Thought leadership: Quality and security key focus for real estate debt

The search for better returns over the last few years has seen many insurance company investment portfolios diversify into a range of alternative assets with real estate debt an increasingly common choice.

In the current market environment, with central bank interest rate rises being implemented or under consideration in many markets, some insurers are wondering whether this remains a sound option.

If you look for quality and multiple layers of security, however, you need not worry, argues M&G Investments in a new paper European real estate debt: Protection across market cycles.
They have words of reassurance for CIOs reviewing the place of real estate debt in their portfolios today:

“Investors in senior real estate debt benefit from a range of downside protections. The first is seniority, in the form of a first-ranking charge; the second is security over the underlying real estate asset, which includes a substantial equity cushion and also protects against potential falls in real estate values”.

Managers or investors that typically originate the majority of their real estate loans directly with borrowers tend to have a clear focus on quality and security. The physical asset security can offer important protection for fixed income investors, while the floating rate interest also available on a range of real estate loans can protect against a rising rate environment.

Origination is key and the paper explains how the process to evaluate whether to lend rests significantly on the cashflows of the borrower. In particular, it is important to focus on the capacity of tenants to meet their rental obligations and the capacity of the borrower to repay or refinance the principal at the end of the loan term.

Senior real estate debt investors also benefit from a range of added downside protections:
• Seniority by being the first investor in the capital structure to be repaid
• Lenders have explicit security over the underlying asset in the form of real estate
• Lenders benefit from protections in the form of bespoke covenants, which also act as early warning signs if borrowers are struggling to repay.

Nevertheless, a strict underwriting process and scenario modelling to understand the true behavior under stress are important if investors want to realise and maximise the protections inherent in real estate debt.