Is now the right time to invest in CRE debt in the U.K.?

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Based in London, Christian oversees the origination, portfolio management and business development activities for Nuveen Real Estate’s debt platform in Europe. Here, Christian gives his view on why now is the right time for investors to engage in commercial real estate (CRE) debt in the United Kingdom.

What is CRE debt?

CRE debt is typically structured as a loan secured on commercial real estate. It offers income-focused returns through periodic interest (and principal) payments, culminating with the repayment of the remaining principal at maturity.

Why could investing in cre debt be a good investment strategy?
Well-managed CRE debt provides performance protection through diversified, stable income streams. CRE debt benefits from a substantial degree of downside protection provided by the ‘buffer’ of the sponsor’s equity. While there is typically no additional upside to debt returns in a rising market, the sponsor’s equity will absorb the first loss in a falling market. In addition, contractually-agreed interest payments insulate the lender from the volatility of a changing rental income profile. As real estate market cycles become shorter and more difficult to predict, this insulation and degree of certainty is increasingly regarded as highly attractive by investors.

U.K. CRE loans usually include substantial performance covenants, put in place to protect the lender in the event of capital value or income declines. These typically include a ‘cash trap’, where any surplus income not required for debt service can be retained by the lender and used to reduce the loan, and a default clause, which allows the lender to sell the property if the default LTV is breached. These covenants are typically triggered at thresholds long before the deterioration of income or capital value would leave the lender at risk of loss.

Why is now a good time to invest in CRE debt?

Real estate equity markets are currently experiencing significant volatility, elevated valuations, and heightened uncertainty. An investor focus on income, given the low interest rate environment, is now paramount.

As such, the potential downside protection investment attributes of CRE debt are becoming increasingly sought after; alongside stability, diversification and contracted income. CRE debt presents very competitive relative value, compared to fixed income and direct real estate.

Who are the main players in the CRE debt space?

Although CRE debt has always been a fundamental part of the U.K. real estate market, the dominance of banks, until the global financial crisis (GFC), heavily restricted investment opportunities for traditional investors. Since the GFC, stricter regulatory, capital and liquidity requirements have increased the burden on banks’ balance sheets, which has led to a tightening of underwriting standards, significant reductions in the leverage of loans, and substantial increases in loan pricing.

The resulting retrenchment of traditional lenders, as well as the reduction and repricing of available capital, has created a permanent, attractive and executable investment opportunity for non-bank lenders and debt funds to provide a meaningful share of future CRE debt finance in the U.K..

 

How has Brexit impacted the sector?

Since the U.K. announced its decision to leave the European Union, real estate market performance has proven far more resilient than consensus projected. However, given the political and economic complexities of any European negotiation, market forecasts vary significantly, and largely still imply a degree of pricing correction as markets begin to gradually ‘normalise’. Tellingly, most anticipated valuation declines would remain well within the buffer offered by the borrower’s equity in a sensibly structured loan.

Brexit has reinforced the bank retrenchment away from commercial real estate, with a slower, more selective transactional approach. This has opened up further opportunities for non-bank lenders to achieve higher returns on the same quality of asset, with speed of execution increasingly held at a premium. Direct investor activity has been buoyed by the prolonged low-yield capital market environment, but with parts of the U.K. real estate market looking late cycle, and Source: CASS CRE Lending Survey 2017 & Mid-2018. Traditional Bank Lenders (RHS) Margin (2007=100)(LHS) Is now the right time to invest in CRE debt in the U.K.? well-documented geo-political uncertainties, in our opinion, CRE debt’s future returns look very compelling. A CRE debt strategy offering potential downside protection and income-focused returns is well positioned to offer investors competitive relative value.

What are the current opportunities in the sector?

In the context of retrenching traditional lenders and the persistent narrow focus on prime assets, increased opportunities for well-capitalized, specialist, alternative finance providers exists. Investment opportunities can be found in those assets currently ‘off the radar’, particularly core-plus assets in established markets. With robust underwriting, ideally informed by direct real estate expertise, these undeserved markets present the most appealing prospect for the selective ‘cherry-picking’ of transactions, backed by strong fundamentals and robust return characteristics.