Commercial real estate debt investment makes a comeback
Renewed interest and appetite, especially in Europe, comes as investors increasingly seek better risk-return profiles with higher, stable yields
In the years before 2007, a significant expansion of real estate debt occurred globally, especially in Britain and elsewhere in Europe. This was driven by lenders providing unprecedented leverage at historically low loan margins and an "originate to distribute" model that transfers transaction risk to a third party. By mid-2007, the ability to securitise or syndicate commercial real estate loans virtually ceased in the British primary market, and secondary market volumes slowed considerably. Banks were left with low-yielding, over-leveraged property loans to manage.
Since then, the loan market has faced tightened economic and regulatory pressures affecting capital ratio requirements, leverage ratio limitations, legacy asset concentration and the requirements of rating agencies and investment analysts and investors, reducing balance sheet exposure. Many global banks have cut back on loans.
Historically, banks have provided the majority of debt finance. According to Morgan Stanley Research, in 2012 banks and bank-related lending comprised 90 per cent to 95 per cent of the market in Europe and Britain. Asia-Pacific has a similar reliance at 75 per cent to 80 per cent, while the US is at 55 per cent to 57.5 per cent.
Investors are increasingly seeking a better risk-return profile with higher, stable yields. Against the economic backdrop of reduced debt supply and the low-yield conditions, capital markets have begun to play a major role in supplying finance for real estate debt.
This has brought about renewed interest and appetite in commercial real estate debt as an attractive and competitive investment asset class, especially in Europe. Both Asian and global investors have greater accessibility to high quality commercial real estate assets for medium and long-term yield.
CRE debt, a loan secured by a commercial real estate property, is in many aspects similar to a fixed-income, bond-like investment as tenants support quarterly interest payments. It can be tailored to match the risk-return profile of investors.
Commercial property debt's ability to generate handsome and predictable returns while absorbing significant income and property market volatility makes it an attractive investment. The net rental income generated by the property is typically higher than the debt servicing requirements and the value of the property is higher than the loan amount. In short, the very nature of CRE debt is conservative and has a defensive risk profile.
The scope and diversity of investment options is another positive and attractive feature of the asset class. Investors can construct their portfolio based on traditional real estate parameters, collateral asset types, jurisdictions and the related currency, as well as the locations.
CRE debt generally offers comprehensive security packages that help protect investors' control of assets in case of distress and potential enforcement. Investors have the flexibility to implement asset management plans, liquidate and monetise the assets or recover the investment.
While a debt investment remains stable for longer during periods of property value declines, it is still sensitive to significant declines and can also lead to return reductions. If a property value and rental income increase, the debt will not participate in the increased returns that direct real estate investment would provide. Britain has a stable commercial real estate profile, aided by a liquid, transparent market place, a creditor-friendly jurisdiction and a well-understood legal framework. Britain is also the largest real estate and real estate finance market in Europe, with transaction levels at £63 billion compared with Germany at £41 billion last year.
British commercial real estate volumes have rebounded, with £56 billion of direct transactions last year, compared with £53 billion in 2013 and £33 billion in 2012. Although capital values remain below their 2006/2007 peak levels, commercial real estate yield has been tightening in the past 24 months.
Also, price tightening is loosening up in the British market and beginning to bottom out. Britain provides an attractive and executable investment strategy for performing investment CRE loans in the current state of relative market pricing.
For enhanced returns, lending against strong secondary and regional assets is an attractive opportunity to take advantage of the credit supply and demand mismatch between debt providers and borrowers. A recent study illustrated that the funding gap in Britain still remains the most under-served portion out of the Europe market and represents nearly 30 per cent of Europe's total financing gap.
There are risks and uncertainty around economic growth, global political stability and rise in interest rates, with expected volatility in the market. Bearing that in mind, investors would see the appeal for core-like and higher returns available from the financing of quality secondary and regional assets, where the secured debt investor is in a priority protected position in the capital repayment order.
Christian Janssen is the head of CRE debt at TH Real Estate