More than most sectors, commercial real estate could do with a fresh start this New Year. The figures for December are not out yet, but property values fell 3.9 per cent in the first 11 months of 2012, according to the closely-watched IPD benchmark. But even if the wind does not change - and consensus forecasts suggest it won’t - there’s a way to invest in property that spares you the pain of valuation write-downs: lend against it.
The advantage of a loan is that falling real-estate prices only matter if they completely erode the borrower's equity cushion. Provided the equity cushion is large enough - 30 per cent or so should easily allow room for any further erosion in real-estate values - lenders can collect a comfortable return while taking on minimal risk. We all understand this principle because that’s how banks make money from our mortgages. Less well known is that you no longer need to be a bank to issue a mortgage - private investors can profit too.
There are two types of property-debt instruments you or I can buy. First, the second half of 2012 saw a spate of retail bond launches. Five listed property companies -
Buying a property company's retail bond is not, strictly speaking, lending against property. That's because - with the exception of the Alpha Plus issue - they are backed by corporate balance sheets rather than specific assets, making them slightly riskier than a true mortgage. Investors need to be comfortable with the corporate strategy and management as well as the property.
The second option, which obviates this problem, is to buy shares in a fund that acts as a property lender. This is an even newer phenomenon than the retail bond: shares in Starwood European Real Estate Finance, London’s first mortgage fund, only started trading on 17th December. But it probably won’t be the last - two other specialist fund managers, ICG Longbow and Cheyne Capital - are looking to launch similar vehicles this month.
Starwood has pledged to pay a 7 per cent dividend yield on its net asset value. It will achieve that by issuing loans secured against high-yielding property in Britain and Northern Europe, either as senior or mezzanine lender. Its blended portfolio loan-to-value (LTV) will be no higher than 75 per cent, giving a 25 per cent equity cushion for falling property values. The ICG-Longbow fund will operate the same business model, but with a lower risk-return profile - it will pay 6 per cent by issuing senior loans in the UK at an average LTV of 65 per cent.
Retail bonds and mortgage funds are very different kinds of instrument, but, for property companies, they fill a common funding gap left by the banks. Morgan Stanley has estimated that European banks will reduce their real-estate exposure by €350-€600bn (£285-£490bn) over the next three to five years. Property companies desperately need alternative sources of debt, both to refinance existing mortgages and buy more buildings at the low point in the property cycle.
In the United States, banks have only ever been part of the picture; their share of property lending is as low as 50-55 per cent, says Peter Denton of Starwood. Among their competitors are a whole class of "mortgage real-estate investment trusts" (Reits), including a $3.1bn (£1.9bn) vehicle managed by Starwood. But in Europe, banks have enjoyed a near complete monopoly. As The Economist explained in an excellent special report last month, that’s now changing: European insurers, pension funds, asset managers and bond markets are forming a so-called ‘shadow banking system’ by reinventing themselves as lenders.
The launch of mortgage funds in the UK is a hugely welcome part of this trend - though they cannot benefit from the tax-efficient Reit structure under current legislation. Welcome because, along with retail bonds, they fill another gap left by the banks: with even the best cash-deposit rates barely exceeding inflation, investors are desperate for low-risk investments that earn a real return.
Of course, both instruments come with more risk than a state-guaranteed bank deposit. Retail bonds are unsecured, depend on the solvency of their issuers and may be illiquid. Charles Gowlland, a portfolio manager at Smith & Williamson, advises against buying more than about £500,000 of any issue. "It’s relatively early days and you can’t have confidence you can get out in size." Listed mortgage funds, meanwhile, come with the volatility of the stock market and no fixed redemption date or value. The danger is that the market reprices the shares when interest-rate or inflation expectations change - though Starwood has introduced discount-control mechanisms to guard against this.
Still, the income streams on offer seem generous by comparison with these risks. That may be because this is a dysfunctional market - banks are withdrawing from the market for regulatory rather than economic reasons. Seth Klarman, the ‘new Warren Buffett’ whom my colleague Philip Ryland profiled last month, has even opened a London office to capitalise on the distress in European debt markets. Private investors should follow - now that they finally can.