This article was sponsored by Colony Capital. It appeared in the Debt Fund Report alongside the April 2019 issue of PERE magazine.
While much of the interest in real estate debt investing has been generated by investors allocating capital to senior loan positions that provide stable but lower returns, Colony Capital has tended to focus on debt positions in the middle part of the capital stack. Chief investment officer and head of credit Kevin Traenkle, and Nadra Moussalem, managing director and head of Europe at the Los Angeles-headquartered real estate investor, tell PERE how they are seeking to achieve equity-like returns through debt-like positions.
PERE: How would you characterize current investor demand for the real estate debt space?
Kevin Traenkle: We are seeing more and more investors carving out a bigger allocation specifically for real estate debt offerings. That is prudent because on a global basis the risk-adjusted rates of return that credit and debt investing provide are currently very high given where we are in the market cycle. That demand is emanating from lots of different capital sources, ranging from public entities like mortgage REITs, which tend to like strong dividend yields without a whole lot of volatility, to global institutions looking to achieve more opportunistic returns while remaining within the credit space. The latter tend to invest through private closed ended-funds, which have a higher tolerance for risk and volatility. There are a lot of opportunities coming out of Europe for more value-add and opportunistic returns and we are also seeing more investors from the European region interested in this strategy.
PERE: Why are higher-risk real estate debt strategies popular at this time?
Nadra Moussalem: When many investors in Europe started to invest in credit they were trying to mirror the type of risk they were underwriting when investing in fixed-income instruments, so they began with the senior end of the debt spectrum. A couple of years ago it was still possible to find very attractive margins in Europe in financing core and stable assets because there was a massive imbalance in the demand and supply of credit. However, that situation has evolved. Core senior loan margins are much tighter again, so there has been a general view recently that this might be a good time to diversify credit portfolios by investing in other parts of the capital stack which provide more attractive risk-adjusted return profiles.
KT: Through opportunistic credit investing you can generate compelling returns that approach returns you would expect from a value-add equity fund. Given where we are in the market cycle, with more subdued inflationary pressures on real estate asset prices, being in the credit space and still getting almost equity-like returns is an attractive proposition.
NM: In 2008 in the US and in 2013 in Europe, we saw windows open to secure opportunities that had credit-like profiles in terms of risk and equity-like asset returns, so it seemed to us that a very interesting place to deploy capital is between traditional senior debt and sponsor equity.
PERE: Why are conditions in the European market more favorable for credit investing than they are in the US right now?
NM: After the global financial crisis, tighter regulations were introduced in the European banking industry that had a growing impact on traditional lenders’ ability to provide liquidity. In the meantime, there was also a trend toward lenders focusing on their home markets. Because Europe relied a lot on bank and balance-sheet lending, that opened up a broad gap between credit supply and demand, which was widened further because most of that liquidity was directed toward a small section of the market. If you were seeking funding for core product you would find a lot of capital. On the other hand, if you were a smaller sponsor or needed financing for a situation that was slightly more complicated, or had some value-add component, then there was much less capital available. Some mezzanine funds were created, some debt funds with senior strategies were launched, but if you aggregate all those new products and compare that to the banks’ balance-sheet lending pre-global financial crisis, you find a very large chasm that does not yet seem anywhere near being bridged.
KT: We are still active in the US, and we still see compelling opportunities there from time to time, but more often than not, the risk-adjusted returns are higher in Europe right now. There has been considerable asset appreciation in the US, and the markets are stable and mature. We also see more competition to provide financing in the US.
NM: There have been times when it was exactly the opposite. In 2008-12, I remember looking at the deals we were seeing on each side of the Atlantic and credit deals in the US showed better returns than the equity deals in Europe.
PERE: What situations provide the best opportunities for managers to deploy capital through opportunistic and value-add credit strategies?
NM: Typically, opportunities arise in situations where the borrowers do not fit with the strategic objectives of the mainstream lenders. They might be smaller developers or entrepreneurs whose capital structure is in need of an injection of funding, but that want to retain control, or those seeking to transition assets from their current state to a more stabilized situation. While our capital may seem expensive at times compared to traditional lending, many sponsors are rather focused on the significant value we help them create, and that they are happy to share.
A common situation is where you have a loan that was made years ago, perhaps at the time of the financial crisis, and now represents around the fair value of the asset or slightly above it. That loan has been dragging on while lack of capital expenditure has led to a decline in the quality of the underlying asset and impaired its profitability. As a lender you can step in and recreate some equity in the capital stack by buying back the loan at a discount and providing some liquidity to the sponsor to perform capital expenditure that improves the quality and value of the real estate. After a couple of years, when that is done, you can find a more traditional source of capital willing to refinance the sponsor and make an exit. You can also acquire non-performing loan portfolios and then foreclose on assets when needed, or help more constructive borrowers refinance and retain ownership.
In Ireland, we backed the best local developers to get their projects out of foreclosure by Ireland’s ‘bad bank,’ the National Asset Management Agency (NAMA). We would buy those assets from NAMA together with the developer and provide them with capital to begin construction or reposition the projects. Again, as those projects mature and begin to lease up, they become bankable again through more traditional sources of funding so we then start to repatriate some of our capital while sharing in the upside based on a formula set up with those sponsors. For example, last year we teamed up with developer Jonny Ronan to develop Fibonnaci Square site in Ballsbridge, Dublin, where he was in discussions with Facebook for a new headquarters building. At the time, traditional financing sources were not available, but now that a lease has been signed with Facebook the risk profile of that asset has changed dramatically.