Against a backdrop of high inflation, downward revaluations and rising interest rates, real estate debt is looking increasingly attractive, especially while the risk premium for direct property has yet to find its level.
Since the global financial crisis, when the regulatory environment became more onerous for banks and their appetite for risk reduced, there has been an acceptance within the industry that debt finance – particularly for more complex situations – will need to come from a wider range of sources.
Now, amid more challenging market conditions than have been seen in recent years, a significant opportunity is emerging as banks reduce their lending volumes once again, potential borrowers struggle to find the funding they need and equity investors look for downside protection, diversification opportunities, more predictable cashflows and ways to continue making attractive returns.
While rising rates put upward pressure on yields, potentially affecting real estate equity returns, they offer the potential to boost returns for real estate lenders, who are better positioned to maintain returns even as values fall, given the debt position represents a percentage of the building’s value.
Data from the IPF estimates the UK funding gap to be approximately £37bn. Part of this gap will be filled by incumbent equity but that will not be an option for all borrowers, hence the pressing need for mezzanine and preferred equity.
The UK commercial real estate debt market remains dominated by banks and insurance companies. For various reasons, mezzanine and preferred equity are not segments where they are, or can be, active. We can, therefore, expect to see alternative lenders’ market shares grow. In its recent sentiment survey, the Loan Market Association found that 62.4% of respondents believed debt funds would demonstrate the greatest growth in real estate lending in 2023, versus 14.4% for banks.
Mezzanine lending represents a particularly interesting opportunity. While the equity owner shoulders the first loss if values deteriorate, the mezzanine lender’s returns could remain stable, provided valuation reductions are not excessive. A reduced appetite for risk from senior lenders could also lead to mezzanine debt operating at a lower level of risk, improving the likelihood of recovery while offering higher returns as the base rate continues to rise.
Of course, debt investment is not for everyone, and not every debt opportunity is a golden one. In a more difficult economic environment, banks are, of course, right to be nervous: inflation and issues at a tenant level can affect the income generated by the underlying asset and reduce the chances of the debt being serviced and repaid; or, in situations where the underlying asset is under development or renovation, rising construction costs may prevent the completion of the developer’s business plan.
But the advantage for investors operating both equity and debt strategies is that they have an innate understanding of the sector and the market so can pick and choose opportunities and sponsors more carefully, effectively further reducing the risk.
As we look to open up our investment strategy to credit, we are aiming to be active across the capital structure. In an ever-changing market, the ability to pick the most suitable risk-return profile will mean we are well positioned to take advantage of opportunities across the cycle.