David Worsfold
IIE Roundtable, 22nd February 2018
The real estate debt market has changed dramatically since the global financial crisis of 2007-08 and it is now an asset that should be firmly on insurers’ investment radar screens. This was the theme of the of the Insurance Investment Exchange roundtable on 22ndFebruary 2018, held in conjunction with M&G Investments.
A combination of factors have changed the market making it more attractive as an asset that is increasingly finding a place in insurers’ portfolios. The strained position of the banks following the financial crisis has meant there has been a significant reduction in the amount of bank capital available for buying property. This has pushed up the margins as borrowers have accepted they need to pay more to obtain the capital they need.
The regulatory squeeze on bank capital is unlikely to relent so the diminished attractiveness of long-term debt is not going to change and the switch to other sources of capital will continue. Alongside this there has been a marked drop in the average loan-to-value as lenders have become more cautious, shying away from funding high-risk, speculative property investments, and have also reflected the rapid rise in property prices over the last few years.
This has produced an attractive combination of improved margins and decreased risks. Indeed, many parts of the real estate market are today experiencing the lowest loan to value combined with the highest margins ever seen.
While this has enhanced the asset in the eyes of insurers, it has not solved all of the issues they might have with it. In particular, the relatively illiquid nature of real estate debt on the one hand for non-life players and the frustratingly short loan periods coupled with the ability to refinance, which means duration is not quite long enough on the other for longer duration insurers.
General insurers find it hard to commit to less liquid assets as they need to have confidence that when faced with major claims, they can quickly realise their investment holdings. Life and annuity companies have the opposite problem, as they are looking for assets with a longer duration than the five to seven years typically found within real estate debt in the post-Solvency II risk adjusted world. They are also looking to lock in cashflows, which may be at odds with property owners.
The majority of property owners are not keen on committing to ownership for ten years plus. With leases strongly trending towards shorter terms as leaseholders look for five year break clauses, owners who want to hold property for longer than ten years have to have a high degree of confidence that they can re-let the space twice or risk high void rates. They also have an eye on the flexibility to refinance should better opportunities appear. Still, there is movement as the nature of capital in the sector shifts and though small, the volume of loans that display the coveted fixed cashflows desired by insurers under the matching adjustment mechanism for their balance sheet are growing.
Overall, the market has proved resilient to the obvious shocks such as the Brexit vote. There was a short term post-referendum dip in the values of City and Canary Wharf office space with some funds heavily committed to those sectors having to temporally freeze redemptions. The market has now largely recovered from that setback.
The relative attractiveness of the sector in the UK against government bonds has improved, especially following the post-referendum depreciation of Sterling. This has made the UK property market more attractive to buyers and nudged up yields faster than comparable markets elsewhere in Europe.
Insurers highlighted concerns about the quality of data about the market, in particular the time lags which make their own portfolio valuations harder. Some had also seen the annual performance figures of some funds distorted by a few very large trades.
Against that, the supply of good quality properties for funds to invest in is relatively secure with a lot of European real estate debt needing to be refinanced in the next few years.