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[Interview] Real estate debt

M&G picks logistics, residential property for 2022

UK real estate debt likely to see strong investment demand, driven by higher yields than other parts of Europe's

Oct 12, 2021 (Gmt+09:00)

Duncan Batty, M&G's real estate debt co-head.
Duncan Batty, M&G's real estate debt co-head.

London-based M&G Investments expects the logistics and residential real estate markets in most parts of Europe to continue to offer attractive returns next year, taking advantage of the pandemic-induced liquidity reduction in the debt markets, said its real estate debt co-head.

Both segments will likely remain the key beneficiaries of the global shift toward e-commerce accelerated by the global pandemic and of the chronic housing undersupply.

"In this low interest rate environment, real estate debt continues to offer compelling risk-adjusted returns for investors with significant premiums relative to equivalently rated corporate bonds," M&G Investments' real estate debt co-head Duncan Batty told The Korea Economic Daily. 

By country, the UK real estate market is expected to see high levels of investment demand for both equities and debt in 2022, driven by their higher yields than those in Continental Europe.

In comparison, real estate debt in Germany will likely deliver lower returns compared with the UK and southern European countries like Spain and Italy, given the country's local lenders tend to dominate the financing market at very tight spreads.

"We believe that stock selection and loan structuring will remain key in 2022," Batty noted in a recent email interview. With 15 years of real estate experience, he has been co-leading M&G's real estate debt investments since April of this year.

To set it apart from other real estate debt lenders, M&G focuses on investments at scale and provides a one-stop debt solution to the borrower. Those factors put it into a less crowded corner of the market, he added.

Last year, M&G committed over £1.6 billion ($2.2 billion) to new real estate debt investments, in its second-largest amount of annual investment in real estate debt. 

M&G Investments is part of M&G plc, which was formed in 2019 after taking over the UK-based Prudential's operations in the UK and Europe. 

In South Korea, M&G Real Estate in July 2018 acquired newly-built twin office towers in central Seoul, Centropolis Towers, for 1.12 trillion won in then the country's biggest single property transaction. It funded the purchase with 350 billion won from its real estate fund; 250 billion won from the Korean Teachers' Credit Union; 100 billion won from the Public Officials Benefit Association; and 420 billion won in borrowings against the property.

The following is the full transcript of the interview with Batty. He will deliver a speech for the ASK Conference 2021 hosted by The Korea Economic Daily on Oct. 27. 

On the outlook for UK and European real estate debt markets in 2022:  Any impact of the COVID-19 on the overall market and specific to the UK, is the Brexit premium still there? 

"Looking forward, we expect real estate debt to continue to offer investors compelling risk-adjusted returns on both a relative and absolute basis."

"We continue to see a strong pipeline of investment opportunities in assets and sectors that have remained resilient to the COVID pandemic, creating significant prospects to deploy capital. Covid has undoubtedly impacted the debt markets, with periods of significantly reduced liquidity, particularly in the immediate onset of the pandemic."

"While this has now stabilized, some lenders have pulled back from the lending markets and retrenched to their core, domestic markets, which has resulted in less competition and further opportunities to invest at attractive returns. Limited impact on spreads has been observed. However, there has been a slight reduction in leverage levels improving the overall risk position being taken."

"We continue to see high levels of demand for real estate equity investments in the UK. Investors are keen to take advantage of UK property yields generally being higher than Continental Europe. The lending market shows similar dynamics, with debt generally offering higher spreads than those available in European markets." 

"We believe that stock selection and loan structuring will remain key in 2022. We have witnessed increased divergence in asset performance emphasizing the need to work with borrowers with robust business plans and strong track records."

"Likewise, loans need to be structured to incorporate protection against short-term disruption (for example through reserving mechanisms) and longer-term performance. We expand on this below."

In the low interest rate environment, how does M&G help investors diversify their return streams and risk exposure to European real estate debt? 

"In this low interest rate environment, real estate debt continues to offer compelling risk-adjusted returns for investors with significant premiums relative to equivalently rated corporate bonds."

"Real estate debt investments are typically secured by real assets against which recourse can be taken in a distressed scenario and additional downside protection is available for investors due to the equity cushion which exists between the property value and the debt basis and which bears the first loss of any value reduction."

"The real estate finance team has a strong track record since its inception in 2009. In that time, we have committed £9.1billion to UK opportunities and €3.3 billion to Continental European opportunities, making us one of the largest non-bank lenders in Europe. M&G invests across the capital structure and offers investors the chance to access the real estate debt market at different risk and return points based on their aims."   

"Amongst real estate debt lenders, we have a unique position where we are able to hold loans to maturity, providing a one-stop-shop whole loan solution for the sponsor and by focusing on investing at scale. This allows us to operate in a less crowded space in the market and invest against higher quality assets that retain their value better, or remain more liquid during periods of market stress." 

Which sector or region are we most positive on and why? 

"Real estate debt is an area of investment where stock selection is key. Understanding the unique features of the underlying real estate is key alongside more macro analysis."

"In respect to real estate sectors, we are most positive on sectors and regions that continue to benefit from strong long-term fundamentals and defensive cashflows."

"The pandemic has certainly accelerated the growth of e-commerce in the UK and Continental Europe. The logistics sector was already performing strongly given a broader structural shift towards e-commerce, and the pandemic has only served to speed up this trend."

"In the UK, internet penetration is forecast to reach 26% of total sales by 2021 and 30% by 2025. In Continental Europe, this figure is between 13-19% depending on geography, but anticipated to continue growing rapidly. These features have resulted in significant value growth in the logistics sector and increasingly specialized occupier requirements, so careful due diligence and asset analysis is needed."

"The residential sector has continued to perform strongly throughout the pandemic with the vast majority of private rented sector tenants continuing to service rent throughout the pandemic. In the UK, this strong income profile is combined with chronic undersupply of housing and difficulties for younger people to get on the housing ladder."

"The future of the office sector continues to be a divisive topic. While remote working could be here to stay for some time, the office will evolve to play a key role in learning, collaboration, innovation and well-being. We believe that good quality office buildings in global cities are defensively placed, particularly those let to high quality tenants on long-term leases."

"Particularly, in the UK, we continue to see high levels of demand for real estate equity investments with continued liquidity in the equity markets and compelling returns on both an absolute and risk adjusted basis in debt investments."

"Returns are favorable in certain southern European jurisdictions such as Spain and Italy. However, these markets are often more volatile and so a detailed understanding of the underlying real estate and its position in the local markets together with the enforcement regime and exit options are necessary."

"On the other hand, whilst we are positive on the defensive characteristics of real estate in the major German cities, local lenders tend to dominate the financing markets at very tight spreads and so we do not consider the returns on offer to be compelling on a relative basis."

How has M&G been proactively responding to this dynamic market condition all along? 

"Throughout this COVID period, we have looked to actively mitigate and manage risk in existing investments. In the immediate onset of the pandemic, we worked closely with sponsors to discuss remedial action and find solutions to potential problems. By acting quickly and finding pragmatic solutions, we were able to preserve value and ensure that our interests were protected."

"From a new investment perspective, we continued to focus on a relative value investment approach with an emphasis on stock selection and loan structuring, driven by a fundamental bottom-up analysis of the underlying real estate, whilst at the same time seeking to take advantage of periods of reduced liquidity in the debt markets to achieve attractive returns."

"This culminated in the team having its second strongest deployment year on record in 2020 by committing in excess of £1.6 billion to new investment opportunities often at higher margins and lower leverage than would have been the case pre-COVID for similar quality assets."

What are the key risks that investors should be looking out for as they assess European real estate debt market opportunities? 

"Stock selection is key. All real estate assets are different and understanding the unique characteristics of the underlying real estate allows risks to be properly identified and mitigated."

"Loan structuring and covenants are key techniques to achieve this and obtain protection for investors into debt structure – for example, cash reserves to cover potential deficiencies in income."

"Investors should also be wary of valuation cyclicality – an absolute amount of capital could represent a very different proportion of a building's value at different points in the cycle – so investors should consider the recoverability of debt throughout a cycle rather than at a specific point in time."

"Finally, the expertise of the sponsor, their track record and their business plan for the underlying property should be assessed to ensure they have the necessary capability to deliver, service and ultimately repay the loan." 

"When looking to access the real estate debt market through a manager, investors should look at the manager’s approach to accessing the market: how the manager approaches credit and the manager’s track record of investing."

"Managers with a unique offering are more likely to be able to source investments in a crowded market. Managers with a rigorous approach to credit analysis and a track record over the long term can demonstrate an ability to invest through a market cycle and withstand market volatility."

Yeonhee Kim edited this article.

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