Tom Lloyd-Jones: “The challenges and opportunities are two sides of same coin”

Written by Helen Richards

The real estate debt market has undergone a profound transformation. Over the past 18 months, factors such as shifts in office usage, the normalisation of monetary policies, and a wave of maturing CRE debt have reshaped the landscape.

Meanwhile, higher interest rates and banking sector retrenchment have created challenges, particularly for mid-market borrowers, while simultaneously opening opportunities for agile lenders like Zenzic Capital.

Tom Lloyd-Jones, Chief Investment Officer at Zenzic Capital, brings over two decades of expertise in advisory and investment across alternative assets. As co-founder of Zenzic Capital, Tom has been instrumental in steering the firm to become a leader in real estate credit, managing over $2 billion in transactions since its inception.

Against the evolving backdrop of real estate debt, Tom sat down with GRI Club ahead of his participation at the upcoming GRI Credit Opportunities & RE Debt 2024 to address strategies and trends in the real estate lending space, addressing everything from unique mid-market challenges, to sustainability and remaining competitive.

What key trends do you see shaping the landscape of real estate debt today? Why does the debt market look so different today?

“The key trends are those that everyone’s been grappling with these past 18 months: (a) the change in usage patterns of office - by far the largest commercial real estate sector and the ‘staple diet’ of many institutional investors’ real estate portfolios; (b) the return of monetary normality which has triggered a wide re-appraisal of value and debt capacity/desirability; (c) a substantial maturity wall in CRE debt coinciding with muted appetite from the banking sector.

To some extent the pig is still working its way through the python, but already you can see the changes wrought by the impact of these events.

First, and probably most visibly, institutional capital has begun to rotate out of office and retail (or at least discard a presumption in favour of these sectors) towards alternatives. This has been most visible in the increased investment activity and demand for sectors like PBSA (where investment volume in the UK has doubled in 2024 versus 2023) and leisure-driven hotels (which I believe is at 185% of 2023 investment levels as at Q3 2024).

Second, the use and attractiveness of hybrid/more highly structured capital has increased and will, in our view, continue to grow. This has largely been a function of the market turbulence over the past 18-24 months; where conditions are less benign the requirement to address risk through structure (to the extent you can) becomes more urgent.

Third, the liquidity in the lower middle-market (£25-50 million tickets) has been disproportionately affected as banking retrenchment continues and capital consolidation in mega funds has increased the minimum ticket size that many real estate credit funds are willing to consider. All that represents a materially different landscape to say just 18 months ago. It feels like we’ve had at least five years of change in 18 months!”


How can lenders remain competitive in the current debt market?
 
“I’m always slightly wary of lenders saying they need to be competitive! It immediately brings Dutch auction processes to mind, where you are dropping pricing and loosening covenants and governance to ‘win’ transactions.

Instead, what we are trying to do is provide capital to the lower middle-market, which is still chronically underserved, in a way which is structurally innovative and tailored to borrowers’ needs. We lend across the capital structure, sectors, and geographies with a range of pricing and duration in both performing and non-performing scenarios. And we do this from a highly responsive and knowledgeable team which hopefully all means there isn’t a lot of competition. As Peter Thiel says: competition is for losers!”
 
How is the increasing focus on sustainability within the real estate market impacting lender attitudes and decisions?

“It is a significant feature at the larger end of the market and it’s now also starting to trickle down into middle-market credit. At the larger end, examples abound of financings where sustainability considerations have driven assessments of the type of assets lenders are looking to support; their assessment of value of those assets; the terms on which they lend; the additional risk they are willing to assume to support sustainability.

Separate from individual credit decisions, capital is also being raised for, and only for, sustainable investment strategies, and in this sense it becomes an investment thesis/philosophy in its own right. Currently it is still a firm-by-firm, investor-by-investor approach, but this could evolve into something more formalised and overt through the likes of a dual interest rate (for instance) for green-lending, which has been endorsed at the recent COP29 by some political leaders.

For us, the area where it has had the most discernible impact is on asset value. The question of whether sustainability focus drives better cash flows (independent of exit considerations) is an interesting one and, in some sectors, there is a premium tenants are willing to pay to utilise or occupy sustainable real estate, whereas in others it’s not clear this is the case.

For some time, we have taken the view that if you finance non-sustainable buildings, then when it comes to buyers (as opposed to tenants), at best you are limiting your buyer pool and at worst you end up with stranded assets. So, it is, in our view, a key component of value and we strive to be uncompromising in this regard across the assets we finance.”


What emerging opportunities do you foresee in the real estate debt market? Are there particular sectors or regions where you see untapped potential?

“We think this is a rich environment for credit, especially in the middle/lower-middle market. The opportunity set we are looking at is deeper than at any time in the last 10 years, encompassing both offensive and defensive transactions, with variety across asset class, term, return component, and geographical exposure.

While there are specific niche sectors and geographies that we think offer particularly strong value, the broadest seam in our view is simply the wrongful neglect of the lower middle-market.”

Regarding SME and mid-market lending, what are some of the unique challenges and opportunities within this market?

“The challenges and opportunities are two sides of the same coin. Origination is more demanding, requiring direct and strong relationships with your borrower, rather than relying on sponsor-led transactions which are often auction-led or syndicated processes.

Most of our borrowers are firms we have had relationships with for a decade or more and we’ve seen how they operate through cycles - good times and bad. But while middle market origination is more complex and time-intensive, the investment returns and structures are typically structurally superior.

I think it is also fair to say that the dispersion in borrower quality is greater in the middle-market than the BSL market, which makes borrower selection even more important. But, then the importance of the credit provider to the borrower in this section of the market creates a totally different relationship dynamic whereby you are a capital partner of significance and borrowers are willing to provide much more in terms of contractual protections, information flow, business plan inputs, and ESG implementation.

The other key thing we see is that to access niche or emerging sectors - which is where we want to focus - the middle-market community is vital. They are invariably first movers in these markets, creating the product that institutional investors want. In an era of higher interest rates, if you are looking to derive strong, absolute, and relative returns within real estate, these are the markets you must consider. 

In terms of credit quality, there is, in our view, an assumption that credit quality per se improves with the size of an enterprise and with the attachment of a sponsor. We feel this assumption is not as well tested as perhaps it should be. For instance, does credit in larger/sponsor-led scenarios automatically improve even if leverage levels are higher, lender protections are significantly looser, and pricing is worse?

What matters, in our view, is that the borrower is of a high quality and well-managed, that the deal is properly structured, and that the borrowers are totally invested in the journey the capital is supposed to facilitate.

And, here there is a significant difference: many middle-market borrowers are owned by founders and families who will typically do everything they can to protect their businesses. This cannot always be said of larger real estate groups or sponsors, who have been known to withhold financial support and ‘hand the keys’ to lenders if it makes financial sense to do so.”


With the mid-market often facing liquidity challenges, how does Zenzic Capital assess and manage risk when extending credit to this segment of the market?

“For us, risk assessment centres around the imperative of capital preservation. If we go back to that analogy of investment - like amateur tennis - being a loser’s game, we place huge weight on not losing money on any given position.

Without summarising our entire investment process and risk framework, I think the key aspects of our process that I would highlight are: first, the depth of market analysis of every sector we invest in. What we are trying to find and verify is the nature and strength of the demand. What we want is a demand that is as close as possible to being non-discretionary and recurring (typically because of demographic or structural tailwinds).

Second, our run downside scenario planning has a deep practical focus. To paraphrase Yogi Berra, in practice, there is a big difference between theory and practice when a downside scenario materialises. Our team encompasses professionals with direct insolvency and work-out experience, so we know how things play out in the real world rather than on paper or on excel! And, the structuring is vital here. We spend an enormous amount of time structuring our facilities, the governance protections, and the collateral packages, so that value leakage during the term (of the type we’ve seen recently in some leveraged loan contexts) is negated, and if the downside materialises, we have the broadest possible powers to take control of operations.

Third, a key focus for us - which we feel is sometimes neglected by some lenders - is the active management and involvement in the business plan of the borrower, as part of the underwriting process rather than a post-completion matter. Sometimes lenders' post-execution plan merely revolves around contingency planning for the downside, but there is so much that can be done aside from that. Loan management begins on day one, where we actively work with the borrower to drive value and help execute the business plan. In this respect, what we try to do is marry the credit approach to structuring and downside mitigation with the approach to value creation of private equity investing.”

With elevated interest rates globally, how have you seen this impact specifically mid-market lending?

“The rise in interest rates has affected the middle market more than larger markets because this market is still more reliant on bank financing and has virtually no access to capital markets solutions, such as bonds or leveraged loan syndications.

There hasn’t been the weight of capital chasing deals that has suppressed credit yields in larger markets, so in that sense the transmission of the higher interest rate into higher cost of credit has been, in my view, faster in the middle-market.

For lenders, provided your borrowers can support the additional cost of credit, it has been beneficial in that senior secured credit can now generate double-digit returns, which has not been possible for nearly 20 years.

The other positive feature of how the middle market has reacted to interest rate rises is that, in the main, there aren’t many middle market firms with large office and/or retail portfolios (given the capital required to play in those spaces). As such, many participants have avoided some of the most painful value correction which has largely centred on those asset classes.

We have also seen some stress and distress coming through - largely a product of overleveraged capital structures - but this has probably been more muted than at the larger end of the market (again, given the relative exposure to office/retail).”

For SME developers seeking finance, what key advice would you offer to help them position themselves to secure funding in today’s competitive market?

“Development is still a dirty word for many real estate credit providers. It carries a large regulatory capital charge for banks, and for many lenders it’s regarded as inherently riskier than investment facilities (even in sectors where valuations have been declining rapidly).

I personally don’t subscribe to the view that a development facility always, and in all cases, carries greater risk than an investment facility, especially if you are able and prepared to structure and monitor rigorously and understand the development process in detail. But real estate developers need to not fight the rules of the game here. They need to accept that they will have to pay a premium for a financing provider that understands development and can properly partner with them throughout the process.

We still see some developers that think the cheapest deal is, by definition, the best deal, but if there are bumps in the road you need a finance provider who has been there before and understands that those bumps don’t necessarily mean there is a serious problem that can’t be resolved if people have seen the issues and the resolutions to them before.”

Join the conversation with Tom Lloyd-Jones as he co-chairs high-level roundtable discussions at GRI Credit Opportunities & RE Debt 2024, along with the most prominent lenders and funds in the real estate debt industry.