DRC Capital on debt as a defensive play

This article is sponsored by DRC Capital. It appeared in the Investor Perspective 2019 supplement with the March 2019 issue of PERE magazine.

Since the end of the global financial crisis, debt investing has developed from the new kid on the block to an established niche strategy within the European real estate market. Now, as the recovery that lifted investment returns across the asset class is beginning to lose its buoyancy, debt strategies are attracting capital that would previously have been channeled into equity investing, says Dale Lattanzio, managing partner at commercial real estate debt advisory platform, DRC Capital.

PERE: What factors are driving investor interest in real estate debt?

Dale Lattanzio: Ten years ago, investors coming into real estate debt funds were particularly focused on high-yielding and mezzanine funds. Typically, it was the real estate allocation in that investor’s portfolio and they were looking at debt opportunistically, thinking that the risk-adjusted returns were good because there was a significant correction in capital values across the board in most asset classes throughout Europe. What we are seeing now is that those investing in debt are still looking at it as an opportunity to get compelling risk-adjusted returns, but are also comparing debt strategies to the equity opportunities in the market place. As investors receive money back from equity strategies, and seek to re-invest it, CRE debt will be the recipient of a decent portion of that capital given where we are in the cycle. Right now, it is harder to foresee cap rates coming in and income going up further across the market as a whole, so investors have to pick their real estate equity strategies very carefully. Debt is a good way for investors to protect themselves should the market deteriorate a bit.

There are also a lot of investors with liabilities that are required to meet a certain annual rate of return. Some of them do not want to take public market equity risk or indeed real estate equity risk. Debt can match up with those liabilities quite nicely. In addition, property debt is becoming interesting for investors because it can be seen as an alternative form of credit investment. Because we have been in a low interest rate environment, we have seen investors that prefer to invest down the risk curve looking at alternative credit because corporate bond yields are very tight.

PERE: Where is investor demand coming from?

DL: Debt funds have evolved and there are many more products on offer. They still include high-yield and mezzanine strategies, but now there are also whole loan strategies that do not take mezzanine positions, but provide a little bit more leverage than the banks, and even products that offer senior mortgage risk. They all offer different risk-return profiles. That means there is also an increasing diversity to the types of investors looking at real estate debt. There is demand now not only from pension funds, but insurers have also shown an increased appetite. Solvency II, which is the regulatory regime that governs insurance company capital in Europe, is more favorable to debt investing than to equity real estate investing. Increasingly, we will see sovereign wealth funds coming into the space. They have been very active investors in real estate and have a lot of capital to deploy. The debt space could be the beneficiary of some of that capital as they consider where we are in the cycle.

PERE: And what kind of strategies do those lenders prefer?

DL: In the last two years we have seen a lot more interest from investors in senior or whole loan strategies. That has been driven by low interest rates and the lack of alternative income-based product in the market. In terms of the underlying assets, investors usually want their managers to build a diversified pool both by property type and geography. For example, in a UK strategy they typically do not want to see all the loans made against offices in London. They like to see the regional cities included in a portfolio, together with different kinds of assets, some stabilized, others parts of portfolios where there might be scope for value-add initiatives.

PERE: Is it difficult to deploy capital?

DL: The key to deploying is to be realistic about return expectations, carefully representing to investors the returns that are available in the marketplace for the risks they are taking. Investors should also consider the manager’s track record with, and network of, borrowers. It is that origination network that enables deployment. Germany is probably unique in our region in terms of the tools the banking system has with respect to refinancing its commercial real estate lending activities. That means it is somewhat more challenging for alternative lenders, but there are usually situations alternative lenders can fulfil even in jurisdictions where the banks are active and offering quite compelling terms. That might be because of the underlying property asset type, the amount of leverage requested or even the loan structure. Ten years ago, the banks provided around 95 percent of all the lending in our marketplace. That has probably been dialed back to 65 to 70 percent as alternative lenders have come in and taken up some of the slack. There is still a growing market, albeit one that is growing at a slower rate.

PERE: What tips would you offer for selecting a manager and strategy?

DL: The market has matured, so investors looking at our space for the first time now have the benefit of being able to look to a number of managers with fairly significant track records. They can see how the managers have succeeded in deploying capital, managing it and achieving the returns they were aiming for. Then have a dialogue with the manager about what is possible. If there is a need in an investor’s portfolio for a certain kind of return profile, there are many strategies available in the real estate debt market. If there isn’t a commingled fund available that meets that profile, then oftentimes managers are able to directly access investments with the kind of risk and return specifics investors might want.

PERE: Commitments to real estate debt funds spiked in 2017 and fell in 2018, according to PERE data. Does this signal waning investor demand in debt?

DL: I think that just reflects the fact the funds in our marketplace mostly tend to go back to market on a similar cycle. I would suggest there were fewer funds out looking for capital in 2018 than there were in 2017. If there were the same number of funds out there looking for the same amount of capital, but they were unable to raise it, that might be pointing to investor attitudes and appetite, but actually I think there were fewer funds in the market because there was quite a lot of capital raised in 2016 and 2017 still being deployed last year.

PERE: What do you anticipate will be the principal headwinds and tailwinds for the real estate debt space in the coming months?

DL: The potential headwinds are very similar to those facing a real estate equity manager – in other words, the macro backdrop: where we are in the cycle, and what is happening at the macroeconomic and political levels. I do not think that interest rates will come up as quickly in Europe as they have in North America, but the starting point for investors considering deploying into real estate strategies generally is that uncertainty. The tailwinds are that debt has a slightly different risk profile because the equity is eroded before the loans take a loss. Meanwhile, historically when we have found ourselves in interesting political and economic times bank lending has pulled back. That means spreads widen a bit, there is less liquidity and more room for alternative sources of debt capital. I expect that to happen again over the course of the next six months.