Debt funds will need to adapt strategies to survive, says Scope

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Real estate debt funds are facing increased competition to lend from newly-liquid banks even as their capital raised looks set to reach new highs, says Berlin-based research house Scope Ratings.

In a special new report on Europe's real estate debt funds, Scope concludes that while demand for real estate debt funds is expected to remain high or even increase further, increased liquidity in Europe’s commercial real estate lending markets will intensify competition for assets, making it harder to source assets suitable for meeting investor’s risk-return profiles. To stay ahead of the curve, says Scope, real estate debt fund managers need to demonstrate flexible and innovative lending strategies, as well as operational strength, to put available money to work efficiently.

According to Harald Berlinicke, director at Scope and co-analyst for the report, “The investment environment is relatively precarious for real estate debt funds as competition from other lenders like banks and mortgage banks that are strongly returning to the market is increasing.” Although isolated co-operation between debt funds and mortgage banks did occur, competition between the two is the norm, he said.

In the long run, Scope even sees “risk of negative returns for investors” because of the difficult investment environment and future market downturns. In other words, debt funds will have to increase leverage or find other “innovative solutions” to be able to achieve the promised returns, the report suggests.

By the end of June 2015, a total of 53 real estate debt funds were looking to raise a combined €33.6bn at end June, well above the €26.4bn that 44 fund were targeting at end-December. The increase reflects strong investment volumes since 2011 as well as investors’ ongoing hunt for yield, and favourable changes to European regulation governing institutional investors. Strong demand for debt funds among German insurance companies and pension funds stems from changes to the German insurance supervision law, the Versicherungsaufsichtsgesetz (VAG)

While Scope believes investor demand will remain high and even increase further, it expects increased competition for assets that can meet investors’ risk-return profiles. Only 29% of capital raised by end-June has been invested, Scope said, reflecting more investment by banks and insurers fuelled with cheap liquidity provided by the European Central Bank’s quantitative easing program.

“Scope believes that i) lower target returns, ii) higher leverage or iii) a broader range of assets are the main adjustments available to debt funds to stay competitive,” it said in its report.

In addition, alternative lenders concentrate on subordinated financing and so-called stretched senior financing – which incorporates some elements of subordinated debt – at higher loan-to-value levels than most banks are willing to consider. But debt funds could focus on Spain and Italy where competition is less intense and margins are higher than the UK, France or Germany.