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Caerus Debt Investments AG
Michael Morgenroth
Michael Morgenroth, CEO Caerus Debt Investments AG
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Fig. 1
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Fig. 2
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Fig. 3
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Fig. 4
Not all debt funds are the same, which is why the question in the heading cannot be answered with a straight "yes" or "no", but in theory the initial answer is "both".
Strategies and terms and conditions of debt funds
The European Association for Investors in Non-Listed Real Estate Vehicles (INREV) currently distinguishes five investment strategies being pursued by debt funds in the area of commercial real estate financing. The senior debt funds invest in loans with an LTV (loan-to-value) ratio up to 60%, while subordinated debt funds specialise in junior and mezzanine loans (LTV of 60‑80%). Whole loan funds cover both ranges.
As shown in the tables below (Fig. 1 and Fig. 2), the various strategies differ significantly in
the way the terms and conditions are formulated (pricing, duration, loan amounts) due to the different risk profiles of the intended financing tranches and the returns investors look for as a result.
Regulation triggers quest for alternative or additional financing options
The question as to whether debt funds can be used as an alternative or in addition to bank loans is being asked primarily as a result of changes in the regulatory environment. The increased capital requirements for loans under Basel III is forcing banks to increase their equity and use it more selectively. For this reason, equity has to be strengthened by adding to reserves and/or reducing risk exposure. One consequence is an increase in loan margins – i.e. borrowing becomes more expensive. Another is that banks also reconsider their real estate loan portfolios and decide to reduce them. If the equity situation is tight, a reduction in the loan portfolio is often the only solution for credit institutions.
However, this does not necessarily lead to financing constraints for real estate projects and real estate transactions. In the area of senior loans, i.e. with an LTV of up to 60%, we do not currently detect a credit squeeze.
Firstly, given that Pfandbrief (German mortgage bond) cover is available for this kind of loan-to-value ratio, refinancing is not a problem for credit institutions. Secondly, there is sufficient buffer (in most cases) because additional financing components of approx. 40% can be accessed. Another factor is that in addition to foreign banks, which favour the German real estate market because of its relatively low level of volatility, insurance companies are also increasingly discovering this as an area for doing business. The Solvency II regulations are making direct investments in "real estate equity" more expensive for insurers, and this in turn is making investments in debt capital relatively more attractive. The investment universe of typical German insurers is changing. Alternative investments with a real estate basis – especially loans – are increasingly becoming a focal point for insurance companies.
German market for commercial real estate financing too competitive for senior loan funds
For this reason, we do not see much demand for senior loan funds in Germany and therefore do not believe they will have high chances of success. There is sufficient competition for this tranche of financing. In this country, this is the territory of the mortgage banks, which not only benefit from years of risk management experience, but are also capable of taking on large-volume loans. What is more, the use of Pfandbriefe for refinancing means they can issue these loans on substantially more attractive terms than a senior debt fund could under normal circumstances (see Fig. 3).
Mezzanine capital provided by debt funds closes the gap caused by Basel III in the area of junior/subordinated loans
As traditional lenders tend to concentrate on financing tranches with an LTV of up to 60%, a financing gap of 15-20% arises for customers. Unless it can be filled with equity, the shortfall has to be made up from other sources of financing.
This "mezzanine" capital can be provided by debt funds, which specialise in this area.
The resulting cooperation between the mortgage bank and the debt fund requires both parties to sign an intercreditor agreement. Nowadays, most banks are significantly less reluctant to enter into such an arrangement than in the past. However, this also means that the debt funds have to know and understand the specific requirements banks make on these types of arrangements.
Excursus: Market for mezzanine capital in Germany
If you assume the total volume of German real estate loans to be €240 billion, with 20% financed by equity and 80% by debt, of which 60% is attributable to senior loans and 20% to mezzanine capital, the total market potential for mezzanine capital for real estate financing stands at an estimated €60 billion.
The volume of real estate loans becoming due for repayment in Germany in the period from 2014 to 2016 is estimated at around €50 billion a year. If you again assume that mezzanine capital accounts for 25%, this would mean potential demand for mezzanine capital of €12.5 billion a year. This indicates the existence of an enormous market, which is increasingly being discovered by investors in Germany as well.
Mezzanine capital provided by debt funds not only closes a funding gap, but can also generate an advantage in terms of financing costs. As shown in the diagram, "Stretched" senior vs. mezzanine capital (Fig. 4), the use of a mezzanine capital component may in certain circumstances lower the overall cost of financing for borrowers. If you replace €25 million out of total debt capital of €75 million with mezzanine capital, the remaining €50 million can be borrowed on attractive terms, because this amount is below the threshold for Pfandbrief cover.
Conclusion
The future of debt funds as lenders does not lie in the provision of financing in competition with banks. In Germany's current banking landscape, they would hardly be able to compete with the country's Pfandbrief banks.
The future belongs to debt funds that aim to work in partnership with banks, with the shared objective of presenting attractive financing offerings so that banks can exit from the high-equity lending business for the riskier financing tranches without leaving their loan customers out in the cold.
by Michael Morgenroth, CEO Caerus Debt Investments AG
