With cost of capital constraints forcing many banks to distribute part of their commercial real estate debt, many fund managers have spotted an opportunity in the market: they are launching real estate debt funds to help fill this gap and to broaden out their existing range of investment strategies.
For investors, managing commercial real estate debt requires experience and specialist skills, so it makes sense for them to invest via an asset manager rather than directly.
The attractions seem obvious: real estate debt offers stable income from long-dated securities as well as an attractive risk/return profile and a portfolio diversification opportunity. For institutional investors, real estate debt is treated favourably under Solvency II capital ratio rules.
A positive outlook
The European commercial real estate investment market had a record 2017, up by 9% year-on-year at EUR 259 billion. Growth was even faster in selected markets such as the Netherlands (up 63% YoY) or Italy (up 24%). Growth rates varies across asset classes: office investment rose by 4.4% YoY to a record EUR 114.5 billion; logistics and hotel investments grew by 67% and 17.5%, respectively.
While economists are forecasting 2018 GDP growth for western Europe at an above-average 1.9%, countries such as France, Italy, Spain and the Netherlands are expected to enjoy significantly faster growth. At the same time, inflation has been contained, reducing the risk of significant interest-rate increases in the eurozone in the near future. Additional evidence of the positive outlook for the region has come in the shape of the upgrade of Spain’s sovereign rating. In sum, conditions look favourable for continued buoyant acitivity in the commercial real estate investment market.
Opportunities in the growing real estate debt market
In recent years, private debt has evolved from a niche of the real estate fund market into a central segment. The launch of a number of large debt funds in the last five years suggests that this is unlikely to change, with fund managers increasingly looking to build debt platforms to take advantage of the constraints imposed on bank lending within the real estate market.
While many investors are yet to consider the sector, a growing number are looking to invest in real estate debt. It seems likely that more will examine these opportunities in greater depth in coming months.
Examples of real estate debt financing include contributing to the renovation of an office building in return for a controlling stake and a position of power to negotiate in a transparent market segment or funding movie theaters backed by a large cinema operator, representing solid collateral, and offering a diversification opportunity in a niche market.
Exhibit 1: Typical senior commercial real estate loan terms accross European jurisdictions
Source: CBRE; 2018
Get the manager to decide the portfolio features
We believe a buy & hold approach works well in this segment. Tapping the real estate debt market involves a specialist asset sourcing capability such as privileged access to a bank’s commercial real estate franchise and relationships with origination partners and sponsors. Since for diversification purposes, assets will need to be selected across regions, security types, industries, etc., it makes sense to hand these tasks to specialists.
Since the application of extra-financial criteria is part and parcel of modern portfolio construction – at BNP Paribas Asset Management , this is a core belief – we believe in assigning this task to dedicated professionals who are focused on integrating environmental, social and governance (ESG) factors into investment processes.
In our view, such an approach means that each project is assessed in terms of the ESG policies and management systems of the sponsors or property owners, and its specific environmental and social performance.
Key performance indicators for each specific project can include its impact on biodiversity, greenhouse gas emissions or energy efficiency. From a social perspective, they could include consulting with impacted communities or improving social wellbeing.
At BNP Paribas Asset Management, we have engaged additional independent expertise to conduct an environmental and climate impact assessment of our assets. Metrics include induced emissions linked to operation, maintenance and asset use; avoided emissions through asset optimisation; alignment with a “2°C” trajectory based on a decarbonisation approach; and the project’s contribution to the energy and ecological transition.
Combing the various criteria, performance indicators and metrics for asset selection, we believe we can provide investors with real estate debt portfolios that meet their and our standards in terms of cash flow, risk/return, credit quality and ESG compatibility.
*This article first appeared in The Intelligence Report – 31 July 2018
 infrastructure debt is part of the private debt & real assets platform of BNP Paribas Asset Management (BNPP AM), which comprises more than 50 investment professionals and manages EUR 7.7 billion of assets (as at end March 2018).