What has caused an increased investor interest in allocating to commercial real estate debt?
Jack Gay: 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 commercial real estate debt are becoming increasingly sought after, offering stability, diversification and contractual income. In addition, while direct comparisons of fixed-rate senior commercial real estate debt and corporate bond returns are imperfect – due to differences in duration, credit quality and the like – research shows commercial real estate debt offers a spread premium relative to investment grade corporate bonds.
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 to the underlying real estate is more volatile. And, 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.
Why did you start considering commercial real estate debt as an investment opportunity?
Seunghoon Lee: The low-interest environment in Korea and resulting adjustment to KTCU’s cost of capital, in addition to the need for lower volatility in our investment portfolio, has resulted in an increased investment into commercial real estate debt due to the downside protection it offers. With lower interest rates expected to be prolonged, as commercial real estate debt offers more similar investment characteristics to bonds than real estate equities, we expect to continue to gradually expand our global commercial real estate debt portfolio going forward.
Which attributes of commercial real estate debt make it most attractive at the current time?
SL: We find overseas commercial real estate debt provides a better risk-return proposition than domestic fixed income or real estate. For example, AA-rated three-year Korean corporate bonds yield 2.8 percent and cap rates for grade A office buildings in Seoul are below 5 percent as of July 2018. In US mezzanine loans, however, we see opportunities to achieve over 5 percent return without taking on excessive risk. We also find that commercial real estate debt provides superior downside protection through the equity buffer, especially in light of cap-rate compression and price appreciation since the GFC.
How much research did you do on the sector before investing?
SL: We try to keep up with ever-changing global real estate market trends by meeting with global fund managers and through industry reports by Jones Lang LaSalle, Cushman & Wakefield and others. As active real estate investors, we receive investment opportunities all the time, which allows us to continually monitor live pricing and lending terms. We plan to stay close to the real estate market and remain flexible in our approach.
Where does it sit in the context of your portfolio?
SL: Our team manages overseas real estate such as office, hospitality, retail, residential and industrial properties. In 2012, debt investments (including preferred equities) accounted for less than 25 percent of the team’s $500 million portfolio. As KTCU’s overseas real estate portfolio has become a major part of KTCU’s overall portfolio, from 3 percent in 2012 to 11.2 percent in July 2018, we saw a need to provide further stability to our investment portfolio by increasing our debt exposure, which now accounts for 78 percent of $3.3 billion of the team’s assets today.
What market conditions are at play, both globally and in the UK?
JG: In the US, real estate market conditions remain well-balanced and economic growth is expected to remain stable in the near to medium term; 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. With an increasing amount of capital targeting commercial real estate debt, we believe it is more important to choose a commercial mortgage origination platform and manager that can couple cycle-test underwriting standards with astute loan structuring. Superior execution of commercial mortgage lending requires size, scale and industry relationships.
And 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 underserved markets present the most appealing opportunity for selective ‘cherry-picking’ of transactions with strong fundamentals and return characteristics.
What performance have you achieved on different loan types/jurisdictions, and what is your preference for different jurisdictions?
SL: We do not report separate performance for commercial real estate debt only. However, since 2012, the overseas real estate team has consistently delivered attractive returns: 5 percent, 8.8 percent, 6.5 percent, 5.8 percent, 8.1 percent and 4.6 percent respectively.
We prefer developed markets like the US and Europe for its liquidity and transparency. Due to uncertainty around Brexit, we’re currently more focused on the US than Europe at the moment. In developing markets like Asia, we take a more conservative approach, focusing on stabilised properties.
What are some of the challenges that you are looking to overcome in the European market?
SL: From a commercial real estate debt perspective, the European market offers a legal framework that is landlord and lender friendly. However, we’re closely monitoring the UK in light of Brexit and its implications to the market. We find that the European lending market is predominantly a senior loan market dominated by banks, and that the CMBS market is less prevalent than the US, making it relatively less attractive than the US market to investors like KTCU with high cost of capital.
Are you assessing additional regions for commercial real estate debt investments?
SL: Since 2015, KTCU has been increasing its commercial real estate debt exposure in emerging markets in Asia, for example China and Vietnam, with Asia accounting for 14 percent of the total commercial real estate debt investments. To mitigate emerging market risks, we remain very selective, focusing on deals with stable LTV and backed by strong sponsors. We also utilise dollar-denominated loans to eliminate local currency risks.
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 market in the US, by introducing a risk retention regulation that makes it less attractive to be a conduit lender who 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.
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 $200 million or more with a very specific focus on each strategy, so 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 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 6-8 percent.
The UK and European markets have traditionally provided fewer options for investors in terms of products because the genesis of the alternative lending sector in the UK really 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.
How important is manager choice?
SL: It is important to us to partner with a manager with deep local knowledge and experience. In selecting managers, KTCU looks into not only track records, but also case studies on failed investments, how a manager responded during a difficult period (for example, during the Global Financial Crisis), consistency of investment strategy, key-man clauses, communications with investors, and reputation in the industry.
This article is sponsored by TH Real Estate and first appeared in the commercial real estate debt supplement that accompanied the October edition of PDI.