In the decade since the global financial crisis, insurance companies have emerged as an important source of debt capital for owners of European commercial real estate.
US life insurance firm Massachusetts Mutual Life Insurance Company, better known as MassMutual, is among them. In 2013, its property-focused subsidiary – known before 2016 as Cornerstone Real Estate Advisers and since then as Barings Real Estate – hired former Royal Bank of Scotland banker Chris Bates to lead lending activities from the firm’s London office, with its parent insurer as its single client.
Since Q4 2013, Bates’ team has completed 20 core loan transactions – meaning senior debt to prime properties – with a total origination volume of £1.6 billion (€1.8 billion), plus £530 million across 12 ‘structured’ transactions, by which the firm refers to any loan written against properties in transition or under construction, where the asset has material or total cash-flow disruption and is subject to a business plan to reach stabilisation. To date, all European loans have been provided in the UK market.
As Barings targets expansion of its debt business this side of the Atlantic, it is aiming to widen its capital base, for the first time inviting external investors into its European real estate debt strategy, as is the case with its US debt business and across its equity activities.
The decision to open its doors comes at a time when a wide array of investors, many of which have traditionally preferred to provide equity capital to the real estate industry, are choosing to put their money to work through debt. Barings is not alone as a lender of insurance money which is choosing now to expand its capital base after years managing only in-house funds.
In October, the property wing of another major insurer – Germany’s Allianz – announced its intention to raise third-party capital for the first time across any of its strategies, choosing debt as the business line to open to outside investors.
In line with growing the sources of its financial firepower, Barings is also aiming to broaden where and how it deploys it.
In October, the firm hired Sam Mellor, formerly a real estate debt specialist at the London-based hedge fund Chenavari Investment Managers, to spearhead a lending drive into Continental Europe, as wellas increasing the emphasis on providing ‘structured’ debt products outside the traditional senior loans usually associated with insurance firms like Barings’ parent.
Real Estate Capital caught up with Bates and Mellor, as well as Barings Real Estate’s head of Europe, Charles Weeks, at the firm’s London headquarters to discuss the merits of inviting external investors into real estate lending strategies.
PUSH AND PULL
While Bates acknowledges that demand for commercial real estate debt is high at this late stage of the cycle, he describes Barings’ decision to capture some of that demand as one driven by “push and pull factors”.
“There is the push from the ownership to grow the business targeting our chosen markets, but also the pull of the increased investor demand for exposure to the asset class,” explains Bates. “Just as we have moved away from having a single source of capital in our US platform to create a diverse capital base, that is the plan we have for Europe.”
Weeks, who has overall responsibility for the property business – debt and equity – across Europe, explains that, while the company has tested the waters of the UK debt market over the past five years, it sees the growth of the investor base as the natural evolution. “In the US, we have a large commercial real estate loan book; 10 times the size of our European commercial mortgage portfolio. There is also a rapidly growing US book of structured loans. There is a desire from senior management to build out debt operations similarly in Europe. As with the equity property business, the clear direction of travel is about raising third-party capital to grow.”
Barings is in the early stage of the strategy. Initially, capital partners which the firm has invested with in equity deals in Europe or the US, or perhaps debt deals in the US, could be invited to participate in individual European loan deals, with a view to establishing lending mandates for institutional partners lacking their own origination infrastructure in Europe.
Quizzed on whether the firm plans to launch third-party commingled funds into its repertoire, Weeks admits no firm plans have been made, though says funds could be a logical progression. The initial strategy is to expand the programme into Continental Europe, while continuing to lend in the UK, initially on behalf of its existing single client, before inviting third-party capital into the strategy in 2019. Discussions are under way with several North American investors which will come into deals on a matched basis.
“Maybe we will start with a club deal or two, then broaden that out to a bespoke mandate,” Weeks says.
“Investors will be parties without their own lending infrastructure,” adds Mellor, “but which have invested in real estate with us in the past. We have a construction finance and a mixed-use financing opportunity, both in the UK, which could be the first deals done alongside external investors.”
While the team are keen to frame the planned growth of the business within Barings’ natural growth plans, they also acknowledge what Bates describes as the pull factor of growing global investor demand for commercial real estate debt.
So, what is driving that demand?
Bates argues it comes down to a greater acceptance among institutional investors of the product as a defined asset class. “We see appetite from fixed income investors as well as real estate allocations, as it has become an investment class of its own.
There is also particular demand for European lending strategies, as there is a feeling among investors that Europe is not as far through its cycle as North America. Another reason for demand is that private real estate debt provides diversification for investors.”
“Some investors have not crossed the Rubicon into private real estate debt yet,” Bates continues, “but many now have separate accounts here and in the US.”
Just as the profile of investors in real estate debt has expanded, so has demand for diverse lending strategies, as investors with differing risk appetites enter the sector. In their hunt for yield, for instance, many Asian investors are looking for the returns generated through high-yielding lending, while those investors viewing property debt as an alternative to fixed income remain satisfied with senior loan strategies, which tend to deliver returns in the region of 2 to 3 percent across the market.
Mellor, who has a background in complex loan deals from his hedge fund days, agrees investor demand is far from uniform: “Certain investors want core mortgages, while others are targeting the higher-yielding product. There is limited demand in Europe for highly leveraged loans, but many investors require mid to high single-digit returns and some downside protection.”
Investor demand for high-yielding debt is relatively niche, Mellor explains, with many viewing the asset class as a defensive method to generate a steady coupon.
Barings’ higher-yielding loan products are, therefore, generally structured as first mortgages, meaning investors are buying into whole loans at sensible loan-to-value ratios, mitigating risk.
“There is a niche in the market, especially in the structured space, where managers can provide a debt product with an equity mindset,” Mellor explains.
On the equity side of the market, Weeks says, core returns today are found around a 6 to 9 percent range, leveraged at up to 30 percent, with some investors, such as Dutch and German funds, tolerating lower returns still. Higher-yielding debt investments, he adds, can match that, with returns on the structured side of the business found around the 7 to 8 percent mark.
It is important that managers understand the type of deal that works for individual clients, meaning separate accounts can bring a single focus to an investment strategy, Bates says. Many investors will not have sufficient allocations to warrant separate account mandates, meaning they are more likely to invest in funds, he adds.
Will Rowson, partner at real estate advisory Hodes Weill & Associates, specialises in raising investor capital for clients. Investors he speaks to have a clear rationale for investing in real estate debt: “It is late in the cycle, and with 30 to 50 percent of most transactions comprised of equity, debt is cushioned in the event of a value fall, so there is a defensive logic. Senior debt appeals to fixed income desks because the return is relatively low. Whole loan and mezzanine lending increases the risk and return, so it starts to look more like real estate risk.”
Managers are increasingly competing for allocations, he adds: “The States is extremely competitive right now. The UK is relatively competitive, but there are few groups that are lending across the whole of Europe, because it is hard to underwrite so many markets.”
Most lenders of insurance company money have taken a measured approach to building businesses, Rowson continues: “Fees from debt funds are relatively low compared with equity, so I can see why a firm would build a team with scale and perform well for in-house money before seeking external money.”
Speaking in private, one debt specialist from a different insurance company, which already raises third-party capital, explains it can combine resources from different mandates to tailor loan deals to borrowers’ needs. “Historically, we didn’t get that flexibility from in-house capital.”
“An illiquidity premium is attracting investors to the alternative income space,” the specialist adds. “QE means fixed income returns are down, so investors are increasingly willing to switch.”
Although its European loan book is currently smaller than several of its non-bank lender peers, Barings’ lending profile has grown over the past year, with large deals including a £200 million financing of the Milton Park business park in Oxfordshire, its largest European loan to date. In May, floating-rate debt, on shorter terms than its original fixed-rate product, was introduced into the product range.
Through its senior, fixed-rate lending, Barings typically provides loans for seven to 15 years, with LTV between 40 and 60 percent, while floating rate debt is provided for three- to five-year terms, at 50 to 65 percent LTV, priced around 200 basis points.
The firm’s structured, or higher-yielding, products are targeted at properties with an asset management aspect, with loan-to-cost of up to 80 percent for terms between two and five years. Pricing on the structured side is around Libor plus 400bps to 600bps, generating 6 to 9 percent IRR.
The evolving institutional attitude to real estate debt reflects the mandate Barings has received from its client, Bates adds: “We have completed ground-up development in the US, while in the UK we have moved into alternative sectors such as student housing. In 2015, we even closed a loan-on- loan deal on some high-end London residential. Their risk appetite is responsive and has evolved over time as more opportunities are reviewed and closed in the market.”
Institutional investors, Bates points out, consider real estate debt one of many alternative asset classes, meaning the merits of the asset class are pitched against a vast array of investment opportunities. “Within the real estate market, we often just consider ourselves in isolation, but investors are searching for relative value across their entire investment landscape – corporate debt, equities, gilts, infrastructure, direct real estate, etc. Many clients have live pricing across all asset classes, meaning real estate debt is benchmarked against many alternatives.”
Although real estate debt is having its moment in the sun, Mellor argues an industry is being established which can remain relevant through cycles. “In late-cycle periods, debt offers attractive yield and downside protection through the equity invested by the sponsor, which absorbs the first loss on any investment. In early stages of the cycle, debt can attract higher returns as asset entry prices are lower and capital scarce,” he says.
The challenge faced by managers is deploying the capital they have raised in more competitive lending environments.
Barings’ decision to expand into Continental European lending is an attempt to expand its playing field, and although no deals have been closed yet, two are in the pipeline for the first half of 2019, Mellor says. Initially, Barings will concentrate on markets in which it has an equity footprint – meaning Ireland, Spain, the Netherlands and Germany are on the agenda.
The European strategy is not a response to Brexit, Mellor insists: “The view of the UK as too highly priced given Brexit is a little dated. We have seen price adjustment on transitional assets and will still be lending in the UK, going forward. Europe is behind the UK in the macro-cycle, with rates still very low and QE only beginning to be withdrawn and also seems to have broadly more favourable rental growth prospects. This has driven cap rates to be tighter for, say, an office in Frankfurt compared with an office in London, which we struggle with a little. So, it’s not as simple as just a binary ‘go to Europe, avoid the UK’; we are trying to assess relative value.”
Banks in markets including Spain and Ireland are back in the real estate finance business, although Mellor points out they remain capped at around 65 percent loan-to-value, with limited ability to fund development. In Germany, he admits it is “frankly impossible” to compete with banks in the senior market, although he argues there is potential to provide construction financing and structured loans, with some sectors such as student housing not yet fully established in the German market.
Asked why he decided to swap life at a hedge fund to join the debt team of an asset management firm, Mellor explains being part of a sizeable business is important at this stage of the market cycle. “In real estate, Barings is a sleeping giant, with huge potential to have a scalable business,” he says. “It has all the building blocks. Across asset managers in many sectors and markets, we have seen a lot of M&A as costs rise, due to factors such as compliance and pressure from investors to get value from managers. As costs are pushed up and fees pushed down, the market favours the most efficient managers, so the conclusion is big platforms are getting bigger. It’s getting harder for smaller and mid-sized debt players to grab investor capital.”
In equity, as in debt, Barings is a far bigger real estate player in its home market of the US. The firm clearly has plans to redress the balance in its European lending operations. Bates describes senior management expectations for the growth of the European real estate lending business as being within a “patient time frame”. However, with investor demand for real estate debt high, the opportunity for growth is out there.
Barings’ progress in European real estate debt
In March 2016, the asset management subsidiaries of US insurer MassMutual – Baring Asset Management, Babson Capital Management, Wood Creek Capital Management and Cornerstone Real Estate Advisers – merged into a $275 billion manager under the Barings brand.
As Cornerstone, the real estate business – now called Barings Real Estate – launched in the US in 1994, followed by a property debt programme. It now has a US real estate lending book of $23 billion.
The European arm, formed in 2010, launched its real estate debt strategy in 2013, lending senior, fixed-rate money on behalf of MassMutual. In May 2018, senior-floating rate debt was added to its strategy. The European loan book stands at $2.25 billion.