Real estate has proved an enduring investment success story at a time of low global interest rates and bond yields, but as the narrative becomes one of late-cycle risk in many Western markets, investors are increasingly drawn to the defensive qualities of real estate debt.
Capital raised globally by private real estate debt funds reached $7.85 billion during the first three months of 2018, compared with $7.36 billion in the corresponding period last year, according to Real Estate Capital data.
The first quarter tends to be a comparatively subdued fundraising period and momentum usually builds as the year unfolds. The Q1 figures suggest 2018 could surpass the 2017 total of $27.36 billion and the 2014 peak of $27.87 billion, which was largely US-driven.
As Matilde Attolico, global head of funds advisory at Jones Lang LaSalle Corporate Finance, observes, US investors spearheaded the move into debt funds around 2010, while Asian investors – especially Korean – and Middle Eastern sovereign wealth funds have been big players.
But she notes a marked change from 2012 in the US and from 2015 in Europe as global investors have turned to debt as a relatively low-risk play on real estate as it moves through the economic cycle in these two regions. Equally important, she says, is the emergence of European institutions.
“It took much longer for European investors to get comfortable with doing real estate debt,” says Attolico. “Now you see real estate debt funds being raised with significantly more European investors. You still see a predominance of US investors in these vehicles, but the investor bases are getting much more diversified.”
Omni Partners’ three debt funds secured against UK residential property epitomise this shift. Elissa Kluever, managing director of Omni Secured Lending, points out that the first fund, launched in 2014, was split 95 percent North American and 5 percent European.
She says that as recently as two years ago, the primary pool where Omni was fishing alongside most managers was North America, largely because “the US and Canadian LPs were much further along the learning curve” on the appeal of private real estate debt than their European counterparts. But European investors make up a third of Omni’s latest fund, which the London-based manager launched in 2016.
“That divergence between the two regions is pretty much gone,” she says. “You do have European institutions which are attracted to the space in a very big way. They accept it’s something that makes sense from a portfolio-mix perspective. It’s like Europe has caught up.”
There remains a clear distinction between US and European real estate debt funds, however. “US real estate debt funds are very attractive to non-US investors on a risk-return basis because the tax treatment of real estate debt strategies is much more favourable and therefore the gross-to-net spread is more attractive. A lot of European, Asian and Middle Eastern investors go into US debt funds because on a gross-to-net basis they are attractive – there is less leakage,” says Attolico.
“Real estate debt funds in the US and Europe are very different. The key metric for me is that very often many European investors don’t like debt on debt. They don’t want their funds to be levered, whereas US funds, by and large, adopt a leveraged strategy. US investors are still looking – even in their debt strategy – for equity-like returns.”
Attolico continues: “The return profiles are clearly coming down, and probably many unlevered funds in Europe have a 7 to 9 percent return profile. Even then, it’s more development loans and transitional assets, as opposed to Europe in 2013 when you could get much higher quality underlying real estate and still get to double-digit returns. The compromise is to go for more granular deals and ultimately a little more risk.”
That 7 to 9 percent return profile corresponds exactly to GreenOak Real Estate, which has stepped up its lending ambitions with a move into Continental Europe after raising two UK-focused debt funds, in 2014 and 2017. The €625 million GreenOak Europe Secured Lending vehicle closed last December, and Jim Blakemore, who heads the London-based credit business, says that two-thirds of the capital is already committed in loans spread across the continent.
“Nothing lasts forever but I do think that debt will continue to become more and more an accepted part of the asset allocation pie for pensions,” says Blakemore.
“We started work on the first debt fund in 2012, and it took a long time to get going. But, believe it or not, there are still a handful of pension fund consultants who have not massively endorsed real estate debt as a product. Likewise, there are some very significant pensions in Europe that don’t really have it in their asset allocation at all, which to me is shocking. So, I think you’re going to see more growth.”
Perhaps unusually for a US manager, GreenOak’s debt strategy is solely directed at the UK and Continental Europe; it sticks to equity investment on its home turf. Blakemore says the new fund reflects the renewed economic growth in many European markets and the fact that they are less advanced through the property cycle than the UK.
He adds: “From a pure investment point of view, there’s a lot of attraction to Europe – and part of it is the currency. There is much more liquidity in the euro and not just out of Europe but globally. Certainly for Asian investors it’s much easier for them to deal with euros than sterling. Europe is a more compelling story.”
Attractive though it is, the real estate debt story is not entirely straightforward. Omni’s Kluever concedes there are concerns that after so much fundraising last year, managers are still sitting on undeployed capital. But she insists: “I don’t think that’s going to stop the industry seeing another bumper year of asset-raising. It comes back to this perpetual theme in investment, which is the search for yield.”
Blakemore says a big talking point among his investors is the regulatory complexity around real estate lending across Continental Europe versus the transparency of even a Brexit-blighted UK. As he suggests, it underlines the importance of a manager’s track record in sourcing and deploying capital, delivering the promised returns.
“Most of the debt funds have been raised in pretty benign property markets, with six, seven years of tailwinds,” he says. “What happens as these funds mature, and markets move back and forth? That will be interesting for investors because then they will have more tools to differentiate strategies and managers. Track records will become more real as the funds mature.”
Track record is also one reason why, as Attolico points out, it is the larger fund managers attracting most of the capital – something not immediately obvious from the raw data but nonetheless, she says, an accelerating trend.
“I’m a big believer that real estate debt strategies have a place in investors’ portfolios, and at this point in the cycle make a lot of sense,” Attolico adds. “However, not all debt is made equal and I would caution investors to look at actual leverage and synthetic leverage, and at how the underlying real estate is generating returns. Ultimately, if you’re doing debt strategies you want to be as far as possible from taking equity-like risks.”