A view of the City of London financial district. Photographer: Jason Alden/Bloomberg
Wealthy investors who like real estate may wonder where to put their money this year as prices for high-quality properties in global developed markets top out.
The answer could be private real estate debt funds that take the place of banks in lending to top-tier commercial properties in prime markets like London, Tokyo and New York. Real estate debt funds may also answer another conundrum for investors in today’s markets: where to get a decent yield. Expected returns on these funds are 8% to 10%.
“We see the opportunity for the next year in real estate being more residing in the debt side of the equation rather than purely on the physical assets themselves,” says Ben Pedley, regional head of investment strategy for Asia at HSBC Private Bank.
One reason for this shift is real estate prices, rising since 2009, are expected to plateau. For many years, HSBC took part in the ride, buying buildings for clients in New York, London and other prime markets.
But today, the better risk-reward trade-off may be in debt: lending to developers who are building or re-financing top-quality properties. What you get is a high-quality security with a return that’s hard to find in today’s low-yield world.
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“Having that deep understanding of the market and an understanding of the debt side, it became very clear to us that real estate debt was becoming an increasingly important opportunity particularly as it relates to A-grade geographies,” says Sam Edwards, HSBC Private Bank’s Asia Pacific regional head of the alternative investment group, mutual funds and discretionary.
Direct investing still attracts investors
Private real estate debt funds are a nice option for clients who are defensive and income focused, and who are willing to forgo the ability to buy and sell a bond or bond fund for the higher potential returns private funds can generate, says Roger Bacon, Citi Private Bank’s Asia Pacific head of managed investments. Bacon says Citi looks for returns on these funds to be in the high-single to low-double digits.
Not all investors are in a defensive mood, however. U.S. commercial and residential real estate remains interesting to Citi clients, although the potential returns appear “less glamorous” than five years ago, Bacon says. Asian investors are also interested in distressed European real estate in trophy cities, both for equity as well as debt investments, and they like real estate in Japan and Australia, although bought with a hedge overlay to account for their currency view.
“We try to have a balanced range,” Bacon says, from aggressive single asset purchases, “all the way down to more plain vanilla debt.”
Real estate debt funds replace bank lending
Private debt funds have surfaced as an option for investors because banks are more cautious about lending since the global financial crisis, largely because tighter bank capital regulations give them little choice. There’s also a shortage of commercial mortgage-backed securities, also thanks to regulation, which had been another support to the lending market in past years. Edwards describes the situation as a “scarcity of capital” that has only become scarcer amid volatility in global markets since the start of the year.
The lack of capital from traditional lending sources created an opening for firms to create private funds financed by investments from institutions, private banks and high net worth individuals and structured like a private equity fund. “There’s a risk aversion that seems to be pervasive across the entire banking industry and alternative lenders for real estate are now significantly large,” Edwards says.
There was a surge in these funds in 2014, as some $25 billion was raised globally, according to Preqin, which tracks the alternative assets industry. That volume slacked off last year to only $14 billion, Preqin says. The size of the market can vary from year to year on the strength of one big fund, and the status of fundraising efforts, but Andrew Moylan, Preqin’s head of real assets products, says demand by institutional investors forced a shift in private funding last year to more high risk/high return offerings than real estate debt. Moylan also argues that banks have come back into real estate “in a big way” in the last year or so.
Yet Edwards says a shift is taking place among private real estate debt funds. They now originate loans, rather than raising money to take over legacy loan portfolios that were shed by banks needed to boost their balance sheets. In 2009, one firm originated only about 22% of the loans in their funds; today the same firm is originating 90% of its loans.
Banks are part of the lending picture, he says, but not in a starring role. Instead, they are a bit player in the group of lenders financing the loan. They are “less price makers in the big deals than price takers,” Edwards says. In other words, private funds are originating loans and setting terms for the rest of the lenders in the group. “Banks don’t hold the balance of power any more as it relates to the lending,” he says.
There are also likely to be more private real estate debt funds in the future as some US$1.4 trillion in commercial real estate debt is refinanced between now and 2018, Edwards says. An official at KKR, one of the firms that creates these deals, confirms more transactions and refinancings are expected to boost demand for financing from non-bank sources.
“The more restrictive regulatory environment for the large banks, as well as the wall of commercial real estate debt that is maturing over the coming years, have combined to create an attractive opportunity for non-bank finance companies with private real estate debt funds, which clearly stand to benefit from this confluence of factors,” says Jim Burns, member and head of KKR’s individual investor business.
Typically, the private fund sells the highest quality portion of the loan. This senior debt is also the least risky, so it brings in the least return. “The credit quality of these opportunities is really high so banks are willing to take the top piece in the capital stack at quite a compressed spread,” Edwards says. By selling off the most senior chunk of the loan, the fund retains the higher-yielding, and riskier, “mezzanine” layer.
A standard private real estate debt fund is usually about US$4 billion in size, and the ones HSBC is selling are backed by top-quality global real estate and high-quality borrowers. Investors receive a quarterly payment like with a bond. The rate on that payment will vary because the underlying loans carry floating interest rates, but the ultimate return should be in that 8% to 10% range.
Investors can think of investing in these funds as a commitment to buy a string of high-quality, yet relatively illiquid, bonds over time, usually up to 10 years, Edwards says. Nearly all of your total return will come from income, not capital appreciation like in a real estate equity fund.
“It’s a simple strategy,” he says. “We want loans to be made for projects that do exactly what they should, and to be paid back in full.”
Annual Fundraising for Private Real Estate Debt Funds, 2007 - 2015
