Demand for punchier real estate debt strategies on the rise

In its new report, ‘Reaching for returns in real estate debt’, Bfinance has found that within the seemingly never-ending hunt for yield, higher-returning real estate debt strategies are attracting investors’ attention.

The report includes data from a new survey of more than 50, mainly European, real estate debt managers, showing the various tactics that funds are using in order to enhance returns.

The consultant stated that many investors are familiar with real estate debt in its more conservative form. However, adding more flexibility in terms of collateral type, geography or loan to value can boost the premium to 300-500 basis points a year, giving returns of approximately 4-6 per cent in Europe and 5-7 per cent in the US.

Investors must ensure that extra yields do not come at the expense of disproportionate increases in risk by understanding which approaches managers are using to deliver an enhanced return. The report outlines five main “risk levers” managers are using to deliver that return. 

Lever 1 is to increase LTV ratios. Most strategies captured in the report — nearly two-thirds — do not push LTV beyond what might be considered a relatively ‘comfortable’ level of 75 per cent.

Although equity providers are willing to pay higher margins on debt that covers a higher proportion of the cost of an asset, higher LTVs make it more likely that the lender will incur a loss if a default happens.

Lever 2 points to strategies with different collateral. Although lenders are lining up to work with owners who can offer the security of prime, stable real estate with blue-chip tenants on long leases, financing other property types can often (but not always) command higher yields.

Lever 3, fund-level leverage was used by more than 40 per cent of the managers surveyed for the report, although Bfinance notes that this figure would have been notably higher with a more US-oriented sample. 

While most strategies seek to generate additional yield from the assets themselves, the consultant states that leverage can be an effective tactic for enhancing returns, particularly where the underlying assets are of very good quality and can therefore support higher leverage at a portfolio level. 

Geography provides another lever. A small number of managers surveyed focus on regions that are less well served by lenders, resulting in more attractive returns. 

The final lever Bfinance has identified is to seek distress. While lenders typically aim to avoid risk, significant upside can be generated by acquiring properties at a discount and then gaining possession through effective enforcement. 

This approach may generate little (if any) yield, but the overall internal rate of return can be very attractive. Anecdotally, even ‘performing debt’ managers typically report higher returns overall from positions where they have had to take enforcement action. 

Trevor Castledine, senior director at Bfinance, said: “Some of the levers mentioned above have been popular for years such as mezzanine debt and higher LTV ratios, which have been used to provide outsized returns. This trend was true even before the global financial crisis.

“While this is the case, others are becoming more widely used in today’s climate: newer strategy types are more likely to tap into specific niches, such as smaller properties, riskier geographies, distressed assets and development or bridging finance.”