This article is sponsored by ARA Venn • CBRE Global Investors • Invesco Real Estate • Madison Realty Capital
One of the starkest differences between the covid-inspired downturn and the global financial crisis has been the response of lenders. In 2008, the banking crisis saw the credit taps suddenly switched off. But in 2020, after a brief pause to survey the altered landscape, banks and debt funds kept issuing loans, even while governments brought in moratoriums on foreclosures.
Increased, if slightly more cautious and risk-averse, loan origination activity is demonstrated by CBRE’s US lending momentum index, which saw a 38 percent uptick in the final quarter of 2020, albeit within the context of a 24 percent decline from its February pre-pandemic level. And that is also the assessment of the participants in PERE’s debt roundtable discussion – two US and two European debt fund managers – who meet online to debate the extent and nature of lending opportunities in the pandemic-altered market on both sides of the Atlantic Ocean.
A member of the European contingent, Invesco Real Estate managing director, fund management, Andrew Gordon, predicts there will be openings for increased activity by alternative lenders. “As the banks have retreated, loan-to-values have come in a bit. There are fewer assets that banks like to lend against, and for those assets, spreads have come in as well as LTVs. That has not pulled the rest of the market down. It has just left a bigger patch open for the rest of us to finance assets that the banks will not touch, or at LTVs they are unwilling to offer.”
Alternative lenders in Europe still hold a fairly small market share compared with the banks, which means they focus typically on transitional lending opportunities, says Paul House, managing partner at London-headquartered manager, ARA Venn.
“Universally, the lenders with the lowest cost of capital are German banks, French banks shortly thereafter, and then just banks,” he says. “The opportunity for alternative lenders is not to compete against the banks. It is to add value in situations when sponsors want more leverage, or cannot get the leverage they want because the underlying asset has value-add elements that the banks view as too risky. The bank market has pulled back leverage to doing deals of 50-55 percent LTV. That creates opportunities for alternative lenders because there are more deals they will not do than those they will do. In addition, Covid has inflicted distress on bank lending books, so they are busy working on their own exposure, particularly lenders that went long on retail and hotels.”
“A lot of that rings true for the US markets as well,” observes Todd Sammann, head of the Americas Credit Division at CBRE Global Investors. “There is a subset of the market that is dominated by the banks because of their low cost of funds – the fully stabilized assets – and that is not going to change.”
Adam Tantleff, managing principal at private equity house Madison Realty Capital, estimates there are as many as 150 debt funds active in the US, many of them focusing on the same “lighter transitional” situations.
He says his firm has lent some $2 billion since the onset of the pandemic, much of it for assets in currently popular sectors in major cities, by focusing on lending in more specialized “high value-add” scenarios where there “could be a completion or construction element, or a partnership dispute,” and which banks, as well as many debt funds, are less able to address.
“There is a misperception in the real estate debt space over the availability and cost of capital,” Tantleff says. “Capital is cheaper and more available for core assets, or for very light transitional situations. Even in the industrial and multifamily sectors, for a higher value-add transaction or a construction-related opportunity, we are seeing well above market rates because of the lack of available capital.”
More debt funds in the US are seeking to achieve higher margins by underwriting more complex loans, adds Tantleff. But he warns that not all of them have the expertise and experience to fully understand the underlying real estate. “If you are trying to get into higher value-add lending today without the infrastructure provided by a vertically integrated structure and a strong track record, then it is very high risk.”
Few investors in European real estate debt favor high-risk strategies at present, which has left them wary of exposure to development finance when carrying out due diligence on debt fund managers, says Gordon. “For example, most of the residential development vehicles that we have seen recently in the UK have been largely funded by banks or private equity firms rather than institutional investors. We think there is a place for development lending. It does produce attractive returns. But it has a modest-sized place within a wider portfolio.”
Sammann responds that development requires capital with a very long-term view. “They can hold not just through the moment of delivery, but develop to hold. That alleviates many of the pressures that a debt holder of a development loan would face. Perhaps the conditions when the property is complete mean it makes good sense to sell. But alternatively, if they are not ideal you can hold through to the next phase of the cycle. We do a lot of development, and a patient capital base is part of the reason why we can get comfortable with that business.”
Many property owners in Europe and the Americas whose tenants have been impacted by the pandemic will have breached their banking covenants, leaving them potentially vulnerable to foreclosure and potentially offering opportunities for distressed buying. Real Capital Analytics estimates there is $146 billion of outstanding or potential property-level distress in the US alone. However, CBRE notes that distressed sales accounted for just 1 percent of total transaction value in the fourth quarter of 2020.
“Debt speaks to a relative value analysis. That has driven a lot of fixed-income interest in real estate credit”
CBRE Global Investors
It is clear that some investors expect opportunities in non-performing debt. In March, Oaktree Capital Management announced that its Oaktree Real Estate Opportunities Fund VIII achieved a final close of $4.7 billion, some $1.2 billion above target, 40 percent of which was already invested in “credit-focused” opportunities. But there is debate among the roundtable participants about how extensive those opportunities will be.
Tantleff says around a quarter of hospitality loans in the commercial mortgage-backed security segment nationally are in default as a result of the pandemic, a proportion that increases to more than half in Manhattan.
“What has been interesting this time around compared with the GFC is that the distress we are seeing is more situational distress rather than real estate distress. There could be distress at the ownership level, for instance. Going forward, hospitality could be an asset class where we see distressed real estate present some good opportunities,” he predicts.
“In the past, we have been able to take advantage of some distressed situations, using them as an opportunity to buy the debt, then restructure and make a new loan to get us into a position we would not have been able to access otherwise.”
Debt funds with expertise in the underlying real estate will be best-placed to recapitalize hotels and retail assets hit hard by the virus, suggests Gordon. “There is just no debt available in the hotels space at the moment, and there are fabulous opportunities if you are confident in your ability to pick the ones that are structurally sound and only struggling temporarily.”
CBRE Global Investor’s Sammann is skeptical. “Even in hospitality, which is the canary in the coal mine of distress because it was the sector first and most dramatically impacted by covid, leisure-related assets in particular have largely recovered, although group-oriented assets will take longer. We have seen precious few enforcement actions taken by banks or by CMBS special servicers. We are just not seeing a huge actionable opportunity in hospitality, or in retail for that matter. The magnitude of the capital raised for distress appears to be disproportionate to the true opportunity,” he argues.
It is difficult to gauge the quantity of non-performing loans in Europe, says House. “The market is still in furlough. The resolution of most European distressed situations has been kicked down the road. Regulators are not letting equity owners remove tenants. And banks have been reluctant to act on covenant defaults. We are reacting in a very European way, slowly and very carefully. There needs to be recapitalization, which will present opportunities. But the US will probably be 12 to 18 months ahead of us.”
Distressed buyers will also require a degree of patience in the US, argues Tantleff. “A lot of people are very surprised there have not been more distressed opportunities. But they forget that there is a lag between when the crisis hits and when the distress hits. A lot of forbearance periods were a year. We will soon start getting to that point. The question is, do governments continue to provide stimulus a little longer, or at some point does the situation become untenable for some sponsors and lenders? Probably the middle to latter half of this year will be when we start to see distressed opportunities arise.”
The participants agree that the pandemic has made fundraising more challenging, particularly from new capital sources. “Real estate debt is still a nascent product for fund investors in Europe, so caution comes to the fore, and covid creates more caution. It has been challenging across the board to raise funds. But the investor view is still positive. It is just that there is a little more caution,” says House.
However, the pandemic also has intensified central banks’ commitment to lower-for-longer interest rates, and therefore drawn more capital out of fixed income allocations and into commercial real estate debt, argues Tantleff. “There is a new class of investor looking at real estate debt: fixed-income investors searching for yield and return. If they can invest in a fund focusing on senior loan origination where, with some gearing, they are getting an equity-like return, they have to at least consider it in this environment.”
“Debt speaks to a relative value analysis. That has driven a lot of fixed-income interest in real estate credit,” adds Sammann. “You have a return profile which is largely on a parity with equity. But with the downside protection provided by playing further down the stack with an equity cushion against your first dollar of risk. That presents a really strong argument for value.”
“There are fewer assets that banks like to lend against, and for those assets, spreads have come in as well as LTVs”
Invesco Real Estate
This year’s PERE Investor Perspectives study demonstrates investor appetite for loans at the senior end of the capital stack, with more than 60 percent of investors surveyed saying they favored senior debt, compared with just over 40 percent for whole loans and around 25 percent for mezzanine finance.
Gordon comments: “A lot of insurance companies we speak to are definitely more focused on senior loans. I am surprised there is not more appetite for whole loans, because we see that as an opportunity. But there is declining appetite for mezzanine. For big ticket sizes of mezzanine of $60 million to $70 million upwards, the spreads are getting really tight. For mezzanine of $10 million to $30 million we are still seeing pretty good returns. But it is hard to achieve scale at that level.”
A challenge for investors in real estate debt highlighted by the panel is the lack of tools with which to assess comparative risk and performance. The participants argue that investors sometimes fail to understand that debt funds that claim to be providing ‘unlevered’ returns often feature structural leverage to enhance performance, while seemingly operating in a comparatively low-risk part of the capital stack. It is agreed that most US funds need to use some kind of leverage to some degree in order to remain competitive.
Meanwhile, in Europe, debt investors tend to be warier of fund leverage, preferring to take risks elsewhere, observes Gordon. “One of the issues in our market is ensuring that investors understand the difference between real estate risk and leverage risk. We have heard too many investors say, ‘You are doing mezzanine loans, and that is too risky for me.’ But they will happily invest in a whole loan fund that is targeting 10 percent returns, which is taking a lot of property risk. Some LPs disregard the fundamentals and believe an unlevered fund with modest LTVs has to be lower risk than a mezzanine fund or a levered fund.”
These issues highlight the need for benchmarking and common terminology to define risk in commercial real estate debt, argues Sammann. “We need to develop the language around risk measurement. ‘Transitional assets’ is too broad a term. Applying the equity overlay is perhaps a constructive approach: core, core-plus, value-add and opportunistic. Using that language helps to drill down to a better understanding of the underlying collateral risks one shop is taking compared with another. We also need a better measure of risk and returns to create accountability. The ODCE funds index allows an investor to understand one core equity strategy’s performance relative to another. But there is no benchmark for what we do on the credit side.”
Over the course of the discussion, all the participants, at one time or another, direct attention to the fact that as an institutional asset class, debt is still a relatively young corner of the real estate universe. However, its resilience though a difficult year has helped to prove that it is now well-established, and is likely to play an increasingly important role in enhancing the future performance of institutional investment portfolios.
A debt to society
ESG compliance is becoming a crucial consideration in loan origination, say roundtablers
As with the equity side of the real estate investment business, ESG has become a hot topic in debt circles on both sides of the Atlantic. European legislation, including the recently-introduced EU Sustainable Finance Disclosure Regulation, and the requirements of institutional investors make ESG-related disclosure inescapable, says ARA Venn’s House. “Reporting it is a requirement now.”
That necessitates a wealth of detailed information, adds Invesco’s Gordon. “We have a checklist of 24 items we have to score for each loan we make, with independent as well as internal assessments of how we should score them. The loan has to meet minimum requirements on each of the environmental, social and governance factors, and a minimum composite requirement before we can proceed.”
Sammann confirms that similar practices are taking hold in the US, with CBRE Global Investors conducting a parallel assessment of new commitments’ ESG attributes.
One of the thornier ESG issues identified by the panel is whether to lend against property where the tenant’s business could be construed as socially undesirable. “There are a few things that are difficult to finance, such as a building where the tenant is producing munitions,” says House, citing the example of an industrial property occupied by an arms manufacturing firm, which ARA Venn declined to finance.
“The difficulty is if the borrower wants to fill some vacant space, you have limited control over the type of tenant they put into it,” says Gordon. Sammann suggests that problem can be addressed through the terms of the loan. “CBRE Global Investors has a list of exclusionary uses in our form loan documents so that we do not find ourselves with a prohibited use inside one of our collateral assets. That provision is negotiated up front so we are not putting ourselves at risk of liability.”
The participants’ predictions for how the real estate debt market will evolve in the next five years
House: In Europe, we will see debt funds and other alternative lenders play a more active role because of the long-term impact of regulation on the banks. As the market evolves, fund sizes will increase, and as larger, more industry-relevant entities are created there will be more standardization in performance metrics and clearer differentiation between risk profiles. As regards the cycle, I don’t see the tide going out so severely that every manager gets massacred. In some cases, deal-level losses will help investors differentiate manager performance.
Gordon: In a lower-for-longer interest rate world, real estate debt will be an increasingly significant part of institutional investors’ allocations. We will see investors demanding more equity expertise from their debt fund managers to supplement their credit-side expertise. ESG will become more important still.
Sammann: The industry will develop a common language and measurement tool to identify the operational and financial risks attendant to the credit business. Measurement will allow investors to track performance and create greater transparency and accountability. That will result in a rationalization of the number of managers in the credit space, just as we have seen on the equity side.
Tantleff: With increased regulation and a continued structural low-interest-rate environment, the 2020s will be the decade when real estate debt establishes itself as a widely-accepted institutional asset class. As investors get more exposure to the sector, they will also better understand that there are different shades of debt, and different ways to go about investing in it.
Meet the roundtable
Managing principal, Madison Realty Capital
Tantleff is one of the three managing principals at the New York-based private equity real estate firm. The company manages around $6 billion of equity and debt investments overall and, since its founding in 2004, has completed more than
$13 billion in real estate transactions and become one of the leading special situations lenders in the US. Madison was the largest private lender of construction finance in the US in 2018 to 2019.
Head of Americas Credit Division, CBRE Global Investors
Los Angeles-based Sammann joined in 2018 from Narrative Capital Management, which
he spun out of Colony Capital where he had served as head of credit strategies. To date, CBRE Global Investors has established a core-plus credit fund and a number of separate debt investment mandates. The investment management arm of real estate services firm CBRE Group, CBRE Global Investors controls around $120 billion of real estate overall.
Managing partner, ARA Venn
Canadian-born House co-founded the commercial real estate debt business of Venn Partners in 2013. APAC-based ARA Asset Management took a majority stake in the firm in March 2020 to create ARA Venn.
Headquartered in London, ARA Venn manages European debt funds with assets totaling over $2.2 billion, and is contracted to originate and manage multifamily and affordable housing loans on behalf of the UK government.
Managing director, fund management, Invesco Real Estate
Gordon joined Invesco Real Estate in October 2020 when the firm undertook a team and asset takeover of the real estate debt finance business of Swiss manager GAM, together with over $300 million of assets under management. He and his team are charged with building up a European debt business for the Dallas-headquartered manager, which controls an $80 billion global real estate portfolio, including $5 billion of US loans.