January 26, 2018 / 8:50 PM / 3 months ago

Investors eye real estate debt funds despite leverage risk

NEW YORK (Reuters) - Portfolio managers forced to rebalance their asset mix because of the global stock market rally are tapping the presumed safety of debt funds tied to real estate, but some money managers say they could be unwittingly increasing their risk profile.

Investors may not realise all the consequences posed by the leverage managers of these funds take on, warns JCR Capital, a middle market real estate investment firm based in Denver. The safest debt holdings are typically made up of government bonds.

Real estate debt funds are often underwritten to return 6 to 7 percent, a doable rate that is about double the returns of investment-grade bonds in 2017.

However, real estate debt fund managers target bigger gains of 10 to 12 percent and achieve this internal rate of return through leverage.

Jay Rollins, managing principal at JCR, said he is not raising alarm bells or bashing debt funds, but he said there are risk and return trade-offs not found in equity funds which managers might not immediately recognise.

“The investor has to look at how much this return is manufactured by leverage and how much of this return is manufactured by the asset,” Rollins said.

Increasing leverage, the amount of debt used to buy assets, raises an investment’s risk.

A record $261 billion has been committed to private equity real estate funds, according to data provider Preqin, or almost double the $136 billion registered at the end of 2012.

This pile of money, otherwise known as “dry powder,” is waiting to be deployed as it takes time to invest in non-liquid real estate. But it is also a sign of caution asset managers are taking at this stage of the cycle as they seek investments that will achieve the returns they have promised their investors.

Still, at a time equity valuations appear rich and the return on bonds is low, investors have boosted their interest in real estate debt funds. There were 140 private debt funds focussed on this asset class at the end of December that had closed globally and raised a record $106 billion, Preqin said.

ALTERNATIVES

The benchmark S&P 500 stock index is up 27 percent since the start of 2017, while world stock benchmarks have climbed equally or even higher.

If equities continue to climb that will drive current allocations further below target for certain sectors, including real estate, said Doug Weill, a managing partner at Hodes Weill & Associates, a real estate advisory firm.

“Although anecdotal, we are also getting the sense that institutions are picking up their pace of investment in new offerings, funds, etc. We think the momentum picked up in the fourth quarter,” Weill said.

Portfolio managers view real estate as a safe investment offering a higher return than other fixed income. But there are risks.

Increased leverage spurs higher returns but may mask weakness in the balance sheet of a fund when times are good, JCR’s Rollins said. Unforeseen market shocks, such as geopolitical events, can reveal a fund’s inability to meet a call on its assets, he said.

Another risk is the equity in a loan may be used more than once as collateral.

However, just as insurance companies have known for some time, investors now realise “there’s a place for private credit in their portfolio and it will help them get to better outcomes,” said Dennis Martin, a managing director at PGIM Real Estate, who is responsible for U.S. fundraising.

A tremendous amount of institutional capital is chasing alternative assets and real estate is still a formidable place to be if you can find the opportunity, said Doug Harmon, head of capital markets in New York at Cushman & Wakefield.

But Harmon acknowledged current valuations make it hard to find the right opportunity, which is frustrating many investors.

“A lot of people are shifting into a safer quadrant,” he said. “The problem has been not from an appetite side. If you can’t find the opportunity, you’ve got to figure out how to shift your allocations.”

Reporting by Herbert Lash; Editing by Daniel Bases and Diane Craft

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