This article was sponsored by Venn Partners. It appeared in the Debt Fund Report alongside the April 2019 issue of PERE magazine.
Venn Partners is placing less emphasis on the UK property market these days, which has so far proved fertile ground for the credit-focused asset manager. The firm is now increasingly favoring lending against value-add real estate in continental European markets. Managing partner Paul House outlines the market dynamics driving the company’s evolving strategy.
PERE: Why might a capital provider choose to back a debt strategy now, rather than making an equity investment?
Paul House: Given the advanced stage in the investment cycle, it has become evident that the core market is priced on the aggressive side and asset purchases in the value-add sector are increasingly competitive, so commercial real estate debt can offer investors an interesting product that is complementary to their real estate investment allocations, and a good diversification within fixed-income investments. Lower volatility and lower deployment costs make debt a compelling case for investors. We do not fund the whole purchase price of a property, with loan proceeds of up to 75 percent loan-to-value, sometimes less, so we benefit from an insulating feature to our target return as property values can stay stagnant or even recede before impacting returns. Nothing in the current market indicates a sharp decline in the value of commercial property assets, but core is aggressively priced and we will see less growth in that space going forward. The use of debt can be viewed positively against that backdrop.
Borrowers also pay for most of the underwriting, legal and valuation work, and other consultants’ reports, so debt has a very low-cost fund threshold. In the equity game, in every deal you must absorb those costs and you may not be able to acquire the asset because someone else is willing to pay more. The expense ratio is much lower in debt than in equity, so in these times of a lot of equity capital chasing deals, this feature might begin to have an impact on the comparative returns of equity and debt strategies. Importantly, the amount of capital going into debt is not massive, and competition is not massive, so we see the market conditions in our space remaining stable for the next few years.
PERE: Where do you see the best opportunities for investing in European real estate debt?
PH: Attractive relative value can be made by creating a strategy where others are not focused, but where the fundamentals remain attractive. Core real estate markets in continental Europe are attractive for equity investors, and there are significant amounts of capital going into that type of real estate. Complementing this, in the occupational markets the rents and vacancy rates backing those assets are strong and it appears they will continue to be so. Supply for the most part is in control.
With this market opportunity, it is a good time to be financing value-add assets to stabilize them and then these properties feed into the much larger core markets. Banks still dominate commercial real estate lending in terms of volume because they have an extremely efficient funding model, which makes competing with them quite challenging if you target where their sweet spot is. For the most part, it is better to choose to go where they are not, and due to regulation and their own prudence, given their own leverage model, the amount of debt they are willing to provide on assets which involve factors like leasing risk, refurbishment, development or operational risk is limited.
Therefore, backing value-add investments provides an opportunity for investors to generate higher returns because the assets themselves are higher returning, and because you can offer loans of up to 75 percent loan-to-value where a bank will typically only go up to 50 percent, then the ability to price capital efficiently is there. There are also opportunities to lend on other asset types that the banks are less comfortable with, such as real estate operating assets like hotels, student housing or care homes.
PERE: Which European markets currently show the most favorable fundamentals?
PH: Our first pan-European value-add fund invested in the UK and selected European countries. We are working up to the launch of a second fund that will take the UK off the list of countries and bring in Spain. Brexit makes investing in the UK more challenging because of the uncertainty. We do not anticipate any massive decline in UK real estate and the market continues to reward private equity managers that are doing their jobs right and adding value to buildings, but nobody knows what will happen.
There are also cyclical reasons to exclude the UK and include Spain. The UK did quite well in the years immediately following the GFC, but in continental Europe the banking crisis of 2011-13 caused further economic disruption. Now, mainland Europe is doing better, including Spain, which has been through the process of recapitalizing its financial institutions and is demonstrating good prospects for GDP growth. A lot of what we do is refinancing the assets that come out of non-performing loans; as Spain is at an earlier point in the cycle, we see some potential opportunities there.
Amsterdam is also a very active market; we recently completed a deal just outside the city taking advantage of the spillover from an office market that has a very low vacancy rate and is cramped for space.
In France, we financed a transaction in the industrial market which is in an earlier phase of the industrial distribution evolution brought on by internet retail penetration.
PERE: Venn Partners was closely associated with the UK private rented residential market. Will that continue to be a focus?
PH: In 2014, we won a competitive tender from the UK government to deploy capital into the PRS sector with a focus on stabilized income-producing properties. That business continues to provide long-term owners of institutional homes for rent with affordable debt where we raise capital with the benefit of a government guarantee and use these proceeds to cost effectively fund loans in the sector. Outside that, as part of our historical view, we also found the UK value-add residential sector interesting. We started doing residential loans back in 2013 when pricing was strong, as was the residential market overall. However, even at that time we did not like all parts of the residential sector and were shy on the high-end subsector.
More recently, our selectivity has increased. We are doing less London-centric UK residential, but have looked to the regions where the pricing of the underlying properties are at more affordable levels. London boroughs, where supply is constrained and if properties can be acquired at a lower price, will continue to provide opportunity. Venn also has a Dutch residential mortgage business and we continue to like residential as an asset class, particularly in continental Europe. The underlying market to purchase residential is expensive everywhere and there is a need for new supply, so we like the residential sector. The more challenging sector is retail. The UK high street is struggling and conditions are not easy in continental Europe either. Online delivery is impacting retail assets everywhere, even if Europe is behind the UK and US in terms of feeling the full brunt of increased internet penetration.
PERE: There are more players in the debt space than before. How does a manager show their value to investors in a more competitive environment?
PH: Investors have a good data set now for the debt funds that have been around for a number of years, so they can discern between different managers’ track record on the approaches they have chosen and how they have been able to perform. That information probably did not exist when we founded our business six years ago. In the commercial real estate lending space, some loans perform better than others, so now investors can see how a manager has dealt with the problems of having potential stress on their books. One can also see how good they were at creating opportunities from the market. For example, we financed deals in the UK pubs sector in 2013, which at the time was quite an avant garde move; since then we have seen some very large and healthily priced M&A activity in that sector.