Roundtable: Real estate debt
Written by European Pensions team
Chair: John Feeney – Head of Real Estate Debt, Henderson Global Investors
Michael Keogh – Senior Investment and Economic Analyst, Henderson Global Investors
Matt Abbott – Senior Real Estate Researcher, Mercer
Peter Martin – Head of Manager Research, JLT Investment Consulting
Chetan Ghosh – Chief Investment Officer of the Centrica Combined Common Investment Fund, Centrica
Matthias Thomas – CEO, INREV
Feeney: Can we begin by discussing real estate debt as a concept, and where it should fit within investors’ portfolios? Is it fixed income, or is it real estate? Different investors will come to different views on that. For me the key fact is that the returns are attractive right across the debt spectrum and real estate debt should have a place in most investment portfolios.
Martin: I look at what I call the yield space – any product that generates income. Within that I cover both bonds and property, as well as other things, and that is a deliberate attempt to get away from the artificial constructs between what is property and what is fixed income. We need income; I’m sometimes agnostic as to the best source and I would rather frame the discussion around how we derive income, and from what source? Real estate debt is an income generative asset class, just one of the many that you can consider.
Abbott: One of the key things in my mind is that this becomes real estate if things go badly. When we look at managers one of the key things that we look for is that they have real estate expertise to deal with any such situations. The other point with pension funds is that they are big holders of bonds, particularly government bonds. Yields being at the levels they are now makes government bonds very unattractive. Against that backdrop, clients are looking for alternatives that are low risk but offer similar types of income. One of the key differences is that 12 to 18 months ago senior debt margins weren’t attractive relative to asset backed securities (ABS), which are more liquid, so you could get the same kind of margins from a liquid source. Now what we’re seeing is that senior margins are picking up, and there is more opportunity to access additional yield.
Ghosh: As a pension scheme we have an indirect property mandate so what we’ve done within that is allow real estate debt to be another one of the tools that our property manager can access as part of their opportunity set. So far, while the story is good around real estate debt, they haven’t felt that it’s good enough to take advantage of yet.
Thomas: I’d like to broaden the perspective a bit with regards to organisational responsibility for the investment. Ultimately if you look at listed, non-listed, direct or debt, whatever form it might ultimately take, the cash flow is driven by the underlying properties in a fund. I think you need to look down to an asset level, and from this perspective debt should sit within real estate, organisationally.
Feeney: It’s interesting to me that some people have this fairly simplistic view of senior as fixed income and subordinated as real estate. Yet, if we look back to 2007 many senior loans went up to 90-95 per cent in value and in fact had a very large element of real estate risk associated with them. Today, capital structures are very different and in many cases the insulation even of a subordinated loan from the real estate risk can be quite significant. We’re seeing plenty of subordinated loan opportunities where there may be 30-35 per cent of equity in the capital structure. To my mind many of those investments look very much like fixed income products. Liquidity is the big difference. Many investors on the fixed income side are simply not acquainted with illiquid products and products where the valuation is not transparent and immediately discernable. Is real estate debt relatively attractive, even with issues around liquidity and valuation?
Ghosh: I certainly don’t think there’s a hurdle for pension schemes accessing real estate debt - the investment rationale makes sense. The difficulty is that it’s probably coming up against more intuitive asset classes like fixed income and property that even lay trustees are fully conversant with. It will probably always be a niche asset class - it’s just whether it fits with the DNA or psyche of that trustee decision-making board.
Abbott: I don’t think that the lack of transparency around valuations should necessarily matter, but in reality it does a bit. I’ve worked with clients that have really doubted this asset class or taken a long time to appreciate this story, simply because they’re scared of the fact that they can’t get a transparent valuation on a regular basis.
Thomas: There is still a lot to be done with regards to transparency, one aspect being valuation. At INREV we’ve just started to open up to the debt space and what we’re going to do. The first step is conducting research, to start understanding the needs of investors and market participants. When we’ve done that initial research we can of course look to start helping our members understand how they can exploit these opportunities.
Martin: My general view is that we’re sometimes of the belief that the need for liquidity can be over-stated. You do need liquidity, but pension funds are long-term investors and can reap the illiquidity premium and invest for that. There are a number of asset classes where valuations are not exact. As long as the techniques are explained and there is transparency and there is
a prescribed methodology to achiev-ing that, I don’t think there’s an issue.
Feeney: It seems to me that many investors, when they think of real estate debt, they’ll think of negative experiences they may have had there. They’ll think of banks mis-valuing their real estate books or sitting on lots of bad assets, they’ll have multiple negative perceptions. Perhaps this will colour their judgement of new real estate investments. What’s your sense
as to how deep the negative perceptions of real estate debt are?
Keogh: There’s a well-founded concern in terms of the exposure that certain banks and others have to real estate. Capital flows are going into the markets where it’s perceived that there is the best transparency or liquidity. In terms of timing I feel some investors are still unaware of the exposure, all the concerns to wider write downs and certain valuation falls so they’re probably not willing to rush in at the moment. It goes alongside a wider realisation that we are in for a much lower return outlook for the market generally. A lot of pension funds and investors have changed their perception of what is now an acceptable level of return, and I think debt is an opportunity for them to access that kind of return with what is quite a low level of risk.
Thomas: There is a question of the quality of due diligence processes, and maybe some investors rely too much on the skills of their co-investors. From our annual investment intentions survey we definitely know that investors want to increase their allocation to real estate, including debt, non-listed and JV club deals, so the type of investments in favour are those where investors have more control.
Martin: The question of JVs and transparency is very interesting because I’ve always found when you’ve got lots of money being thrown at an area then whoever you’re dealing with doesn’t feel that they need to be that transparent. What we need to see now is that even if money is coming into that area then whoever you’re dealing with still needs to be transparent, even when there is scarcity of funding and remain transparent and give that information.
Ghosh: To some pension schemes when they’re hearing that people are borrowing to invest in real estate they could react nega-tively just because generically leverage has become such a dirty word as a result of the credit crunch. That’s not to say the opportunity isn’t right, but I can see how people can react in that way from what we’ve learned over the last few years.
Abbott: Anything that’s new from a pension scheme’s perspective just takes longer to understand. Essentially what we’re coming up to now is a second wave. We had a lot of clients commit money to this sector in late 2010/early 2011.
I think there’ll be more interest in this set of new funds that are coming in the middle of this year because clients have done it already and so the sector is now transparent and is easier to understand.
Feeney: For those of us who are looking to launch real estate debt products, the onus is on us to bring forward the spirit of transparency and where there is uncertainty around the valuations do everything we can to give investors comfort.
In every investment we should have that spirit of showing investors what they’re getting. Matthias [Thomas] you mentioned that European investors want to increase their allocations to real estate and by extension real estate debt. What’s fuelling that?
Thomas: I think it’s a bit too broad to put the whole of Europe into one box, and put all styles in one box. Our investor members are very keen on the stable cash flow of real estate investments. The second issue is volatility. I think the third component is low correlation diversification benefits.
Keogh: I agree with all of those three points, they’re all vital. Again I think it comes back to a desire for yield. You’re getting a negative return on a real basis in other asset classes, no-one really wants to be in gilts for a considerable amount of time, you’d expect. It’s just a general realisation that the liability matching requirements mean they need cash-flows and they need to be in property to do that.
Ghosh: Going into the credit crunch a lot of pension schemes thought they had diversified, but that diversification didn’t work. A key reason property is coming back in vogue is that it is intuitive, understandable and dependable. I just wonder what austerity means for future returns, volatility and correlation; to me that is an unknown. Certainly in the UK, several property sectors are being challenged because of austerity. If you didn’t live in the mark to market world you could probably just take the cash-flow yield happily, but given that we do have a mark to market world there is the question mark as to whether capital values could still meaningfully fall.
Abbott: The liability position of pension funds means they can take a long term view, and as long as they are getting a decent level of income from their investments, capital values being volatile is a lesser concern. If you’d asked me in 2007 whether clients were selling down their property exposure, the answer would have been ‘a limited amount’ because they had a long term view. Where we have seen a lot of interest is almost dividing property into a barbell approach, so a lot of interest in the low risk side of things, long lease funds with very secure tenants, 25 year plus leases, some inflation uplifts in the rent. People aren’t seeing that as a real estate investment; they’re seeing it as a bond investment. On the other side there’s an equity-like real estate investment. Mezzanine debt at 8 to 10 per cent could be thought of as an equity-like opportunistic investment.
Martin: I would agree that a lot of people who put allocations to call balanced property back in most of the 2000s probably aren’t adding too much more, they’ve had the excitement of 2008. They’ll come back but I think memories will be very long. Going back to the income element, the yield, we’ve had diversified growth funds, I want diversified income approaches so if I need income, whether it’s infrastructure, property, secured loans, whatever it may be - put those into buckets and give me an income.
Feeney: Diversification is always trumpeted as a virtue of any new investment class, but how much does it really figure?
Ghosh: Leading into the credit crunch it was probably given more lip service and assumed as a given. Now, you’d probably kick the tyres to see if an asset truly gave you diversification. I think people are kicking the tyres a lot harder now. One of the difficulties is actually getting any sort of data to actually allow you to make that comparison about what diversification it does give you. You’re never going to get as much data going back as you want, and then you have to analyse the drivers behind the return sequence that you’ve seen to date, and whether that will extrapolate going forward.
Feeney: I don’t know how we assess the performance history, and it’s an issue I have when I go out and talk to investors. You simply say ‘the market was very different back in 2006/07 it’s mostly a private market; yes a lot of loans hit the wall but they were bad loans, we’ll do good loans, don’t worry’. I’d rather be able to point to consistent reliable data on loan defaults that goes back many years but we don’t have that. To what degree do you think that’s going to be an impediment?
Abbott: It shouldn’t necessarily be an impediment, but I think it will be. This is a great opportunity for our clients and it’s about understanding the characteristics of the underlying investment. In terms of diversification and the lack of data and so on, these investments throw a spanner in the works because when things are going well you’ve got steady income and your valuations aren’t going anywhere really. When markets fall by 35 or 40 per cent your volatility is all over the place because your capital in the mezzanine space is being eaten into rapidly. You can’t use portfolio theory as it normally stands because you’ve got a low volatility asset until the market goes bad. It’s that concept that will polarise clients. Some clients will take the view that the market won’t fall by 35 per cent and then invest. Some will say they’ve got no idea what the market might do and they’ll steer clear.
Martin: There are people that actually take a direct decision themselves to invest and then there are people that you delegate, whether that be to a fund of funds mandate or something similar. Secondly, I’ve always found as an independent trustee that you can find lots of people with lots of bright ideas to invest in something new. But it’s not just about the opportunity, it’s also when to get out and it’s the governance behind that which is also important. Also, the funds to be invested must be disinvested from somewhere, it’s a question of what in your portfolio has run dry and then you move from there. It’s journey management in some respects.
Abbott: That’s a really interesting point because a lot of pension funds manage their portfolios with a low risk matching bucket and a growth bucket. A lot of these investments, maybe not senior debt, but mezzanine 8 to 10 per cent doesn’t necessarily fit easily into that structure, the clients almost have to have an approach whereby they say this is a great opportunity, and create an opportunity bucket as well.
Ghosh: Governance is a big issue actually. We’ve gone into income generating assets that don’t have the data history, but very much like real estate debt, they have a sensible story behind them. What we made sure we could do was allow ourselves from a governance perspective to, invest in good investment ideas on their standalone merits in the absence of solid historical data.
Feeney: The quality of the manager and the integrity of the individuals involved is going to be very important, and that probably should be a key aspect of the due diligence and governance process. The reality I think is there is no reliable means of establishing a relevant data set that can guide you very much around likely perfor-mance of a real estate debt book.
Thomas: I agree. I think over time there will be data available, and until this data is available it’s the people you put your trust in, or other methods of aligning interest that is important. Right now it’s probably more the larger investors which can take the risk of investing in less transparent investments. If the market transparency increases then this type of investment is open for a larger group of investors and then probably with that liquidity increases. I do hope it’s just a question of time.
Keogh: People don’t want complexity they want clarity. If the data set is not there in time what they want to see is your strategy over that time period, the scenarios you’re running to ensure that what they see is very vanilla, so whatever scenarios you do run they can see their options and where they will be in the marketplace. If they get that they may for the time being accept the fact that there is a lack of data or the performance element of the history.
Feeney: One of the things that I’m unclear about is the degree to which pension funds are actually invested in the space today. Do we feel that it’s a handful, it’s a very small number or is it actually reasonably broad? Have some of the smaller schemes come into this area or is this just going to be for the big boys?
Martin: Direct investments from small schemes will be few and far between. It’s a question of the governance whether it appears in an absolute return bond fund, alternative buckets, there are products where these things can come in and out. There are a whole lot of things out there competing for time that have fantastic returns, low risk, so it’s a question of airtime. It’s a question of what do we feel confident in, what direct investment can actually justify the trustees’ time. If it’s a small amount of money, and if it doubles it won’t make any difference, but if it’s a significant proportion it’s probably too much.
Abbott: Softer issues come into it too. The personalities on the trustee board, even the personality of the individual consultant who is dealing with the client. We’ve had a whole range of clients directly invested in this, big and small. I think it comes down to the consortium being able to grasp the idea and the personalities on the trustee board as to whether they’ll be interested in something new. Clients with multi-manager portfolios will be considering doing this.
Ghosh: The one thing that you have to be wary about is if you’ve got a consultant that’s persuasive, invariably clients who are reliant on that consultant are very likely to follow what they do. What I would urge the pension schemes to try and do is really try and kick the tyres themselves. Even if you have a reliable consultant and advising firm behind you, never take an idea for granted; do your own due diligence.
Feeney: Does real estate debt stand out among the other niche credit opportunities in the market?
Ghosh: I genuinely do think it’s a reasonably compelling prospect, but one of quite a few. It probably stands above those you can easily discard, but there are other viable contenders out there.
Keogh: It is an opportunity largely because we know who has been active in the market already, we know there’s a great deal of people looking at the market. The fact that we haven’t seen a flurry of deals recently may be a good thing, as people are kicking the tyres and looking at the assets more. We feel the opportunity is vast and is going to continue for a considerable amount of time. But, I appreciate your concerns in terms of the markets, that people are looking into the market, but that goes back to transparency and certain valuation concerns. I don’t mind those markets being at the start in terms of an educational movement from those to the wider arena - that will happen once we’ve moved into less dramatic macro-economic backdrops.
Feeney: For me real estate debt stands out because of the scale of the opportunity. The funding gap is so immense that it isn’t going to be disappearing any time soon and there’s an opportunity for real investment on scale. Also because it is tangible in a sense we can understand it through fairly simple demonstration. Part of the trend I think is a revolt against complexity. My sense is that the immediately comprehensible nature of real estate debt and the volume of the opportunity are probably the two compelling features.
Abbott: An example of that would be the very large trend we’re seeing focusing on UK and Germany - the reason being that they are easy environments to work in, with easier legal frameworks. A lot of Europe is a minefield and it’s all these complexities that in the end mean people want to focus on transparent markets which are easier to operate in. Fortunately, this opportunity appears to be wide enough to have enough to go around without taking undue risks.
Thomas: I wouldn’t underestimate the time you need in Germany to actually foreclose a mortgage and repossess and/or take control over an asset. In Anglo-Saxon countries the rule of thumb is that it’s faster. In Germany it can take you up to two years which certainly makes it unattractive if you’re in the opportunistic space.
Feeney: Is there perhaps an advantage in the UK being consultancy-driven to a greater extent? Does that mean that in the UK smaller funds will get access to some of these new products as they emerge that might not be accessible on the continent?
Martin: I think it’s more a question of whichever consultancy you use that they have an open mind and will actually look at these opportunities. There are lots of competing different new ideas out there. We try and think of what the new opportunities are, where we think they will gain traction, and then follow that with research. I would never recommend a blanket approach of 20 new ideas in a six month period; you’ll never get traction on that. We look for the two or three best ideas over the next 6 months.
Ghosh: The way the industry is set up, small schemes have a good chance in the UK of accessing this kind of investment or other niche investments. That’s contingent on the adviser having done that filtration process to work out what they think will be best for their client base. It’s a bit harder to know how that compares to Europe because I think the definition of small schemes is different.
Feeney: Is this an unlikely product for continental schemes where perhaps there’s more conservatism?
Thomas: No, not unlikely. But I think in continental Europe the first movers will be the large investors. I cannot see that somebody would make an effort to take a one million euro ticket. If you look into the cost of carrying out the due diligence process, for both the provider of the product and the investor in the product, I would find it difficult to understand how the economics would work to deliver a positive return after transaction costs.
Feeney: Moving on to the different types of real estate debt offerings that pension schemes may be considering. Do you think that differentiation in the space is stratified largely along the basis of return objective, or are there other potential differentiating factors?
Abbott: There are two camps. There are clients who have a specific place for this type of investment, so senior debt replacing bonds for example. A lot of clients, especially in the mezzanine space, won’t necessarily have a return target in mind. They’ll buy into the idea, they’ll want to be educated on the idea, they’ll want to see a few managers. I suspect that if a client saw three managers who were targeting 9, 11, and 13 per cent they would be relatively ambivalent and would pick the manager they thought could do the job best.
Feeney: What about more racy products, where we’ve seen some people trying to launch 15 per cent plus distressed type real estate debt opportunities. Do those have a space or is there a sort of upper limit on the risk appetite from your clients?
Abbott: Fifteen plus is getting into dodgy territory. The last thing that clients want to do is to invest in something that’s new, something that’s a little bit opaque, something that they can’t necessarily measure very well, with a manager they might not know very well, and then target opportunistic returns and investments. I suspect that the amount of clients going into funds that are targeting 15 plus will be minimal if not zero.
Feeney: We are focused on offering a core product of a high quality with an 8 to 10 per cent type of return for our high income fund and that’s where we sense the greatest uptake. Yet there are plenty of guys out there trying to sell strategies that are higher return, higher risk and focused on lower quality assets.
Martin: There will always be plenty of people out there trying to sell 15 per cent type returns and they won’t necessarily get along great with pension funds. That’s been the case in the past and it will be the case in the future. I think it’s all about generating a sufficient return to a pension scheme, not necessarily about maximising returns.
Keogh: With the whole high income 8 to 10 per cent range, if you pitch that, it’s very important you stick to that. You don’t go chasing excess returns, you don’t go chasing extra risk and I think that’s what the client wants. Given the outlook in the wider market from the real estate side of it if people get an 8 to 10 per cent return from property from the debt side they will be able to live with that quite frankly, especially as I don’t believe you need the risk spectrum to be that great to achieve that kind of return.
Feeney: We’re looking at senior and a conservative subordinated fund, senior with 4 to 6 per cent type return, and a subordinated high income fund offering 8 to 10 per cent. My personal view is that senior debt is an extremely compelling proposition on a risk-adjusted basis. It won’t offer sufficient returns for many investors but I think it’s extremely compelling and it will generally offer low volatility low drama returns.
Abbott: The difficulty is how do you adjust your returns for risk? There’s no true volatility in terms of normal portfolio theory so risk adjusted returns is about adjusting returns on a qualitative risk basis.
Feeney: Will we see an ever growing proliferation of debt offer-ings or do you think that it sort of settles down into a few established areas? I see all sorts of ways this could grow and maybe we’ll see logistics real estate debt funds and maybe we’ll see peripherals real estate debt funds. We’re seeing lots of segregation or segmentation around returns - do we see other forms of proliferation?
Ghosh: I wouldn’t like to see any standardisation based on what target or expected returns are. What I want to see is managers playing to their skills, their expertise and what’s embedded in their DNA. If they think the part of the market that is most secure and the best value for money given their subjective view on risk is the 8 to 10 per cent, then that’s where they play. What I don’t want to see is those guys forcing themselves into a 4 to 6 per cent box when it’s not really where they want to be.
Martin: Logistical real estate funds, or high street shopping centres - whatever it may be, that may come. If there are specialists in that area who know it particularly well, there’s the depth where you can put that money to work, and they can demonstrate that is the way to attain a level of return, fine, but there’s a danger it becomes too esoteric.
Keogh: I like the idea of that, once the area matures. I don’t see why not as long as you’ve got the fixed income and real estate experience to back it up. But let’s not run before we walk.
Thomas: Do you think that as a fund manager you can source sufficient capacities of debt to have, say, 4, 5, 6 funds? Assuming you have 8 or 10 competing funds to have a market that these 8 or 10 competing funds have sufficient sources of generating the debt to have a UK high street debt fund, for example?
Feeney: There are many ways this market could develop. I suspect that probably the mainstay of the market will be fairly simple and straightforward for some time. In an environment of shifting regulation it’s very hard to plan a business where you’re entering into risk debt that may span 5, 6, 7 years. You might know what your capital charge looks like for the next 6 months but a year or two down the track it might change. To what extent is regulation in the pension space figuring?
Ghosh: Solvency II is a big unknown for pension schemes at the moment. I suspect probably most pension schemes aren’t asking the future-proofing question enough at the moment. I don’t think there’s much action yet; people aren’t tempering their behaviour as a result of what Solvency II might possibly mean.
Abbott: There’s the Basel aspect on the banking side and there’s the solvency aspect on the pension side. From what I understand banks have already positioned themselves to be in accordance with Basel whenever it might come in. Solvency II and how it applies to pension schemes is up in the air. The insurance requirements, if they’re applied directly to pension schemes, will increase deficits substantially. From commentators that I’ve spoken to it will not be implemented as it currently stands.
Feeney: Is that a negative for new products like real estate debt, where you’re more trying to establish a product that is unfamiliar in an environment where regulation is shifting?
Abbott: It just depends on how the regulation takes account of risk and reserves. If they view real estate debt as being a bond, a loan or debt investment, then one could assume that the capital reserve applied to that would be less than an equity investment in a real estate fund. In that regard, anything debt-based might become more attractive.
Ghosh: We know that banks are deleveraging or preparing for the new regulation coming in. Firms are holding back from making those decisions they would’ve normally taken because they’re unsure of what is going to be required going forward. All of that is feeding through into a weaker return projection. It’s the air of uncertainty that is not helping at present, but it’s just one of many other risks in the marketplace.
Feeney: We’ve had a good discussion. We’ve discussed the emergence of real estate debt and its tentative inching up in profile as an investment class, and highlighted governance and the need to work closely with investors to ensure that an understanding is achieved of this type of product. We have covered a lot of ground and we have the emergence of differentiated product in this space. That’s very positive; it gives investors lots of choice as they look into it. But, pension fund trustees and consultants have limited bandwidth and we as developers of these sorts of funds will need to be aware of that I think. We’ll need to ensure we’re telling a simple, straightforward message and communicating effectively the benefits to be achieved.