Discussing Debt with DWS

Written by Rory Hickman

In the lead up to GRI Credit Opportunities and Real Estate Debt 2023, GRI Club sat down with Simon Wallace, the global co-head of real estate research at DWS, a German-based global asset manager, to discuss the evolving landscape of real estate private debt and its increasing popularity as an attractive alternative investment. 

With approximately $70 billion of assets under management spanning both equity and debt, DWS offers a unique perspective on the sector. Wallace covered the driving factors behind the rise of private debt, the various debt strategies available, current market outlooks, and strategies for assessing distressed real estate debt.

Private Debt Popularity Surge

Over the past decade, Europe has witnessed a significant surge in the real estate private debt sector. According to Wallace, this growth can be attributed to a confluence of factors. "I think one big driver has been just access to opportunities," he notes. 

In the wake of the financial crisis, traditional lenders took a step back, creating a void in the debt market that alternative lenders eagerly filled. This shift in origination paved the way for experienced real estate equity investors to venture into the realm of private debt, given their unique understanding of the real estate landscape.

The evolution of the past decade has been notable, but the surge in popularity of real estate debt has gained significant momentum in recent years. This surge can be partly attributed to rising interest rates, which have had a contrasting impact on the private equity and debt markets. 

"There has been a lot of media coverage, a lot of chat about private debts since inflation started to rise and interest rates started to pick up," observes Wallace. With interest rates climbing, real estate debt has become increasingly attractive, providing investors with an additional return that had been elusive in the equity market.

Historically, real estate equity investments were valued for their robust cash returns, but private debt is now offering a similar allure. "For those investors who've got used to real estate providing a strong cash return well above the risk-free rate or the cost of finance, debt is becoming increasingly important as well," explains Wallace. This shift has prompted capital sources to explore real estate debt as an alternative to traditional equity investments.

The private debt space also offers a layer of downside risk protection in times of market corrections. As real estate values fluctuate, investments in the debt space can act as a safeguard against substantial price reductions both at the market and asset levels. This added security is especially appealing in today's unpredictable market environment.

Debt Space Competition

However, Wallace is quick to emphasise the competitive nature of the real estate private debt sector. "There's a great deal of interest at the moment towards real estate debt," he points out. Despite the buzz surrounding private debt, fundraising activities have progressed more slowly than some had anticipated. Nevertheless, Wallace remains optimistic, asserting that this trend is here to stay and will only continue to gain traction.

Wallace does caution that success in the real estate debt market requires a deep understanding of the unique dynamics at play. Transitioning seamlessly from equity to debt or vice versa is no small feat, as these investment realms demand different skills, strategies, and insights.

Likewise, professionals experienced in private debt from other industries must take the time to comprehend the intricacies of the real estate market to navigate successfully, particularly when dealing with higher-risk segments.

Making the Switch

Understanding the unique requirements and nuances of real estate debt is essential for success in this rapidly growing market. Wallace explains how transitioning between real estate equity and debt requires a fundamental shift in perspective and skill set.

When operating in the real estate debt arena, the dynamics of your relationships within the industry change significantly. This shift is particularly noticeable when dealing with the brokerage community and origination. Traditional lenders become key partners, granting access to syndications and making the establishment of strong ties with them imperative.

The considerations in real estate debt investments extend beyond mere valuation projections. While investors in the equity space often focus on where valuations are headed over the next five or ten years, real estate debt requires a more comprehensive analysis of risk-return dynamics. Key metrics such as interest cover ratios and the risk of default on loans take precedence.

For senior debt investors, the pricing fluctuations of the investment are secondary to the crucial considerations of loan default risks and refinancing uncertainties at the end of the loan term. While the underlying real estate asset's quality remains significant, its assessment takes on a different dimension compared to traditional real estate equity investments.

A Spectrum of Opportunities

Broadly, real estate private debt can be categorised into three main strategies: senior debt, whole loan, and junior debt, often referred to as mezzanine debt. Each strategy offers a distinct risk-return profile, attracting investors with differing preferences.

Senior Debt - Positioned as the lowest-risk approach, senior debt is often regarded as a cash alternative, providing investors with a stable, albeit relatively lower, return. Wallace points out that senior debt yields around 200 basis points, offering a cash return that can be attractive in today's market. 

This strategy is particularly secure when the loan-to-value ratio (LTV) is low, around 50%, minimising the likelihood of default. Senior debt serves as a cash-focused investment, ideal for those seeking a dependable income stream. However, it may potentially sacrifice some upside potential in a market poised for recovery.

Junior Debt (Mezzanine) - In contrast, junior debt encompasses a wider range of returns and involves varying levels of risk exposure. Investments in junior debt are influenced by factors such as construction finance, the geographical location of assets, and their overall strength. 

With LTVs reaching higher levels, often 75% to 80%, junior debt offers higher returns. It focuses more on internal rate of return (IRR) than cash return, making it appealing to investors who are further along in the market's revaluation process. 

Wallace highlights the importance of a comprehensive understanding of both the market and asset dynamics in the junior debt space, as there is less room for price correction before the possibility of default. Investors in junior debt should be prepared to manage potential issues or problems associated with the assets, making traditional asset managers well-suited for this role.

Whole Loan - Positioned between senior and junior debt, whole loans offer a blend of characteristics that appeal to a wide range of investors. Wallace notes that whole loans provide a return that falls between the returns of senior and junior debt, making them an attractive option. 

Investing in whole loans provides greater control over the loan itself, as it involves dealing with fewer partners. This increased control can be particularly advantageous in the event of unforeseen circumstances, as asset managers have more autonomy in taking action when necessary.

The Outlook for Banks and Lenders

While the real estate sector is not currently experiencing widespread distress, certain pockets, like the U.S. office market, are showing signs of strain. "In certain pockets there's more evidence of it. Those pockets, the US office market for example, is where you are seeing distress, and we do think you will see areas where refinancing will be exceptionally difficult," notes Wallace.

In situations where assets are weak, boasting limited cash flow, or comprise commodity office stock in submarkets at risk of obsolescence, securing financing, whether from traditional or alternative lenders, is likely to be a formidable challenge. 

Even in cases where financing may be available, the cost associated with taking on that finance may be difficult to justify. Wallace predicts that we may witness instances of repossessions or borrowers returning the keys to lenders in these scenarios.

It is important to acknowledge that the current landscape differs significantly from the turmoil experienced during the lead up to the financial crisis. The real estate market is not as highly leveraged today, offering a greater degree of resilience. Wallace asserts that there is room, especially with the involvement of alternative lenders, to accommodate most refinancing needs.

"While refinancing will be more expensive," Wallace acknowledges, "and there may be additional provisions or requirements, such as amortisation of the loan over a period, there is not a great willingness to create or accelerate distress in the market."

Instead, the industry is adopting a more collaborative approach to navigate this period of disruption and transition. The goal is to reposition the market amidst the challenges posed by a higher interest rate environment.

Distressed Debt Strategies

With the allure of discounted deals in distressed real estate debt, investors are eager to seize opportunities, especially in a changing market landscape marred by defaults and uncertainty.

Wallace underscores the importance of recognizing that real estate, even in a debt context, remains fundamentally tied to the underlying properties. Amidst market uncertainty, distress, structural shifts, and potential economic downturns, understanding the unique dynamics of each property is paramount. Real estate assets can exhibit significant variations in performance, with the best assets performing vastly differently from the worst.

The rapid impact that losing a tenant or income can have on property valuation, even in senior debt scenarios was also emphasised. In weaker markets, this can lead to swings in property value of 10%, 20%, or even 30%. Such volatility can raise questions about the viability of the loan and the ability to service it.

For investors eyeing distressed opportunities, Wallace recommends focusing on the quality of income and the cash flow supporting the loan. Scrutinising tenant covenants and assessing the risk of default or business failure is crucial, as is giving consideration to different sectors due to the varying performance across industries.

In the current landscape, residential properties and logistics spaces are viewed favourably for their high-quality income potential. However, in a sector like offices, where vacancies are rising, caution is warranted - particularly for weaker secondary assets. 

The retail sector, while holding up reasonably well in recent quarters, faces challenges, especially in the face of a cost-of-living crisis. The recent bankruptcy of retailers like Wilkos in the UK serves as a stark reminder of the potential vulnerabilities.

Pricing Opacity

Understanding true pricing in the market is also a key factor. Different countries offer varying levels of transparency regarding pricing and valuations. In more transparent markets like the UK, pricing and valuations tend to align closely. However, in less transparent markets with fewer benchmark transactions, determining accurate pricing becomes more challenging.

Wallace advises investors to delve deep into assessing the actual value of underlying assets. Over the past year, many markets have witnessed valuations decline by approximately 20%, and in some cases even more at the individual asset level. A 20% swing in valuation can push loans into default territory, underscoring the importance of accurate pricing assessments.

What’s Next in Debt?

“In line with our market view, we continue to see value across the capital structure. The current market environment, however, makes whole loan financing appear particularly attractive.” adds Alexander Oswatitsch, Head of Real Estate Debt Europe at DWS. “Thus, we anticipate to focus our capital raising efforts on a flexible, pan-European whole loan strategy while the level of asset risk remains to be determined.”

“We believe a real estate debt transformation strategy could be of value for both sponsors who require capital in addition to bank financing, and for institutional investors who would like to support the transformation of the real estate sector, but have a lower risk appetite.”

To benefit further from the expertise of DWS on the increasingly prominent role of the private debt space, be sure to register for GRI Credit Opportunities and Real Estate Debt 2023, taking place in London on November 30.

Industry leaders in real estate capital, credit, and debt finance markets will gather for a series of informal, closed-door discussions, offering personal anecdotes and insights to identify potential debt opportunities, as they explore the prospects that lie ahead in 2024.