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Schroders on the opportunities for real estate debt

As banks continue to retrench, there is a huge unmet need for real estate credit across Europe, says Natalie Howard, head of real estate debt at Schroders Capital.

This article is sponsored by Schroders Capital. 

How would you describe the level of investor appetite you are seeing for real estate credit?

Natalie Howard

Investors have increased their allocations to private credit generally, in order to achieve the complexity and illiquidity premiums that the asset class offers. But over the past 10 years, the majority of that capital has gone into infrastructure, leveraged finance and direct lending.

By comparison, relatively little has gone into real estate debt. I think that is partly because a lot of institutions have allocations to real estate equity already and there wasn’t the understanding of the benefits of a separate debt allocation. That has definitely changed.

Investors now see real estate debt as a natural extension of their private credit portfolio and particularly like that it is backed by a real asset.

There is also a recognition that as more and more money has flowed into direct lending and leveraged finance, the risk profile of those asset classes has increased, as covenants have decreased. We have also seen the introduction of leverage on leverage, in order for managers to maintain the high single-digit or low double-digit returns that their investors have become accustomed to.

Investors are increasingly aware that the regulatory regime that has been put in place, in terms of capital cost, actually prohibits banks from doing anything other than straightforward investment grade lending, where there is low leverage on stabilised assets.

There is, therefore, a huge funding gap where borrowers are looking for slightly higher leverage or are looking for leverage on operating assets or value-add and transitional assets. The only option in those situations is for borrowers to work with alternative lenders, and investors are able to benefit.

But those alternative lenders are in short supply. European real estate credit is a €1 trillion market and yet there are probably no more than 20 real estate debt managers in the region, including the smaller, more specialist strategies. In continental Europe, only around 6 percent of real estate debt is provided by the alternative lenders. In the UK, the figure is around 20 percent and in the US it is 40 percent. So, there is a blueprint for significant growth. Add to that, the risk reward dynamics in the leveraged finance and direct lending fields today, and it is easy to see why more investors are looking to real estate debt.

Where can those investors find the most interesting real estate credit opportunities?

We are agnostic about the sector that a property is in. We are focused on taking the least amount of risk possible for the returns we are targeting. Of course, Schroders Capital has a view on what the office market is going to do, or the retail market or logistics. But when it comes to debt, we are more interested in the quality of the individual property, the quality and track record of the borrower, and the debt structure that we are putting in place.

A good example would be the UK retail sector. Most banks won’t lend to retail, which can present us, on occasion, with really attractive opportunities. Firstly, there has been a massive rebasing of pricing. We have seen 50 percent loan-to-value transactions on property valuations that have been rebased by 70 percent. That gives us a really strong starting point. These transactions are commanding a premium of between 4 and 5 percent.

A couple of years ago, you would have been looking at a return of 2 to 3 percent. Given the lack of available capital, we are reviewing transactions in this space on assets that are trading very strongly, in excellent locations. This is a good example of identifying mispricing and being able to cherry pick the right opportunities. Remember, we don’t get any of the upside, we only get the downside. That means that risk mitigation is paramount.

Does that sector agnosticism extend to alternative asset classes?

Yes, we will look at healthcare, hotels, data centres and leisure facilities. We are also very comfortable with operating assets, residential and then the main sectors. Interestingly, what we are unlikely to do too much of is logistics, because those assets are keenly priced based on growth projections that haven’t actually happened yet. Across all sections, I see development opportunities as particularly attractive. The lack of capital in that part of the market is presenting really attractive transactions with market-leading borrowers.

How do you think a new, higher inflation, higher interest rate environment is going to impact real estate credit more broadly?

Most loans have some sort of interest rate protection so you can typically mitigate that risk through a cap. But if interest rates rise, the risk-free rate will rise too, and because the premium that real estate equity commands must stay intact, we would expect to see yields expand. That means a decrease in value and therefore a decrease in the equity cushion that is ahead of the debt. We mitigate this risk by using long term sustainable yields and not current valuation yields, which gives us a margin of safety.

We look at property values through the cycle to ensure we still have a reasonable equity cushion ahead, whatever the path for rates. We always underwrite a downside case that is completely unrelated to the equity’s business case, because they are glass half full, while we are glass half empty.

Does working alongside the equity team bring benefits though?

Absolutely. We sit alongside the 200 Schroders Capital real estate equity professionals and we have investors on the ground all over Europe. That means, when we want a view on what offices in Birmingham are doing, or residential in Paris, we are getting on the ground feedback from individuals who are buying, selling and letting real estate day in and day out. They know what is going on in those markets and that is very helpful to us in terms of feedback on individual transactions.

How else can real estate lenders differentiate themselves, beyond price and structure?

If there are other lenders bidding on a transaction, the pricing tends to be fairly similar, so it is very difficult to win on price alone. Certainty of execution is very high on borrowers’ agendas. They want to know that if you issue them a term sheet, then you are going to deliver on that term sheet and not start moving the goal posts.

That gives alternative lenders a real advantage over the banks. Banks find it hard to offer certainty of execution because credit departments frequently change their standards, and the individual that a borrower is dealing with may not necessarily know what the current thinking of that credit department is.

Service is obviously also very important – the fact that you are returning borrowers’ calls and that you communicate clearly what it is that you expect the borrower to deliver on in order for them to receive the money.

Finally, it comes down to people. Good originators in real estate debt will have a wide network of relationships that they maintain. Real estate is a person-to-person business and borrowers like to deal with individuals who have delivered for them before. They also want to know they are going to have an ongoing relationship that will last throughout the life of the loan.

What role is ESG playing in real estate credit today?

We classify our funds here at Schroders Capital as Article 8 under SFDR, which means we promote sustainability. We do that by analysing both the borrower and the underlying real estate we’re lending against through a proprietary scorecard we have created. The advantage of being part of Schroders is being able to leverage the group’s ESG and sustainability resources to create a scorecard that is robust, repeatable, and reflects the nuances of the real estate debt market.

In the context of real estate, the E in ESG is relatively easy to score, through energy efficiency and other measurements. The S is a little more challenging to incorporate. Part of that involves the building, and part involves the borrower.

Finally, the G primarily comes down to the borrower. You are looking at how they run their business, how they interact with their tenants and staff, and what their own ESG policies are. All of that combined generates a score that we report to our investors on a quarterly basis.

What does the future hold for real estate credit?

Schroders Capital has invested a huge amount of money to build out a best-in-class real estate debt platform. That is because we believe the asset class has enormous potential for growth, and ultimately to become a mainstay of institutional portfolios in the same way that leveraged finance and direct lending has. We don’t believe that banks are going to change their position, and therefore there is a huge opportunity set out there.

I think it is telling that whilst we spent the first several months of last year building the business and making sure all the operations were in place, without doing any active marketing to borrowers until Q4, we still received more than €22 billion of transactions, completely unsolicited. That tells me that the funding gap is real and that borrowers are desperately looking for alternative sources of finance.

And, of course, investor appetite for private assets continues to grow and, given the ability to tailor the return profile of an asset from between 1 and 2 percent to 10 percent, I believe the asset class is going to be the recipient of a substantial increase in allocations in the years to come.