M&G on mitigating late-cycle risk

The European commercial real estate lending market faces numerous headwinds. John Barakat, head of real estate finance at M&G Investments, explains how managers can protect their investors’ capital while generating a return.

This article is sponsored by M&G Investments

Q: In this prolonged cycle, how do managers mitigate risk for real estate debt investors?
A: Investors are trading off upside potential for downside protection. One of the major risks when lending money into real estate is procyclicality; when things are worth more, people lend more. Today’s 70 percent loan-to-value is the equivalent of 90 percent a few years ago on a nominal basis, because property values are higher. Real estate lending continues to be about making sensible decisions around quality stock, proper sponsorship, proper operating expertise on the part of owners and making sure assets are suited for their purpose. Office stock which was well-designed 20 years ago will have nothing to do with what is necessary for effective asset deployment today. The world has changed, and the use of space has changed.

Late-stage risk is here although that doesn’t mean a turnabout is imminently inevitable. My personal view is that this late stage of the cycle will continue for a while longer, predominantly driven by the interest rate cycle. The latest growth statistics for most of Western Europe, the US and China have not been as robust. Looser monetary policy globally generally leads to a more sustained business cycle. Central bankers seem to want to manage things in a way that will permit easy money policy to continue for some time.

Q: If interest rates are lower for longer, is there a danger of managers being pushed up the risk curve because returns are relatively modest?
A:
That risk does exist. The investment environment in 2013-14 felt a lot easier than today. Finding a sensible return is more challenging now. You can take higher levels of risk today to earn slightly lower returns than you were earning a few years ago. Managers need to be mindful of that. The questions for third-party investors are: what are the alternatives and what are they really seeking? We have found over time that investors’ return expectations have aligned more with what the market opportunity is.

We continue to manage some conservative capital that wants to be invested in the highest quality assets at the lowest leverage points and is willing to accept a lower return for that. And we manage capital on behalf of investors that are looking for something akin to equity but with downside protection, so they are willing to accept slightly less than pure equity returns but still take meaningful risk to achieve it. For us, it has been about marrying those two investor groups to provide capital into the borrower market in an efficient way.

Q: Is development finance an opportunity or a potential risk for debt fund managers?
A: For development to be sensible, supply must be relatively constrained and rental levels need to justify the construction and holding costs for sponsors to build projects. That always means you are pretty far along the cycle. When the market has fallen significantly, that is not generally the time you see lots of new development going up because either there is excess space on the market or it is cheaper to buy standing assets than it would cost to build them. All those factors need to be considered.

One of the important things about development finance is that it is an intensive management process for a lender – at least it is if you are going to do it properly. Having the in-house capability and expertise to manage a situation if it goes wrong is also critically important in that space.

Managing a development loan comes down to micro factors – it is not possible to generalise about a particular property sector or any one location. For example, we are doing a mixed-use project in a major European city centre that involves significant retail, and there are people who would question the sense of developing more retail. Even though the scheme is in a market where retail vacancy is 2 percent or less, that space has to be let in a challenging retail environment. But you have got to be prepared to weather the challenge in retail.

Q: Should managers position their loan portfolios away from retail, given the crisis in the sector?
A: There are still very sound, knowledgeable and experienced operators who know how to navigate more challenging waters. There will be ups and downs along the way, and even with the best operators, fortunes can change more quickly than expected. You have to be prepared for that, and then you need to ask yourself the traditional questions that are present and constant in most real estate investment strategies: are you comfortable with the quality of the location, the quality of the space on offer and the demand for that space? You might say yes to the first two questions, but you must acknowledge that we are operating in a market in which demand is significantly lower than it has been.

Q: What measures are used to mitigate risk more generally?
A: We have a lot of investors, particularly those who want exposure to the senior, first mortgage portion of investing, that are driven by a credit-rating process and credit analysis, and they tend to be credit investors. For them, the alternative to investing in a 50-60 percent LTV asset is to buy a corporate bond. They think about it as something akin to an investment grade exposure, so they really are comparing illiquid mortgage credit against public bonds. We provide them with some basis by which they can compare those two alternative investments and make a judgement as to whether they are being paid adequate value for one versus the other.

Q: How concerned are investors about Brexit and wider political uncertainty?
A: If you draw red lines around those places in the G7 or G20 where you feel there is more political uncertainty than there was 10 years ago, then the investable universe becomes pretty small. Political risk has spread across Europe and therefore investors are not singling out the UK as much as some might fear due to Brexit. Having said that, there has undoubtedly been some slowdown in UK activity. It is undeniable that it will be better for the investment market and the continuity and predictability of that market for this question to be resolved. Investors do not like uncertainty and removing that big uncertainty from the market has got to be a positive from a real estate credit and investment perspective.

Q: Given all the headwinds and uncertainties, how do you assess the outlook for real estate debt?
A: There is no question that there is way more investor appetite for real estate debt as an asset class today than there was even five years ago, much less 10 years ago, when the industry really started on this journey. The variability between one year to the next year is less significant to me than the long-term trend, which has been for investors across the institutional market to accept and include debt as part of their exposure more broadly. That is a strong and positive trend.