PERSPECTIVE3-5 min to read

Strategies for Private Real Estate Debt in Asia

01/09/2023
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Authors

Andrew Haskins
Head of Strategy and Investor Advisory, Real Estate, Asia Pacific, Schroders Capital

Both globally and in Asia Pacific (APAC), the market need for private real estate debt continues to increase as banks become more reluctant to lend to real estate. At the same time, investor demand for private real estate debt as an asset class is rising fast. This reflects 1) the downside protection offered by real assets as security and 2) the stable interest and principal payments offered by credit, which are attractive to insurance companies and pension funds. Providers of private real estate debt are primarily specialist real estate fund managers. Market experience suggests that working closely with borrowers and understanding their businesses greatly reduces the need to enforce loans.

Large international investors are primarily interested in commercial real estate debt in big, highly liquid markets, notably the US. It thus makes sense to raise capital for private real estate debt strategies in APAC within the region, ideally at a country level. In APAC outside Australia, Mainland China and Hong Kong SAR look like the key markets which combine a clear need for additional financing channels from borrowers with local institutions (especially insurance groups) likely to be willing to invest in private real estate debt at home. In Australia, lower-tier property developers are typical targets for private real estate debt lending, but in Asian markets private equity real estate firms and asset operators look more promising as target borrowers.

Introduction

Private debt fills a market gap that is created when borrowers cannot readily access other forms of debt financing. There may be several reasons for this, for example, reluctance by banks to extend loans to certain sectors or lack of a developed corporate bond market in a particular jurisdiction. Private credit provision by specialised debt funds (typically run by private equity groups or other large fund managers) expanded rapidly in the US and Europe after the Global Financial Crisis, when banks pulled back from riskier lending – in large part, due to regulatory tightening – and focused their corporate activities on larger clients.

Private real estate debt is a subset of private debt. The lenders are similar, while the borrowers are typically smaller real estate developers or private equity real estate funds. One important difference from other common categories of private debt lending is that real estate private debt loans are secured against physical assets in the form of buildings. Private debt now makes up about 40% of all commercial real estate lending in the US – a market worth over USD5.0 trillion by some estimates. In Europe, private debt makes up nearly 10% of the estimated EUR1.4 trillion (USD1.5 trillion) commercial real estate lending market. Comparable figures are not readily available for APAC.

Originally, private equity firms offering general private debt mostly targeted high-return lending to smaller and weaker corporate borrowers. As large US-based private equity groups such as Apollo and KKR acquired insurance companies (in their cases, Athene and Global Atlantic, respectively), so they obtained substantial additional funds for investment in the form of insurance premiums. US regulations require insurance companies to invest primarily in higher-rated categories of debt. These developments increasingly led the private equity owners of insurance units to target investment-grade lending to larger, more stable companies.

A similar trend has taken place in private real estate debt. The business began with higher-risk, higher-return strategies such as mezzanine financing. However, in most regions a greater range of products has become available lower down the risk curve, including investment-grade debt and sub-investment-grade senior loans. This has broadened the appeal of private real estate debt as an asset class to investors with lower risk tolerance.

Figure 1: Examples of private real estate debt strategies in Europe

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Note. IRR = “internal rate of return”. Source: Schroders Capital (March and June 2023).

Market need for private real estate debt in APAC

There are several reasons why the market need for real estate private debt in APAC has increased.

Reluctance by banks to lend to real estate sector

The APAC banking sector is fairly well-capitalised, and overall has probably been less affected by regulatory pressure under the internationally accepted Basel capital framework to strengthen balance sheets and limit lending than the banking sector in Europe or the US. Even so, banks in many APAC markets have become more cautious about lending to the real estate sector. This is especially true in Mainland China, where traditional real estate developers focused on mass residential projects have experienced severe financial stress over the past few years in the wake of overbuilding and price declines – stress which has resulted in numerous defaults on debt repayments and debt restructurings.

Besides Mainland China, Hong Kong Special Administrative Region (SAR) and South Korea stand out as markets where banks have become more reluctant to lend to real estate. In Hong Kong, commercial real estate investment volumes fell 17% over H1 2023 (and 47% in Q2), reflecting not merely the highest interest rates in developed APAC, but also apparent growing risk aversion on the part of the territory’s banks. In South Korea, anecdotally, it is virtually impossible to obtain bank financing for development in the oversupplied logistics sector. In Australia, banks appear mostly less reluctant to lend, but market evidence suggests that they have been curtailing lending for residential development.

Borrowers expanding from developers to private equity real estate firms

As a consequence of banks’ growing reluctance to lend to the real estate sector, at a global level property developers are no longer the main or only category of real estate borrower seeking financing. Increasingly, private equity real estate fund managers require access to private debt, especially for Value-Add investment projects. In Europe, such large and well-known firms as Hines, KKR, Blackstone and Brookfield have recently appeared in private debt transactions not just as lenders, but as borrowers. It is reasonable to expect a similar trend in APAC.

Lack of a corporate bond market in real estate in most APAC countries

Mainland China has the largest tradable corporate bond market in APAC, while the corporate bond markets in South Korea, Hong Kong SAR, India and Indonesia are also sizable. However, only Mainland China has high levels of corporate bond issuance by real estate developers – mainly the large, listed groups with a residential focus. In contrast, in Australia, for example, there are almost no corporate real estate bonds in issue. In any case, bond issuance is a financing solution readily available only to large, listed companies. It is not a solution for smaller, unlisted developers or for real estate fund managers.

Markets with a funding gap

The term “funding gap” refers to expected difficulties in refinancing outstanding loans, caused by rising interest rates and downward revisions in property valuations. CBRE estimates that there is currently USD177 billion of outstanding senior commercial real estate debt in APAC, with a funding gap of USD5.8 billion set to emerge in markets between 2023 and 2025. 2By total volume, Australia faces the biggest funding gap, but South Korea faces more immediate pressure, with a high volume of loans set to mature in 2023. Office properties are likely to face the greatest funding gap of any sector, since this is the sector expected to be most impacted by declines in capital values.

Investor demand for private real estate debt as an asset class

Globally, private real estate debt funds now total around USD1.3 trillion. There are many reasons why institutional investors have shown increasing interest in real estate private debt as an asset class. Most of these reasons apply in all regions, including APAC. So far, private real estate debt fundraising has been heavily concentrated in North America and Europe, leaving APAC looking very underserved.

Figure 2: Private real estate debt fundraising by region: 2013-H1 2023 (USD million)

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Source: Preqin (August 2023)

Higher returns, lower risk at this point in real estate cycle

Many global real estate markets face the highest interest rates for many years and, notably for offices, falling capital values. This situation will not last: at some point interest rates will stop rising, and capital values will stop falling. For now, however, real estate debt strategies arguably offer higher returns for lower risk than real estate equity strategies. For example, in core Western European markets (see Figure 1), real estate debt funds currently offer 8%-12% gross IRRs available at 60 70% loan-to-value ratios on repriced valuations, in jurisdictions with strong creditor protections.

In APAC, interest rates are stable or falling in the two largest real estate markets, Japan and Mainland China, but they have surged in most other markets and may still rise further. Capital values are also falling for certain real estate types, especially offices but also logistics warehouses (in Australia, after a huge-run-up over the past few years; in South Korea, due to oversupply), reducing potential total returns on equity investment strategies even if income returns stay unchanged. Against this background, the gross IRRs of 12%-15% or higher offered by junior debt, mezzanine or preferential equity private real estate debt funds currently available in, for example, Australia are compelling.

Diversification from more liquid investments

Private real estate debt offers diversification benefits when added to a portfolio of more 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. Floating-rate loans reduce the exposure of a debt portfolio to interest rate movements because the loan coupon is reset at the beginning of each interest accrual period to adjust for any change in the reference interest rate.

Strong downside protection

Private real estate debt is secured by hard assets, in the sense that the recovery of a real estate debt investment is dependent on the value of ring-fenced, physical property. This differs from corporate bond investments, where recovery for bondholders is generally more dependent on the management of a business as a going-concern. This collateral backing can help to enhance both the quantum and timing of recovery values for real estate debt investors in the event an investment does not perform as expected.3

Naturally, the security offered by real assets counts for most in countries with strong legal protections. Most of APAC’s developed markets have strong legal frameworks with adequate protection for creditors. However, among the large developed markets, only Australia, Hong Kong SAR and Singapore have legal systems founded on English common law, the legal system with which international investors are likely to be most familiar.

Stable cashflows attractive to insurance companies and pension funds

Private real estate debt is a fixed-income investment offering a schedule of stable interest and principal payments. This is attractive for institutional investors such as insurance companies and pension funds looking for highly predictable income streams. Borrowers usually have the right to repay loans at any time, but to mitigate this risk of prepayment, loans often benefit from repayment penalties. 4Furthermore, private real estate debt offers the potential to improve capital efficiency and returns on capital under risk-based capital frameworks (e.g., the Solvency II regime in Europe) if collateral can be captured and modelled.

Private real estate debt becoming more popular among APAC institutions

The attractions of private real estate debt have particular resonance for certain APAC institutions. For example, South Korea’s public pension fund, the Korean Teachers’ Credit Union (KTCU), plans to allocate one-half of its foreign real estate allocation to debt. Specifically, for all new capital invested in overseas real estate in the next 12 months, the investor will allocate around 50% to real estate debt, 40% to Value-Add equity strategies, and 10% to secondaries.5

While some institutions prefer direct lending, others prefer to invest in real estate debt through commingled funds. Three South Korean investors including KTCU interviewed in a recent industry publication expressed their interest in committing capital as LPs into private real estate credit funds run by strong GPs in the US, UK and European markets. 6Naturally, it does not automatically follow that these institutions would be willing to commit capital to private real estate credit funds in APAC.

Market participants

Participants in the private real estate debt market vary by region, but include large fund managers and investment banks such as PAG, PGIM, Oaktree, BentallGreenOak and Goldman Sachs (perhaps especially in APAC), together with specialist real estate fund managers such as Savills Investment Management, ICG and LaSalle (perhaps especially in Europe). Banks have, of course, not entirely withdrawn from lending to the real estate sector, not even in the US where adoption of private debt in general is highest and the office market is under probably the greatest pressure. In Europe, the small-cap lending teams of banks such as Lloyds and HSBC continue to operate in the same market space as the private real estate debt operations of fund managers and private equity firms.

Risks

Risks in the private real estate debt business include both traditional real estate risks such as downward asset revaluation and tenant delinquency, and financial risks such as high loan-to-value ratios in deal financing and sharp interest rate increases. It is important to test income and value regularly (if possible, quarterly) and to know the borrowers well. Developer borrowers in particular frequently encounter construction delays and other operating problems, and loan covenant breaches or technical defaults are quite common. Usually, such problems can be resolved if lenders work closely with borrowers, while legal protections in many markets allow lenders to take control efficiently and quickly in the event of full-blown default.

Providing that this approach is followed, Schroders Capital’s experience with private real estate debt activities in Australia and Europe suggests that the need to enforce loans is low, and that irrecoverable loan loss rates are negligible. In certain APAC markets, it may be necessary for private real estate debt fund managers to assign individual staff to oversee each asset, to review borrowers’ accounts thoroughly, and to request personal guarantees from them. Again, however, working closely with local borrowers usually greatly reduces the need to enforce loans.

There are, of course, different approaches to risk management. Some fund managers aim to be the sole lender in each private real estate debt transaction in order to maximise control over the terms of the loan. Other fund managers prefer to invest in syndicated loans in order to spread risk among several parties.

Recommended strategy

Which are the best markets in Asia?

Australia already has a large and flourishing private real estate debt market. In APAC outside Australia, the most promising markets for promotion of real estate private debt strategies are those where there is an evident market need for additional debt financing. Mainland China and Hong Kong SAR fall into this category. In Japan, where interest rates are very low by global standards, and in Singapore, where banks are less reluctant to lend than in Hong Kong, the need for additional debt financing is less evident. In South Korea, there is a high market need for additional debt financing, but it is a country that is difficult to serve from outside for cultural and linguistic reasons.

Which investors should be targeted?

Experience suggests that large international investors are primarily interested in US commercial real estate debt. This offers low-risk exposure to the world’s largest and most liquid real estate market. Most North American or European institutional investors invest in APAC to achieve extra financial returns from diversification, and some may consider expected IRRs of 12%-15% from private real estate debt investment in the region to be too low.

It therefore makes more sense to try to raise and deploy capital for private real estate debt strategies in APAC within the region, and most probably at an individual country level. This is especially true for Mainland China, a market towards which various international institutional investors have become cautious due to geopolitical risk, but where there is a large domestic investor base including big insurance companies seeking to invest their capital. Hong Kong SAR is also the home base of several large insurance groups which typically have high investment portfolio weightings in their local market, although more probably in equities than private assets.

Which loan products should be offered, and to which borrowers?

The experience of Schroders Capital in other regions suggests that in Asia it makes sense to offer both investment-grade debt funds and higher-return, sub-investment-grade debt funds. More complex strategies like real estate mezzanine financing (where loans are secured not directly by the property asset, but by a pledge of the borrower’s ownership interest in the asset) also offer potential for more experienced or specialised fund managers.

In terms of product, smaller loans of between about USD10 million and USD100 million look like the right target offering. In Australia, typical private real estate debt borrowers are lower-tier property developers. In Asia, the real estate markets in Japan, Hong Kong SAR and Singapore are dominated by large or medium-sized developers which are mostly quite well-capitalised, and so do not really need additional borrowing channels. In Mainland China, there are many real estate developers which require support, but they tend to focus on traditional residential real estate which is under severe pressure and should not be a target for lending.

In general, therefore, operators of real estate assets such co-living apartments or affordable rented housing look like more plausible borrowers, together with private equity real estate funds active in markets or real estate segments offering growth potential or good value where bank financing is drying up. For private equity real estate funds, this may well imply lending to their direct competitors. It ought to go without saying that the private real estate debt business of a private equity firm should never lend to the firm’s own private real estate equity business, due to the obvious conflict of interest.

Which are the best sectors to target for loan provision?

It is best to try to direct loans to those parts of the real estate market which are preferable from an investment perspective. Schroders Capital Real Estate APAC follows a Value-Add strategy with a sector-agnostic approach, meaning that we are willing to consider many different properties for their potential to be upgraded or converted to other uses. All the same, we believe that there are segments of the real estate market which offer superior growth potential linked to underlying trends in the APAC region or which represent good value. These segments include rented housing, logistics in certain markets, medical real estate and hospitality, as summarised in the chart below.

Figure 3: APAC: major real estate themes

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Source: Schroders Capital (August 2023)

The outlook in APAC for offices, the largest traditional sector, is hard to gauge. Except for Australia, office markets in developed APAC have been less affected by home working than most western markets. Even so, many cities are seeing high supply, e.g., Shanghai and Beijing (where the vacancy rate is 19%-20%) and Hong Kong (15%), and these cities have low or negative rent growth. While in such an environment there is little incentive to invest in offices for income, we see sustainability-led office upgrades as a viable Value-Add strategy in various APAC markets. It could well make sense to lend to other real estate fund managers with a similar view.

The outlook for retail real estate, the remaining large traditional property sector, is brighter. While retail real estate yields have reached high levels after years of pressure, the sector has almost certainly passed the bottom. Rebounding consumption and the return of tourism have driven modest growth in retail sales in most developed APAC markets (especially Hong Kong SAR) so far in 2023. Retail rents should pick up in Hong Kong and Singapore this year after years of weakness, while Shanghai should also see higher rents despite the moderating pace of retail sales growth in Mainland China in Q2. Lending for investment in the retail sector should no longer be seen as very high-risk.

ESG considerations

It makes sense for real estate fund managers to apply expertise in ESG principles to private real estate debt provision as well as private real estate equity investing. This is not just for charity: it is starting to become accepted that real estate with stronger ESG credentials boosts rents, attracts tenants and safeguards future value. Schroders Capital’s European private real estate debt team has developed a two-step process which assesses both the borrower and the underlying real estate. Adopting a similar loan review process in private real estate debt activities in Asia ought to be helpful.

APAC still seems a few years behind Europe in terms of appreciation of the importance of ESG principles. It may, therefore, be necessary for private real estate debt providers to make a significant market effort to convince potential local private real estate debt clients that attention to ESG principles can enhance credit quality. In this context, the comments on corporate loans from Schroders Capital’s Australian private debt business below are very pertinent.

“Sustainability-linked loans are relatively new in Australia and I think the market needs to distinguish between what is real and what is marketing. I’d like to see borrowers incentivised in the form of more generous benefits and margins. You could argue that default risk is therefore lower, so we would accept lower margins. To date, the market really hasn’t viewed sustainability as a credit enhancement. We’d like to see pricing being adjusted to reflect reasonable sustainability objectives.”

Schroders Capital, Q&A: Building reliable income with private assets, Nicole Kidd (12 January 2022)

1SONIA or Euribor (respectively, 5.2% and 3.6% for one-week Euribor as of 8 August, 2023)
2CBRE, Analysing the Funding Gap: A Bird’s-Eye View of the Asia Pacific Commercial Real Estate Debt Market (May 2023)
3Primary source: Schroders Capital, What can real estate debt offer insurance companies? (June 2021, by Natalie Howard)

4Primary source: Ibid.

5Source: PERE article, KTCU to put half of its foreign real estate allocation in credit (11 July, 2023).

6Source: PERE article, South Korean investors pivot to real estate debt funds (5 July, 2023)

Important Information

The information in this market update is current as at September 2023 and does not necessarily reflect subsequent market events and conditions. This update is provided for information purposes only and does not provide individual financial, legal, tax or investment advice. Past performance is not indicative of future performance. Graphs and charts are used for illustrative purposes only and do not reflect future values or future performance. The statements and statistics contained herein are based on material believed to be reliable but are not guaranteed to be accurate or complete. Investments strategies should be evaluated relative to each individual’s objective in consultation with their legal, investment and/or tax advisor. Schroders Capital is not liable for any errors or omissions in the information or for any loss or damage suffered.

Copyright © Schroders Capital 2023. All rights reserved

Authors

Andrew Haskins
Head of Strategy and Investor Advisory, Real Estate, Asia Pacific, Schroders Capital

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