For real estate investors seeking secure returns, private debt is an increasingly inviting strategy given the current environment which is marked by low returns from fixed-income investments, high prices for equity investments that may appear risky and political uncertainty in many regions.
“The sector is becoming more mainstream than it was five to seven years ago. Commercial real estate debt used to be more of a niche play and now an allocation is becoming part of institutional investors’ fundamental line up,” says Jack Gay, TH Real Estate’s global head of debt. Gay has dubbed debt the real estate investment industry’s ‘superfood.’ “It may not be as appetising as equity, but it’s really good for your portfolios.”
Gay talks about the factors that make debt appealing, specific routes to investment and the regional dynamics and regulatory environment in both the US and Europe.
What has caused the increase in investor interest in and allocation to commercial real estate debt?
JG: Real estate equity markets are currently experiencing significant volatility, elevated valuations and heightened uncertainty; moreover, a ‘lower for longer’ interest rate environment is leading investors to seek income ahead of capital returns. In this situation, the investment attributes of CRE debt are becoming increasingly sought after; offering stability, diversification and contracted income. In addition, CRE debt presents very competitive relative value compared with fixed income and direct real estate.
What market conditions are at play, both globally and regionally?
JG: In the US, real estate market conditions remain well balanced and economic growth is expected to strengthen over the next several years, but the business cycle and real estate cycle are mature and the Federal Reserve is expected to continue to gradually raise interest rates. This transitional period creates risk and opportunities for commercial real estate lenders, as stronger economic growth implies stronger demand for all types of real estate but with associated cycle risk. An understanding of real estate market dynamics, supply/demand fundamentals and associated risks combined with the skills and long-term perspective to effectively underwrite, structure and price risk are essential in identifying attractive relative value.
In the UK and Europe, in the context of retrenching traditional lenders and the persistent narrow focus on prime assets, we feel opportunity can be found in ‘off the radar’ assets, particularly core-plus assets in established markets. Assuming robust underwriting, these under-served markets present the most appealing opportunity for selective ‘cherry-picking’ of transactions with strong fundamentals and return characteristics.
What specific routes to investment are available to investors wanting to access real estate via the debt part of the capital stack?
JG: Many large investors opt for separate accounts. Typically, an investor might give a manager $100 million to $200 million with a very specific focus on each strategy. They might say, ‘I need to clear 3.5 percent in long-dated fixed rate mortgages,’ or, ‘I want a mezzanine strategy that will clear 5 to 6 percent.’ The manager might then match that capital with its own capital or other separate account capital in a proportion that makes sense for them. Large, scaled managers have plenty of appetite for that.
As for debt funds, investors have choices about the kind of return profile they want to adopt via two primary approaches that US managers have taken. One is a closed-ended structure with higher potential returns often driven by loans in the mezzanine space and meaningful leverage incorporated into the fund vehicle. Another is an open-ended structure with a core profile and potential returns in the mid-single digits. Managers offering a lower yielding, open-ended, core strategy are increasingly inclined to add a blend of other loan types, typically transitional loans and some subordinated debt, to provide investors with enhanced potential returns of 6 to 8 percent.
The UK and European markets have fewer opportunities for investors in terms of products because the genesis of the alternative lending sector in the UK only happened after the financial crisis. Until that point, it was dominated by the banking sector with only a relatively small proportion available in the capital markets and from certain insurance companies. However the range of debt fund vehicles on offer is expanding rapidly and generally becoming more sophisticated. There is a full spectrum of products in the market, and some of the more recent funds such as ours have been hybrid-type strategies.
Whichever way an investor goes, because the real estate debt market is highly competitive, relationships and contacts with industry-leading borrowers, brokers, investment bankers and potential co-lenders are needed to generate consistent transactional flow.
Many investors are comfortable with debt in the context of public investments. How does private real estate debt differ and what expertise is required?
JG: In the US, investors can place their capital in real estate debt by taking the public route via mortgage REIT investments but the correlation of the income of the REIT compared with the underlying real estate is more volatile. In general, mortgages command a premium to other fixed-income instruments. The private market is a little less efficient than the public markets, but that presents opportunities for stronger pricing. There is a higher barrier to entry to get into the mortgage space than there is to buying bonds because of the expertise and resources that you need to run a real estate debt platform. For these reasons and because the debt market is highly competitive, relationships and contacts with industry-leading borrowers, brokers, investment bankers and potential co-lenders are needed to generate consistent transactional flow.
How is the regulatory environment impacting debt instruments?
JG: Regulation aimed at preventing future banking crises has impacted banks’ ability to lend, creating opportunities for alternative lenders. Basel III in Europe and Dodd-Frank in the US are two pieces of regulation introduced following the global financial crisis with the purpose of restricting the volume of riskier loans that banks are allowed to make and, as a consequence, have made higher-risk borrowing more expensive. While banks have been picking up their lending activities in the US, it has been relatively conservative, so there is a bit of a gap in the capital stack for slightly higher-leveraged loans.
In addition, Dodd-Frank regulations have disrupted another rival to debt fund lenders, the commercial mortgage-backed securities (CMBS) market in the US, by introducing a risk retention regulation that makes it less attractive to be a conduit lender which issues CMBS.
We don’t expect there to be a significant relaxation of the regulatory environment in Europe either. Long-term structural change in the non-bank lending sector in the UK and Europe is only going in one direction. The effects of Brexit on the UK regulatory environment remain to be seen, but it is likely that opportunities for alternative lenders will continue for several years. In the longer term, there will be more opportunities in the construction financing space due to banks’ restricted investment criteria. Attractive risk-adjusted returns may be available if you can get comfortable with development risk and pick managers with a real knowledge of the underlying real estate.
Recent TH Real Estate research summarises the five primary characteristics that make debt attractive:
Stability: A more secure part of the capital stack than equity, offering substantial downside and performance protection through the buffer of sponsor equity and loan structuring.
Income: Stable, income-based returns.
Relative value: Historically attractive risk-adjusted returns relative to fixed income investments and direct real estate, especially late cycle.
Diversification: A portfolio diversifier to fixed income and direct real estate investments, with compelling return and correlation attributes.
Market opportunity: Structural changes in the US real estate lending market create long-term opportunities for experienced lenders to create real estate debt portfolios with a balance of short- and long-term debt to mitigate expected increases in interest rates.
This article is sponsored by TH Real Estate. It appeared in the July/August 2017 issue of Private Debt Investor