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Commercial real estate debt investment makes a comeback
TH Real Estate, a global real estate fund manager, looks at commercial real estate debt investment opportunities in Europe and how this may fit into Asian investors’ portfolios.
Christian Janssen 7 Oct 2015
 
   
In the years prior to 2007, a significant expansion of real estate debt occurred globally, especially in Europe and the UK. 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 securitize or syndicate commercial real estate loans virtually ceased in the UK primary market, and secondary market volumes slowed considerably. Banks lenders were left with low-yielding, over-leveraged property loans to manage.
 
Since then, the bank-lending market has faced tightened economic and regulatory pressures affecting capital ratio requirements, leverage ratio limitations, legacy asset concentration, rating agency, and investment analysts’ and investors’ requirements, thereby reducing balance sheet exposure. These have caused many global banks to reduce the loans being offered.
 
Historically, banks have provided the majority of debt finance. According to Morgan Stanley Research, in 2012 banks and bank-related lending comprised 90-95% of the market in Europe and the UK. Asia-Pacific has a similar reliance on banking finance at 75-80%, while the US is at 55-57.5%.
 
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 capital market 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 (CRE) 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.
 
The case for CRE debt
 
CRE 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 which 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.
 
The case for the UK
 
The UK has a stable commercial real estate profile, aided by a liquid, transparent market place, a creditor-friendly jurisdiction and a well-understood legal framework. The UK is also the largest real estate and real estate finance market in Europe, with transaction levels at £63bn compared with Germany at £41bn in 2014.
 
We have also seen UK commercial real estate volumes rebound, with £56bn of direct transactions in 2014, compared with £53bn in 2013 and £33bn in 2012. Although capital values remain below their 2006/2007 peak levels, commercial real estate yield has been tightening in the past 24 months.
 
We also see the price tightening loosening up in the UK market and begin to bottom out. With our knowledge of market size, quantum of transactions and financings possible in each jurisdiction, the UK 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 in the UK 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 UK funding gap still remains the most under-served portion out of the Europe market and represents nearly 30% 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 head of CRE Debt and fund manager at TH Real Estate   

 

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