This article is sponsored by Schroders
Covid-19 has not deterred Schroders in launching its pan-European real estate debt platform – quite the opposite. The lending gap left by banks has widened in the wake of the pandemic and the asset manager is determined to capitalise on senior debt and high-yield opportunities across the UK and continental Europe. “We have a similar business in the US with circa $15 billion AUM and that’s certainly the trajectory we are hoping for within Europe,” says Natalie Howard, Schroders’ head of real estate debt, who was hired in November to lead the new business line from London.
Why is Schroders expanding its presence in the European real estate lending market now?
There has been a desire and a focus to grow our private debt business, and real estate debt is one of the obvious additional asset classes, because it provides relatively easy accessibility. It’s a huge €1.25 trillion market, therefore it’s very scalable and it also offers clients different risk/reward flavours. With that in mind, last year Schroders asked me if I would come on board and set up their real estate debt business for the UK and Continental Europe.
In the conversations we had, the continued retrenchment of the banks was very clear. We’ve seen this over the last 10 to 12 years in the UK, in the same way as the US saw it post the savings and loan crisis in the early 90s, how the banks shrunk their balance sheets and so other players had to move into the real estate debt market in order to satisfy demand. The UK is following the US in that path and now we see this opportunity in Europe, which is also following that direction of travel.
We are seeing a lot of the domestic lenders retrenching within their home markets and, in Europe, these are predominantly banks. This started before covid, but the pandemic has accelerated the trend of risk aversion. They’re looking at their balance sheets, they need to rebuild them, and they need to write off their losses.
“We are seeing a lot of the domestic lenders retrenching within their home markets and, in Europe, these are predominantly banks”
As the banks continue to retrench in their home markets, that creates the opportunity for alternative lenders to come into the space. Historically, these players have been the insurance companies looking for investment-grade real estate loans, which is where the banks play. So, we are starting to see that follow on happening within Europe.
And then in the nascent alternative lender market, there are also the lenders who are active in the non-bank space, so providing stretch senior, whole loans and high-yield loans, some of whom are having to retrench, either due to having to manage potential issues within their own book, or they’re struggling to raise follow on funds. In particular, smaller players, as investors migrate back towards larger managers, because people are looking at the next two or three years seeing a potential downturn and thinking that the small niche asset manager is less attractive. So, that’s really the scene as we saw it last year – and we saw it as a huge opportunity.
How can real estate debt help institutional investors in times of crisis?
Real estate debt offers a very interesting investment that performs well through the cycles. Part of that is you always have a good equity cushion ahead of you, and part of that is about ensuring that you have the best form of control as a lender. We typically provide first mortgages, whether that’s investment-grade, stretch senior or whole loans. Being the first mortgagee puts you in charge, it puts you in control, and therefore when you look at the recovery rates in comparison to unsecured credit, they are much higher with secured real estate debt.
Investment-grade loans provide a complexity premium over investment-grade corporate bonds, which is also attractive because not only are you diversifying away from unsecured credit to secured, you’re also getting that complexity pick up of about 100-150 basis points for a comparable risk. That’s particularly interesting for insurance companies because secured real estate loans have a lower capital charge than unsecured credit.
When we move across to pension funds, which are looking typically for what I would call the sub-investment-grade risk, they can access those mid-single-digit returns they want through real estate debt. That’s interesting for them, also because they’re able to relate that back to ratings – we can provide indicative investment ratings to our investors, which ticks the boxes for them.
For investors like sovereign wealth funds, wealth managers, family offices or the real estate equity investors who are maybe looking to come out of equity because maybe they want to diversify at this point in the cycle, they are able to get those high single-digit or low double-digit returns through a high-yield strategy. That typically involves a higher-risk property where you’ve got a first mortgage or a lower-risk property where you’ve got a second mortgage.
Therefore, you’ve got different attractions for different sets of investors, depending on what their investment requirements are.
Where are you seeing the best covid-driven lending opportunities?
As a lender, you’re not really picking where you think the key areas of the property market are because, actually, you’re following the equity.
But we have had quite an interesting market test going on here. We’ve been incredibly busy over the last four months setting up the funds, all the internal compliance and all the plumbing that is involved with setting up a new business in a big asset manager.
Other than a press release in January and an email saying, ‘here’s my change of email address’, we have not begun actively marketing to borrowers. But even without telling people what we’re doing yet, we have already looked over €7 billion of transactions.
So that tells me two things. The first thing it tells me is the lack of liquidity within the real estate debt market is quite substantial and we think that’s set to continue. The second thing it tells me is that my email works, and people knew where to send stuff to [laughs]. So, we see that opportunity is somehow confirmed on a very practical level. The opportunity is very much there.
Given the current ‘lower-for-longer’ trend, are higher-risk debt strategies more in demand now?
Certain pockets of investors’ portfolios are undoubtedly interested in high single-digit returns and usually that’s from alternative investment buckets or from real estate equity investment buckets. And so, they view it as coming down the risk curve, because if you come from equity into junior debt or opportunistic whole loans, you are de facto taking less risk than you are in the equity. Which is an interesting play for them. But if an insurance company was looking at high-yield debt, they wouldn’t be attracted to that amount of risk at all. So, it all depends on your investor audience.
That’s why it’s important to have specific strategies. We have three strategies and each of them is designed to be attractive to a different part of the overall client base at Schroders. There are one or two investors who will go into more than one strategy. But in the main, you can broadly bifurcate them into insurance companies wanting investment-grade senior debt; the pension funds targeting senior loans through our stretch senior and whole loans strategy; and some pension funds as well as real estate equity and alternative allocations, who are interested in high yield. Sovereign wealth funds are always interested in high yield, not remotely interested in investment grade.
What challenges are investors in European real estate debt markets facing now?
You’re undoubtedly going to see some losses with existing alternative lenders, particularly in the whole loan and high-yield space because almost everybody has exposure to retail and to hotels and it’s not necessarily clear as to whether that space is going to be able to come back. Once you’ve lost earnings, those earnings never come back again – somebody has to pay for that. And if the equity hasn’t paid for it, the debt pays for it. So, it’s inconceivable to me that nobody apart from the banks has lost money over the last 18 months. Therefore, I think that is a challenge for investors, how forgiving are they going to be about existing funds’ track records.
“Real estate debt offers a very interesting investment that performs well through the cycles”
Also, for a lot of investors, they are still getting used to what is a brand-new asset class for them. Even though you have a very broad range of investors across the eight or 10 managers operating in this space, that’s a very small part of the global investor universe.
So, a lot of the conversations that we’re having with our investors are about what real estate debt is, how it behaves and why this is a market opportunity. We’re talking to people where this is their first time investing within private debt and I think for these investors that’s the challenge, getting up the curve in what is a new asset class for them.
But if you roll forward five years, I think all investors will have some exposure to private debt in some shape or form in their portfolios. Because even if we do start to see a little bit of inflation coming through that starts to feed through to slightly higher government bond yields, it’s not going to rocket up to 5 percent. Therefore, in order to get a little bit more on their returns, investors are looking towards private assets, they’re looking towards private debt.