More than ever, investors need a real estate debt strategy

The era of cheap money, so they declare, is over. For those who can invest via real estate lending, that enhances return prospects. Property debt can currently offer near core equity target returns for a much better protected position lower in the capital stack. That is ultra-attractive on both a nominal and risk adjusted return basis.

Although the Bank of England increased its base rate at a post ‘Black Wednesday’ record pace (+75 bps) earlier this month, there are signs that the global central bankers might just be beginning to think about lifting their foot off the rate hike pedal. Australia’s central bank has already done so, the Bank of Canada is raising rates by less than predicted and there are reports of increasing internal dissent at both the European Central Bank and US Federal Reserve. Yet, there’s no particular reason to believe property debt is going to become significantly more expensive or less in the near term.

With property yields rising, but still low and higher debt costs set to persist for a while yet, there are thus far fewer deals to finance at the moment. Yet this bid-offer spread impasse in the underlying property investment transaction market will break – as it always eventually does. Motivated sellers of good quality assets/collateral will likely include: financial institutions driven by denominator effects; REITs looking to sell above implied NAV discounts; balanced property funds look to shift overweight target sector allocations back to hug benchmarks; and those without access to extra fresh equity capital and unable to secure the same level of debt upon refinancing.

Complementary mix

Strategic property investors – those looking to maximise risk-adjusted returns in the long term – can benefit from an allocation to both debt and equity real estate through the cycle. For example, real estate debt exposure can be built up through the top of the cycle into the downswing, forgoing frothy peak equity returns but limiting the inevitable downside to come. Meanwhile, exposure to equity can be increased during the recovery phase, when return expectations are rising.

The optimal property debt allocation will depend on the individual investor’s objectives including target returns and risk tolerance. The basic principles of investment diversification suggest a minimum and therefore meaningful property debt allocation will begin at around 15-20%. That could rise to over 50% for the most risk intolerant, long term capital sources. Another benefit is that in a multi-strategy investment portfolio, European property debt returns will provide powerful diversification benefits.

The source of this diversity is simply a reflection of the fragmented nature of the national European economies, and their property market practices, regulations and legal frameworks. lnvestors and asset managers that have local property market presence and expertise can easily navigate that complexity; central allocators, perhaps less so.

The US is easily the deepest ($2.6tn) and most mature real estate debt market. While Europe is a little smaller ($1.9tn) and less transparent, it is absolutely rife with opportunity.

There are fewer types of capital sources in Europe with a very heavy overreliance on banks (c.80% in the UK and over 90% of lenders/financing on the mainland). Post GFC banking regulatory oversight (Basel III) has been specifically designed to restrict banks on higher credit risk exposures including real estate. This is particularly the case for mid to higher LTV whole loans, mezzanine debt and any value-add or opportunistic property investment activities, including speculative development. This is now much less attractive to banks and that is exactly why Europe will continue to provide fertile grounds for non-bank real estate capital to flourish in the coming years.