The increased prominence of commercial real estate debt within investors’ strategies has provided European property debt fund managers with greater reserves of capital to deploy in loan deals. The challenge, in an increasingly competitive real estate lending market, is finding the right investment opportunities with which to meet investors’ returns expectations.
M&G Investments, the asset management arm of UK insurance group Prudential, was one of the early movers in Europe’s alternative real estate lending market in the wake of the global financial crisis. Head of real estate finance John Barakat launched the property lending business in 2008, since when the firm has invested more than £8 billion (€9.1 billion) in commercial mortgages in the UK and Europe.
The business continues to lend on behalf of its parent insurance company, as well as third-party clients, across a range of strategies, including senior, whole loan, mezzanine and development finance. In the 12 months to October 2018, the firm took in commitments of more than £650 million to its commingled strategies, in addition to £250 million to segregated mandates.
Real Estate Capital spoke to Barakat and Peter Foldvari, co-head of investments, about the challenges of raising and deploying capital for real estate debt strategies in a late-cycle market.
Real Estate Capital: In a more competitive real estate debt fundraising environment, how do managers convince prospective investors to entrust their capital to them?
John Barakat: When investors think about commercial real estate debt, they consider different criteria from other asset classes, because it can offer a very niche proposition. Investors consider a manager’s track record, their specialisation and the scale of their activities. Some investors want a broad-brush approach to property debt, while some want exposure to a niche strategy, such as mezzanine lending. The attractiveness of a manager comes down to whether they can demonstrate their capability in such markets.
More managers have entered this space in recent years, but, relative to other asset classes, there are not that many active in Europe. It is a different situation in the US, where there are at least 50 private real estate debt managers. In Europe, banks are still providing 75 percent of real estate debt.
REC: Why are more investors allocating capital to real estate debt?
Peter Foldvari: It has become a well-known asset class. Organisations such as our competitors and us have been marketing real estate debt for 10 years now, so investors are familiar with the product. Back in 2008 to 2010, the product was not well known, and investors needed to be educated and convinced.
As more investors gain exposure to private debt and real estate debt, they see it is additive to fixed-income portfolios or real estate portfolios. The increase in allocations is also due to the point we are at in the cycle; we had a large investor call us to say they wanted more exposure to European real estate but, due to the market being late-cycle, they were more comfortable with debt rather than equity. Equity does not have as much downside protection as debt, so if investors risk-adjust their expectations, returns from debt can be comparable.
JB: There are two major trends in capital flows. There is huge demand for real estate debt from developed Asian markets. Also, institutional investors, including insurance companies, have an unquenchable thirst for yield. For many insurers, the attractive regulatory capital treatment of real estate debt has led to more mortgage exposure.
REC: Is it getting more difficult to deliver the returns investors demand from real estate debt?
JB: Investors have adjusted their expectations of debt, just as they have on the equity side. Pre-crisis, every opportunity fund would have a 20 percent-plus return target, and post-crisis, there was a period where funds were achieving those returns because property valuations became distressed. But as we have got later into the cycle, equity returns have come under pressure and those aiming to deploy equity capital have revised expectations into the mid- and low-teens.
The same trend is evident in the debt space. There are multiple strategies, with a mix of target returns, depending how much risk investors are willing to take. However, even mezzanine returns have come in; a few years ago, at least a mid-teens return could be achieved, whereas the market today is in the high-single, low-double digit territory. Returns are not the same as in 2012 or 2013, but it is the same situation across all credit markets – corporate credit, asset-backed securities, leveraged loans etc.
For investors looking at real estate debt compared with fixed income, the alternative is usually investment-grade corporate bonds and senior debt offers good relative returns. For real estate-focused investors choosing between equity and debt allocations, debt allows them to bring some downside risk mitigation into their portfolios.
REC: How are lending strategies adapting to the market?
PF: For managers, writing whole loans has become more popular. Due to our multiple sources of capital, we have been able to do this for some time. Our focus has been using senior and junior capital together in transactions and it has allowed us to grow the business to the size it is today. We see a growing number of competitors offering whole loans, selling down the senior portion to banks. We can hold senior debt on behalf of our clients, including Prudential, which has been a distinguishing factor for us as we can tell borrowers we can write and hold a whole loan for its duration.
There is greater demand for development finance, which is another way to generate returns in this part of the cycle. There are also investors in need of finance for properties with a transitional element to them. That sort of lending does not suit all investors, but some are comfortable with that risk. There are European geographies which offer higher returns, as well as sectors which are slightly out of favour. Retail is a challenged sector, but we have closed retail deals this year. Such deals can be done, provided they meet lending criteria and we are comfortable with them. It is also important to note M&G has a large real estate equity business, so that gives us an added perspective on potential investments.
REC: What are the main threats to the private real estate debt market?
JB: The main threat is procyclicality and some investors taking risks they don’t understand, which will catch them out in a downturn. There is no such thing as a risk-free investment in real estate. It’s OK to take some risk – mezzanine lenders today need to take risk, which means potential loss in a downturn, but that doesn’t make you a bad manager. However, it is essential to take a long-term view on market values. Managers cannot lend to the same criteria today as in 2014, as the market has changed.
Lenders also need to consider political factors. Historically, we haven’t needed to consider political risk a major factor. But look at the UK in the past four years; we’ve had general elections, the Scottish referendum, the Brexit vote and now speculation about a change in government.
REC: How long do we have in this real estate credit cycle?
JB: In terms of investment volume, it is no secret we reached the high-point in this property cycle a couple of years ago, so we are lending with one eye on when the cycle will turn. The business of lending is not just about tracking the spot market; it’s about where you will be in the futures market as well. However, there is huge interest in the real estate debt space and it is an asset class which people are prepared to play in even when the market becomes a little rocky. We have never been a loan-to-own player, but this is a market which evolves with the cycle, and there will always be ways for debt strategies to remain relevant.
This article was sponsored by M&G Investments.