Sure, £1bn-plus funds are a safe bet, but they’re not where the standout returns lie
While mega funds and insurers target larger loans, investors should consider the attractive returns available within smaller-balance loans
“Bigger is better” has been a recurring theme of the commercial real estate debt market in recent years. But while mega funds and insurers targeting larger loans dominate, investors should also consider the attractive returns available within smaller-balance loans.
A business maxim began circulating in the 1970s that said: “Nobody gets fired for buying IBM.” The theory in IT circles was that if your competitors were using the same operating systems as you were, everyone knew the risks, and everyone was playing it safe. Therefore, choosing the biggest name was seen as a lower risk decision. A similar mindset seems increasingly prevalent for investors when allocating to real estate debt, but there are other options.
Filling the gaps
The growing importance of non-bank lenders in the European real estate debt markets since the financial crash is well documented. Non-bank lenders comprised 28% of 2020’s UK loans, according to the Business School (formerly Cass). Private debt funds and insurance companies are increasingly filling the gaps in the market where banks have retrenched but as the non-bank lender market has matured, the size of the average fund has materially increased. This is a replication of the trend that has been evident in the real estate private equity market.
The sector continues to attract large investment managers establishing new debt platforms leveraging off significant investor relationships. Only recently we saw AllianceBernstein launch with €1.2bn of initial capital for their European debt platform, and LaSalle Real Estate Debt Strategies IV targeting €1bn. The INREV Debt Vehicles Universe 2020 study showed that non-listed real estate debt products had a record high of €32bn raised globally in 2019. With these large commitments comes a pressure to deploy efficiently, thus leading to a focus on larger average loan sizes.
Smaller loan appetite
For the biggest players, focusing on the larger end of the market delivers platform efficiency gains, facilitates quicker deployment of large commitments, and makes the whole due diligence and “know your customer” process simpler. The downside for the market is that the appetite to provide smaller-ticket loans – sub-£25m but most acutely under £15m – is more restricted. As a result, the small to mid-market commercial real estate lending market is underserved.
A focus on this neglected part of the real estate lending market means we are delivering to investors outsized returns on a comparative risk basis relative to larger loans, while avoiding loan-on-loan leverage.
Sponsor quality
When speaking to investors we are often asked whether operating within the small-to-mid loan market means dealing with less sophisticated sponsors, but our experience has been quite the opposite. Borrowers have included global private equity real estate players and established property companies. When we have lent to less well-known sponsors, they are personally invested in the transaction, demonstrating a strong alignment of interest alongside our own.
Operating at the smaller end of the lending market requires a more localised approach, which is why we feel it is important to have a senior, on-the-ground presence in each main market.
Impact of Covid-19
Real estate lending in the UK fell by 23% year on year in 2020, according to the Business School’s UK Commercial Real Estate Lending Report, on the back of significantly reduced investment activity. While CBRE reports that UK commercial property capital values fell by 7.6% in 2020 – albeit with sizeable sectorial variations in performance. The significant pausing of market activity in 2020 along with a rebasing of valuations across several asset classes, coupled with reduced liquidity from a number of existing lenders dealing with legacy loans is providing attractive opportunities for new lending.
“There is no doubt that investors will always be drawn to the biggest names in the industry, because of the size, reputation and scale, but there are less competitive parts of the lending market that offer investors attractive returns”
In a yield-starved world, it is no surprise that an increasing number of institutional investors are drawn to the running yield and downside protection offered by commercial real estate debt. Indeed, the uncertain market backdrop and growing concerns over the recent inflation of asset prices (especially fixed income alternatives) are all positives for the asset class. And although there is no doubt that investors will always be drawn to the biggest names in the industry, because of the size, reputation and scale, there are less competitive parts of the lending market that offer investors attractive returns.
A well-functioning commercial real estate marketplace should serve the needs of all sponsors, large and small. Smaller loans can still generate premium returns, while offering investors a welcome level of portfolio diversification. If you work with quality sponsors whose interests are aligned with the lender; maintain a disciplined approach to key leverage and debt serviceability metrics; and create strong lender protections though bespoke covenant and security packages, then there’s really no reason why investing in smaller-balance loans should carry any greater risk relative to investing in larger deals.
Written by Gareth Williams, Head of Real Estate Finance
Featured in React News on 26th May 2021 Sure, £1bn-plus funds are a safe bet, but they’re not where the standout returns lie | React News (reactnews.com)
Read more about our commercial real estate debt investment offering, or please get in touch with the team directly: realestatefinance@qsix.com.
