Why European real estate debt is compelling now: M&G

Real estate debt has gained recognition as a viable investment vehicle for several reasons.

Firstly, investors may benefit from the security provided by the underlying real estate, which serves as collateral for the debt. This priority claim over the proceeds derived from the real estate offers capital protection. Additionally, investors have the flexibility to choose the risk and return profile they desire by investing in senior or junior real estate debt or a combination of both.

Senior real estate debt represents the lowest risk position in the capital structure, typically accounting for 50-60% of a building's value. Investing in senior debt grants investors a first-ranking claim to income and proceeds from the underlying real estate. M&G, for instance, structures senior real estate debt to achieve an investment-grade rating, enabling a comparison to similarly rated corporate bonds.

On the other hand, junior real estate debt holds a secured position that ranks ahead of equity but behind senior debt. With loan-to-value levels typically ranging from 60-80%, junior debt offers higher absolute returns.

▲ Is European real estate debt a good investment opportunity for investors now?

In our opinion, European real estate debt represents a compelling investment opportunity.

Presently, senior real estate debt in Europe offers a spread premium relative to similarly rated corporate bonds, averaging around 75-100 basis points over the last five years. Gross unlevered internal rates of return (IRR) of 10-13% is currently available for junior real estate debt in Europe, based on M&G Real Estate Debt data.

This favorable comparison to European real estate equity returns is particularly noteworthy when considering the protection against potential value deterioration of the underlying building offered by being in a debt position.

Additionally, real estate debt may provide downside protection in uncertain markets. It benefits from an equity cushion that absorbs value falls, making it an attractive option amidst the current macroeconomic environment in Europe. Structural features like loan-to-value and interest cover covenants further enhance the resilience of European real estate debt by providing early warning signs of potential credit issues.

Traditional bank lenders retreating from real estate lending due to regulatory capital requirements has created a supply/demand imbalance, presenting a significant deployment opportunity.

It is estimated that approximately €200 billion of real estate debt is due to mature in the UK, France, and Germany in 2023 and 2024 alone, according to data from Bayes Business School, International Real Estate Business School, Institut de l'Epargne Immobilière et Foncière, PwC’s Strategy&, Banque de France and PGIM Real Estate as of September 2021.

In such market conditions, non-bank capital can fill the refinancing gap and achieve higher returns at lower risk levels.

▲ Which sectors and countries offer the best opportunity?

The dynamic of traditional bank lenders reducing their real estate loan books exists across the UK and European markets, creating a supply-demand imbalance continent-wide. Historically, absolute returns have been higher in the UK compared to continental Europe.

However, with the continued retrenchment of bank capital, the gap between the two regions could narrow. The attractiveness of opportunities will be influenced by investor preferences for duration and tenor.

The continental European market has traditionally offered five-year floating rate loans, while the UK market has a combination of fixed and floating rate loans with a five-year duration.

It is important to note that real estate is idiosyncratic, requiring a bottom-up underwriting approach to understand and mitigate risks associated with specific transactions.

While compelling investment opportunities exist across sectors and countries, a thorough analysis of individual risks is crucial to appropriately price and mitigate them.

Areas with lower liquidity, such as construction finance, could provide the most attractive returns. However, the underlying construction project's risk profile must be analyzed and closely monitored throughout the project's duration.   

▲ What are the challenges and benefits?

The challenges and benefits of investing in real estate debt revolve around its private and idiosyncratic nature. Property market expertise is essential to source and underwrite real estate debt effectively while identifying and mitigating risks along the way.

Managers with a unique financing proposition, strong deal sourcing capabilities, track record, and long-term relationships are often best positioned to source attractive risk-adjusted opportunities across different geographies and sectors.

In the case of M&G, our focus on self-origination, combined with senior and junior debt investment capabilities held to maturity, allows us to provide large-scale debt financings with support from specialist real estate and restructuring teams.

This unique proposition and competitive advantage can enable us to deploy capital efficiently and offer investors potentially attractive risk-adjusted returns across the capital structure, aligned with their desired risk and return profile.

The value of investments will fluctuate, which will cause prices to fall as well as rise and investors may not get back the original amount they invested. Past performance is not a guide to future performance. The views expressed in this document should not be taken as a recommendation, advice or forecast.

By Dan Riches and Duncan Batty, M&G Real Estate Finance co-heads

Dan Riches joined M&G in 2010 primarily to originate, structure and execute investments in real estate debt. With more than 23 years of experience in the sector, he is involved with the structuring and marketing of the Real Estate Debt Fund series which has raised more than £3bn of investor commitments.

Riches previously worked in the European CMBS group at S&P Global and prior to that worked at RBS where he originated real estate finance transactions. He has been a member of the Royal Institution of Chartered Surveyors since 2000 and holds an Honours Degree in Land Economics from Sheffield Hallam University.

Duncan Batty joined M&G in 2011 primarily to originate, structure and execute senior loans, and to raise capital for dedicated senior debt strategies. With more than 17 years of experience in the sector, he has structured and co-managed segregated accounts for a number of senior loan investors and is a published author on a variety of real estate finance-related topics.

Batty previously worked in the real estate finance practice of Bryan Cave Leighton Paisner LLP having qualified as a solicitor in 2006. He holds an Honours Degree in Law from University of Nottingham and completed Legal Practise Course at Nottingham Law School with distinction.

Jennifer Nicholson-Breen edited this article.