The private real estate debt market has found itself in something of a virtuous circle in recent years, with increasing investor demand sparking a greater product offering from managers, which in turn has provoked larger allocations.
As the global macroeconomic environment looks more uncertain, investors are keener than ever to take advantage of the defensive qualities of private real estate debt. That said, the growth in the sector is structural and should continue regardless.
Hugo James, divisional director, private credit, at Macquarie Asset Management, notes that the market is also supported by “a very diverse range of borrowing requirements in real estate, as the product range there has expanded too.” Regulatory pressures around the world have also pushed banks away from real estate lending, although the effect of this varies from region to region. It has been more significant in the US than in Asia, for example.
“There is clearly quite a wide spectrum of real estate debt – from investment-grade debt with some downside protection to very opportunistic preferred equity – but I think there are a lot of interesting opportunities in the middle,” adds James.
“Investment-grade real estate debt tends to be part of the fixed-income allocation,” he continues, “but more stretch loans and mezzanine financing are providing returns more in line with those available in real estate equity investments.”
“Real estate debt is a very versatile investment instrument, offering diversity in products, sponsors and geographical markets”
For Dutch pension group APG, the main attraction of the sector “is in the risk-return profile, as we can achieve equity-like returns without taking the full equity risk,” explains Robert-Jan Foortse, head of real estate Europe.
Roland Fuchs, head of European real estate finance at Allianz Real Estate, says: “We see real estate debt as an alternative to fixed income, with diversification being a key instrument for our investors’ balance sheets.
“Debt is also an alternative to real estate equity where it acts as a frontrunner or a market entry product prior to future geographical equity expansion, while maintaining the ability to remain in markets where pricing trends and/or exposure do not recommend further prime core equity investments.”
Geoff Souter, head of real assets credit at CPP Investments, adds: “Real estate debt is a very versatile investment instrument, offering diversity in products, sponsors and geographical markets. The opportunities can be both passive and active, short and long term, allowing for portfolio construction and optimization. Returns in this space can also be as attractive as equity, with the underlying hard assets offering good downside protection.”
A port in the storm
Real estate transactions have slowed this year in some markets as inflation and interest rates have risen. The volatile global political situation, with war continuing in Ukraine and ongoing tensions between the US and China, means debt’s preferred position in the capital stack offers downside protection and so is more attractive during times of uncertainty, James explains.
Fuchs agrees: “Within the current volatile environment, lending is one of the most defensive plays.”
APG’s Foortse adds: “In more uncertain market circumstances, having an equity cushion taking a potential first loss ahead of us limits our risks. At the loan-to-value levels we provide, we would be happy to assume the equity position in these projects. Furthermore, it typically provides for more stable cashflows than direct equity investments, hence reducing volatility within the portfolio.”
Other investors see opportunities to help real estate borrowers through tough times. “We also have been providing sponsors with flexible corporate-level debt to accelerate growth, which can be especially valuable during periods of market dislocation,” says CPP Investments’ Souter.
Capital raising for real estate debt funds has grown significantly in the past decade, PERE data shows, although the total of $47.7 billion raised in 2017 has not been surpassed since. The largest private real estate debt fund, Blackstone Real Estate Private Debt Strategies IV, closed in 2020, while Brookfield also closed a $4 billion fund last year. This suggests the growth of private real estate debt is structural.
“When we started to add real estate debt products to our portfolio early after the GFC,” says APG’s Foortse, “we thought it would be a tactical play and that window of opportunity would close as soon as markets would normalize. By now, we have realized that real estate debt investment has a structural place in our portfolio.”
Onwards and upwards
The broader range of investors, lenders and borrowers in private real estate debt has contributed to a larger range of debt and debt-like products. “These include commercial ground leases, for example, providing debt-like characteristics with very long-term income, lifetime mortgages, lending to social housing,” explains Macquarie’s James. “The growing importance of ESG, and the ‘S’ in that, is making lending to the social housing sector more attractive to investors.”
Indeed, ESG is an area where investors are keen to see more options, adds James. “We are seeing more ESG clauses in loans and more of a focus on the topic from both lenders and borrowers. It is now firmly on the agenda.”
APG’s Foortse agrees: “We believe more emphasis can be put on promoting and encouraging sustainable initiatives,” he says. “There are many ways in which this can be done; one example could be a borrower benefiting from a lower margin should a redevelopment achieve a certain building certification. Although a nascent market, we see more lenders thinking about this, and as the market evolves we expect more consistency and standardization within the sector.”
Fuchs says ESG considerations are also important for Allianz and its partners. “From the viewpoint of Allianz and the likeminded institutional investors we partner with, the debt products they aim to invest in should offer diversification across sectors and geographies while contributing to ESG targets.”