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Our specialists assess whether it might be better to access real estate markets via debt rather than equity at this point of the cycle, and the premia available from private assets.
Assets not listed on public markets are receiving much greater attention, as pension schemes, insurance companies and other long-term investors are challenged to meet their return requirements through traditional investment strategies. In our latest quarterly report, our alternative income specialists look more closely at whether it might be better to re-orientate towards senior real estate debt rather than equity as interest rates normalise, and consider how bank deleveraging is creating new opportunities in lending markets.
Key themes: Reorientation towards senior real estate debt rather than equity as interest rates normalise
Our analysis suggests the property cycles in both the UK and Continental Europe are well advanced and have limited pockets of value. In some prime markets, valuations are close to or above pre-crisis levels. Income return may be below the real estate debt return, and five year total return forecasts for direct equity investments are modest.
Finding value? Under-over pricing analysis in European property markets, including the UK
The analysis includes hurdle rates (required returns) for UK and European markets for the end of each year from 2001 to 2017. By comparing the hurdle rate at the start of the year with the total return over the subsequent five years for each market, we developed an over/under pricing estimate for each year for all markets. For the 2017 period we used our in-house prime total return forecasts. We assumed the property premium - which consists of the volatility, liquidity and transparency premium and, in selected markets, the currency premium - remains constant through time, so the only variable that changes in our analysis of the historic hurdle rate is the adjusted risk-free rate of return. We also incorporated in-house real estate stock estimates.
In these late stages of the cycle, it may be beneficial to take real estate exposure via debt rather than equity, focusing on senior debt with moderate loan-to-value ratios. This is a pragmatic approach that recognises the potential downside in capital values as interest rates begin to normalise.
“As financing prime assets has become extremely competitive, with gross margins down to around 135 bps over UK gilts, we see more attractive opportunities in solid investment grade risks that fall outside banks’ appetite,” according to Gregor Bamert, Head of Real Estate Finance. “Risk-adjusted returns from secondary markets or regional assets with high quality sponsors are likely to be higher.”
UK real estate debt may offer better risk-adjusted returns than equity in the late stages of the property cycle
Structured Finance: New opportunities in fund financing as bank deleveraging evolves
Stricter bank capital requirements mean that deleveraging is a well-established theme in private markets, but the impact is evolving from sales of established back book transactions to new transactions. We expect opportunities to emerge as monetary stimulus is withdrawn and funding markets react to higher costs, bringing other intermediaries to the table.
One area of innovation is fund financing. A growing number of pooled funds lending to small and medium sized enterprises (companies with EBITDA of around £20m to £50m) are seeking to raise finance to enhance returns, as well as bridge the gap between receipt of capital from investors and investment opportunities. With banks increasingly constrained, these pooled funds are looking elsewhere for this type of financing.
“Providing fund financing offers an attractive risk/return profile given the seniority in the capital structure, while the lender potentially retains a degree of control over which companies the funds lend to,” says Munawer Shafi, Head of Structured Finance.
Unless stated otherwise, any sources and opinions expressed are those of Aviva Investors Global Services Limited (Aviva Investors) as at 5th December 2017. This commentary is not an investment recommendation and should not be viewed as such. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Past performance is not a guide to future returns. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested.