Insurance companies are increasingly seeking investments that offer both attractive returns and make efficient use of capital. A growing number are recognising the valuable role that real estate debt – specifically senior mortgages on commercial property – can play within a core fixed income portfolio – and the multiple benefits it can offer large-scale investors with longer investment horizons and capacity to accept illiquidity.
The world’s lending landscape has undergone a significant shift since the global financial crisis, with a host of factors reining back the availability of bank capital for borrowers. That change has been reflected in the European real estate debt market too. With tighter capital requirements seeing banks scaling back their lending activity in this space, institutional, non-bank lenders have increasingly moved in to mop up robust borrower demand. Today, non-bank capital comprises 6.4% (c. €117 billion) of the European real estate market1, compared to only 0.8% (c. €14 billion) in 2008.
At the same time, the decade of ultra-low interest rates since the crisis has spurred a worldwide hunt for yield by the insurance sector, as well as other institutional investors, to support their long-term investment needs. This has primarily been achieved through diversification into private and illiquid fixed income as well as cashflow rich asset classes such as infrastructure. Real estate debt is a key investment opportunity in this vein.
A relative value opportunity
For insurance companies, senior real estate debt investment can present a set of outcomes well suited to their needs.
First, the relative value proposition is at its most attractive for many years. When compared to corporate bonds of similar credit risk, senior real estate debt investments currently offer spreads, or risk premia, of around 200 basis points higher – the most compelling relative value since 2011. This reflects the significant narrowing of corporate bond spreads in recent years, as well as the relative illiquidity of the investment.
At the same time, commercial real estate debt is backed by security against physical underlying assets, namely the property that has been mortgaged. This can help to enhance both the quantum and timing of recovery values for the investor if a loan fails to perform as expected. Senior loans have a typical loan to value (LTV) of 50-65%, so are significantly over-collateralised by the underlying real estate, ensuring higher recoveries with minimal losses, compared to an average of just 40% for corporate bonds. Crucially, because the debt is underpinned by significant collateral, insurers can potentially benefit from greater capital efficiency under Solvency II, depending on the model they use.
Senior real estate debt is underpinned by a schedule of stable interest and principal payments, attractive for insurers seeking predictable income streams. While borrowers have the right to repay their loan at any time, loans often feature prepayment penalties to mitigate this risk.
Further, it can provide diversification benefits to a portfolio of traditional asset classes, due to the specific value drivers of individual properties. The loans can either pay a fixed-rate coupon or a margin over a floating reference interest rate (e.g. Euribor or Libor).
Finally, as a private asset class, real estate debt offers investors the potential to negotiate bespoke terms for each individual deal, in particular robust covenant packages, giving them the power to negotiate directly with the borrower in the event of a default for greater bargaining power, the ability to proactively deal with emerging problems before they escalate and a more streamlined workout process for distressed loans.
Accessing the asset class
Real estate debt is an alternative investment that benefits from a number of structural features that could appeal to traditional fixed income investors looking for both investment grade and sub-investment grade debt.
The changing regulatory landscape and resulting reduction in bank capital available for real estate lending in Europe has created an attractive opportunity for large-scale institutional investment into the asset class.
While compelling opportunities exist, the ability to access the asset class and release that relative value for their investors is key for insurers. At M&G Investments, we strongly believe that managers with the expertise and resources to lend whole loans (junior and senior tranches) directly to borrowers are best placed to do exactly that.
We believe the most effective way to optimise risk and return for investors is to directly originate whole loans with borrowers, tranche these into senior and junior investments and to hold and manage both tranches. This gives borrowers the security of knowing the identity of their counterparty throughout the loan term, which is particularly valuable in more complex transactions.
It can also lead to enhanced deal flow, as well as creating a pricing advantage which we endeavour to pass straight on to our investors.
1Source: Cushman and Wakefield, data to end-2015
Written by John Barakat, head of real estate finance, M&G Investments