Commercial mortgage debt: a value opportunity

John Barakat argues the case for commercial mortgage debt in today's economic environment

Some of the most attractive relative value investment opportunities at the moment are to be found in European real estate debt - the provision of five to seven year senior and junior loans against commercial real estate.

Investors with an equivalent time horizon could expect to receive annualised total returns of 1% or more above comparable senior corporate credit and in the mid teens, or as much as 12% higher on junior loans for credit and default risk that would broadly equate to that of high yield corporate bonds.

For years, this asset class has been dominated by the banks. They have offered borrowers capital on a relatively high loan to value (LTV) basis, often at comparatively cheap levels from a borrower's perspective.

The credit crunch changed everything. Now, banks have shrinking bal-ance sheets and are less able to lend as before. Some have exited the sector full stop, others can only lend up to £/€ 50 million on an individual transaction and almost all are limited to 60-65% loan to value secured on prime real estate. These limits mean larger transactions, higher loan to values and non-prime assets are all struggling to attract debt, thus creating the investment case.

This reduction in lending has created a vast gap, calculated by one source as in excess of €40bn this year alone.

Europe's pension funds can step in to fill at least part of this gap. Indeed many are already doing so, lending at the 75-80% LTV level, in what we call 'mezzanine' real estate debt.

Here, institutions can exploit a number of favourable market trends simultaneously.

Firstly, the refinancing require-ment will be considerable. Many existing loans were arranged at the height of cheap lending in 2005-2007, and come up for maturity in the next year or so. In addition, commercial property values have fallen and this will create investment opportunities as these refinancing dates approach. If anything, this refinancing requirement is likely to grow, with an estimated minimum £220bn of deals to be rolled over or renegotiated in the UK alone.

Second, a corollary of weaker bank balance sheets is that many need to liquidate commercial real estate loans they already own. This creates opportunities to buy existing loans, and given some banks will be forced sellers, these loans are likely to be available at attractive values.

New rules provide the third trend likely to favour real estate debt investors. Capital adequacy guide-lines under Basel II and III have permanently eliminated the rationale for bank participation in some parts of commercial real estate lending markets (i.e. mainly below the 'BBB' credit quality levels). This suggests there is a very long term role for pension funds to play.

Lastly, securitisation markets remain closed. Commercial real estate debt is no longer being packaged up into vehicles such as asset backed securities in any significant way. The return of a robust CMBS market may be several years away. This means the door is open for longer to investors who want to lend against commercial real estate directly.

Investing in real estate debt is far from easy. It requires an efficient blend of real estate and credit work, analysing every component of the loan in great detail, from the quality of the real estate and local market and the security of income to the importance of proper loan documen-tation. But the market is growing, as is the breadth of opportunity.

While Europe's pension funds are unlikely to provide every single cent of the required €40bn it is undeni-ably a buyers' market. Investors can expect pricing to favour them.

Written by John Barakat, head of real estate finance and fund manager of the M&G real estate debt fund, M&G Investments

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