Duncan Batty (left) and Dan Riches (right) are the co-heads, Real Estate Finance at M&G Investments
For institutional investors across Asia, private credit, including real estate debt, can offer compelling relative value in a post-pandemic world, where there is now a greater focus on downside risk protection. However, bottom-up analysis and a cautious approach are crucial as we enter an environment with increasingly heterogenous asset performance.
Asia-Pacific institutional investors had exhibited concerns about the impact of Brexit on both the UK and Continental Europe. The post-Brexit agreement between the UK and the European Union has provided clarity, allaying concerns over a hard ‘no-deal’ scenario and prompting investors to look again at opportunities in Europe, particularly in the UK. Moreover, there are increasingly reasons to be optimistic about the outlook for the UK and Continental Europe as vaccine rollout programmes progress and society continues to re-open.
When it comes to real estate finance, the pandemic has presented selective investment opportunities. But where should investors be looking? And how can they identify transactions that are supported by strong long-term fundamentals?
Consider areas that traditional lenders are circumventing
Firstly, it’s important to understand what has changed since the pandemic first hit last year. Once financial markets stabilised following the March 2020 coronavirus-related downturn, compelling opportunities within the real estate debt sector started to appear. Institutional investors saw improvements in value when compared to the pre-Covid-19 world in most real estate sectors, with lower loan-to-value levels and more favourable pricing.
From an investment market perspective, traditional bank lenders have become increasingly cautious – with some pulling back from lending across real estate. This has opened up opportunities for institutional investors such as pension funds and insurance companies. Interesting areas for non-bank lenders include transitional and development assets, where supply and demand dynamics look favourable. In terms of geographies, banks are focusing on more defensive assets in core regions, enabling other investors to take advantage of compelling return premiums across Southern European jurisdictions, such as Spain, Italy and Portugal.
We continue to see a strong pipeline of investment opportunities in assets and sectors that have remained resilient to the COVID pandemic, creating significant prospects to deploy capital. Looking specifically at the UK, we continue to see high levels of demand for real estate equity investments, with investors keen to take advantage of UK property yields generally being higher than those available in Continental Europe. The lending market shows similar dynamics, with debt generally offering higher spreads than those available in European markets.
Focus on resilient assets with strong fundamentals
Generally, the most attractive assets appear to be those that are Covid-19-resilient – especially assets that benefit from defensive cashflows, long leases and robust long-term fundamentals.
Notably, the pandemic has accelerated the growth of e-commerce. Online retailers, including grocers, need warehouses with strong transport links, meaning that logistics and industrial warehouses have benefited from the abrupt shift in shopping habits. The logistics sector was already performing strongly given a broader structural shift towards e-commerce, and the pandemic has only served to speed up this trend. To give some context, UK internet penetration is forecast to reach 26% of total sales by 2021 and 30% by 2025. In Continental Europe, this figure is somewhat lower varying by geography between 13-19% but anticipated to continue growing rapidly. These features have resulted in significant value growth in the logistics sector and increasingly specialised occupier requirements so careful due diligence and asset analysis is needed.
The residential sector has continued to perform strongly throughout the pandemic with the vast majority of private rented sector tenants continuing to service rent throughout the pandemic. In the UK context, this strong income profile is combined with chronic undersupply of housing and difficulties for younger people to get on the housing ladder. Similarly, despite some volatility during the height of COVID, student accommodation continues to see strong levels of investor demand and we continue to see strong uptake in 2021, particularly in the UK, following record numbers of student applications.
Keep an eye on pandemic-related sector changes
There is still some uncertainty surrounding several sectors in the wake of the pandemic. The future of the office sector, for instance, continues to be a divisive topic. While remote working could be here to stay for some time, the office will evolve to play a key role in learning, collaboration, innovation and well-being. We believe that good quality office buildings in global cities are defensively placed, particularly those let to high quality tenants on long-term leases.
Elsewhere, as a result of lockdown restrictions the retail sector has experienced decreased foot traffic and tenant insolvencies – which have subsequently impacted on rent collections and net operating income. There have also been substantial drops in the value of retail assets. This is due to the ongoing uncertainty regarding long-term underwritable cashflows for these properties. Having said that, there are still some attractive opportunities available – such as retail warehousing and supermarkets that have been somewhat immune to the pandemic. The latter has distinguished itself from the broad-brush negative sentiment experience across retail given their predominant focus on bulk and discount goods (with limited online presence) and perceived COVID secure shopping experience.
The hotel sector has experienced pandemic-related distress. However, as lockdown restrictions have eased, we have seen opportunity for leisure focused offerings given they are likely to be less impacted by continued uncertainty surrounding future business travel, in our view. Overall, it may be possible to deploy capital at improved levels of pricing.
We believe that during 2022 stock selection and loan structuring will remain key. All real estate assets are different and understanding the unique characteristics of the underlying real estate allows risks to be properly identified and mitigated. Loan structuring and covenants are key techniques to achieve this and obtain protection for investors into debt structure – for example cash reserves to cover potential deficiencies in income. Investors should also be wary of valuation cyclicality – an absolute amount of capital could represent a very different proportion of a buildings value at different points in the cycle – so investors should consider the recoverability of debt throughout a cycle rather than at a specific point in time. Finally the expertise of the sponsor, their track record and their business plan for the underlying property should be assessed to ensure they have the necessary capability to deliver, service and ultimately repay the loan.
When looking to access the real estate debt market through a manager, investors should look at the manager’s approach to accessing the market, how the manager approaches credit and the manager’s track record of investing. Managers with a unique offering are more likely to be able to source investments in a crowded market. Managers with a rigorous approach to credit analysis and a track record over the long term can demonstrate an ability to invest through a market cycle and withstand market volatility.
- Duncan Batty and Dan Riches, Co-Heads, Real Estate Finance at M&G Investments