Built on solid foundations

With banks in retreat on all fronts, private real estate debt has become an attractive asset class for investors seeking certainty. By John Bakie

One of the biggest victims of the 2008 global financial crisis was the real estate sector, which saw banks rapidly withdraw financing amid falling property prices and fears over credit worthiness. The vacuum they left saw some clever financiers develop private real estate debt funds as a way to fill this gap and capitalise on continued demand to finance real estate projects and purchases.

Much as private equity real estate funds sought to apply the private equity model to the property sector, real estate debt has done similar with the private credit model and offers senior and mezzanine loans from a private pool to provide real estate finance sponsors and developers funding.

As an asset class, real estate debt offers attractive prospects for investors. A lot of the debt is senior and secured against real physical assets, which can provide a substantial downside cushion. Mezzanine is also popular and the prospect of an equity kicker from a sector that has, overall, seen reliable price increases can offer a good upside for investors open to taking on more risk.

In contrast to more liquid forms of debt which are typically uncollateralised, real estate debt has physical buildings as its collateral, with loans worth typically much less than the value of the asset against which they are secured. While loan-to-value ratios did creep up to unacceptably high levels prior to the financial crisis, lessons learned since then means LTVs in real estate lending today are generally much lower, at around 75 percent or less. Cashflow is even more attractive as tenanted buildings will have a reliable source of ongoing income from rents, enabling real estate debt vehicles to pay attractive regular yields. Costs for ongoing maintenance and building management are also relatively predictable.

Not all rosy

But the picture isn’t all rosy. Fundraising for real estate debt vehicles suffered after the financial crisis, in common with most other private markets funds, but was rejuvenated in 2012 as the crisis receded, with more than $20 billion raised globally, rising to a peak of just over $39 billion in 2017. Since then it has fallen, dropping by almost half to just $20.4 billion last year.

Notably, $15.66 billion of this capital was raised during the first half of 2018 and slowed to a trickle in H2, reflecting growing concerns about the global economy and political tensions around Brexit in Europe and an ongoing trade dispute between China and the US.

One UK-focused real estate debt investor tells PDI: “Brexit uncertainty is hitting deals. We were in discussions with a financial sponsor about a UK-based property deal, but they were forced to pull it due to the lack of clarity on what the UK’s future relationship will look like.”

While events such as Brexit might not directly impact lenders, the effect on the confidence of financial sponsors, which are a vital source of dealflow, could pose deployment problems for real estate debt funds that are typically less of a concern for banks.

But private real estate debt lending also has some tricks up its sleeve that are not available to the banks. While they benefit from the same kind of mortgages, notes and guarantee documents as a bank, they can be more flexible on underwriting and covenants in a way banks cannot, enabling them to do deals in markets that banks would simply write off as too challenging.