Study: CRE debt offers core-like returns

Real estate debt funds can deliver returns on a par with core real estate equity investing with less risk, particularly if they seek out opportunities outside primary locations, according to a Partners Group report, PDI can exclusively reveal.

Bank deleveraging has created a $163 billion funding gap for commercial real estate in Europe, according to Zug-headquartered asset management firm Partners Group in a new report, citing DTZ data. Alternative lenders eager to fill that gap are offering an increasingly attractive alternative to core real estate equity funds given yield compression, particularly if they are prepared to look beyond prime real estate deals.  

“These real estate debt opportunities can provide investors with attractive core-like returns while providing an attractive position in the capital structure with adequate downside protection provided by equity cushions,” the report said.

“In today’s environment, debt offers a safer part of capital structure which can be acquired at lower loan-to-values determined on a lower value base. Income can be secured through higher spreads available for both senior and mezzanine debt. Based on our analysis, strategies that are capable of capitalizing on this opportunity through investments in floating-rate senior secured debt with strong covenants as well as mezzanine debt financing for secondary markets in Europe will be capable of achieving core-like returns for investors, albeit in more secure positions in the capital structure,” it concluded.

Against a backdrop of improving fundamentals in the European real estate market on both the public and private sides, investors have seen yields on core properties in 'safe haven' markets compress significantly since 2010 and are now close to pre-crisis levels. Partners cites the examples of 431 Oxford Street, London – sold recently for a reported net 2.9 percent yield – or 1 Rue de Ventadour in Paris, which is understood to have sold for a net initial yield of just 3.8 percent.

“The increased competition is likely to put prime returns under pressure trending towards the long term averages of 6-8% per annum,” the report said.

Non-traditional lenders are forecast to grow market share in the UK from 7 percent to 15 percent over the next three years according to DTZ predictions cited by Partners. In Europe, the forecast shift is from 2 percent to 7 percent.  In the US, such lenders account for 23 percent of overall CRE lending.

Lending criteria remain very selective, Partners said, with lenders focusing almost exclusively on prime properties and / or those backed by strong sponsors. There has been very limited appetite for construction loans, it added.

Prime properties yields are highly correlated to interest rate changes, the report argues, whereas secondary markets are better insulated. A meaningful increase in interest rates – a question of “when”, not “if”, the report points out – would rapidly result in covenant breaches in prime deals.

A typical senior loan with a loan-to-value covenant of 75 percent on a prime asset would breach its loan-to-value covenant with just a 100 basis point rise in the interest rate, Partners said. “Conversely, a senior loan on a secondary asset does not breach the same covenant even well after a 300 basis point expansion in the interest rate”, the report added.

Mezzanine financings are more sensitive to changes in interest rates, although secondary property deals were, as with senior deals, more robust.

“A mezzanine loan on a prime asset breaches an LTV covenant of 85 percent with only a 50 basis point increase in interest rates, while a mezzanine loan on an asset in secondary locations does not breach the same covenant until after a 225 basis point expansion,” Partners said. 

For further analysis of the report, read the April edition of Private Debt Investor magazine.