Real estate debt’s resilience is reinforced

The pandemic has accelerated lender diversification, with alternative debt providers gaining in prominence. Meanwhile, investor interest continues to rise due to attractive risk-adjusted returns.

Major global private real estate debt markets are gradually reopening following a period of relatively muted transactional activity during last year’s lockdowns. Still, fewer lenders are active in the space amid the ongoing economic uncertainty, which presents an opportunity for alternative debt providers to selectively fill the gap.

As liquidity returns, non-bank lenders are increasingly sourcing debt deals in the US. According to consultancy CBRE, alternative lenders and life insurance companies captured a 66 percent market share of total US real estate debt originations in Q4 2020.

In Europe, however, real estate finance remains a bank-led market, although alternative lenders have gained market share as commercial banks have decreased property lending due to tightening regulation over the past decade. In the UK, for instance, non-bank lenders and insurers accounted for 28 percent of new property debt origination in 2020, up from 15 percent in 2012, according to figures from the Business School at London’s City University. Accelerated by the pandemic, private debt is becoming a true alternative to traditional bank lending in continental Europe as well and, consequently, some non-bank debt providers are expanding into the continent.

Intermediate Capital Group’s real estate arm, ICG Real Estate, is one such lender. Martin Wheeler, co-head of ICG Real Estate, says the London-based firm has expanded its debt platform in Western Europe after seeing how domestic banks have pulled back “strongly” from the market – except in Germany – following the outbreak of the pandemic.

Non-bank lenders and insurers’ share of UK new property debt origination in 2020

Percentage of insurance companies intending to increase exposure to real estate debt in the next 12 months

“Across Europe, the dominant domestic lenders still form the biggest percentage of the lending market,” he says. “But they are still largely inactive, other than for the most risk-averse type of lending: best sponsors, portfolio lending and certain sectors like supermarkets.”

This means the number of deals available for non-bank players in the market has increased. “Looking at our pipeline for the Partnership Capital Strategy, we have roughly twice as many deals in it today as we had coming into the pandemic,” Wheeler points out.

‘Interesting opportunity’

Michael Kröger, head of international real estate finance at German bank Helaba, says the tightening of lending standards for banks and regulated institutions is “for sure” opening space for alternative lenders. However, he does not expect this to grow to the extent that banks will be largely replaced. “The banks’ balance sheet lending is largely relationship-driven and will continue to play an important role for the whole industry,” Kröger says. He adds that the banking community, including Helaba, is constantly refining its risk management and underwriting standards, which in some cases leads to a more cautious approach.

With active banks being more risk-averse and therefore focusing on low-risk property lending, the high-yield debt space is particularly attractive for alternative real estate lenders. “High-yield lending is more competitive because that’s where most of the alternative debt plays,” says Natalie Howard, head of real estate debt at asset manager Schroders, which is targeting senior debt and high-yield real estate lending through a new European platform. “But even though it’s a smaller part of the overall market, we still believe it is an interesting opportunity – particularly in Europe, where you can count the number of non-London-based alternative lenders on one hand.”

As alternative lenders prove active in Europe, pan-European strategies occupy a pre-eminent position within global non-listed real estate debt vehicles, accounting for 74 percent of their total target equity, according to INREV.

The industry body says investors in North America and Asia-Pacific have a strong preference for non-listed real estate debt strategies. It notes that private debt is not yet in the top three preferred strategies for investors in Europe – although it is growing strongly.

In this sense, Aviva Investors’ 2020 Real Assets Study, which provides insight into European institutional investors’ appetite for real estate, infrastructure and private debt, finds that 46 percent of insurance companies and 39 percent of pension schemes intended to increase their exposure to real estate debt.

Investor appeal

Fund managers report growing interest in real estate debt as allocations from institutional investors surge

Investor interest in debt is rising. In 2019, non-listed real estate debt strategies attracted a record €32 billion globally, representing a circa 50 percent increase on the previous year, according to the INREV Debt Vehicles Universe 2020 study.

Trevor Castledine of bfinance has witnessed the asset class’s increased popularity among institutional investors. “Last year was probably our best year in real estate debt, and there has been increasing interest for a couple of years,” he says. “It was a bit quieter in the pure corporate lending space, but we saw big allocations to real estate debt coming from large institutional insurers and pension funds.”

“Increased appetite for real estate debt has been driven by the fact that returns available in liquid credit, corporate bonds for instance, are getting tighter and tighter,” says Barry Fowler, head of alternative income at Aviva Investors, which is overseeing £21 billion ($30 billion; €24 billion) of debt and long income investments across real assets.

Disappointing yields

Trevor Castledine, senior director, private markets at investment consultancy bfinance, agrees: “Yields from fixed- income continue to be disappointing – and if they start to rise, this would lead to losses in capital value – so I think this is driving more investors to real estate debt, as they seek the characteristics of high credit quality, while increasing returns and introducing a degree of protection from long-term losses in capital values. At the very safe end of the asset class – that is, 50-55 percent loan-to-value – investors are probably getting 75-100 basis points pick-up versus investment-grade bonds, as well as lower volatility.”

Castledine explains that although real estate debt has been “an absolute staple” of large insurance companies’ investment portfolios in the US, it is a newer asset class for many European insurers, which are increasingly migrating to senior debt strategies. It is attractive to a wider range of investors, however. Pension funds might use real estate debt as a yield-enhancing alternative to bonds or, with slightly higher risk characteristics, as a diversifier to an existing private debt portfolio. Meanwhile, family offices, private foundations and endowments, which traditionally seek higher yields, might be interested in higher LTV or non-core strategies that target enhanced returns.

“Through these higher return strategies, which can target high single digits, private credit investors are diversifying risk from other high octane private investments such as opportunistic credit, distressed credit or leveraged fund investments,” Castledine says. “Also, for some of these strategies, the confidence in terms of the pace of deployment may be a little higher than could be the case with some of the more esoteric, corporate debt opportunities.”

Wheeler says the disruption caused by the pandemic is also boosting private real estate debt’s risk-adjusted attractiveness in relation to equity. “Investors see the European real estate market as adjusted pricing-wise, but they are still relatively cautious about investing,” he says. “So, real estate debt looks really compelling when investing in a market that has adjusted downwards – not massively but enough – and where the lenders are taking an attractive slice of the overall return that’s available from the underlying property.”

Strong senior margins

From a risk-adjusted return basis, Wheeler is seeing “really strong” margins in the senior space – the widest since ICG began its senior debt programme in 2014. Outside of that, in the more transitional assets where there is weaker demand from an equity perspective, the financier is looking at double-digit returns at LTVs 5 to 10 percent lower than before the pandemic.

Lenders have seen better financing terms. However, the disruption caused by the pandemic has also had a significant impact on global real estate markets and polarised the sectors therein. Retail and hospitality have been hard hit. By contrast, segments like logistics, data centres and residential look poised to outperform due to structural, long-term dynamics.
“There are really strong dynamics, led off by the distribution space including last-mile, data centres, residential, retirement living… where you can underwrite demand from occupiers driven by demographic or structural changes, so these sectors aren’t affected by the pandemic,” Wheeler says.

“High-yield lending is more competitive because that’s where most of the alternative debt plays”

Natalie Howard

Although there is increased uncertainty in the use of office space, some lenders are willing to back the asset class. “We are happy to provide debt for offices, but for the right offices,” Fowler says. “For us, the location of a building has always been important, but it’s also vital that we understand what the building is used for. If an office is used for back-office administrative work that can easily be done from home, then we think it has a questionable future. However, if an office is in an attractive location and it brings people together, to strategise and add value through collaborative activities, then those are the types of buildings we like.”

Fowler says wellbeing facilities and environmental credentials are important features underpinning tenant demand and, ultimately, driving the value of office buildings. He adds that as borrowers try to improve the efficiency and carbon footprint of their buildings, there is more interest in sustainable lending: “We can include sustainable frameworks on our loans, so that we can link them to environmental improvements by the borrowers on the underlying asset, which is not only appealing to our investors, but also to our borrowers.”

Aside from distress in certain retail and hospitality loans, industry players agree real estate debt has strengthened its position through this crisis. The combination of low leverage, and a wider pool of debt providers and lenders with a stronger capital base have contributed to a more resilient debt landscape compared with before the global financial crisis.

With the pandemic accelerating banks’ risk aversion, alternative lenders have more room to access debt opportunities, which is translating into better financing terms. These strong dynamics make real estate debt a compelling opportunity offering attractive risk-adjusted returns for investors. Consequently, market participants are optimistic allocations to the asset class will increase.