying property or speed of execution. There are still attractive terms available,” adds Lattanzio.
Residential development offers attractive returns
One sector in particular to benefit from price widening caused by market destabilisation is UK development.
DRC’s Lattanzio notes increased lender interest in financing residential property: “Returns are available because there has been a significant lack of capital for anything but the best schemes.”
The likes of LaSalle Investment Management and ICG-Longbow have targeted UK residential development. ICG-Longbow recently made its first central London investment as part of a residential development programme launched 18 months ago, financing a development project with a £135 million loan. Total residential commitments for the programme now stand at £268 million.
“There’s a bit of a residential shake-up going on in central London; everything has realigned to lower sales prices and you can price capital to reflect the risks. It’s a good time to be investing when other people have challenging baggage. This was a realistic deal with a good sponsor and we got our fair share of the pie,” explains ICG-Longbow co-founder
Another trend has been interest in operational businesses such as the fledgling private rented sector.
“High-yield funds need multiple as well as internal rate of return, which is difficult to achieve through development deals alone,” says PGIM Real Estate’s Andrew Radkiewicz. His firm’s strategy is to “allow people to build core portfolios that institutional investors want” by issuing funding to deliver, hold and operate stock.
Lenders are attracted to the sector’s supply/demand dynamic as well as the global institutions developing the assets. However, obstacles include finding projects with the right scale and the fact that lending margins historically have been tight which has made it tough for high-yield lenders to compete.
“High-yielding whole loans are just about as expensive as equity so it’s not something borrowers can easily take,” says GAM’s Jon Rickert.
Development is a specialist’s game, he adds: “You can get good returns but it’s a very labour intensive activity and it doesn’t really generate cash yield.”