Composite: Depositphotos.com, Babii, REFIRE
German institutional investors say they expect an 8% return from whole-loan real estate debt at a median loan-to-value ratio of 70%. Yet Ralf Markfort, who is responsible for real estate debt, shipping and corporate loans within the investment division of Ärzteversorgung Westfalen-Lippe—and was the sole institutional allocator participating in the CAERUS webinar—called that combination “a wish”.
At the webinar, attended by REFIRE, Markfort said current senior margins for good property with dependable income were approximately 150–160 basis points. Mezzanine debt was different: there, he confirmed returns of 10–12%.
An 8% whole-loan return may therefore be attainable, but not while also retaining stable cash flow, moderate leverage and the structural simplicity investors say they want.
That contradiction provided the most revealing finding from the research, undertaken by Hochschule RheinMain on behalf of Düsseldorf-based CAERUS. Finland’s listed alternative-investment manager CapMan acquired a 51% interest in CAERUS last year, adding an international dimension to the German debt manager. Real estate debt accounts for an average 1.6% of the surveyed institutions’ portfolios, while one-third plan to increase their exposure during the next one to three years. Further allocations are credible; the terms upon which investors expect to make them are less easily reconciled.
Fixed income has become a competitor again
Ärzteversorgung Westfalen-Lippe began investing in real estate debt more than a decade ago, when conventional fixed income produced approximately 1% and the institution needed to support an actuarial return of around 4%. It accepted additional property and development risk because safer bonds could not provide the required income.
That logic has partly reversed. Fixed income can once again meet the institution’s requirements, forcing real estate debt to compete against a simpler and more liquid alternative. Markfort said his organisation was reducing portfolio complexity and would not currently finance the opportunistic or value-add assets most likely to produce an 8% return.
CAERUS’s analysis reached much the same conclusion. Producing the return demanded by respondents would generally require lending against value-add property or pre-let development, accepting greater risk or introducing leverage within the debt fund.
The survey nevertheless found that 60% of respondents would in principle finance project development. That surprised Dr Matthias Thomas of CAERUS, who said many institutions remain cautious after losing capital on developments during the present cycle. Respondents may, he suggested, have been considering the full seven-to-ten-year life of a fund rather than their appetite during the next 12–24 months.
Markfort’s institution is not ruling out development lending, but would require an established sponsor, a strong track record, a leading city or recognised hidden champion, and preferably substantial pre-letting. The difference between stated willingness and investable appetite is therefore considerable: an institution may accept “project development” as a category while rejecting most projects currently seeking finance.
Leverage solves the return problem by creating another one
Back-leverage offers another route to the desired return. A debt fund can borrow against its property-loan portfolio, using cheaper financing to increase returns to its investors. The structure is widespread in the United States but unusual among the institutions surveyed: 12% currently use it, rising to 15% when planned implementation is included.
The principal objection was increased risk. Investors questioned whether a leveraged debt fund retained the real-asset security that attracted them in the first place, while also citing the absence of established standards and the additional complexity.
Markus Kreuter of CAERUS acknowledged the problem. Where a warehouse facility is secured against a portfolio of loans, difficulty affecting one property can bring the others within the lender’s security pool. That creates the possibility of risk spreading across an otherwise diversified portfolio.
Kreuter invoked the structured-finance experience preceding the global financial crisis, recalling tranched structures supported by monoline insurers before concluding that the industry would have to “do it better than in 2007”. Back-leverage does not necessarily recreate those structures, but financial engineering cannot be treated as free return.
Markfort also questioned whether every institution possesses the expertise needed to underwrite complex property credit. Some smaller pension institutions had, in his experience, accepted materially weaker security packages than larger investors would tolerate. Growth in real estate debt will therefore require more than additional allocations: institutions need the capability to assess security, monitor execution and intervene when a business plan fails.
REFIRE: Institutional interest in real estate debt is growing from a low base, but the survey reveals a mismatch between the return investors would like and the risks they appear willing to accept.
An 8% return at 70% LTV becomes plausible through value-add lending, selected development exposure, mezzanine debt or leverage within the fund. Each route, however, removes one of the qualities conservative institutions also value: stable cash flow, moderate risk, structural simplicity or direct real-asset security.
Investors can lower their return expectations, accept more property risk or permit managers to introduce financial leverage. The webinar offered little evidence that they can preserve the 8% target and all the protections surrounding it.