The case for real estate debt

UBS’s Anthony Shayle explains to Pensions Age why real estate debt can be an attractive opportunity for pension fund investors

Please could you provide an overview of what real estate debt is?
Real estate debt is broadly wherever we would see a bank lending on real estate, which, in this context, is commercial real estate, not residential. This includes lending against office buildings, retail and industrial property. The source of debt being talked about here is from non-banking entities, which would be lending against real estate as if they were banks. These alternative sources include insurance companies and specialist debt funds (funds).

Insurance companies tend to be quite cautious, rather like banks. Their loan to value (LTV) is typically around 40-50 per cent and they tend to lend for a minimum of 10 years and often up to 20 years.

Funds are generally set up with institutional money. They tend to fall into two geographic categories: those looking at UK property, and those with a pan-European focus. Funds invest in different ways and, by way of background, if you went back to 2004-7, you would have found banks lending at 65-75 per cent and in some cases, even up to 90 per cent. That has been substantially reduced because of the global financial crisis and capital constraints following Basel III and ‘Slotting Guidelines’. This has brought senior lending from banks down to the 50-60 per cent range.

What funds are doing now is taking that broad 75-85 per cent lending and breaking it into different categories. So some funds will lend purely senior debt, typically with a five year maturity and 50-60 per cent LTV. Some funds call themselves stretched senior, which means they work to about 65 per cent LTV, and then there are whole loan funds, which run up to about 75 per cent LTV. These are all senior lenders. Then there are another group of funds called subordinated lenders. They start at around 50 per cent and will lend up to or slightly above 75 per cent LTV. They are typically junior or mezzanine lenders. The fundamental difference between subordinated debt and senior debt is the quality of the security and the interest charges or return requirements of the lenders.

There are three types of fund structures available, closed-end funds, open end funds and public vehicles, although there are very few of the latter two forms. Most of the new funds launched over the last few years have been closed-end funds. It should be emphasised quite strongly that most of the types of lending tends to be highly illiquid loans. So if it is considered that real estate is viewed as illiquid because it takes three to six months to realise investments, these loans are even more illiquid. This is because they tend to be bilateral facilities, one lender/one borrower, for which there is a very limited secondary market in which such commitments can be bought and sold.

Why should pension funds be looking at this market now in particular?
We believe that the current market opportunity presents significant potential for investors. The banks have retrenched and there is a very large funding gap in commercial real estate lending market. It is generally considered to be around £30-£40 billion in the UK alone for the next three to five years. What that tells us is that there is an opportunity for non-banks to be involved in commercial real estate lending where they may be able to generate above-average returns, i.e. something that offers investors a quasi or proxy-like exposure to real estate without taking all of the equity risk.

What should investors consider when looking to invest in real estate debt?
There are probably three key issues to be considered. First is the risk/return expectation. Second is where does fund allocation come from? Is it fixed income or real estate or something in the middle i.e. a hybrid? One of the features that tends to guide investors is the nature of risk and return of the underlying funds. If the funds are investing into bonds, it tends to be seen as a fixed income allocation and if the funds are much more driven by the performance of the underlying asset it would more readily fit into a real estate allocation.

Third is the need to really understand the objective of making an investment into real estate debt. Making an allocation from fixed income, you are likely to be seeking stable returns through a lower risk fund i.e. a senior debt fund; if you are allocating from real estate then there may be appetite for a higher risk/reward category. It is important to understand what objective is being fulfilled by making such an allocation before researching and looking at the various offers in the market.

What trends have you seen occurring?
It is interesting to compare the European market with the US, which for 30 to 40 years has been a more constrained banking market similar to Europe of recent years. The UK is showing a trend towards the style of the US market in terms of the different/more diverse sources of available debt. Therefore the question becomes, is this transient, or will we revert to the market style pre-crash i.e. say 2004? When we look at the pressures on the banking market, from a regulatory point of view and capital constraints, the banks are likely to be substantially more cautious compared to where they used to lend for a very long time. This probably does not mean three to four years, but potentially the next 10, 15 or 20 years. I think that will make alternative debt funds more attractive to borrowers. As soon as the market adapts by accommodating alternative debt sources, funds, for any period of time, there is the strong possibility of them becoming an established and recognised source. If that happens I think we will see this as a very long-term trend.

I also think you might find pan-European funds well established five years on from now. There will be an improved ability to transact in different countries, because of changes to the lending environment, be it regulatory or banking rules. Some platforms that are being established now will grow, increasing their presence in a number of countries, enabling this to occur. Investors will certainly be seeking pan-European products.

As the market matures for alternative lenders the demand for loans may slow and therefore the ability of the funds to identify and source potential borrowers will become increasingly important. The ability of the fund/portfolio management team to both assess the borrower as a reliable manager of the real estate and continue to monitor the loan over its life is fundamental to ensuring the performance of the loan is not allowed to deteriorate.

The size of the funds in the current market is important given the larger a fund the more difficult it may be to deploy the funds in an increasingly competitive environment. Investors should be asking managers to demonstrate they have the borrower sourcing channels and the systems to ensure that style drift does not take place to simply deploy funds that were raised in a market that is then out of kilter with what is required.

We have been acutely aware of the expectations of the investors in these aspects as we have developed our debt funds platform in the UK, and have worked to establish the systems and procedures necessary to ensure the underwriting processes are rigorous, with tight loan monitoring procedures. Both are embedded in the real estate team. The issue of fund raising in evolving markets has been addressed by consciously limiting the size of funds in the face of strong investor demand. The ability to source opportunities to lend is a major competitive advantage and the relationship with the other parts of UBS provides a unique set of introductions.

Why should pension funds allocate to real estate debt?
There are probably two key reasons. Firstly, investors could be diversifying away from traditional fixed income so there could be a non-correlation advantage. Secondly, on the property side it would be an investment that brings a lower VaR. In other words the volatility associated with these funds is generally considered as low relative to real estate from being secured, mortgage based, lending. If compared to the situation of investing directly into real estate equity, the senior debt, with a first charge, and mezzanine (subordinated debt), usually with a second charge, can offer the potential benefit of reducing correlation to the real estate equity risk. It would be important to have a degree of confidence over the asset quality with a well-structured security package. This should result in portfolio returns having a lower correlation to real estate returns. Thus by adding debt funds to a real estate portfolio, an element of de-risking can be achieved. If you were to move up the return spectrum to a mezzanine fund, with expected returns within the region of 10-15 per cent pa, then you are talking about value add equivalent or in the extreme something like a private equity fund.

Whilst you are not receiving the same returns as the pure equity investment, the second charge provides an improved measure of risk. So debt funds seek to provide increasing amounts of proxy to real estate returns, but with lower levels of risk.

Anthony Shayle is UBS Global Asset Management’s global real estate head UK debt, managing director

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