Senior Loans overshadow Mezzanine in debt fund lending

With the banks in retreat on classical lending, and ever more alternative lenders, including debt funds, insurance companies, family offices and other investors increasingly stepping in to fill up gaps in the capital stack - if not provide the full financing - institutional investors are increasingly looking at the optimal structuring of their financing.

German consultancy group Wüest Partner Deutschland has been surveying real estate fund managers from Germany and abroad who are offering investment products for German institutional investors in the area of real estate private debt.

A total of 47 debt funds are currently available to the group, ("a very small universe") with most of the products in the UK, North America and Germany itself, according to the survey. In all, 29 managers responded, who together manage a loan portfolio volume of €182 billion.

One of the key take-home messages from the survey is the misperception that debt funds are all about risky but high-yielding mezzanine financing. In reality, the market is now much more about senior lending, as the survey highlights.

Wüest Partner comment in their report that this aspect is indeed surprising, but puts it down to the greater PR efforts of those companies focussing on the higher yielding mezzanine segment, rather than the more defensive pieces of the lending.

The investment strategies of these funds are predominantly in the area of defensive senior loans – in other words, senior financing, considered more risk-averse. While in Europe fund products focusing on office real estate attract the most money (€31.2 billion) with a share of 26% - in the multi-storey residential segment it is €25.2 billion (21%). According to Wüest Partner, in North America it is the residential segment with a volume of €25.7 billion (41%), followed by offices with €23.6 billion (38%). In other words, almost 8.0% in North America is bundled in these two types of use.

The spread is greater in Europe, says Wüest Partner, with the funds tending to invest in different asset classes. For example, student housing, shopping centres or logistics and industrial properties also play a comparatively large role with a total financing volume of €36 billion, which is almost one third of the existing loan volume. In North America this figure is only around 10%.

With a loan portfolio of almost €62 billion (34%) and 14 investable funds, the UK is currently the largest single market in the analysis. North America follows with a loan portfolio of around €55 billion euros (30%) and 15 active funds. Germany is the third largest private debt market with about €24 billion euros (13%) and four investable fund products. Overall, the investment volume in credit funds is spread over only nine countries worldwide, which the researchers found surprising. Wüest Partner says these also include France, Spain, the Netherlands and Italy.

Compared to the private equity survey in the previous year, the geographical diversification of real estate private debt funds is quite weak, says Wüest Partners' Stefan Stute, Director and Head of Investment Consulting. The asset class has only established itself as pan-European in recent years - the US and UK have a head start. "It is only against the background of increased equity regulation and the withdrawal of banks that a market for real estate private debt has also developed in continental Europe," said Stute.

Only five per cent of the invested capital is tied up in project developments, mostly follow-up financing, according to Wüest Partner.

The share of senior loans in the surveyed loan portfolio volume of €182 billion in Europe and North America is 63%, according to the survey. By comparison, the market share of mezzanine financing, the most prominently highlighed in Germany, is only 15%, followed by whole loans (14%) - both structures that have been gaining in popularity for a few years. The latter are used, among other things, to simplify the appraisal process, as whole loans get the required mezzanine and debt capital from only one provider. 

In North America, ten out of 15 underwritten funds (67%) are heavily weighted towards Senior Loans, while in Europe twelve out of currently 31 investable products (39%) pursue this investment strategy. Eleven funds (35%) invest in whole loans and mezzanine financing, three funds pursue exclusively mezzanine strategies (10%). "For us, the result with such a high product offering of senior loan funds is surprising, given how in general discussion the focus is often only on mezzanine funds," said Stute.

Wüest Partner believes the supply of these loan funds is only going to increase further in 2021 and 2022., partly because of the pressure on returns from investors. The target yields of investment products with a senior loan strategy in Europe range from 3% to 8%, while North American products seeking between 4% and 10%. Mezzanine funds achieve 8-10% returns in Europe and 6-12% in North America. 

"The significant spreads in target returns show that even within seemingly homogeneous investment strategies, a very differentiated view of the individual strategies is necessary," said Stute. Given the fallen yields on real estate itself, debt funds and their returns are likely to become even more interesting in the years ahead.