DWS: Junior lending will offer attractive risk-adjusted returns during the recovery phase

The Frankfurt-based manager says more caution among banks during the pandemic has created opportunities for subordinated lenders.

As large parts of the European real estate market start to recover in the next six to 12 months, risks will also start diminishing, making the case for junior lending particularly attractive, asset manager DWS said in a research report.

DWS’s latest European Real Estate Debt Strategic Outlook explored the opportunities for investors across European property markets. According to the report, it is at this point in the cycle, when a recovery phase is looming, that junior debt can perform well on a risk-adjusted basis.

A rise in junior lending margins since the onset of the pandemic, combined with improving real estate market conditions are, according to Simon Wallace, the global co-head of alternatives research and strategy at DWS, the two main reasons behind the firm’s positive outlook for subordinate lending.

“Since the start of the pandemic, junior lending margins have risen sharply but they are only one part of the equation, and not enough to justify increasing exposure to this part of the market,” he told affiliate publication Real Estate Capital.

“At this end of the capital stack, real estate fundamentals are of utmost importance. And while risks certainly remain, we are encouraged by signs of recovery across European real estate – whether it be economic reopening, higher levels of rent collection or the return of capital growth, market conditions are improving.”

Wallace added that, although these improving market conditions should not diminish the importance of fully understanding the underlying real estate and the quality of its income, they should allow “experienced real estate lenders to achieve an attractive risk-adjusted return from junior debt”.

According to the report, while junior margins were reported to have risen by around 25 basis points for logistics, 50bps for offices and 75bps for retail during 2020 in the UK, returns also appear to have increased in Germany, with a majority of mezzanine lenders achieving returns in the 10-12 percent range, up from 9-11 percent in the previous year.

Logistics, followed by offices, are the property sectors DWS predicts will offer the best junior lending opportunities on a risk-adjusted basis. The report added that retail carries too much risk in many cases. Country wise, offices in the Benelux region present, according to the report, good risk-adjusted opportunities, as they benefit from positive long-term occupancy trends and relatively stable values.

The report added that more caution among banks during the pandemic has created opportunities for subordinated lenders. In Germany, it said, the number of lenders offering mezzanine finance increased by 9 percent last year to reach 155, and those surveyed provided a total of €6.9 billion of mezzanine finance, up by almost 20 percent year-on-year.

But even here, the paper noted, lenders are being more selective on what type of property they will lend against. While almost all subordinated lenders in Germany continue to offer mezzanine for offices and residential properties, retail and smaller niche sectors saw notable falls in the number of willing debt providers.

Frankfurt-based DWS operates a real estate lending strategy itself, though which it provides finance including junior loans in European markets. It was ranked 26th in the 2021 Real Estate Capital Debt Fund 30, having raised €754 million of investor capital in the previous five years for its European lending strategy.

This article first appeared in affiliate publication Real Estate Capital