The changing face of real estate credit

The real estate debt fund market has exploded in the past decade, with $301 billion raised, data from Real Estate Capital USA shows. Although fundraising has dipped somewhat since the peak of 2017, when 114 funds closed for $43 billion in aggregate, there are a considerable 198 real estate debt vehicles on the road as of January 1, targeting a combined $51 billion.

Fundraising first hit double figures in the wake of the financial crisis, of course. “Post-GFC, major changes in financial regulation aimed at preventing another economic downturn restricted bank lending practices and allowed for the proliferation of real estate debt funds,” says Justin Guichard, managing director for real estate debt and structured credit strategies at LA-based-manager Oaktree Capital Management.

“Loans with characteristics that fall outside today’s bank lending practices may offer higher returns, providing opportunities for real estate debt funds to earn an attractive yield for providing this liquidity to the market. As an ability to create large, diversified portfolios is viewed attractively by investors, and holistic financing solutions are valued by borrowers, alternatives firms have been successful at raising and deploying ever larger fund vehicles, giving more access to the asset class than ever before.”

Roland Fuchs, head of European real estate financing at Allianz Real Estate, agrees: “Appetite for real estate credit has grown substantially and continues to accelerate.”

The objectives that investors are looking to meet with a real estate credit strategy are also changing. Ten years ago, it was about achieving duration, with the emphasis on long-term liability matching, and allocations came from investors’ fixed income portfolios. Now, there are a broader set of reasons for accessing the asset class, and allocations are coming from both real estate and fixed income buckets.

“Real estate credit is one of those asset classes that can serve a number of different purposes,” says Isabelle Brennan, senior director in the global credit solutions division at CBRE Investment Management. “It offers bond-like characteristics, which means it can work as a fixed income substitute, but it also has underlying real asset security, so it is familiar to real estate equity investors.”

“Debt is also a great product for embedding ESG ambitions in an investor’s real estate or fixed income book”

Ronald Fuchs
Allianz Real Estate

A real estate credit strategy also offers the ability to optimize risk capital charges. This is particularly important for insurance groups and pension funds. “In that sense debt definitely compares favorably with equity – at least the first ranking mortgage part of it,” Fuchs says. “Debt is also a great product for embedding ESG ambitions in an investor’s real estate or fixed income book, because it is a product that can be neatly adapted to those targets in terms of both data collection and the types of financing provided.”

Meanwhile, credit can represent an efficient way of deploying capital, as transaction costs are typically far lower than for equity. From a manager’s perspective, there is an excellent cross-selling angle: the borrower base is identical to the counterparties on the equity side, so adding debt to the product mix allows them to broaden the conversation.

But the real advantage of credit, of course, is that additional layer of downside protection. “It provides excellent risk protection in cyclical and volatile markets, as has been evidenced over the past few years,” says Fuchs. “Investors are able to remain active in real estate, but in a more resilient manner.”

Indeed, early-intervention mechanisms have served the industry well. Guichard says: “One of the reasons that the real estate sector has largely weathered the covid storm is the regulatory environment created in the aftermath of the GFC, which forced market participants to reduce risk taking, and therefore restrained the irresponsible real estate lending practices that contributed to the prior crisis.”

Meanwhile, that added downside resilience comes at only a modest discount. Cap-rate compression has reached a point where it can be challenging for equity managers to produce a current return. “In that context, an allocation to credit services the dual objectives of delivering attractive current yield with reduced volatility, owing to a more senior position in the capital stack,” says Todd Sammann, head of the Americas credit division at CBRE Investment Management.

Fuchs agrees: “I don’t think we will see appetite for real estate credit go into reverse, when the returns you can achieve on the debt side are much closer to the equity side than they have been in the past. Today, depending on risk appetite, you can achieve returns in the core to core-plus investment-grade space of 2 to 4 percent, which is not far off the cash-on-cash return you can achieve with equity.”

Evolving opportunities

Not only has the real estate credit market grown dramatically, but it has also become more nuanced. Ten years ago, the scope of available debt product was binary. “Today, the offering is much wider, both in terms of geography and product,” says Fuchs. “There are pan-European funds rather than just single-country funds, and there is a far greater offering in the mid and low investment-grade space, which is equivalent to core, core-plus and value add on the equity side. That mid-risk market just wasn’t available before.”

There is also diversification in terms of investment themes. Today, you can find a specialist debt fund focused on almost anything – hotels, logistics, retail, established assets, refurbishment. The choice is now comparable with the equity markets. Of course, some of those products are faring better than others; the pandemic caused a violent shift away from traditional brick-and-mortar retail, for example, and ushered in an expanded set of products.

“This shift sustained the demand for industrial space, the new darling category of the real estate market,” says Guichard. “Life sciences, data centers, self-storage and apartments were also tagged as covid winners.”

From a credit standpoint, the life sciences sector is particularly attractive due to long-term leases, favorable industry trends and the attractive credit profile of well-capitalized tenants. This has created a spate of opportunities to finance the repurposing of offices. Banks and life insurance companies have supported this trend, although debt funds tend to be competitive in development or redevelopment situations.

Out-of-favor sectors include office buildings, particularly commodity or older office buildings lacking modern amenities and safeguards, which have suffered as work-from-home has become a standard component of the employee experience.

The pandemic also led to an immediate tightening of credit standards, with some lenders effectively ceasing to provide capital to certain markets. “This left many borrowers with few options to finance high-quality but out-of-favor assets such as resort hotels, recently constructed office product and residential condominiums, and led to a massive spike in credit spreads, which act as a real-time indicator of the relative risk of certain asset classes,” says Guichard.

Building conviction

This, of course, generated substantial risk-adjusted returns for credit investors who moved forward with conviction during such uncertainty. While the private loan market is typically less efficient due to its relationship-based nature, in the midst of forced selling, the traded securities markets such as CMBS, CRE and CLOs provided broad opportunities for investors.

“The office sector has taken a beating during the pandemic and many lenders appear to have redlined the sector entirely,” agrees Sammann. “But while some form of work from home is clearly here to stay, workplaces will also have an important role to play going forward. The challenge, and the opportunity, is to identify the combination of office attributes that will attract the lion’s share of tenant demand and investor capital going forward. Meanwhile, a lack of competition means we can generate greater return through higher coupons and drive more robust loan structures than in other sectors.”

Real estate credit is an important complement to equity strategies for many investors, and the benefits are clear. Managers that build conviction around the themes of the future, while remembering the lessons of the past, will fare well in a very different economic environment going forward.

Infrastructure debt

Infrastructure debt is increasingly viewed as an important component of many investors’ real assets portfolios.

“The amount of capital raised in infrastructure debt each year has more than quadrupled over the past decade,” says Kit Hamilton, co-head of Macquarie Asset Management’s private credit team. “Furthermore, not only has investor appetite grown, but it’s also shifted from investment grade to sub-investment grade, as well as into different jurisdictions as investors have less of a home bias, and as global markets mature.”

Meanwhile, the supply side for this asset class has been buoyed by factors including regulation requiring banks to hold additional capital against its mortgages, derivatives and securitization assets, and the rationing of capital among internal business units, says Andrew Jones, QIC’s head of private debt. “These actions by the banks have left a gap which non-bank lenders are now filling to meet institutional investor demand.”

That demand is being driven by investor appetite for defensive income streams with strong yield, particularly in this lower-for-longer environment. “Infrastructure debt offers the advantage of access to investments with contracted or regulated cashflows, target assets providing essential services, stable earnings streams, high barriers to entry and a developed markets focus,” says Jones.

However, the role that infrastructure debt plays can vary. Some investors view it as private credit, typically at the higher-returning end of the asset class. For others, it is an attractive fixed income alternative to corporate bonds. Or it can fall into the infrastructure bucket. “As it has a wide range of characteristics, it can straddle a number of asset allocations and may fall between the cracks of in-house teams,” says Hamilton. “This is something we’ve seen investors acknowledge and have sought to address.”