Schroders: real estate debt offers investors secure income

In a challenging market, the funding gap in real estate debt creates investor opportunities, says Natalie Howard, head of real estate debt at Schroders Capital.

This article is sponsored by Schroders Capital. 

How can real estate debt provide secure income for investors in the current market?

Natalie Howard

One of the popular attributes of real estate debt is its ability to provide a risk/return balance that suits an individual investor’s risk appetite, all the way from 3 percent to 10 percent. Because the loans generate quarterly interest payments, they give the income stream that investors are looking for.

In addition to the choice of risk/reward balance, investors also get a choice of weighted average life, so pension funds coming to the end of their lives can have a short term of two or three years and others can go out to much longer time horizons, stretching as far as eight to 10 years. This allows investors to dial return and duration up and down to suit their portfolios in a more challenging market.

As we see inflation coming through, that is going to feed into slightly higher returns with the spread over swaps remaining constant, and the loans often being floating rate. Real estate debt is therefore a natural inflation hedge, and the increase in interest rates also means that investors can take less risk for their target level of return. As things become more volatile, real estate debt offers investors a secure source of income, given the physical asset that underpins the loans. Having contractual cashflows in the form of rents, which are correlated to inflation over time, provides further comfort in more challenging times.

Where do you currently see lending opportunities as a result of dislocation?

The funding gap is enormous in real estate debt. We are seeing such a broad range of transactions across the debt capital stack and across all sectors. The shift we are seeing is in the super-vanilla market, where we are seeing a good flow of transactions because people would prefer an alternative lender to a bank, given the speed and certainty of execution, and also because banks have pulled back from the market.

The other thing we are starting to see for our senior lending and high-yield funds is more traditional bank borrowers, such as global financial institutions, coming to us for funding because it is simply not available from banks. That leaves them with a limited number of options, particularly for commercial development funding.

That allows us to take a lot less risk for the returns we are delivering to our investors and makes this a really attractive part of the market to be in. We are also seeing full suites of covenants being negotiated with borrowers, almost without question, because it is such a lender-friendly market right now.

How do you think real estate debt will develop?

Our view is that the funding gap in real estate debt is structural and therefore here to stay. In the short term, we are not aware of a substantial number of alternative lenders setting up new platforms, and we think that is unlikely to change. Partly that is because there is such a hurdle to entry in this market, driven by the dearth of real estate debt professionals and the substantial start-up costs required. We have 10 people in our real estate debt team, and we leverage across the resources of Schroders, so it is quite a significant initial capital outlay.

We do not see the banks coming back any time soon, and we are not expecting a substantial number of additional players to enter. But this is a €1 trillion market across Europe and the UK, so even if another 10 alternative lenders were to come in, that would still just be a small drop in the ocean.

Finally, we are seeing a lot of LPs that have already invested in different areas of private credit now moving into secured private credit. Infrastructure and real estate debt are definitely big areas of focus for a lot of investors right now, given their natural inflation hedge and the security offered by real assets.

How are you engaging with borrowers on DE&I?

Our real estate debt funds are categorised as Article 8 under the Sustainable Finance Disclosure Regulation. To achieve that categorisation, we have a proprietary framework that we follow, which reviews both the borrower and their business practices as well as the underlying real estate. A significant focus within our framework is on the ‘S’ of ESG. That means looking at our borrowers’ diversity statistics, as well as reviewing their overall internal culture and workplace satisfaction. We also look at the hiring policies in place and score the borrower, sharing our analysis and best practice with those who are falling short. That is all knitted into our framework and is part of our investment underwriting process.

We really believe lenders are able to have an influence over borrowers’ broad ESG policies, and that is a real positive because property companies are realising the importance of being proactive, particularly if they want to access capital from sustainable lenders. We have a scoring system of one to five on ESG metrics and we will only invest if a company scores three or above (or two and above for transitional assets). Having a binding criteria is really important and means that our borrowers have to engage with our process if they want financing, and they need to be reaching minimum thresholds across a wide variety of topics and metrics.

One of the investments we are making this month is a good example because the borrower had started to put an ESG policy in place but we insisted that was done before completion of the loan. We recommended a third-party specialist conduct an ESG review, and the borrower then invested the amount of money required to put in the policies and address the recommendations made. These range from simple EV car charging points to a properly articulated ESG policy and board level responsibility for ESG. The recommendations are now being implemented by the borrower as part of their capex programme, specifically addressing points covering each of the E, S and G.

What can be done to attract more diverse talent into the real estate debt space?

When I think about my team, I am very pleased to say that we have good diversity across males and females, as well as growing diversity by race. We do not see a particularly diverse pool of talent to hire from, and diversity in real estate has definitely been a challenge for the industry. But that is starting to change and we are certainly seeing more women coming through chartered surveying and real estate banking, for example.

As a firm, we are involved in a number of projects focused on attracting diverse talent into the industry at junior level, whether that is through apprenticeships or offering work experience to those that may not be aware of the opportunities on offer. Those are incredibly important initiatives for opening up the industry and building that diversity of thought that is so important for good, cutting-edge decision-making.