Real estate investment used to be a very simple business. An investor would acquire a building, install or manage tenants and then sit back and collect the rent. These days, there is a lot more to the bricks and mortar business than bricks and mortar.
The use of debt in institutional portfolios has been on the increase in recent years, as interest rates have fallen dramatically in Europe and the US. Economists predict a low interest rate, low return environment
for the short to medium term at least. So more and more investors are looking to boost returns through leverage.
As many institutional investors are restricted from leveraging their direct property portfolio, their main debt exposure comes through investment in indirect funds or in real estate securities. Most European unlisted funds and real estate companies use debt
and gearing has generally been able to improve returns in the current benign real estate and interest rate environment.
Recent research from De Montfort University in the UK shows that UK banks increased their lending to commercial real estate by almost a third in 2004, with unlisted funds as enthusiastic borrowers.
However, some commentators have said the amount of debt in the real estate market is too great and that some borrowers and lenders will suffer. “We’re drowning in liquidity,” says Dale Anne Reiss, who heads Ernst & Young’s real estate practice in the US. “Banks are lending aggressively, and every flavour
of institution thinks real estate is the best alternative out there. Some of us remember an equal degree of enthusiasm in the late 1980s just before the market collapsed.”
The amount of debt used by unlisted funds varies, but a 50/50 debt equity split is not unusual. However, in opportunistic funds, the proportion of debt is much higher.
Debt is also beginning to play a part as something that can be seen as a real estate investment, although this is challenged by some. Commercial mortgage backed securities (CMBS), mezzanine finance, non-performing loan and even senior mortgage debt can be seen in some circumstances and by some investors as a real estate investment.
CalPERS, the largest pension fund in the US and one of the largest real estate investors in the world, used to only have real estate exposure through providing mortgages (which it still does). However, the group now has a direct and indirect real estate portfolio in addition to its mortgage services. Head of real estate Mike McCook says CalPERS does not invest in CMBS through its real estate allocation, but through its fixed-income allocation.
However, GIC Real Estate, the investment arm of the Singapore government, invests in CMBS and treats the bonds as a semi- real estate investment.
The various differences of opinion over debt investments come because real estate returns can be seen to have both equity and bond-like characteristics. The stream of contractual lease payments resembles fixed income, while the residual value of the asset is equity-like. Indeed, many recent buyers of real estate assets have been attracted by the bond-like characteristics.
Private investors, who have taken advantage of low interest rates to leverage their equity, often pick bond-like properties in order to provide them with secure income above their debt costs. Such investors are not terribly interested in the residual value or in exploiting real estate skills to increase that value. It is very much a passive investment.
Recently, a number of products have been launched which strip out the equity and fixed-income-like aspects of real estate investments so they can be sold to investors looking for different risk/return profiles.
One such is the Caspar Fund, launched by Henderson Global Investors. The fund is based on an underlying portfolio of 61 commercial properties in the UK, with a value of nearly £750m (e1bn). Investors can gain access to the portfolio in two ways, through a Jersey property unit trust with an eight-year life, very similar to a number of property private equity vehicles and through securitised bonds listed on the Irish Stock Exchange.
Desmond Jarrett, client director for the new fund, says: “An investor can select the combination of bonds and equity that suits their risk/return and liquidity preferences and know that both the bond and equity exposure have the backing of the same portfolio.”
The bonds are listed on the Irish Stock Exchange and represent 72% loan to value (LTV). The bonds were rated by Fitch and S&P and just over 50% of the issuance was given an AAA rating. All four tranches have investment-grade ratings.
Jarrett adds: “The fund’s gearing, could be
considered high but cash flow risk has been controlled by hedging all interest costs and achieving an average spread over LIBOR of just under 34 basis points.”
Andrew Creighton, the fund manager for Caspar, says the portfolio will be managed to improve performance for the equity investors. “Our investors are seeking a secure and attractive income return and our investment guidelines reflect that. The fund has a high exposure to industrial properties which lifts the income return. The portfolio’s pattern of lease expiries is well spread over the eight year fund life and our objective is to keep the average unexpired term at 10 years or longer.”
Non-performing real estate loans are often a debt investment which turns in to an equity investment. Non- performing loans are those which are in default for some reason, either through the failure of the lender to repay the interest or principal as agreed or because a loan-to-value or some other covenant has been breached. These loans are often packaged by lending banks and then sold on to opportunity funds and other investors not averse to taking in high risk propositions. The loans are sold for a proportion of face value. In recent German non-performing loan deals, buyers have paid as little as 60% of the value of the loan books.
Despite being debt products, non-performing loans require a lot of real estate knowledge as the investor is likely to have to take control of the underlying assets on which the loans are secured if borrowers’ problems cannot be sorted out. These can then ether be managed in order to provide some income or, more likely, sold. It is impossible to manage them without a deep knowledge of the underlying real estate and equally impossible to handle without financing expertise.
Opportunity funds often securitise the non-performing loans, funding payment of the bonds they issue through management and/or sale of the underlying real estate.
The first real securitisation of a portfolio of non-performing loans came in 1999, when Morgan Stanley securitised portfolio of Japanese non-performing loans backed by 700 real estate assets.
Since then, there have been a number of similar transactions in Asia and in Europe, in Italy. Recently, the opportunity funds’ focus has been on Germany, where a number of massive portfolios of non-performing loans have been bought from German mortgage banks.
Last year, US investment firm Lone Star bought a e3.6bn portfolio of non-performing loans from German bank Hypo Real Estate – a world record non-performing loan deal. Since then, Morgan Stanley Real Estate Funds and Citigroup combined to buy a e394m real estate-backed non-performing loan portfolio from Hypo Real Estate.
Investing in these transactions is impossible for most institutional investors to do directly, as the specialist knowledge and huge balance sheet required are beyond them. The main ways to get in are to invest in an opportunity fund which will invest in such products or to invest in the bonds issued when non-performing loans are securitised – which brings us back to the debate over whether CMBS is a real estate investment (see panel).
Investors might also look at mezzanine finance, As the name suggests, mezzanine financing is the portion of finance between equity and senior debt. For example, an investor looking at a €100m property might only have €10m of equity and be only to get senior debt to a loan-to-value ratio of 80%, thus requiring an extra €10m. This could be provided as mezzanine financing. The cash will be advanced as if it were senior debt but the repayments will have to take into account the extra risk attached. In some cases there will be an agreement whereby, as well as receiving interest, the mezzanine lender will share in some of the upside of the deal, should it be successful, thus attaching equity-like returns to the debt provision. Often, however, the lender is not interested in getting equity-like returns and just demands a much higher margin.
In Europe, there is not a wide market in mezzanine exposure. Mezzanine finance tends to be provided by and syndicated between the major lending banks, with few opportunities for other investors to get involved.
In the US, where securitisation emerged and where US investment banks have developed the most sophisticated approaches to financing, it is much easier to invest in real estate debt products.
There are mortgage REITs which invest in portfolios of CMBS, senior debt and mezzanine and which in turn provide a simple, liquid investment for institutional and other investors who want to gain exposure to real estate debt. There more investors are prepared to see investments which are backed by real estate assets as real estate investments, even if the returns are more analogous to fixed-income products.
In Europe, there are few opportunities to invest in real estate debt and investors in real estate are more likely to prefer options which gain them exposure to real estate performance in a more conventional fashion. Nonetheless, with US players such as Lone Star, Morgan Stanley and non-performing loan/CMBS specialist Crown Northcorp entering the market, change may be afoot.