Real Estate Debt is the Real Deal

Why economic uncertainty need not deter investors from real estate, explain Arnaud Heck and Cyril Hoyaux, co-heads of the AEW/ Ostrum real estate debt platform, in a Q&A


What has changed in real estate debt over the last years?

AH: The non-bank market for real estate debt has deepened considerably. The trend for banks to focus on short-term lending has continued, so long-term lending to real estate projects is increasingly falling to investors. There were 37 debt funds for real estate last year, up from a low 10’s when we started investing in 2012. As a proportion of the market, funds and insurances, represented just over 3% of all lending to real estate back then, and that has risen to around a quarter of all lending to the sector now. But it’s still not enough to finance all the projects out we are seeing. The debt issuance remains generally, in markets addressed by our strategies, between €200b and €240bn each year. The increased portion from non bank lenders should be playing a bigger part of a market worth around €1 100bn and growing. The landscape is still in construction¹.

Remind us again how real estate debt works?

CH: Real estate debt is different to investing directly in real estate although benefiting from strong common points. The loans are backed by real estate assets, including office buildings, retail properties, residential properties, student housing, senior housing, hotels, light industrial assets and logistics.

The difference is that direct real estate investments can be volatile and capital is at risk, whereas real estate debt tends to provide predictable returns and low volatility. We invest in senior real estate loans, which are the first to be paid if something goes wrong.

By limiting the loan-to-value (LTV) of a real estate debt portfolio to 65%, investors get further downside protection. That’s to say, the real estate asset would have to lose about 35% of its value before a senior loan strategy with an LTV of 65% would start eating into investors’ capital.

Isn’t the real estate market risky just now?

CH: Yes and no. There is plenty of investment acquisition activity in Europe and then increasing needs for financing, which is positive for us. But the market may have reached a peak for some segments. These include logistics and offices in core Western European locations such as Paris, Frankfurt and Amsterdam. But many core assets in stable European locations such as Belgium and Spain still offer value. Thanks to our network of 12 offices across Europe and to our research capacities, we cover 95 different local real estate markets. We have then to invest in submarkets with positive trends.

Economic uncertainties strengthen the argument for approaching real estate through debt. Recovery rates in the case of default are high compared with senior secured bonds and way above sub-ordinated debt. In any case, with secured debt, default rates are close to zero. In fact, we have never had a default in seven years of real estate debt investing.

Have you changed what you invest in?

AH: We have been investing in this asset class a long time now and we are used to adapting to new situations. In fact, we have raised more than E1.5bn since Ostrum AM and AEW launched a real estate debt platform in 2012, and have made repayments of approximatively E500m to investors.

We have decided not to invest in UK for the moment as we offer our clients stability and visibility, what is difficult to predict for UK deals. This was not an easy decision, but we have stringent criteria for our investments and we can’t expose our clients to unknowable risks on the Brexit, real estate market, currency or refinancing risk.

However, thanks to the combination of Ostrum AM’s credit expertise and AEW’s reach, we have research and transaction capabilities on the ground across continents, particularly in Europe and there is a world of opportunity out there. We examine assets in all the major jurisdictions and some of the smaller ones too, searching for robust risk-return opportunities.

While Germany, France and the Benelux is still perceived as the core bulk of our investments, we see our lending levels increasing from here, leading to even higher levels of selection and diversification within our portfolios.

Has your investment approach changed?

CH: No. But we have refined the process and how we explain it. In essence, we divide the universe of real estate debt opportunities into two buckets, and select assets from each.

The main bucket, from which will represent 70% of our investments, consists in financing standardised assets such as offices, retail space and logistics, in core countries such as France, Germany, Benelux and Spain which have stabilised cashflows.

The “enhanced” bucket, on the other hand, contains financing on alternative asset classes such student or senior housing, hotels or light industrial, or assets that produce less stable cashflows or, assets which are situated in slightly less economically-stable countries. This bucket has the potential for higher returns and is about 30% of the portfolio.

Every asset is different in real estate– how do you know what you’re buying?

AH: In a changing environment you need flexibility, a sound risk approach, and experience. Experience is not just about grey hairs but also about know how as well as mastering a subject from each and every angle and having a deep network of skills and contacts. This is definitely not an asset class for first-time investors.

By pairing Ostrum AM, a global fixed income expert, with AEW, a world-leading real estate investment and asset manager, we think we have almost limitless flexibility to adapt to different situations. Ostrum AM has 51 portfolio managers , a credit research team and 12 financial engineers, while AEW has 186 investment managers on the ground in 10 European countries as well as a real estate research team.

Besides the uniqueness of combination, strong sourcing capacity has allowed us to create a proprietary database that gives us access to a huge range of deals and pay the right price for them. It is possible to invest in real estate loans by relying on third-party data providers, but having our own, market-leading database allows us to see how the market is moving in real-time and compare this to historical data to create more accurate valuations and return expectations.

As well as unearthing deals, the value of a proprietary database is to help us see how the market is moving ahead of competitors, with the aim of protecting our investors from sharp changes in market trends.

What returns are possible today?

AH: We think we are in the part of the economic cycle that is good for debt relative to equity. With good recovery rates on senior secured loans, returns are likely to be attractive versus other debt assets. On investment grade portfolios, expected returns are 125bps above the risk-free rate¹, which is the average of a number of government bonds across the eurozone. When compared to investment grade liquid bonds, the difference is even more striking, with little volatility of valuations in our asset class versus a significant one on liquid assets.

What would you say to first-time investors in this asset class?

CH: We understand that investors are cautious about real estate. We believe that real estate transactions will still be strong in the years ahead, but maybe focused on slightly different assets than in the past. Flexibility and diversification should allow real estate debt investors to access strong returns with considerably less volatility than for many other debt instruments.