The complexity premium in real estate debt

Banks have been persistently withdrawing from real estate lending for over a decade because of regulatory changes that have deterred lending. That withdrawal has left a vast market in commercial real estate debt (CRED) for alternative lenders, insurers or large asset managers.

In continental Europe the total CRED market is around €1 trillion, while in the UK it is in the region of £200 billion, an increasing portion of which requires non-bank investment. We believe Covid-19 will only accelerate banks’ withdrawal, and further expand the opportunity.

How big can it get? In the UK, non-bank lending now accounts for nearly 27% (£54 billion) of the CRED market. In Europe it’s much lower. Non-bank lending comprises less than 6% of the overall market (€72 billion). However, over the next decade both markets are expected to grow and match US levels, where alternative lending comprises around $4.8 trillion or 40% of the $12 trillion CRED market.

At the same time, the familiar story of low rates and elevated listed equity markets mean the investor desire to diversify risk exposures and return streams burns as hotly as ever. As with other private assets, CRED can demonstrate a return advantage over comparable corporate instruments, and investor interest continues to rise.

Here, we break down the drivers of that excess return, differentiating between the so-called illiquidity premium, and the returns that depend on specialist skills we call the “complexity premium”.

Breaking down the return premium

For commercial real estate debt, the team must be first and foremost focused on taking the least amount of risk for the return available. Although it occupies a lower point on the overall risk curve, debt has all the downside risk, without the upside return potential associated with equity. The payoff is that real estate debt adds the dependable cashflows and certain term for repayment common to other debt types, plus an additional return.

Illiquidity…and beyond!

Borrowers who are unable to access public markets will pay a premium to access finance. With investment grade real estate debt, investors can achieve an uplift over investment grade credit of around 100-150 basis points (bps) without adding additional risk to the portfolio (accepting, of course, that liquidity is impacted). This premium is most accurately ascribed to illiquidity premium, given the comparability to more liquid instruments. CRED continues to be a “lenders market” and as such has not seen any downward pressure on margins, increase in risk or decline in “full covenant” packages that carry the most lender-friendly terms. This is due to the supply demand imbalance and the “funding gap” mentioned earlier.

Consistent premium vs. investment grade corporates


Source Schroders. ReD refers to real estate debt

Within private debt, CRED is one of the largest and most accessible debt classes, offering investors a wide range of risk/return to suit their investment needs. This means that investors have the highest degree of flexibility in setting and controlling both risk and terms for the investment.

Investors can reduce risk by moving down the “capital stack” from real estate equity to real estate debt. Within real estate debt, investors can further tailor risk by using high-yielding CRED, senior loan or investment grade debt according to their requirements. CRED can also carry both floating - to provide a natural hedge against rising interest rates and inflation - or fixed rates, to be used within a liability matching portfolio.

The flexibility reduces the relevance of illiquidity, given that liquidity chiefly poses a challenge only when it ebbs and flows. If an investor has tailored the liquidity profile of their portfolio with private debt, it should not vary as it can in liquid markets.

Complexity premium in CRED

Lack of transparency within the European real estate debt market and high barriers to entry contribute to premium beyond illiquidity. Whilst investment grade CRED benefits from a greater proportion of illiquidity premium, senior loans and high yield investment benefit from higher returns due to the additional complexity they carry.

Experienced teams can provide access to the market through long established networks, bringing structuring and - most importantly - real estate knowledge to manage the complex downside risks that real estate debt can present. Financing transitional or development assets involves a deep understanding of how to mitigate construction, letting and borrower risks, in addition to anticipating potential events that may result in downside.

Specific to real estate debt are also material improvements in environmental, social and governance (ESG) disclosures, such as energy labels and certificates. This allows greater measurability of impact and the pursuit of highly specific ESG objectives. The UK Government has committed to reducing carbon emissions by 68% by 2030. Industry recognises that 42% of the UK’s carbon footprint relates to the built environment, with 75% of the building stock energy-inefficient.

Even so, total real estate green or sustainable lending recorded in 2020 was just $14.1 billion globally. A recent climate change survey reported that 40%of Europe’s largest banks were still “business as usual” and only 15% identified as climate-related risk managers. A sustainable investment programme will attract better tenants and improve business performance. This in turn can deliver enhanced returns and tangible positive impacts to local communities, the environment and wider society for the long term.

These are only a few elements of the return in real estate debt we believe are more appropriately ascribed to complexity premium rather than illiquidity. Although liquidity remains an important consideration in real estate debt – as indeed it is in any investment – we think investors will benefit from a deeper understanding of the drivers of their private asset returns.