A strategy for uncertain times: A combination of structural and cyclical developments have given real estate debt an appealing risk-return profile in today’s European market
One of the results of post-GFC increased regulation in the banking sector has been the rise of alternative lending sources in the real estate debt market.
While traditional banks still remain dominant players, their stake in the market has decreased significantly. In the UK — Europe’s most transparent market — banks were the originators of 95 percent of loans in 2007. By mid-2018, their share of new originations had dropped to 85 percent. This gap has been filled with new debt sources, such as specific real estate debt funds, and is set to grow.
Incoming regulation, including Basel IV and rules that require higher capital reserves to be held against real estate loans, will continue to drive banks towards the perceived safety of mainstream vanilla real estate lending. Ultimately, this will benefit alternative lenders, who will step in where banks have retrenched.
This ongoing restructuring of the real estate lending landscape has opened new paths for investors who are seeking access to real estate performance, while closely managing their downside risk in the event of a market downturn or rising interest rate environment.
All about income
With its diverse markets and economies, and the unsynchronised nature of growth across the region, Europe is an attractive landscape. The equity- and bond-like characteristics of real estate performance add further appeal for those looking to capture capital growth cycles while also benefitting from a strong income component. Real estate has delivered strong income and predictable cashflow over the past 15 years within Europe (see “European real estate” chart on page 27), with income providing in excess of 70 percent of total returns.
The upcoming real estate cycle will be less focussed on capital growth and more on income. Therefore, testing the resilience of in-place income and ensuring appropriate senior interest hedging will be key to ensure healthy interest coverage for commercial real estate loans.
The nature of senior and mezzanine real estate debt cashflows (interest and principal repayments) means that investors can rely on them for relatively secure and predictable investment returns. Unpredictability of cashflows resulting from loan prepayments is often mitigated by the penalties that are attached to such early redemptions.
If we assume that downward rates are more of a short-term phenomenon and that we will be entering a period of rising rates over the next 10 years, then the income from real estate debt is an attractive feature for investors seeking to match their liabilities, such as pension funds and insurance companies.
The right time
Another consequence of the GFC is that loan-to-value (LTV) ratios are now lower, which has created an opening for mezzanine lenders.
According to the MSCI Pan-European Real Estate Index, real estate capital values fell almost 20 percent, peak to trough, across the last cycle. Pre-GFC, it was typical for senior loans to prime commercial real estate to be agreed in excess of 75 percent LTV. However, following the GFC, senior LTV ratios of between 50 percent and 60 percent are now more commonplace, increasing the opportunity for specialist providers (see “Typical financing structure” chart below).
In the face of increasing regulation, senior LTVs are expected to remain low compared with the previous cycle, drawing in further alternative lenders. Competition from banks, along with historically low interest rates, has led to a dramatic reduction in senior debt returns, while subordinated debt returns have remained stable.
The European real estate debt market has so far managed to retain a disciplined approach to loan structures, maintaining most of the loan covenant protections, unlike other private credit markets. It is the low LTV, and these covenant protections, that make now a good time to enter the market.
Furthermore, according to the latest INREV Fund Termination Study, there is set to be a wave of fund terminations between now and 2022 — more than 90 percent of funds have provisions to extend or rollover. Current market conditions will, in all likelihood, dictate that extension clauses are exercised, driving further demand for debt refinancing and recapitalisation.
In comparison to equity investment, debt is characterised by a lower risk profile. While the various merits and drawbacks of every real estate sector have a strong influence on equity investor decision-making, a debt investor is less influenced by intricate sector analysis, as they focus on the term, income coverage and sponsor to mitigate risk. This makes it much easier to create portfolios that are diverse in both asset type and jurisdiction.
Demand for European property has grown steadily over the past 10 years, as has the number of actual transactions that have taken place. Even for most core investors, real estate is still a debt-driven asset class and, in the context of increasing transaction volumes and increased competition for assets, we expect the need to increase loan facilities across Europe to continue.
At the same time, European markets are entering a mature stage of the cycle. And it is at this point that debt investors have the added advantage of being relatively protected from capital declines.
The return generated by an equity investment in real estate comprises both contracted income and capital growth (as seen in the chart on page 27). The capital growth component of total return represents the changing value of the asset as assessed by external valuers, and it introduces significant volatility into the total return.
Equity investors experience this volatility as values fluctuate in response to the market and valuer sentiment. To a certain degree, real estate debt returns are protected against value volatility, and an investment in real estate debt will likely deliver more stable returns for a longer period of time — even in an environment of falling values.
Although protected by a significant equity buffer, investors in debt are not completely protected against a falling market. After all, a deteriorating economic environment will increase the likelihood of corporate failure and tenant default. In this case, lenders are able to protect their investment by enforcing their security and liquidating the underlying collateral. This is generally a relatively simple exercise, as the borrower is typically an SPV that owns the property and has no employees or moveable assets.
Real estate debt investment can therefore provide a strategy that mitigates downside risk. Its increased equity cushion and security ranking ahead of equity in the capital stack can all contribute to delivering attractive risk-adjusted returns as we enter choppy and unpredictable waters.
Simon Durkin is a director and head of European real assets research at BlackRock Real Assets.