Barings: Shortage of debt-on-debt finance may hinder credit funds’ performance

Debt fund lenders may need to lower their return expectations as banks become reluctant to provide funding lines, warns the real estate manager.

Real estate debt fund managers may struggle to source debt-on-debt funding lines from banks due to the covid-19 crisis, making it difficult for them to hit their return targets, warns real estate manager Barings.

In a research note, the company’s head of European real estate research, Paul Stewart, said debt funds may begin to target purely unlevered returns of 4-5 percent in core-plus and value-add lending strategies due to difficulties sourcing such facilities.

Speaking to PDI‘s sister title Real Estate Capital, Sam Mellor, Barings’ head of European origination – structured real estate investments, said the current crisis has forced banks to reconsider their appetite for real estate lending, leading some to pull back from providing credit facilities to non-bank lenders.

Sam Mellor

Mellor explained that the issue is more acute in the US market than in Europe, were fewer debt fund managers leverage their funds. He added that whole loan lenders, rather than those alternative lenders with lower-yielding debt strategies, are most likely to be affected.

“Debt-on-debt is far more prevalent in the US,” he said. “You have insurance companies who are doing lower loan-to-value ratios and lower yielding debt, but these would be unaffected as they are typically unlevered. This is more about those who are perhaps looking to issue whole loans and selling off the senior piece or alternatively doing whole loans and putting leverage on them. For lenders who rely on this, it means their returns are lower.”

Mellor added: “Lenders either need to adjust their return expectations or they need to do less lending – or do both. It’s harder to adjust the returns if you have already raised money with a higher return target.”

Banks pull-back

More generally, Mellor noted a pull-back from banks in real estate financing since the covid-19 crisis began.

“There was a big liquidity crunch in March and lots of banks were drawn on corporate revolving credit facilities, resulting in constrained liquidity,” Mellor said. “At the same time, their funding costs were going up. This combined with concerns about loss provisioning has affected banks’ appetite to lend to the sector.”

In its report, Barings, which lends on behalf of US insurer MassMutual, noted that banks’ reduced appetite for real estate may create opportunities for non-bank lenders to buy debt from them. It said that as investment banks’ usual option of securitising or syndicating loans remains closed off, opportunities may exist to buy loans at attractive prices from banks “looking to unload risk”.

The company also said that real estate investment trusts trading at big discounts will likely become cash-starved and struggle to refinance their capital, resulting in potential opportunities for debt funds to provide fresh finance at high single-digit returns.

“Debt funds may be interested in providing finance for opportunities for REITs that are being taken private,” added Mellor. He pointed to US alternative investment manager Apollo Global Management’s May acquisition of UK-focused logistics REIT Atlantic Leaf for £152 million (€170.4 million), as an example of such take-privates.

Debt will remain difficult and more expensive to source well into 2021, according to the Barings report, partly due to competing demand for bank capital for general corporate lending. As a result, debt costs have risen for both core properties, in which Mellor has seen a widening of around 25-50 basis points, and at least 100bps for the more transitional assets.