Investors prove slow to board the property debt bandwagon

Debt funds have won few commitments to date, but that could change soon, writes Jane Roberts

The competition to raise third-party capital to invest in real estate debt is heating up:  three initial public offerings have been launched in the last quarter of 2012, while a raft of private equity raisings for debt funds is under way. Debt is undoubtedly the focus of interest in property’s capital raising world.

Investors are keen to get on board –  apparently. At INREV’s conference in Frankfurt last month, the session on debt investing was the most popular, says research director Casper Hesp. And in INREV’s last Investor Intention’s survey, published in January 2012, real estate debt funds were investors’ and fund-of-fund managers’ most popular alternative investment mandate, with 41% saying they were likely or very likely to make an investment in 2012 or 2013.

But few have actually done so this year. The tone of INREV’s European real estate debt fund study, published last month, was more cautious. It concluded: “The idea of investing in real estate debt is still new to European investors and in the past three to four years managers have been educating investors about this part of the market, partly because real estate debt has had an image of being a high-risk investment.”

So will 2013 be the year more investors  commit to these products? And if so, who will they be? Will they want lower-return, ‘pure’ senior debt yielding 4-6% returns, or higher-return whole loans, subordinated debt, mixed debt or distressed loans?

Investors’ identities under wraps

For obvious reasons, the managers that have already raised capital for property debt are secretive about their investors in so competitive a climate.

So far, there have been few investors for senior debt strategies: M&G Investments’ and AXA REIM’s in-house clients have invested in senior mortgages from fixed- income allocations. AXA and latterly AEW Europe, which raised an initial €250m for senior debt, claim to have third-party capital.

A different category of investors, from real estate rather than fixed-income, have been the first movers into mezzanine loan vehicles, including Dutch and UK pension funds, at least one German insurer and one or two multi managers (see table).

Identifying the future fixed-income investors for senior debt is not easy. With no contacts in this sector INREV was unable to interview any for its debt fund study. It only interviewed seven investors, a couple of which have yet to invest, although it also interviewed more than 15 fund managers, some of whom have raised capital.

An informed source says that fixed-income investors will come, but it will take time. With most fixed-income portfolios yielding only about 2.25%, the prospect of investing at twice the return for similar risk is attractive, but investors have their issues.

“Your average fixed-income man has 90% of capital in liquid assets and is more of a market trader,” says one sponsor raising capital for a senior debt fund. “If he has capital in less liquid assets, it’s likely to be something like long-dated ground rents, infrastructure or social housing. If a manager asks: ‘Would you like to invest in private, illiquid debt?’ he’s likely to be slow getting round to it, especially as these products are  in fund structures, which is more difficult.”

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One trend as the market matures is that  fund managers’ strategies for investing in new loans are becoming more various and subtle than simply senior or mezzanine,  widening investors’ options, but potentially making them more complex to understand.

For example, the three debt fund flotations this quarter are all very different, apart from the fact that they all incorporate investing in senior debt and promise higher returns than the 3-5% market-rate coupons for ‘vanilla’ senior loans on prime or high-quality commercial investment property.

This implies that their strategies differ from senior loans provided by most banks and insurers and that they expect investors, retail or institutional, to view their products as essentially real estate investments.

ICG-Longbow’s Senior Secured UK Property Debt Investments (SSUP) initial public offering promises a 6% income return and an 8% internal rate of return when fully invested, based on 6.5-7.5% coupons. Starwood Capital’s IPO SEREF is targeting a 7% dividend yield and 8-9% net total return, while Cheyne Capital is unlikely to go to the market with much lower returns.

ICG-Longbow says its listed senior fund will make UK-only loans for four to six years  that are “bilateral, non-syndicated and senior, with no subordinated debt”, but will lend at loan-to-value ratios of up to 65%.

Many banks, including pfandbrief banks, cannot lend at such high LTV ratios, but insurers often will, for longer dated, large amortising loans. So for some deals, 55-65% LTV levels are now priced as junior not senior debt, so cost borrowers more.

ICG-Longbow chairman David Hunter says: “The starting point was the property market. Obviously, you need a property yield to be above a lending yield, but yields for the bulk of the UK property market are high and accommodate higher debt pricing. Most property outside London yields 7.5-8%, and if you can borrow at 7% at a 65% LTV ratio, the basic economics works.”

Safe income products are in demand

Hunter says ICG-Longbow and adviser and book builder Investec are marketing SSUP to retail investors and small institutions. “The  private wealth advisers are stuck for what to invest in,” he adds. “Government bonds have very low yields and equity teams aren’t sure what’s going on. Investec says there is demand for a safe income product and people’s eyes light up at the 6% yield.”

Starwood, on the other hand, plans to invest flexibly across the capital stack, at ‘attachment points’ of 25-70%, “across a combination of whole, senior and subordi-nated loans”. So it could offer borrowers a one-stop shop, then sell the super senior portions to fixed-income investors, keeping higher-yielding debt pieces for its investors Renshaw Bay, the new alternative asset manager that has hired bankers Jon Rickerts, Lynn Gilbert and Christian Janssen among others to its property team, has a similar strategy and has £150m from private backers in a debt fund first closing.

CBRE says the senior debt shortage has impeded some pure mezzanine investment propositions, while others have had to include stretched senior, or senior debt, when putting out mezzanine debt.

But other sources say levering higher- yielding junior or mezzanine business by making whole loans can be controversial, especially if the loan is split between different clients of the same manager. Hunter says ICG-Longbow “categorically” will not do it with SSUP and its mezzanine funds, as “we think inherently there is a conflict”.

Pramerica has also opted to source separate loans for its next private debt vehicles, one investing in core junior debt and one with a mezzanine strategy, and is avoiding senior lending altogether.