Fund study takes snapshot of evolving debt vehicles market

INREV report outlines real estate debt’s attractions as a new market to many, writes Jane Roberts

INREV’s European real estate debt fund study is its first attempt to analyse what is a new market sector for most of its fund manager and investor members. “Everybody is eager to understand the market in more detail and to benefit from it,” says report author Vitaliy Tonenchuk, INREV’s senior research and database manager.

INREV interviewed more than 23 respondents, mainly fund managers. Some of them had raised and invested capital, mainly for subordinated debt investing, such as DRC Capital, Pramerica Real Estate Investors, ICG-Longbow, LaSalle Investment Management and AXA Real Estate.

Of the seven investors or potential investors interviewed “some had invested in subordinated debt funds, some did senior lending and some were just looking”. Two wished to remain anonymous; the others were Gothaer Asset Management, a German insurer, and Dutch pension fund adviser APG, which have invested in mezzanine funds; Allianz, which has made German senior loans; and pension fund consultant Russell Investments.

The study summarises real estate debt’s attractions for investors as: better loan pricing for lenders; attractive risk-adjusted returns; protection from falls in real estate values; a fixed annual income element from a fund’s launch; and likelihood of lower capital requirements on commercial property debt for insurers and potentially pension funds.

All European debt funds are closed-ended, the study says. Most subordinated or whole- loan funds have a five-to-seven-year term, with a one- or two-year extension option. Some senior debt funds have up to 10-year fund terms. All have 24-36 month investment periods, some with an option to be extended for a further six months.

While interest rate margins have shot up,  low Libor and Euribor rates mean total senior debt costs are “comparable to pre-crisis levels”. Senior debt is cheaper in Germany and France than the UK, but for higher-risk subordinated or whole loans, pricing is similar in different countries (see table 1).

Mezzanine fund returns have dipped from the 15%-plus promised three years ago (see table 2), because senior loans have become harder to secure, making it tougher to offer only mezzanine loans.

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Penalties for prepayment

Fund managers and borrowers agree that funds should be compensated in the case  of early repayment by penalties and profit- sharing clauses, based on the remaining loan term and the borrower’s actual internal rate of return, compared to the projection at the outset. Some funds have minimum loan periods or must maintain a certain yield.

However, INREV points out that while UK legislation favours such clauses, it is more challenging to get them enforced in Germany, France and elsewhere in Europe. Debt origination mainly provides stable income returns, but for mezzanine lending there is often a capital return on exit.

All funds implement management and performance fees, the former based on invested capital, the latter paid at fund termination (see table 3). A number of funds also charge commitment fees. Senior debt fund management fees are less than half those for subordinated debt investing, reflecting the lower risk-return profile.

All the funds expect borrowers to repay loans at the end of the term, but one or two-year extensions may be agreed. In the case of default, managers said they would use specialists to manage the property; those belonging to firms with direct real estate expertise, like Henderson and M&G, pointed to their colleagues’ property experience.