European real estate debt The case for senior commercial mortgage investment September 2015

Transcription

1 Spread (bps) European real estate debt The case for senior commercial mortgage investment September 2015 For fixed income investors, the case for senior commercial mortgage lending remains strong, with loans providing spreads more than 100 basis points wider than comparable corporate bonds. The asset class offers a range of features that align with institutional investors requirements, from investment grade risk and low volatility to security and credit diversification. Loans can be either fixed or floating rate, giving a typical portfolio a lower duration than an average corporate bond strategy, an attractive characteristic in an environment of rising interest rates. Developments in Europe s commercial real estate debt market in 2015 have reinforced the attractiveness of senior commercial mortgage lending for institutional investors. Transaction volumes are rebounding and credit quality remains strong. At a time when many investors are active in their domestic residential mortgage markets, a Europe-wide commercial mortgage strategy can offer a wider opportunity set in which we see a range of very compelling investment opportunities. Secure and stable investment grade risk Senior commercial mortgage lending continues to appeal to European institutional investors as an investment grade credit strategy that can complement public corporate bonds, domestic residential mortgages or commercial mortgage-backed securities (). The asset class, which typically provides private three to ten-year loans on commercial properties at loan-to-value (LTV) ratios of about 50-65%, can offer predictable income, security and low volatility to institutions comfortable accepting a degree of capital illiquidity. The interest payments, which are typically quarterly, provide consistently good levels of running returns, an attractive outcome for investors with high current liabilities. Though spreads on senior commercial mortgages have come in from the all-time highs at the end of 2012, in the UK they have stabilised at average spreads of bps almost double their pre-crisis levels, according to De Montfort University. 500 UK senior mortgage spreads compared with European corporate bonds Title: Arial bold size 10. Rounded rectangle height 0.8cm Jan Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Jan-14 Jan Spread Premium Senior Commercial Mortgages EMU Corporate 3-5 year A Source: M&G, BofAML Euro Corporate 3-5 year A-rated Index (ref ER32), De Montfort University, as at 31 July 2015

2 No data No data The illiquidity premium Compared with a typical portfolio of investment grade corporate bonds, senior commercial mortgages can offer both attractive compensation and stronger investor protection to offset their lower liquidity. At a time when returns on European investment grade credit have undergone prolonged declines, senior commercial mortgages offer a premium of 100 to 150bps over similarly-rated corporate bonds, as the chart below shows. The same is true against other fixed income securities. Research conducted by real estate consultancy CBRE for the UK market, illustrated in the chart below, demonstrates the excess spread offered by UK senior commercial mortgages over other property exposure such as UK real estate investment trusts (REITS) in Q % Excess returns on senior mortgages relative to fixed income assets Title: Arial bold size 10. Rounded rectangle height 0.8cm year Gilts itraxx Main itraxx Crossover UK REIT UK AAA Crp Bonds Q Q UK AA UK A -0.5 UK BBB Source: CBRE MarketView, UK Debt Prospects, Q3 2015, as at 30 June 2015 Newly originated senior mortgages offered a 230bps higher return than that obtained on five year gilts in Q Against corporate debt, as represented by the itraxx Main investment grade CDS index, the return premium stood at 140bps. The asset class also showed relative value compared with REIT bonds and generated comparable returns to similarly rated UK. In contrast, the average yield on five-year German bunds in Q was only 4bps, since the yield was negative for a large part of the quarter; equally, Dutch government bonds yielded an average 9bps. Essential features Senior commercial mortgage lending is a private, investment grade credit strategy. Interest payments can either be structured as floating rate, priced at a spread over Libor or Euribor, or fixed rate, priced at a spread over swaps for the relevant tenor. The secondary market for loan trading is still relatively immature, unlike corporate bonds, which are actively traded, and for which there is a limited secondary market. Investors are typically compensated for the lack of liquidity through both a spread premium and credit enhancements. In our experience, this trade-off is most compelling for institutional investors such as insurance companies and pension funds with long-term liabilities, who are naturally suited to more illiquid investments. Before the financial crisis, banks dominated the commercial mortgage lending market in Europe. During the crisis, banks withdrew from the market and regulators increased capital requirements. Alternative lenders saw the opportunity to enter the market, with the result that underwriting standards tightened, leverage declined and margins widened. Post-crisis, a wide range of opportunities are on offer for institutional investors looking to benefit from the attractive risk-return profile available.

3 Security and covenants Senior commercial mortgage loans offer considerable credit enhancements relative to bonds. The most important is the security over physical property, which gives investors superior downside protection to unsecured corporate debt. They also incorporate a strong suite of financial covenants to guard against downside risk in property performance. At M&G each of our senior loans is rated internally and we aim to structure our senior mortgage loans to achieve ratings in the range of BBB to A. A single-tranche senior mortgage loan always gives the investor a first-ranking fixed charge against the property. In a stressed scenario, this means that if the borrower defaults, the investor can take control and sell the property, with repayment ranking ahead of all other creditors. This is not always the case with other forms of property exposure such as a multi-tranche, for example, where investors purchasing the A- rated tranche could have one or two senior tranches ranking ahead of them in a default scenario and therefore typically expect lower recoveries. A senior mortgage typically also offers a superior level of control compared to investment in a single tranche of a multi-tranche securitisation. At M&G we originate most of our mortgage loans directly with the borrower which means that typically we control 100% of the loan notional. This means we can take decisions for the sole benefit of the senior loan investors. This is not the case when investing in a single tranche of a multitranche deal, where investors will typically make up a small percentage of the overall debt balance and will need to take decisions alongside other investors with competing interests and usually need to work with a bond trustee. Lastly, and crucially, by originating loans directly, M&G is present at the negotiating table with the borrower from the outset. This allows us to make decisions throughout the underwriting process for the benefit of our investors, which is not the case in a where often the originating bank retains little involvement in the transaction beyond the underwriting stage. By being present from the start, we are able to structure the loan documentation in ways to mitigate the risk of capital loss, including negotiating bank account mechanics to allow us to remain in control of cash flow, structuring the covenant packages to allow us to take action if performance deteriorates and setting reporting requirements to give us the best visibility on the borrower s business plan.moreover, we retain the relationship with the borrower, which benefits the ongoing asset management of our positions and often leads to repeat business to the benefit of our investors. Beyond domestic residential mortgages Trends in Europe s domestic mortgage markets also support the appeal of an allocation to senior commercial mortgages. Across Europe, institutional participation in domestic mortgages has increased significantly in recent years as banks withdrawal has enabled non-bank investors to gain market share. Dutch institutions have been particularly active: local investment funds had invested a total of 6.7 billion in residential mortgages at the end of 2014, up 81% year-on-year, according to De Nederlandsche Bank, while residential mortgage portfolios held by life insurers totalled 44.3 billion at the end of 2014, almost 9% of their total assets. While Dutch investors have been drawn to the attractive spreads offered by the asset class, growth in demand is now exerting downward pressure on yields. Ten-year mortgage loans of less than 75% LTV the equivalent in credit quality to senior commercial mortgages earned a median spread of 185bps before fees and charges as of 18 September 2015, while for 100% LTV the median spread stood at 250bps, according to financial advisory and investment firm Bishopsfield Capital Partners. Senior commercial real estate loans compare favourably to these levels, with a typical portfolio offering bps spreads net of all fees and charges. The Europe-wide opportunity set and broad sector mix of property use offers Dutch institutions diversification beyond the domestic mortgage market.

4 Why now? Prime commercial real estate lending in Europe has ramped up over the past 12 to 18 months as improved investor sentiment has driven a significant increase in transaction activity. Deal volumes in 2015 are anticipated to surpass the pre-crisis record of Liquidity in secondary property debt markets has improved, particularly in peripheral Europe, and transactions are generally larger: half of all deals in Q were of more than 100 million in size. New lending remains focused on core markets such as the UK, Germany and France, but volumes have also picked up significantly in both Ireland and Spain. According to CBRE, the total value of European investment transactions reached more than 216 billion in 2014, 29% higher year-on-year. European commercial real estate debt stock outstanding at end-2014 Rest of Europe, 24% UK, 35% Iberia (Spain and Portugal), 5% France, 13% Germany, 23% Source: CBRE, as at 31 December 2014 The investment case continues to be compelling: analysis by CBRE in 2015 estimated that more than 500 billion of outstanding European commercial mortgage debt is due to mature and will likely be refinanced over the next three years. In the UK, approximately 72% of all outstanding commercial real estate debt is due for repayment during the four years from 2015 to 2018 inclusive, according to De Montfort University research. Credit standards remain strong with stable LTV ratios and comprehensive covenant packages in place, and margins on senior mortgages have stabilised. Evolution of the European commercial real estate debt market Title: Arial bold size 10. Rounded rectangle height 0.8cm Typical capital structure 2012 origination Equity Typical capital structure 2015 origination Equity Mezzanine / C- Mezzanine 75-80% LTV Mezzanine / C- Mezzanine 75-80% LTV Stretch-Senior / B- Stretch Senior: 60-70% LTV Stretch-Senior / B- Stretch-Senior: % LTV Senior Loan / A- LIBOR % % Senior Loan: 50-60% LTV Senior Loan / A- LIBOR % % Senior Loan: 50-65% LTV Source: M&G, as at 17 September 2015

5 This represents a sizeable investment opportunity for institutional investors, which continue to grow their presence and challenge the dominance of bank lenders. Insurance companies and non-bank lenders are now taking a significant share of loan originations as the market becomes more institutionalised and borrowers seek more diverse sources of funding. In the UK, for example, banks participation in new loan originations has almost halved to 39% in 2014 from 72% in 2008: Share of new loan originations in the UK, 2007 to 2014 year end 100% 11% Title: Arial 4% bold size 10. Rounded rectangle 3% height 5% 0.8cm 12% 13.5% 90% 11% 23% 21% 10% 14% 21% 80% 6% 11% 13% 12% 17% 15% 5% 70% 20% 27% 26% 13% 11% 60% 16% 13% 50% 16% 11.5% 40% 72% 30% 58% 57% 52% 50% 48% 20% 43% 39% 10% 0% UK Banks and Building Societies Other International Banks Insurance Companies German Banks North American Banks Other Non-Bank Lenders Source: M&G, The UK Commercial Property Lending Market Research Findings 2014 Year-End, De Montfort University While Europe s bank deleveraging cycle is coming to an end and traditional lenders are regaining their appetite for commercial property debt, the institutional presence is expected to remain established, which should support the stability of the market. Where do we see opportunities today? For experienced pan-european lenders such as M&G, these conditions throw up a wide range of investment opportunities. We have a wide platform of origination channels across both the UK and continental Europe and our ability to source and structure whole-loan transactions, hold loans for the entire term and undertake large, complex deals that others find challenging enable us to take advantage of relative value when it emerges. Recent loans have focused on the office, retail, hotel and multi-family residential sectors, where we have been able to secure attractive spreads. We have also been active in the industrial and leisure sectors in prior years and continue to consider new opportunities on an ongoing basis. In geographical terms, we are seeing attractive value in regional UK and selected European markets: we continue to consider opportunities in the Netherlands, Ireland and Spain at present. We target jurisdictions across Europe where we perceive good relative value for the level of risk we are underwriting. This takes into account the legal framework of each jurisdiction and in particular the ease of enforcement of security should we need to enforce on our senior mortgage. To date, these markets include the UK, Ireland, Germany, France, Spain and in Scandinavia and Benelux.

6 For more information contact: Andrew Swan +44 (0) John Atkin +44 (0) Annabel Gillard +44 (0) Henry Barstow +44 (0) Sunita Dey +44 (0) For Investment Professionals only. The distribution of this document does not constitute an offer or solicitation. Past performance is not a guide to future performance. The value of investments can fall as well as rise. The success of these investment strategies and their suitability for investors are not guaranteed and you should ensure you understand the risk profile and products you plan to purchase. The services and products provided by M&G Investment Management Limited are available only to investors who come within the category of the Professional Client as defined in the Financial Conduct Authority s Handbook. They are not available to individual investors, who should not rely on this communication. Information given in this document has been obtained from, or based upon, sources believed by us to be reliable and accurate although M&G does not accept liability for the accuracy of the contents. M&G does not offer investment advice or make recommendations regarding investments. Opinions are subject to change without notice. M&G Investments is a business name of M&G Investment Management Limited and is used by other companies within the Prudential Group. M&G Investment Management Limited is registered in England and Wales under number with its registered office at Laurence Pountney Hill, London EC4R 0HH. M&G Investment Management Limited is authorised and regulated by the Financial Conduct Authority. 0525/MC/0615_UK