THE EVOLUTION OF REAL ESTATE DEBT FUNDS AS AN ASSET CLASS
- The reduction in property lending from traditional banking sources after the financial crisis created an opportunity for a range of new non-traditional lenders to enter the market.
- Since 2009 real estate debt funds have emerged and today form a core part of many investors’ portfolios in both the US and Europe.
- Q1 2016 data from Preqin shows that 86% of investors were surveyed were satisfied with the returns generated by debt funds and 46% of those polled plan to increase private debt allocations in 2016/2017.
- Benefits of debt fund investments are relatively predictable and stable income, certainty in the capital stack, diversification and low correlation with certain other asset classes.
The financial crisis obviously had significant negative effects on both financial and property markets across the world. The overall market downturn combined with a sudden contraction in liquidity available resulted in the tightening of lending criteria, which contributed to a drastic fall in traditional real estate lending activity. This created an opportunity for a range of new non-traditional lenders eager to allocate capital but with limited opportunities for growth. Amongst others, under the ‘direct lending’ umbrella an alternative asset class of real estate debt funds (REDFs) was born and today is firmly established in both US and Europe.
Data from Preqin’s 2016 Global Private Debt Report shows that private debt fundraising reached a six-year high in 2015, attracting $85.2bn (€74.9bn) in capital commitments, up 18% from $72.2bn in 2014.
What are real estate debt funds and how does debt differ from equity?
Real estate private debt funds are pools of private equity-backed capital that have mandates or targets to originate senior and mezzanine real estate collateralized loans for qualified borrowers. Most are structured to execute a specific loan strategy or investment goal. REDFs have shorter terms than typical private equity and infrastructure funds and their investment period is shorter. In addition, there is usually an ability to recycle funds during the investment period rather than distribute capital to limited partners. In terms of fees, they range from 1% to 1.5% for senior and secured loans, to 2% to 2.5% for distressed opportunities, with returns in the teens.
Debt investing differs from equity in many ways. The former focuses on mitigating risk at every turn in order to maximize the probability of earning a fixed rate of return and collecting specified fees. Conversely, equity investing seeks multiple avenues of potential upside to compensate for the downside risk of losing the entire investment amount to a debt holder or for other reasons. The main distinction is that the debt investment (the underlying loan) is backed by a hard asset as collateral, and not just a business plan outlining potential goals.
Benefits of real estate debt funds investments?
Recent surveys carried out by practitioners indicate that there are three main reasons to invest in private debt funds:
- Relatively predictable and stable income: One of the big selling points for private debt funds is that they deliver a steady, high yielding income to investors, usually on a monthly basis. In an ultra-low yield investment environment, monthly distributions that can average around 8% on an annualized basis can look highly attractive.
- Certainty in the capital stack: By issuing senior debt, direct lending funds take priority to other forms of financing such as mezzanine loans, preferred equity or equity. When designing a real estate investment strategy, allocating a portion of money to an income-oriented product that is senior to all other positions in a capital stack is an excellent diversification tool.
- Diversification: Allocating capital across as large a pool of loans as possible optimizes predictability in loan performance and, hence, mitigates single loan risk exposure.
- Low correlation with other asset classes: Given the nature of senior lending and debt activity, private debt usually has a lower correlation to equities than traditional fixed income.
The growth of real estate debt fund market has been rapid since the financial crisis and we have seen a significant amount of fund managers participate actively in the market. This has increased competition and caused a trend of decreasing deal margins. However, with improvement in the global economy, we continue to see strong interest in this ‘new’ asset class from various investors across Europe and believe that the real estate debt fund industry will continue to offer an attractive opportunity in the current low growth environment.
About Avamore Capital:
Avamore Capital is a special situations lender that provides loans to property traders, property developers, property investors, and other property entrepreneurs. Loan sizes are between £0.5m and £5m with larger loans possible in conjunction with its partners. Avamore Capital provides a flexible approach, quick feedback and very fast drawdown, subject to due diligence.
For further information please visit www.avamorecapital.com or contact firstname.lastname@example.org