When it comes to real estate debt, embrace the gap

02 Dec 2010

Normally, the common-sense idea is to mind the gap and avoid getting caught and dragged across the subway platform to an indeterminate injury or untimely demise.

But a recent report from Mercer Investment Consulting (see summary in this Mercer newsletter – for the full report (free) email here: kweku.obed@mercer.com) on real estate debt actually recommends the opposite: jumping into the funding gap created between what real estate in most parts of the post-housing market bubble is worth and how much banks and other lenders are willing to dole out to allow people to obtain financing.

The report follows another recent study we at AllAboutAlpha.com covered, noting the opportunities REITs are purportedly offering investors.

Indeed, as was suggested by those focused on the REIT space, from crisis always comes opportunity and the global housing market downturn is no exception. According to Mercer, from the aftermath of the economic downturn and “material” structural changes in the global real estate market have emerged new opportunities in the debt markets and the suggestion is investors should be jumping head first into.

Specifically, the report looks at real estate capital values in developed markets, which it estimates fell by up to 40% before recovering slightly. At the peak of the market, banks would lend senior debt at up to 80% loan-to-value (LTV) ratio. As LTV covenants were subsequently breached, lenders adjusted their terms and widened their margins, but in a lot of the cases the underlying rental income wasn’t compromised.

According to Mercer, estimates of the gap in Europe for 2010-2011 are over $195 billion if senior LTVs stay below 60%, with over a third of that amount in the U.K and another fifth in Spain. In the U.S., the estimated gap for the next three years is $1.1 trillion if senior LTVs stay below 70% (see illustration below on the funding gap and the opportunity for nontraditional lenders).

For borrowers, there are basically two ways to bridge the gap: one, bring along another equity investor for the ride and share the equity risks and returns, or two, go out and get higher coupon-enhanced senior or mezzanine debt, paying a relatively high coupon while retaining the asset and keeping the majority of capital growth in the back pocket.

To be sure, the report notes that while there are quite a few places in the world where declining real estate values and declines in tenant distress and falls in rental income have created a funding gap, there are also parts of the world where the Great Recession didn’t have as much of an impact on real estate or the broader economy. “In these locations, perhaps for the first time, we are seeing widespread existence of loans  whose LTV covenants have been breached beyond hope of recovery by recent capital value falls, but which continue to be serviced – indeed, in some cases interest and debt service coverage ratios have risen.”

In other words, there are a lot of still-performing loans out there that don’t have a snowball’s chance in hell of getting refinanced through traditional channels, but are certainly going to be in need the treatment when the time comes – this is called “undistressed debt with a distressed borrower” in Mercer’s terms.

So how does one potentially profit from jumping into the gap? Basically, go out and find a manager with a high level of skill and confidence in the undistressed capital structure – geared, mezzanine, senior and ungeared – and then sit back and wait for the returns to roll in, especially on the mezzanine level where they mostly come in the form of income.

There are also opportunities in the distressed space: buying debt at a discount and earning a return either by selling it back to the borrower at a discount to face value but a premium to the discounted purchase price, restructuring the debt so that it becomes performing or foreclosing, repositioning and selling the actual underlying property, etc.

So sure is Mercer of the benefits of investing in real estate debt that they even allude to the “j-curve” effect on invested capital, per the chart below.

The moral of the report? Don’t mind the gap at all. In fact, taking advantage of the funding gap in real estate is the new, better and even safer way to earn a return – more so than traditional real estate equity.

Just remember: In taking the giant Mercer-endorsed leap into the gap, keep your head down when the next unstoppable train wreck comes barrelling into the station.

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