We are in a market where there’s a lot of geopolitical instability, and investor returns from an equity standpoint against real estate have been quite low. Why now for European real estate debt?
This is a typical ‘interesting’ market – a lovely euphemism – but in a way there’s nothing much new under the sun. The real estate cycle is typically a decade long, with many good years and a couple that are, let’s say, ‘terrible’ years, so you can undo quite a lot of good over that period.
The reason why we’ve been in real estate debt for a good 10 years now is to try and find a way through that cycle in a way that’s not dependent on cycle timing. Now clearly there are parts of the cycle that are much more beneficial as a lender and parts that are more beneficial as an equity investor. We’ve had a fantastic run recently where rates have gone up – so absolute returns have gone up for us – margins are more elevated so returns are, again, higher, and at the same time we’re looking at our existing portfolio which is seeing continued good performance. So real estate debt, the more senior in the capital structure it is, the better it has performed, and that’s a great way of demonstrating the value of real estate debt as a component part of a real asset strategy. I think that’s the benefit that we’re seeing, and we can deliver that benefit all the way through the cycle.
Research suggests interest rates could be falling. What are your views on that – in terms of real estate debt – and what do you think are the key takeaways?
We’ve had a great run the last couple of years because there’s been volatility in the underlying equity market. If there’s no volatility there, then there’s not much need for a defensive strategy. So what we’ve seen is a volatile world, both geopolitically but also in the interest rate environment, of course, pushing yields out in the absence of generic rental growth has made real estate debt a really valuable component of any investor’s portfolio.
The problem that we are potentially looking at is that debt becomes somewhat unaffordable. If you want a senior loan, 60% loan to value on a good quality asset, is the asset actually generating enough income in a world where rents may be growing a little bit, but not so much that they can afford a base rate of +4% margin. So, would we like interest rates to come down a little bit?
Potentially, yes, it’s probably worth having slightly lower absolute returns to get a market that is a little bit more active and debt that’s affordable.
Grade A office space has faced significant challenges since the pandemic. Would you say it’s a cause of concern?
I think ‘offices’ have become a little bit of a ‘dirty word’, and perhaps unjustly so. We’ve been very cautious on offices for many years now and so in a way we would argue that probably it should have been slightly dirtier then, than it is now.
In fact, what we’re seeing is that the use of the office has come back, and it’s reflected in the rents. Rents are higher now than they’ve ever been, which is great. It possibly is higher now than it’s ever been on a smaller subset, because what the office needs to provide to the tenant is changing and changing a little bit quicker than we would have seen in the past. So if you think of an office as a building that needs to last 50 years, if it only lasts 25 because by then the requirements of the tenants have changed to such a degree that it is no longer fit for purpose, that clearly would be a concern. We have seen that in some parts of the market, but for prime offices in London, Paris, and so on, actually the rents are higher than they’ve ever been, and that will be reflected in capital values again.
So, we’ve seen a dislocation between the utility to the tenant and the value that represents to the investor, which is a great time to be investing. After almost five years of not doing any office deals, we actually went back into that market in December, and we did a fantastic loan that I think is great value. It’s a new building, all the bells and whistles that you could possibly want, and you get a good return. Are there problems in the office market? Undoubtedly there are some, but in every market there are assets that are well worth taking on.
What other assets have you financed as part of your senior debt offering?
We cover pretty much all the real estate asset classes – we have mentioned offices already, we do retail logistics, as well as some of the other asset classes like hotels. What we do often when we consider loans is to say, what is the purpose of the asset for the occupier? Because, at the end of the day, the value of the asset is a derivative of the value it represents to the occupier. You saw during the pandemic that offices were perhaps not as mission critical all the time, certainly for a while, but in hotels, let’s say, you cannot run a hotel without the building. Often the building is the hotel, albeit there’s a big management operation behind it. So we have found that we’ve had great results in funding high-quality hotels across Europe, but also we’ve done similar with logistics assets where in the right location they are hugely valuable assets and present a very reliable cash flow stream.
Some institutional investors may not have considered European real estate debt. What would you say to them to make them reconsider?
Every investment has a purpose and you find that those institutional investors have allocations to real estate and they clearly know what they want from that – but, it is a cycle that has highs and lows, and the purpose of real estate debt as a counterpart to real estate equity is to smooth the ride through that cycle. So, you cut off some of the highs by being allocated to something that has a limit to its upside, but you can cut off some of the lows as well by being a component part of a portfolio where that component will outperform in bad times. If a typical cycle is 10 years, we outperform for five years, equity for the other five years, and this is an exposure to the income component of real estate – which is the more stable component – without so much risk to the capital value component.
