Anyone who has ever messed about on a riverbank knows that if you take a gnarled old log bristling with branches out of the mud the water will seep into the nooks and crannies left by the imprint.
In much the same way, real estate debt funds have thrived on both sides of the Atlantic in recent years. New rules on capital provision mean the banks can no longer be found in many of the medium-risk, let alone high-risk, areas of commercial property lending.
“Traditional providers of capital are still highly constrained,” says Ryan Krauch, principal at Mesa West Capital, a commercial real estate lender headquartered in Los Angeles with a capital base of $3.5 billion. “The private markets are going to fill that space.”
Real estate debt funds have certainly proliferated since a surge in 2013. Between January 1 and mid-June this year they raised $19 billion globally – more than in the whole of 2012, according to data from PDI Research & Analytics.
Firms like Mesa West cannot compete with the banks for the safest deals. “We don’t do 10-year fixed-rate loans on Manhattan high rises,” Krauch points out.
But Mesa West does compete on the next rung up. Krauch enthuses, for example, about its $210 million five-year loan to refinance the office and parking components of the John Hancock Center, a Chicago skyscraper. He explains that it was only 85 percent occupied – below the 90 percent which many banks require. However, “I’d take 85 percent for a building like that on any day of the week”.
Krauch claims that Mesa West is “probably the most conservative private lender you will find”. It does very little mezzanine and tends to charge 3 or 4 percent for deals of up to 75 percent loan to value. It squares the circle between relatively low loan rates and the need among institutional clients for 7 or 8 percent annual returns, net of fees, by taking on leverage.
Mesa West’s conservatism is understandable. In the US, and on a more local basis in Europe, insurers had made real estate loans for decades on their own account, jostling with a small number of third-party funds set up by UBS and others.
However, Mesa West was one of the first firms to set up a third-party fund for the US market, back in 2004. Four years later the financial crisis hit. At one point about half of Mesa West’s portfolio was “in stress or a workout situation”. However, “the vast majority paid their money back” – allowing investors to make, in the end, a positive return. “It was painfully hard, but ultimately we were able to prove the model,” Krauch says.
The experience of the credit crunch helps explain why funds spend a lot of time managing their portfolios.
Anthony Shayle, London-based manager of the £241 million ($342 million; €305 million) UBS Participating Real Estate Mortgage Fund, a debut fund for the UK market launched in 2013, says that all debt funds are at least fairly active. This is the result of a “much lower tolerance towards default” than banks caused by the detrimental effect that just a small number of loans can have on a fund’s total return.
Europe was a little behind the US in setting up debt funds – but not far. AXA established a third-party fund in 2010 after entering the market on its own account five years earlier. The French insurer is even more conservative than Mesa West. It aims for spreads of 1.5-3.5 percentage points above prevailing interest rates, says Isabelle Scemama, head of real asset funds at AXA IM Real Assets in Paris. AXA manages €20 billion for third-party clients.
Other lenders occupy much smaller markets. Fort Amsterdam Capital specialises in bridging loans of one-and-a-half to two years or so to developers in New York that need the money for multi-family and mixed-use properties.
“We are definitely a niche player – this isn’t meant to be a gargantuan fund,” says David Schwartz, managing partner. “We have access to about $100 million of equity to deploy to this over the next 12 months.”
The 10-12 percent rates which Fort Amsterdam Capital charges are many times what most bond investors could possibly enjoy, and even AXA’s more modest rates look attractive when compared with most of the corporate bond market.
However, prudent investors are likely to ask whether the increasing number of real estate loan funds on both sides of the Atlantic will erode rates to the point where the premium relative to interest rates in public markets starts to look small.
One response to this, made by several debt fund managers, is that they are only filling the gap left by the banks, leaving total loan supply static or possibly lower than before.
Debt fund managers also argue that, unlike public bonds or even some other loan markets, real estate lending does not have the characteristics of a commoditised market. Real estate debt remains more customised and opaque than the market for leveraged loans, for example.
“This is not pre-structured product for sale – the only way funds can access it is through primary origination,” says Andrew Radkiewicz, London-based co-head of Europe at PGIM, the investment management arm of US insurer Prudential Financial.
“Very rarely will someone come to us and say, ‘Price us this mezz tranche.’ They’ll say, ‘I want to buy this property.’”
WHY DEBT FUNDS ARE BIG IN JAPAN
The banks have withdrawn from riskier real estate loans because of the huge pressures they face to reduce risk. Investors are filling the gap enthusiastically because they are having to increase risk in order to increase reward, though they defend such forays by arguing that the risk-reward trade-off is very attractive.
“In the low interest rate environment, all investors are struggling to find a return,” says Axa’s Scemama.
Real estate funds provide a partial solution for investors with long-term liabilities, such as insurers and pension funds, she says. “Real estate funds are less liquid than bonds, but investors with long-term liabilities can have a part of their balance sheet that is less liquid.”
AXA real estate funds’ 40 or so clients are, says Scemama, “all big fixed-income players”.
Not all of the fixed-income players in real estate debt are domestic. “Our investors mostly came from the US before, but in the past three years we’ve had a lot more interest from foreign investors, such as Asian institutions,” says Krauch of Mesa West Capital.
He notes a particular surge in interest from Japanese and Korean investors: “They’re faced with interest rates that are so low that they’re having a hard time fulfilling their fixed-income requirements.”
The yield on 10-year US Treasuries was a measly 0.4 percent in mid-June – in Japan the corresponding yield was precisely zero.