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 

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.