Q Why invest in real estate debt rather than in the real estate assets themselves?
The volatility of returns in debt investment is minuscule compared with direct investment. If asset prices go up, direct investors in real estate stand to make a lot of money, but debt investors generally do not. But when prices drop, direct investors can also lose a lot of money, whereas debt investors do not unless they have invested in highly leveraged loans. Moreover, in many markets banks have scaled back their lending to all but the safest and simplest commercial property transactions, mainly because of higher capital charges. This has created a large and profitable opening for non-bank/alternative lenders.
Q Is volatility particularly relevant at this moment, because real estate investors are highly aware of the risk that prices might fall?
If you are an investor in UK property with concerns not just about Brexit but also about where we are in the property cycle – this has been a long bull run, after all – this could well be the right time to consider debt. If you still like direct investment in real estate but you are just nervous about the next three or four years, you might want to strategically invest your capital in medium-term debt, which is a naturally maturing investment: you do not need to sell the assets, and you get your money back at the end of that three- or four-year term.
Q Sceptics would argue that real estate debt has become riskier because investors have taken more risks in response to greater competition.
We, and arguably the industry in general, have certainly been relatively constant and prudent in our underwriting. For example, for our segregated insurance company accounts we have rarely gone above loan-to-value ratios of 65 percent, and for our real estate debt funds we have set a limit of 75 percent. We have also been strict, like the vast majority of lenders in the UK market, about keeping performance covenants for loan to value and for other metrics that allow us to monitor our investments and step in to protect ourselves when necessary.
Talk of increasing competition has also been rather overdone. Overall, underwriting standards in this sector have remained reasonably solid and pricing has been reasonably constant but with moderate tightening. This indicates that while on paper it looks like there is an increasing number of lenders in the UK and other European markets which we are interested in, the actual supply of capital has remained relatively well in balance with the demand for capital.
Overall, there is still significantly less debt in the property market than 10 years ago, according to the CASS/DMU survey. It is clear, though, that a number of lenders are struggling to deploy capital at their required risk and reward parameters, but for the subset of lenders who are most active in the market and have created appropriate debt strategies, there is still a good amount of opportunity.
Q What pricing do you aim for?
For lower-risk senior secured loans on stable assets we aim for swaps plus 125-200 basis points. For mid-risk loans we aim for swaps plus 300-600bps, and for more value-add, opportunistic investments we aim for swaps plus 600 to 1,000bps. The advantage of the TH Real Estate platform is that we can offer a wide range of financing types and leverage points with pricing to reflect each loan’s specific risk profile.
Q If this is real estate investing but with regular income and lower volatility of return, which bucket do investors put it into?
If you had asked me that question three to five years ago I would have said it was rife with uncertainty. Every investor had their own idea of the “right” allocation, or alternatively investors would themselves not know where to put their capital. The fixed income team would say that it was not really for them as it might contain too much real estate risk, the real estate people would say that it was not really for them either as it was too far removed from real estate, and eventually the CIO would have to decide where it fitted. Clearly this hampered investment.
However, as time has passed the trend has been that real estate debt increasingly falls within real estate investment strategies and we see a growing trend of investors who were traditionally only interested in direct strategies putting their capital to work in debt strategies.
Q Why do you like the UK?
The UK has the largest real estate market in Europe. It is also the most liquid and the most transparent European market and is the most creditor-friendly legal framework. So, from a lender’s perspective, it is a dream.
The legal framework is even better than in the US. For example, there is no bankruptcy protection, so the process of enforcing a loan is faster and more certain for the lender. Moreover, taxes are subordinated to the mortgage lender, so in a sense the government is a subordinated unsecured creditor. We also have performance covenants on our loans, which is much less common in the US.
Q What kind of investments do you like in the UK?
Despite the Brexit uncertainty, we are still pretty bullish about London and the south-east of England, where we have our largest exposure, but we have also lent against properties in large UK regional cities such as Manchester, Edinburgh, Cardiff and Birmingham.
By value we have made most of our loans on office buildings, but we are very enthusiastic about logistics, and have also financed community prime retail, student accommodation and other asset classes.
Within the logistics sector we are big believers in the last mile. This is partly because of the continuing growth in online shopping, and partly because last-mile logistics units are often in places where people want to live. This means that there is scope for profitable change of use and redevelopment of these sites for residential use.
We also generally like development and refurbishment projects, which offer good returns in part because banks have largely withdrawn from this market. For example, we recently financed a speculative office development at 80 Fenchurch Street in the City of London. It was an empty site of a demolished property, with a brand-new building being constructed there without any pre-lets.
Q What other European countries do you like apart from the UK?
We have investment mandates to invest in debt in Ireland, Spain and the Netherlands and several other continental European jurisdictions, though we have not yet made any investments there.
Pricing in these countries is good, partly because these markets are smaller than several other European countries, so there are fewer lenders. By contrast, other jurisdictions like Germany are very well supplied with debt by banks and other lenders.
We can also lend in these three countries without getting a banking licence. The legal frameworks are also attractive to lenders, though not quite as robust as in the UK. Finally, the property fundamentals are good, economic growth is strong and the real estate markets in the right location are resilient.
Q But there are risks within these economies too. For example, Ireland is the country most exposed to Brexit apart from the UK itself.
Every market has its risks. In Ireland, for example, the market has had a huge run up over the past five years, so you could make the argument that it is at the peak of the market and question how sustainable this is given its relatively small size. But it is a dynamic country with an economy that is doing great and projected to continue doing so, and a government that has put its house in order.
Will Brexit have an effect? Probably, but we have to remember that debt investors have a little bit more margin for error then direct property investors. Finally, in any market you have to pick the assets, projects and sponsors you want to invest in very carefully.
This article is sponsored by TH Real Estate and first appeared in the commercial real estate debt supplement that accompanied the October edition of PDI.