What are the risks in high yield real estate debt?

Income investors have it tough at the moment. Even high yield bonds in the US are now yielding less than the rate of inflation.

Finding appropriate risk/return opportunities in #thezero is a challenge for investors, and one which will continue for some time to come.

Against this backdrop, the private high yield real estate debt markets in Europe and the UK are offering attractive returns, which are enticing a new cohort of investors who may not be as familiar with the types of risk that need to be assessed and managed.

Why private real estate debt is growing

Banks have been stepping away from real estate debt lending since the Global Financial Crisis (GFC). Regulatory changes have made the sector less and less appealing from a capital cost perspective for banks, and this has been particularly acute at the high yield end of the market.

The supply/demand imbalance has created a funding gap between the financing capacity of traditional lenders and the demand for new loans. This offers alternative providers of capital the ability to generate  good returns.

Types of loans

Banks have grown particularly unwilling to finance specific areas of the high yield real estate market. Development assets, for example, may not fit for a bank with a focus on fully let investment grade properties.

There’s also a lack of risk appetite for ‘unstabilised assets’, or ‘transitioning properties’. Unstabilised or transitioning assets are those with a significant proportion of unlet space, or those assets going through significant change, such as an office building being converted in to a multi-use building including retail, restaurants and apartments.

For capital providers with deep experience in the sector, this structural reduction in available capital is contributing to a ‘lender’s market’ and offers an opportunity for generating strong returns.

Managing the downside

In the high yield market, one of the most important decisions real estate debt investors have to make is how to manage risk. In our view, investors are wise to choose either property risk, or structure (leverage) risk, but not both at the same time.

The first involves a high quality asset with high levels of debt, while the latter involves a higher degree of property uncertainty, but with a conservative debt package.

Source: Schroders, July 2021

Real estate risk

Supporting borrowers who may be renovating, repositioning or building new property, inevitably comes with a number of associated risks.

Taking real estate risk therefore involves analysing a borrower’s business plan and being comfortable with the underlying assumptions being made. Investors will analyse every aspect of the proposed transaction, including costs, timings, rental potential on competition and property value at exit. To do so they will use both internal intelligence and third party advisers to get comfortable with the proposal and structure the loan to best mitigate the risks.

Real estate debt investors use a full suite of covenants - including loan to costs (LTC) and loan to value (LTV) - to ensure that clients’ capital is invested within a prescribed level of risk.

Working with experienced borrowers with a strong track record is of paramount importance. Underwriting the business plan with covenants which allow for full control of the asset in the event of a covenant breach or delayed delivery is essential. Doing so means that recovery rates in the event of default are incredibly high.

Here we show an example of property risk in a development loan in the Netherlands. The asset will be a high quality, ESG-led property in a core market. The property risk comes from the execution of the development strategy.

Source: Schroders, July 2021. BREEAM is the world’s leading method for assessing the sustainability of building projects and buildings.

Debt risk

Real estate debt investors can also take lower real estate risk, but with higher leverage. Higher leverage on a stabilised and high quality property, offers investors an alternative route to access higher returns. In some instances, mezzanine loans may also be attractive, bridging the gap between cheaper senior bank style debt (up to 50-55% LTV) and equity, to offer investors a premium return.

Here we look at a mezzanine loan at a LTV of 85%. The assets are in high quality locations, with high occupancy and with a diversified income base.

Source: Schroders, July 2021

Tailoring your risk

Investors looking for yield can find attractive risk adjusted returns in private real estate debt. By choosing between leverage risk and the underlying real estate risk, investors can create a diversified portfolio of loans with different risk profiles. With bespoke underwriting for each asset, lenders can provide investors with double digit gross returns, including high single digit quarterly income, while protecting and managing the downside.