Institutional demand for 'punchier' real estate debt strategies on the increases, says new bfinance report
A new report from bfinance finds that, amid the seemingly never-ending ‘hunt for yield’, higher-returning real estate debt strategies are attracting investors’ attention.
Among bfinance’s international institutional client base, demand for strategies with a higher risk/reward profile grew significantly in 2020 and has remained strong in 2021.
Many investors are familiar with real estate debt in its more conservative form. However, adding more flexibility in terms of collateral type, geography or LTV (eg 65 per cent) can boost the premium to 300-500 basis points per year, giving returns of approximately 4-6 per cent in Europe and 5-7 per cent in the US. The report includes data from a new survey of more than 50 real estate debt managers, showing the various tactics that funds are using in order to enhance returns.
bfinance reports that investors are using these strategies in a range of ways: to complement high yield bond portfolios, bringing diversification and volatility reduction; they can sit alongside private corporate debt, with similar returns – but very different risk exposures; they can even supplement property portfolios, with minimal (if any) reduction in target returns versus core/core+ real estate equity strategies but meaningful diversification and faster deployment.
Investors must ensure that extra yields do not come at the expense of disproportionate increases in risk by understanding which approaches managers are using to deliver an enhanced return. New data shows the prevalence of different strategies.
Lever 1: increase LTV ratios
The report states that most strategies captured – nearly two thirds – are not pushing LTV beyond what one might consider a relatively ‘comfortable’ level of 75 per cent.
Although equity providers are willing to pay higher margins on debt that covers a higher proportion of the cost of an asset, higher LTVs make it more likely that the lender will incur a loss if a default happens. Moreover, higher financing costs can also make defaults more likely. It can therefore be tricky to strike a balance between extracting a higher return and the LTV limit at which one feels comfortable. This is particularly challenging in the current Covid-19-influenced climate, since it is harder to establish property valuations with the required level of confidence.
Lever 2: change the collateral
Lenders are lining up to work with owners who can offer the security of prime, stable Real Estate with blue-chip tenants on long leases. Financing other property types, however, can (often, but not always) command higher yields.
These choices result in very different risks. Non-core or cyclical property types might prove less resilient through economic cycles. Transitional properties, which might be untenanted or have tenants on short leases, can involve risks being taken on a successful repositioning or a change of use intended to deliver higher yields in future. So-called value-add property, where significant additional expenditure may be needed for refurbishment or even construction, brings further potential risks, and higher rewards yet again.
Outside of the ‘IG’ world, most lend against more than one property type. Mezzanine and whole-loan strategies tend to focus on core+ and value-add properties, while strategies that lend against development properties tend to focus on first-lien debt at more conservative levels. Strategies that combine stretch levels of financing with higher-risk collateral are also available – and not for the faint-hearted.
Lever 3: add leverage
Fund-level leverage is used by more than 40 per cent of the managers in this sample, although it may not always be the main source of higher returns. While most strategies seek to generate additional yield from the assets themselves, leverage can be an effective tactic for enhancing returns, particularly where the underlying assets are of very good quality and can therefore support higher leverage at a portfolio level. It is important to note that the 40 per cent would have been notably higher with a more US-oriented sample.
Aside from fund-level leverage, individual positions within the portfolio can also be levered. Mezzanine loans, for example, deliver higher returns but at the expense of subordination to other lenders and higher expected losses proportionately should something go wrong, although sensible structuring and a proactive workout approach can mitigate some of these risks.
Lever 4: look to under-served geographies
A minority of managers focus on regions that are less well-served by lenders, resulting in more attractive returns. Yet there is rarely a supply/demand ‘free lunch’: a weaker economy makes credit risk implicitly higher; some legal systems make it harder to take enforcement action when defaults occur. Geographical differences are not only relevant on a country-by-country basis: even within a single jurisdiction there may be higher-yielding locations. Local knowledge and targeted origination capability are needed to make these trade-offs profitable.
Lever 5: seek distress
While lenders typically aim to avoid risk, significant upside can be generated by acquiring properties at a discount and then gaining possession through effective enforcement. This approach may generate little (if any) yield, but the overall IRR can be very attractive. Anecdotally, even ‘performing debt’ managers typically report higher returns overall from positions where they have had to take enforcement action. One does not have to play the vulture: distressed properties that have historically been financed by ultra-conservative lenders might simply need a more flexible or higher-LTV solution to get through current difficulties.
Trevor Castledine, Senior Director at bfinance, says: “Some of the levers mentioned above have been popular for years such as mezzanine debt and higher LTV ratios, which have been used to provide outsized returns; this trend was true even before the Global Financial Crisis (GFC). While this is the case, others are becoming more widely used in today’s climate: newer strategy types are more likely to tap into specific niches, such as smaller properties, riskier geographies, distressed assets and development or bridging finance.”