FEATURE: Debt and the LP evolution

In the wake of a funding gap created by the retreat of traditional lenders, institutional investors are flocking to real estate debt strategies. Evelyn Lee charts the evolution of this discreet opportunity and assesses the debate over separate accounts versus funds. PERE Magazine, June 2012 issue

Take a look at the recent hires at a number of US state and large city pension funds, endowments and foundations over the past year, and a common thread begins to emerge: many of the new recruits have backgrounds in commercial real estate debt. Judging by the recent investment activities of many limited partners, that’s no coincidence.

“More and more investors are interested in investing in debt,” says Jack Taylor, head of the global real estate finance group at Prudential Real Estate Investors (PREI), the New Jersey-based real estate investment management business of Prudential Financial.  “Institutions that as recently as 18 months ago thought they would never invest in a debt strategy now are seeking it out.” 

Investors have become increasingly interested in real estate debt for a multitude of reasons. “In the wake of the financial crisis, a lot of people had issues with their equity real estate portfolios or their real estate securities portfolios and realised they needed more income than perhaps they might have been seeing out of their current basis,” says Robert Little, chief investment officer at Cornerstone Real Estate Advisers, a Hartford, Connecticut-based real estate fund manager. He adds that, given the relatively low cap rates on core real estate equity, current income becomes quite important.

In addition, wider than average spreads, along with fairly tight underwriting criteria, have been attractive to institutional investors, points out Jay Mantz, president of Rialto Capital Management, a Miami-based real estate investment and management company. “You also have to layer in the fact that interest rates are and continue to be at an extraordinarily low level, so I think that people are looking for yield,” he adds.

Meanwhile, an unprecedented number of real estate debt opportunities are expected to emerge globally over the next few years. The global debt funding gap is expected to reach $216 billion over the next two years, although this may partially be offset by dedicated debt funds that are expected to provide $47.5 billion globally over the next two to three years, according to property services firm DTZ. Of that, $24 billion will target the US, $7.6 billion will target Europe and $15 billion will target multiple regions.

“There is a unique situation where you have a loan maturity schedule that has never been seen before in the US,” says Mantz, who was the head of Morgan Stanley Real Estate Investing before joining Rialto in October 2011. More than $1.725 trillion in commercial mortgages are scheduled to come due between 2012 and 2016, with $362 billion expected to mature in 2012 alone, according to data provider Trepp. Moreover, nearly two-thirds of the maturities are estimated to have loan-to-value ratios in excess of 100 percent.

An alternative to core

For sure, investors are attracted to real estate debt’s higher returns relative to fixed-income investments. Debt offers “equity-like returns without the equity risk,” explains John McClelland, principal investment officer for real estate at the Los Angeles County Employees Retirement Association (LACERA). He views the $39.2 billion pension plan’s real estate debt investments as “an alternative to new core investing that I might otherwise do.”

McClelland says he finds the returns offered by senior loans, which typically have loan-to-value ratios of up to 50 percent, to be “not interesting,” since the resurgence of available capital for such debt has driven yields down to about 4 percent. Instead, he is focused on subordinate debt, including mezzanine financing, preferred equity and B-notes. This type of debt carries a higher loan-to-value of 50 percent to 75 percent, where “in exchange for a higher risk level, yields go up significantly” to 7 percent to 8 percent.
McClelland considers this type of real estate debt “my safest type of investing” because, in lieu of making a core real estate investment with a 6 percent return, he can place debt that offers a 7.5 percent return without having to take on the risk of owning an asset. On the flip side, “I’ve conceded that, if there’s appreciation in the property, I’m not getting it,” he says. “I’ve traded upside for safety because I’m getting a 7.5 percent return instead of 6 percent.”

A separate piece

While subordinate debt is the area of the real estate debt market that most commingled funds are targeting, LACERA isn’t investing in debt through a fund. When the pension plan made the decision to invest in commercial real estate debt in 2010, it decided to do so through two separate accounts. After issuing a request for proposals in September of that year, the pension plan selected Cornerstone and Quadrant Real Estate Advisors in 2011 to manage the mandates, which totalled $200 million each.

“We like to have as much control as we can over an investment strategy,” says McClelland. “Commingled funds offer the least amount of control.”

McClelland notes that LACERA is considering allocating up to $300 million in additional commitments to Cornerstone and Quadrant this year – something it’s able to do with a separate account but could not do through a fund. “I get to change investment parameters without having to get any sort of agreement from the other limited partners, and I get to add or subtract the capital allocation,” he says. Fees also are more advantageous under a real estate debt separate account, since investors don’t need to pay the promote.

Indeed, a growing number of investors are opting to invest in real estate debt through separate accounts rather than funds. “Separate account capital for US commercial real estate debt investing has increased, coming from domestic and non-US investors, with a significantly notable increase in the amount of activity from non-US investors,” says Scott Booth, a principal at The Townsend Group. While the Cleveland, Ohio-based real estate consultant counted half a dozen accounts dedicated to lending in 2006 and 2007, the firm now is aware of a dozen that are in the market, with another dozen in various stages of discussion or formation.

Meanwhile, the overall number of new commercial real estate debt funds in the market has been on the decline in the US. Townsend tracked 145 real estate debt funds during 2008 to 2009, but that number dropped to roughly 110 between 2010 and 2012.

Not for every LP

Separate accounts, however, generally only work for larger investors that can commit a substantial amount of capital to a real estate debt strategy. Regardless of an investor’s size, “if your appetite is only $100 million, maybe looking at a fund makes sense if you can achieve reasonable diversification by making investments in one or two funds,” says McClelland. Meanwhile, smaller investors that only have $50 million to invest in real estate debt can only do so through a fund.

In addition, McClelland argues that it is a lot easier and faster for a public pension fund to get money committed through a fund than it is to conduct a search and negotiate a separate account. While a separate account allows LACERA long-term exposure to real estate debt, he says: “We had to do a lot of work on the front end that you wouldn’t have to do with a fund.”

Making a commitment to a commingled fund typically could be done in as little as three months’ time – from the first meeting with the sponsor to conducting due diligence on the GP and the fund strategy to negotiating and signing an agreement with the sponsor. By contrast, setting up a separate account is easily a nine- to 12-month process.

The search and contracting process involves writing and publishing the request for proposals, waiting for respondents to prepare their proposals, receiving and vetting the responses, conducting multiple interviews with candidates, making the manager selections and then negotiating the agreement. “That takes time, particularly if there’s board or advisory committee involvement, where they have limited meetings and you have to get on people’s schedules,” McClelland says.

Cornerstone’s Little says he has seen steady demand from investors for both funds and separate accounts. In addition to managing the LACERA separate account, the firm also announced a final close in April on $315 million for its Cornerstone Enhanced Mortgage Fund. Both the fund and the separate account are investing in first mortgage debt secured by transitional properties, with about half of the capital from the two vehicles now invested or committed.

While the firm is seeing a good amount of inquiry on separate accounts, many sovereign wealth funds and other foreign investors still want to avoid the exposure that comes with making a substantial commitment via a separate account. Therefore, Little believes there will still be good demand for commingled vehicles.

More refined

LACERA and the rise of separate accounts focusing on real estate lending demonstrate the growing sophistication of investors with regard to real estate debt investments. PREI’s Taylor notes that, when the firm launched its debt platform in 2009, there was less definition in investors’ minds as to what it meant to be investing in debt funds or debt strategies. However, as a couple of years have gone by, investors are targeting different, more refined categories within debt investing, ranging from loan-to-own plays to senior loans to mezzanine debt to distressed note purchases.

In addition, as investors have become savvier about investing in real estate debt, there’s more clarity within the organisations as to who handles these investments. Previously, “debt investing in real estate was either somewhat new or totally new to many of these investors, and sometimes they were having difficulty deciding” whether such investments came out of fixed-income, real estate or another department, says Taylor.

Indeed, one reason that real estate debt funds can be complicated to track is because commitments aren’t always made through an investor’s real estate allocation. The California Public Employees’ Retirement System and the California State Teachers’ Retirement System, for example, both invest in real estate debt through their fixed-income allocations, while the Florida State Board of Administration (SBA) does so through its strategic investments asset class.

Riskier appetites

In general, there’s appetite across all the different strategies, argues Taylor. Overall, investors are now more willing to deploy capital in riskier debt strategies than they have in previous years. Two years ago, new originations largely were limited to properties that were fully leased by blue-chip tenants in major markets. Now, investors are more willing to originate or acquire debt for non-stabilised assets in second- and possibly third-tier markets.

“There’s an increasing acceptance and appetite over the past couple of years for higher-yielding investment strategies, both in terms of people seeking more yield and being a little less risk averse,” says Taylor. However, many investors are shying away from high-risk junior bond CMBS and loan-to-own strategies because of the potential turmoil associated with such investments.

Indeed, debt funds focused on new loan origination – comprising core mortgage, high-yield and mezzanine lending – have increased over the past two years, while the number of funds targeting opportunistic and distressed credit opportunities spiked between 2008 and 2009 and is now moderating, according to Townsend.

Given the lack of pressure for banks to write off troubled real estate assets, the number of potential deals for opportunistic and distressed debt funds has been “disappointing relative to high expectations,” says Townsend’s Booth, who oversees the firm’s commercial real estate debt-oriented investments. “High-yield senior as well as subordinate lending opportunities, on the other hand, continue to be prevalent, especially in the UK and Europe, due to a diminished competitive landscape in the face of strong refinancing demand.”

Diving into distress

Distressed real estate debt, however, is the main draw for some investors that are allocating capital in the debt space. “Our interest in real estate debt is primarily in distressed opportunities, where we may see attractive risk-adjusted returns due to the de-leveraging occurring in the banking system,” says Trent Webster, senior investment officer of strategic investments and private equity at Florida SBA.

The $159 billion pension plan also is pursuing opportunities in residential real estate, junior and mezzanine debt, particularly in areas of the market where capital has not been as readily available. Its real estate debt commitments included $375 million via funds and $218 million via separate accounts as of 31 March.

Florida SBA has been investing in real estate debt funds since 2008 and most recently made a $75 million commitment during the fourth quarter to Colony Capital’s Colony Distressed Credit Fund II, a commercial real estate distressed debt vehicle with $1.4 billion in aggregate commitments to the primary fund and its sidecars. At press time, that fund was more than 50 percent invested and nearing a final close.

“Banks still have a significant amount of distressed loans that they need to work out and monetise,” says Rialto’s Mantz. His firm buys troubled loans and real estate assets, as well as the B pieces of new commercial mortgage-backed securities, and has seen a steady flow of distressed deals coming from the regional and local community banks, which often have four to five times more relative exposure to real estate than the large money-centre banks.

“This is the busiest we’ve ever been in terms of deal activity,” adds Mantz. “As the banks start to recover and are generating more earnings, it has allowed them to monetise some of their distressed assets.”
Rialto’s debut fund, Rialto Real Estate Fund, closed on a total of $700 million in equity in November. The vehicle, which first began investing in November 2010, is expected to exhaust all of its capital by the second half of the year. Mantz declined to comment on the fund or future fundraising.

Debt down the road

Overall, deal flow for real estate debt funds and other strategies is expected to pick up in both the US, which is a more liquid and competitive market, and Europe, which is more constrained but less crowded in terms of lenders. “Investors are accelerating their interest both in the US and in Europe,” says Taylor, whose PREI is targeting new originations only in Europe and loan acquisitions and originations in the US. “There seems to be a broader base of investors interested in the US, but there’s a concentrated significant interest in Europe as well.”

Transaction activity in Europe has been more stop-and-go because, “in general, the market there is in fits and starts due to the greater macroeconomic uncertainty,” Taylor says. Meanwhile, US transaction volume for real estate debt has been on the upswing again after slowing near the end of the first quarter. 
As for aggregate lending volumes in the region, Taylor expects an increase of 10 percent over 2011 numbers. Lending activity “will be consistent or picking up, in conjunction with the increase in investor interest,” he adds.