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Hunting outside London

Commercial real estate senior debt isn’t all about lending against trophy assets and in times of uncertainty. ICG-Longbow believes the best opportunities may lie further afield.

ICG-Longbow has been providing a range of loans to diverse borrowers across all sectors of the UK commercial property market since 2007. Here, we catch up with Martin Wheeler, co-head of ICG-Longbow, and David Mortimer, head of real estate senior debt, who reflect on how the UK commercial real estate debt market of today has been shaped.

With uncertainty high following the triggering of Article 50 and a snap election in the UK having been called, why would an institutional investor choose now to invest in a new asset type such as CRE senior debt?
 Investors tend to gravitate to safer investments as risks increase and real assets have always been seen as a sensible investment option at times of political or economic uncertainty. We see CRE senior debt as being the most defensive way of accessing returns from real estate, as it can provide positive returns from the coupon, even if there is a material property value (or general asset price) correction.

DM: Also, with bond yield being held low and liabilities high, the additional spread obtained from investing in CRE senior debt can prove very attractive to investors.

Could you tell us about the evolution of the UK real estate senior debt market, and the role of fund managers within it? 
 Prior to the financial crisis, real estate debt was highly concentrated among a handful of dominant bank lenders. Since 2010, banks have retrenched and sold off loan books, managed down positions, and restricted new lending. The door was open and alternative capital providers have stepped in. Roll forward to today and the breakdown is around 65 percent banks versus 35 percent private debt. Most of this new entrant capital is provided by insurance companies and pension funds – either investing directly, if they have the scale, or via managers.

MW: Ten years ago, there were no managers. Those now seen as the “tier one” managers were launched around 2010 or before and now typically offer investors multiple CRE debt strategies, while smaller, more niche entrants, have entered the market later. We see that as a healthy development, not just in offering institutional investors a greater choice in accessing the sector but the introduction of diverse capital sources also de-risks the property market as a whole.

So what are the different CRE debt strategies now on offer to investors and are they here to stay?
 In 2010, most of the debt funds were mezzanine and high yield. Over the last three to four years, funds within the real estate debt space have increasingly offered additional strategies, including development finance and a notable shift to providing quasi investment-grade senior debt with an ultra-low risk profile in the worlds of real estate investment and direct lending. While the returns are commensurately lower, they still offer a premium to traditional investment-grade fixed income.

DM: We believe the opportunity for investors now is enduring: bank retrenchment has continued and regulatory headwinds combined with tighter lending criteria have further reduced bank appetite. They are focused on servicing core clients to whom they can market other products. As we just focus on investing, we can cover a broader spectrum of experienced borrowers and talented property managers who might not fit the bank model. Traditional lenders are still there, but plenty of opportunities remain for alternative capital.

“Prior to the financial crisis, real estate debt was highly concentrated among a handful of dominant bank lenders”

What are the key features of a typical CRE senior loan? 
Loans are secured by a first legal mortgage over a single property or portfolio of properties. This gives the lender a first-ranking claim over tenant rents, which pay the interest coupon, and capital, which is repaid via a refinancing or sale typically after 5 to 10 years. Senior loans are usually in the 55-65 percent loan to value (LTV) range, well below the typical 75-80 percent LTV written prior to the financial crisis. Investor returns come from lending margins of 2.5-3.5 percent over libor, plus arrangement and exit or prepayment fees.

A broad spectrum of property assets can offer security for the loans, from traditional office and retail assets through to hotels and student accommodation. Larger trophy assets, especially in London, offer an opportunity to deploy big chunks of capital quickly, but that part of the market is heavily supplied by traditional banks and overseas lenders as well as some new entrant institutional capital.

We operate in the mid-market, typically financing multi-let properties or portfolios of smaller assets and often lending in the regions or suburban London. We like granular income from multiple tenants to dilute credit risk, and property values are generally less stretched outside the M25. That’s also a part of the market where we find there is an under-provision of debt capital, allowing for better deal flow and greater returns without taking on more risk.

Why does CRE senior debt make sense from an investor perspective? 
 For insurers, CRE debt is favourably treated under Solvency II – it can help with liability matching and adds portfolio diversity as it tends to be less correlated with other fixed income products. Yield maintenance clauses also often feature, to protect lender cashflows in the event of early redemption – this helps with matching adjustment portfolios. From a pension fund’s perspective, you give up the liquidity of a similarly-rated corporate bond but you get an illiquidity premium – often as much as 150bp or 200bp, which for an investment-grade instrument is a big spread pick up in a low-yield environment. We see a great opportunity for smaller institutional funds to invest through a pooled fund, and they don’t have to commit vast amounts. Larger investors and insurers can do the same or can often negotiate bespoke mandates, or even go it alone.

What are the differences between real estate senior debt and corporate senior debt?
 The key difference with corporate private debt is that CRE senior debt can be investment grade whereas corporate direct lending is almost exclusively sub-investment grade. The returns for real estate senior debt are lower than for corporate, but the risk profile is very different.

How do you view current market conditions and, in light of that, what are your investment preferences? 
 We are in a reflective mood given the geopolitical uncertainty, but the UK economy continues to do well. CRE debt is underpinned by strong property market fundamentals, with record employment and the supply of new property outside London having been constrained for many years, while property continues to offer an attractive yield premium over gilts. So for selective managers the investment fundamentals are quite favourable. We’re wary of City of London offices because of Brexit and the potential impact on financial services, especially at a time of historically high rents and values, but in the regions, rental levels and values look more sustainable.

“Ten years ago, there were no managers. Those now seen as the “tier one” managers were launched around 2010”

MW: It’s important to remember we’re in an era of uncertainty – even in the regions, a single tenant property could see adverse effects from Brexit and other developments, so it’s more important than ever to avoid taking binary or specific risks. As well as seeking income diversity, we like to back borrowers which can grow rental income through management of the properties, as this improves our risk position over time. It’s a better proposition than backing a property let to a single tenant, where a shortening lease term or weakening covenant strength will negatively affect value.

How do you see your business developing over the next 12 months?
 Pension consultants say they have never been busier with enquiries from overseas investors about how to get into UK real estate. When there’s uncertainty, real assets are a sensible exposure and the UK economy still looks in good shape. There are question marks over London but we still see serious flows of capital coming in from Asia, as shown by the recent investment in the Cheesegrater building. If you’re going super-defensive, then real assets are a good plan and why not have exposure to first mortgages against real assets? We tend to do better when there is risk and uncertainty in the market than when everyone is feeling upbeat, so we are looking forward to the next 12 months.

This article is sponsored by ICG-Longbow.