Seizing the moment

Read this article to understand:

• The compelling opportunities emerging in real estate debt
• The benefits of a multi-asset approach
• Why covenant protection in private debt agreements is important

After a turbulent period during 2023, the real estate debt market showed promising signs of recovery in the first half of 2024.

As this recovery phase continues, liquidity remains a critical factor, with banks and other lenders focusing on transactions that meet stringent credit and risk parameters. Competition for some loans is intense.

But while the landscape looks challenging, there are attractive opportunities for those with the expertise to navigate it, especially if they also have the flexibility to implement a multi-asset approach.

As Aviva Investors research shows, illiquidity premia for real estate debt investments are at the highest levels in a decade (Figure 1).¹ “Brown-to-green” projects – or lending for improvements and renovations to inefficient building stock – look particularly compelling.

Debt dynamics provide a further indication that we are seeing a shift in market conditions. Real estate debt tends to reprice quickly when rate expectations change, more so than real estate equity. As such, the cost of finance has been higher than property yields for an extended period. But now debt costs have stabilised and headline property yields have adjusted, so this inversion is no longer in place. Real estate debt financing is therefore becoming accretive, in the UK and within various sub-sectors in Europe.

In this Q&A, Gregor Bamert (GB), Sima Kotecha (SK) and Nick Solomon (NS), Aviva Investors’ head of real estate debt, head of high yield strategies and real estate finance, origination director, respectively, discuss their assessment of risks and opportunities in the current environment, the sector-specific challenges and geographic nuances that influence their investment decisions, and the importance of diversification, risk management and adaptability in multi-asset portfolio construction.

How would you summarise commercial real estate debt activity in the first half of the year and what are the key themes shaping real estate debt markets in H2?

GB: We are at the early stage of a recovery in transaction volumes. We’ve seen a significant increase in activity on the lending side; there is substantial liquidity and lending capacity from banks and other lenders for transactions that meet their credit and risk parameters. In sectors with strong underlying demand, considerable financing volume is available. However, liquidity remains limited in other areas.

NS: 2023 was a quiet year for most lenders. They entered 2024 under-lent, expecting interest rates to decrease, but the fall in rates was slower to materialise than anticipated. This has led to relatively low transaction volumes and high competition.

The investable universe is smaller than it has been historically, but when lenders are comfortable with the asset class, they compete heavily. This results in a landscape of relatively low returns for asset classes that remain attractive to lenders.

Where do you see opportunities?

SK: The illiquidity premium for different sectors has varied over time. We've been lending for 40 years, which has given us an extensive dataset to work with. This shows margins in real estate debt are currently at their highest in the past ten years (Figure 2). Combined with a period of stabilising property values, this makes it a compelling time to invest in real estate debt.² Specifically, we are seeing attractive opportunities across the risk spectrum away from traditional senior debt for non-bank lenders that benefit from wider investment parameters.

GB: One area where we think there is opportunity is in brown-to-green transformation, or broader repositioning and refurbishing of assets. There is strong demand for modern energy-efficient buildings that are both fit-for-purpose and sustainable, helping tenants meet their own sustainability criteria and reduce energy costs. The increased costs of refurbishment due to high interest rates have created challenges for some lenders, but we continue to see these projects as a compelling proposition given the relatively higher risk-adjusted returns available.

Can you discuss some of the other opportunities currently available in the market and the trends driving their availability?

GB: Firstly, we are looking at areas that are out of favour due to sector-wide challenges, such as offices and retail; here we are seeing opportunities to pick out assets with better fundamentals. Secondly, there are types of loan that are more operationally intensive, such as those for refurbishment and development, which tend to provide opportunities for stronger returns.

SK: The debt funding gap, and the current position in the property cycle, provide opportunities to bridge that gap.

Geographically, these opportunities are more likely to arise in the UK than in Europe, partly because the European Central Bank (ECB) started cutting rates earlier and the differential in base rates is likely to continue in the medium term. Lenders in the EU have been quicker in putting capital to work than their counterparts in the UK, so margins have been compressing in the euro zone relative to the UK. That gives us a natural bias toward the latter, but we will continue to monitor both markets should opportunities emerge.

What are the benefits of approaching real estate debt within a broader multi-asset private debt strategy?

SK: There are three main benefits: risk, reward and deployment.

In terms of risk, a massive benefit is the diversification it brings. For example, an infrastructure debt transaction has different performance drivers compared to a real estate debt transaction, which brings diversification to your portfolio.

Regarding reward, a multi-asset approach allows investors to look at where there is relative value across different asset classes and tilt a portfolio accordingly. And, in terms of deployment, such an approach opens up a wider investment universe and enables better quality and faster deployment. For instance, in structured finance and private corporate debt, stress in the banking sector can suddenly create a lot of activity and lead to opportunistic investments.

And what about the main challenges?

SK: Data and information availability are two significant challenges. To benefit from risk-reward diversification, investors need reliable underlying data, which can sometimes be difficult to come by in private markets. This is where in-house proprietary tools to help gather and analyse information can be helpful.

GB: In the real estate market, we are in a recovery stage. While some parts of the market are improving, others continue to look weak, so investors must make sure their underwriting captures these dynamics appropriately. The debt funding gap means some borrowers will come under more pressure than might have been the case previously.

NS: This ties back to the point about the investable universe being smaller for certain assets. For example, offices (especially dated assets needing capital expenditure to appeal to tenants), are facing the biggest challenges. Such assets often fall outside lenders’ appetite; additionally, the higher interest rate environment continues to exert pressure, exacerbating these challenges.

How do you assess and monitor the financial health of borrowers in your portfolio?

GB: This is something we have worked on for many years, largely as a result of our own experience with long-dated lending. Over a longer period, things can change significantly so continuous proactive monitoring is important. You can't just wait until something happens.

We are fortunate to lend against assets across the country, with a portfolio that includes over 1,100 properties which are occupied by over 4,000 tenants. We regularly monitor these assets, and while our standard approach is thorough, we adopt an even more intense approach when dealing with higher risks of individual transactions, reporting on them and taking appropriate action to monitor the financial health of borrowers.

We receive quarterly covenant compliance including updated rent rolls across our book, so are able to keep up-to-date with broader occupancy and rental trends as well. All of this information is hugely helpful, but ultimately having open and direct communication with sponsors and borrowers is the critical part of ongoing management and monitoring.

NS: Another key factor we monitor is the credit rating for each loan, which is a dynamic measure of the loan’s creditworthiness. The rating considers refinance risk, which is the extent to which a loan can be refinanced at maturity. Given the current market conditions, existing loans will likely be refinanced at higher interest rates than they are currently.

What are the typical covenants or protections you look for in private debt agreements?

SK: There are three main covenants that work well together: first, debt yield, which is a good measure of risk for stabilised assets; second, loan-to-value (LTV), which simply measures the leverage in the transaction, looking at the outstanding loan balance relative to the value of the underlying property; and third, the debt service coverage ratio, which allows us to monitor how well net operating income (NOI) covers outgoing debt-service payments.

Debt yield monitors the NOI over outstanding debt, providing a reliable measure of transaction specific risk, since it doesn’t include cyclical or market parameters like interest rates or valuations, and is harder to manipulate through altering loan terms such as amortisation. It effectively indicates how quickly we can get paid back from the underlying investment if something goes wrong. It’s useful for broader multi-asset private debt portfolios, as it can also be used outside of real estate for income-generating assets, making it easier to compare transactions.