The opportunity in European real estate debt

Executive summary

The European real estate debt market has changed dramatically since the global financial crisis of 2007-2008, with a combination of factors leading to a reduction of bank capital available for borrowers. This in turn has provided an opportunity for institutional, non-bank capital to enter the market in scale to meet borrower demand. Non-bank capital comprises 6.4% (c. €117 billion) of the European real estate market, compared to only 0.8% (c. €14 billion) in 2008, and continues to grow.

Today’s market offers an attractive investment proposition for real estate debt investment characterised by good relative value when compared to corporate bonds of similar credit quality. An investment in real estate debt can deliver stable cashflows due to its fixed income nature, as well as provide hard asset security for an investor due to the property collateral backing the loan. Bespoke covenants for each asset aim to give additional protection, as they act as early warning signs in the event of borrowers struggling to repay the loan or there is deterioration in the value of the property.

At M&G, we believe it is essential for lenders to undertake extensive due diligence on a property’s cashflow predictability and sustainability during the underwriting process, including credit analysis on the underlying property asset as well as an assessment of the credit quality of tenants and the terms and length of leases. This analysis allows bespoke underwriting assumptions to be used to build up cashflow profiles for loans, which in turn can be stressed to assess loan performance in different economic scenarios. Further, we believe directly originating whole loans (senior and junior) with borrowers so they only have to deal with one lender is an attractive proposition for borrowers, which enables us to find more value opportunities.

This paper explores the key features of real estate debt, the evolution of the lending market post-crisis and the reasons why real estate debt is attractive to institutional investors today.

This paper will talk in detail about the following:

• Real estate debt explained

• Capturing the investment opportunity

• The investment case for real estate debt

• The market for European real estate debt investing

• Digging into the detail – investor protections and the importance of covenants

• How to invest in real estate debt

• Conclusion

• Glossary

2

Real estate debt is used to refer to private loans, or mortgages, secured against commercial property. Real estate debt can be secured against a variety of commercial property types, with common examples being offices, shopping centres, industrial and logistics units, hotels, private residential rented properties, and student accommodation.

Real estate debt investments typically comprise loans as opposed to bonds. There are some key differences between loans and bonds that investors should bear in mind when making investment decisions:

Real estate debt explained

Loans Bonds Conclusion

Collateral package Generally benefit from dedicated collateral (e.g. a first ranking mortgage on a physical property).

Often unsecured credit obligations of an issuer with no dedicated collateral.

In a default scenario, investors in loans benefit from specific, ring-fenced collateral, which is used to repay all secured creditors before senior unsecured creditors.

Liquidity Illiquid instruments with limited ability to trade positions in a secondary market.

Highly liquid instruments with a large, active, secondary market.

Loans offer an ‘illiquidity premium’ to compensate investors.

Number of investing parties

One or few given lack of secondary market.

Many due to active secondary trading of bonds.

The relationship between lender and borrower is far closer for loans than for bonds.

Loans are typically non-recourse, which means that lenders are solely reliant on the property for both scheduled interest payments and the repayment of loan principal at maturity and therefore have no recourse to the sponsor, the ultimate owner of the property. To ensure that the property asset(s) are legally separated from other assets and liabilities of the ultimate owner of the property, real estate loans are typically advanced to ‘special purpose vehicles’.

Europe’s real estate debt market presents a compelling opportunity for investors as there is a significant requirement for real estate debt finance in the market, and alternative lenders, such as asset managers, are in a good position to capture these opportunities.

The two users of real estate debt finance can be categorised as:

• Purchasers of commercial real estate requiring finance to acquire more properties – acquisition financing

• Existing owners of commercial real estate looking to replace existing financing – refinancing

The amount of new debt issued for acquisition financing has increased substantially in recent years due to increased acquisition volume and an increase in the average debt used per transaction. As Figure 1 shows, the proportion of acquisitions financed by debt has steadily grown since the global financial crisis, with CBRE, a leading commercial property and real estate services advisory company, estimating that 46% of a record €255 billion of European commercial property investment in 2016 was financed by debt. Assuming this reliance on debt finance continues, the market opportunity going forward should remain compelling.

Capturing the investment opportunityFigure 1: Debt has played an increasing role in real estate acquisition financing since 2009

European real estate acquisitions and proportion funded by debt

Source: Amended from Figure 2 of CBRE 'European Commercial Real Estate Finance 2017 Update'

Amount of debt used to finance CRE acquisitions (€ billion) Value of CRE acquisitions (€ billion)% of acquisition volume debt financed (RHS)

2001 2002

300

250

200

150

100

50

02003 2004 2005 2006

€ bi

llion

2007 2008 2009 2010 2011 2012 2013 2014 2016

100

90

80

70

60

50

40

30

20

10

0

% o

f deb

t use

d in

CRE

acq

uisit

ions

2015

54%57%

58%61%

64%66%

73%

49%

37% 37% 37%

38%40%

44%

47% 46%

3

In addition to new acquisition financing, lenders can also take advantage of the opportunity to refinance existing debt.

As shown in Figure 2, approximately €450-500 billion of real estate debt in Europe is expected to mature, and therefore need refinancing, in the next three years. As loans in Europe typically have a term between three and seven years, borrowers would need to refinance loans on a rolling basis should they wish to retain ownership of the properties. Therefore, we believe there is a healthy pipeline of opportunity to refinance debt over the medium term.

Figure 2: A healthy pipeline of potential deals to be refinanced over the coming years

Maturity profile of European real estate loans (€ billion)

Source: Amended from Figure 4 of CBRE 'European Commercial Real Estate Finance 2017 Update'

RoE Iberia France Germany UK Netherlands2017

200

150

100

50

02018

€ bi

llion

2019 2020 2021

Relative value and access to illiquidity premium: For real estate debt investors, the relative value proposition is attractive. Senior real estate debt investments, when compared to corporate bonds with a similar credit rating, have offered higher returns over the past five years, as can be seen in Figures 3 and 4.

Strong investor protections: The terms of any particular loan are usually heavily negotiated between borrower and lender. Real estate debt is a private asset class, and while standardised industry documentation is encouraged and regularly used, the key contractual terms of each deal are customised to ensure the investment reflects the specific risks of the underlying property and the business plan of the borrower. Part of these negotiations will focus on the type and level of financial covenants to be included in the loan documentation, which will be specific for each loan and further protect the lender in adverse scenarios.

Clear workout process when dealing with distressed loans: The fact that real estate loans will typically be held by one or few underlying investors, compared to multiple investors in a public corporate bond issue, mean that lenders can negotiate directly with the borrower in the event that a default occurs. This direct negotiation process can give real estate debt investors greater bargaining power, the ability to proactively deal with emerging problems before they become material and should lead to a more streamlined workout process for distressed loans.

The occurrence of an event of default allows the lenders to enforce their security over underlying properties and liquidate the property collateral to recover their loan. Holders of senior real estate loans, with first-ranking

security and clear covenants, can typically ensure that this enforcement and liquidation can be done in a timely manner.

Investments backed by hard assets: The recovery of a real estate debt investment is dependent on the value of ring-fenced, physical property. This differs to corporate bond investments, where recovery for bondholders is generally more dependent on the management of a business as a going-concern. This collateral backing can help to enhance both the quantum and timing of recovery values for real estate debt investors in the event an investment does not perform as expected. It is also important to note that senior real estate loans have a typical LTV (loan to value) of 50-70%, so are significantly over collateralised by the underlying real estate. In the event of default, this ensures higher recoveries with minimal losses, compared to an average of 40% for corporate bonds.

Stable cashflows: Real estate debt is a fixed income investment benefiting from a schedule of stable interest and principal payments, which is attractive for insurers looking for higher predictability of income streams. Borrowers do have the right to repay their loan at any time, so to mitigate this risk of prepayment, loans often benefit from prepayment penalties in the event the borrower decides to repay the loan early. The prepayment penalties can vary from a fixed percentage of the loan amount, which usually declines the longer the loan is outstanding, to full ‘make whole’ / ‘spens’ protection, whereby the borrower must compensate the lender for losing out on coupon payments that would have been received throughout the life of the loan.

The investment case for real estate debt

• Relative value when compared to corporate bonds with a similar risk profile

• Strong investor protections as the contractual terms of each loan can be customised to help protect and preserve investors’ capital

• Greater bargaining power and clear proactive workout process for dealing with distressed loans compared with corporate bonds

• Hard asset security as the loan is backed by a physical asset in the underlying real estate, with a value significantly in excess of the loan

• Stable cashflows suitable for institutional investors who are seeking high quality and predictable income streams

• Diversification from more traditional, liquid investments

Investors that allocate to real estate debt can benefit from the following attractive investment characteristics:

4

The changing landscape for non-bank lendersSince the onset of the global financial crisis, the European real estate debt market has undergone fundamental changes, with banks facing increased capital requirements under new regulations such as Basel III. While banks remain the dominant players in real estate lending, holding 70% of outstanding debt at the end of 2015 (see Figure 5), the ongoing disintermediation of the market has seen non-bank lenders increasingly looking to fill the void left by banks that have either reduced their activities or withdrawn from the market completely.

At the end of 2015, non-bank lenders in Europe had grown to represent 6.4% (€117 billion) of the real estate debt market, compared to only 0.8% (€14 billion) in 2008. Despite this rapid expansion, European non-bank lenders still account for a significantly lower market share compared to their counterparts in Asia and North America, which held approximately 20% of loans in their markets at the end of 2015, suggesting there remains space for non-bank lenders to continue to grow within Europe.

Figure 5: Non-bank lenders are becoming an increasingly large portion of the real estate loan market

The change in composition of global real estate markets – 2008 vs. 2015

Source: Cushman & Wakefield, February 2017.

Current conditions ripe for investmentWhile lending criteria has been tightened since the global financial crisis, demand for real estate debt has remained strong. This has created opportunities for alternative lenders to source investments offering attractive risk-return profiles.

As one of Europe’s core markets, the UK benefits from strong real estate fundamentals and a lender-friendly legal framework. In 2015, UK commercial property lending hit a six-year high, up 19% year on year, according to findings from De Montfort University. Importantly, a quarter of this lending was financed by non-bank lenders compared to no meaningful participation between 2007 and 2011 (see Figure 6).

There has been a marked shift from the lending landscape prior to the global financial crisis, when lending criteria were more lax; LTV ratios were typically high, margins low, and property valuations at peak levels. By contrast, market dynamics at present are generally characterised by more conservative valuations with real estate debt offering higher returns at lower LTV levels than before the crisis.

Figure 6: Non-bank lenders now a larger portion of the UK real estate debt origination market

Composition of UK real estate debt origination market

Source: Amended from De Montfort University Commercial Property Lending Market: 2014 Year-End (Figure 12, Page 16) & De Monfort University Year-End 2016 Commercial Property Lending Report (Figure 2, Page 13)

The market for European real estate debt investing

Banks CMBS Non-bank Bonds

2008 2015

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02008 2015 2008 2015

North America Europe Asia PacificBanks Non-bank

2007 - 2011

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02013 2014 2015 2016

80%75%75%77%85%100%

15% 23% 25% 25% 20%

Figure 3: UK senior real estate debt investments offer higher returns than corporate bonds

UK senior real estate loan margins vs. corporate bond spreads

Source: De Montfort University End-Year 2016 Commercial Property Lending Report (Senior CRE debt margin), BofA Merrill Lynch (BBB and A rated GBP corporate 3-5 year asset swap spread)

Figure 4: UK senior real estate debt premium

UK senior real estate loan spread premium vs. corporate bonds

Source: BofA Merrill Lynch (BBB and A rated corporate 3-5 year asset swap spread)*UK senior CRE debt spread premium calculated as the difference between the equally weighted average of CRE debt margins from the De Montfort University report and the BofA Merrill Lynch 3-5 year BBB and A rated GBP corporate asset swap spreads

Senior CRE debt margin (all sector average) A rated corporate debt spreadBBB rated corporate spread

2011 2012 2013 2014

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02015 2016

Bps

Spread premium* vs A corporate debt Spread premium* vs BBB corporate debt

2011 2012

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02013 2014 2015 2016

Bps

5

While the sharp pullback in LTV ratios reflected a broader trend of post-crisis deleveraging and de-risking, loan margins tend to vary depending on the supply of available capital and perceived credit risk of individual investments. Therefore, as banks reduced lending activity during the crisis, margins rose to compensate for higher credit risk and lower overall availability of debt capital. The market appears to have reached a point in the cycle where credit standards have stabilised at ‘new normal’ levels, with LTVs considerably lower and margins considerably higher than pre-crisis levels. In an historical context, real estate lending currently offers significantly improved relative value than at any stage during the ten-year period leading up to the global financial crisis. As Figure 7 shows, in the UK, average senior real estate debt margins have stabilised around 200-250 bps, almost double their pre-crisis levels, while LTV ratios remain significantly below the levels seen previously.

The picture is similar throughout the rest of Europe – LTV levels are still low in an historical context and far below the peak seen in 2007. Further, overall lending volumes remain below pre-crisis levels and the opportunity for non-bank lenders remains strong as traditional bank lenders have less capacity to refinance maturing loans. Importantly, the increase in bank regulation post-global financial crisis means it is unlikely that banks’ lending criteria will return to pre-crisis levels as initiatives, such as Basel III, make it far more capital-intensive for banks to provide high LTV loans.

Figure 7: Higher real estate debt returns at lower risk levels than pre-global financial crisis

UK senior real estate debt LTV by property type

Source: Amended from Figure 52 of De Montfort University Year-End 2016 Commercial Property Lending Report and Figure 16 of De Montfort's report 'The UK Commercial Property Lending Market: Year-end 2008 Research Findings'

UK senior real estate debt margin by property type

Source: Amended from Figure 49 of De Montfort University Year-End 2016 Commercial Property Lending Report and Figure 14 of De Montfort's report 'The UK Commercial Property Lending Market: Year-end 2008 Research Findings'

Prime o�ce Prime retail Secondary o�ce Secondary retail

00 01 02 03 04 05

85%

80%

75%

70%

65%

60%

55%06 07 08 09 10 11 12 13 14 15 16

LTV

Prime o�ce Prime retail Secondary o�ce Secondary retail

00 01 02 03 04 05

500

400

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006 07 08 09 10 11 12 13 14 15 16

Mar

gin

(bps

)

Lenders will usually take out a mortgage over the commercial property which gives them a first legal charge against the property, ensuring that the loan ranks ahead of any other lender.

Interest on the loan is usually paid quarterly by the borrower from the rental income it receives from tenants of the property. Interest can be fixed or floating rate depending on the specifics of the loan, but floating-rate loans are generally hedged by the borrower to ensure that the rental income streams generated by the property are able to continue to pay loan interest even in a rising interest rate environment.

Financial covenants can act as early warning signs The type and level of financial covenants are set at the beginning of the loan agreement and can act as early warning signs of any deterioration of property value or rental income. Importantly, financial covenants are set at levels specific to each lender and asset, which should allow both full interest payment and full recovery of the loan principal in the event that the lender has to enforce and sell the property.

Financial covenants in real estate debt financing are often credit metrics, such as LTV and interest coverage ratios, that have been analysed upfront and are then continuously monitored throughout the term of the loan and are tested for compliance, typically by annual revaluations of the properties and quarterly cashflow statements.

The ratio of net rental income (after expenses) to interest due for the loan is called the interest coverage ratio. If the interest coverage ratio is set higher at the start of the loan, then in the event that this covenant is breached, there is still some headroom i.e. the loan can withstand further falls in rental income, before the borrower is unable to pay the loan and the lender is forced to take remedial action.

Financial covenant packages for real estate loans also typically include both ‘cash sweep’ and ‘default’ covenants. A breach of a cash sweep covenant occurs after a modest deterioration in the property value or rental income, and forces the borrower to use any excess cashflow from the property (after payment of loan interest) to pay down the loan principal or hold this cash in a lender-controlled escrow account. A cash sweep covenant breach does not constitute a technical default of the loan.

Similar to the cash sweep covenant, a default covenant serves as an early warning signal of distress well before a technical default or any other default occurs. The default covenants are breached after a greater deterioration in property value or rental income occurs, at which point the borrower usually has the right to repay enough of the loan to satisfy the covenant breach. If the borrower is unable to do this, the lender has the right to assert more control over the operations of the property or even force a sale in order to try to recover the outstanding loan balance.

Digging into the detail – investor protections and the importance of covenants

6

We can illustrate how these covenants can be used to help to protect and preserve investors’ capital. Figure 8 shows the percentage fall in property value and rental income that a loan can withstand before a breach of the cash sweep and default covenants, putting the loan principal and interest payments at risk.

As shown in the example in the table below, the day one LTV is 70% and the interest coverage ratio is 1.50x. A cash sweep covenant set at 75% LTV, is triggered if the property value falls by more than 6.7% from day 1 levels. In reality, the property value can fall by as much as 25% (i.e. 100% - 75% LTV = 25% headroom) before the loan stops being fully covered by the property collateral and the loan principal is at risk.

A default covenant set at 80% LTV, is triggered if the property value falls by more than 12.5% from day 1 levels. The headroom in this example equates to a 20% fall in the property’s value, before the loan stops being fully covered by the property collateral and the loan principal is at risk.

Similarly for interest coverage, a loan that has a cash sweep covenant set at 1.35x and a default covenant set at 1.25x can withstand further falls in rental income before it goes below 1.0x and the borrower cannot pay interest in full.

Figure 8: Example of a typical financial covenant package and headroom from initial levels

Typical whole loan financial covenant package

Day 1 level

Cash sweep level

Default level

Loan to value 70% 75% 80%

Embedded equity cushion*

30% 25% 20%

Change of property value since Day 1

- -6.7% -12.5%

Interest coverage ratio

1.50x 1.35x 1.25x

*A percentage by which the property value can fall before the loan stops being fully covered by the value of the collateral property

Underwriting analysisWhile the LTV is the most commonly used risk metric in real estate debt investing, more sophisticated lenders will undertake a far more rigorous cashflow and market analysis and not rely on LTV as the sole measure of risk. This is because LTVs can move around substantially and therefore distort the fundamental creditworthiness of an asset.

Real estate debt by its nature is a cyclical asset class and therefore it is important for lenders to adjust LTVs upwards or downwards based on the expected volatility of the value of the property being financed, in order to withstand changing market conditions through an economic cycle. Generally, investors prefer predictability of cashflow and so properties that benefit from long-term, contractual income from tenants with high credit-worthiness will typically exhibit far less volatility in value than transitional assets that require reletting or capital improvement works to be undertaken.

Prudent lenders will therefore undertake extensive due diligence on a property’s cashflow predictability and sustainability. This will include both an analysis of any current, contracted income and importantly, the ability to replace income on an ongoing basis.

Part of M&G’s comprehensive underwriting process includes performing credit analysis on the underlying property asset being financed as well as assessing the credit quality of tenants and the terms and length of leases. For example, a loan that we have rated investment grade, taken out against a headquarters building of a tenant assigned a credit rating of ‘A’, with a 25-year lease may provide leverage up to 70% LTV, whereas a loan that we have rated investment grade, taken out against a hotel in a coastal resort that relies heavily on summer tourism for the majority of its income may only provide leverage up to 40% LTV. This highlights the importance of performing credit analysis on both the property asset and the tenant using our internal credit ratings process.

By assigning a credit rating to each asset and tenant independently, we can examine how an investment’s cashflow and income streams are impacted under a range of potential scenarios and assumptions based on differing values for each of the variables (costs, tenant quality, leases etc). In this way, we can formulate a ‘base case’ underwriting scenario using conservative assumptions for these bespoke inputs. We will also run a ‘downside case’ scenario to assess a loan’s performance against the background of a stressed economic climate.

Types of real estate debt investmentsAt LTV levels of 70-80%, a fall in property values in excess of 20-30% would result in capital loss for the lender, which makes the loan too high risk for a traditional investment grade credit investor, who in today’s market will typically lend up to 60-65% LTV. However, we believe the appropriate LTV also depends heavily on the fundamental creditworthiness of the underlying property as well as the tenants, as we have discussed in the previous section.

If the borrower wants to borrow more than 60-65% LTV, the market solves this problem by topping up the senior loan with a subordinated junior loan to reach the borrower’s total financing need. This can be done either with separate senior and junior loans provided by separate lenders, or instead by one lender providing a single, ‘whole loan’ for the full 70-80% LTV. A whole loan is a single, higher LTV loan which is often subdivided into separate senior and junior loan ‘tranches’. The senior loan created by this ‘tranching’ process has a first ranking claim against the property and its cashflows, and the junior loan (also referred to as a mezzanine loan) has a second ranking claim against both the property and its cashflows after the senior loan.

The junior loan is a higher risk investment than the senior, investment grade loan, as it can withstand less deterioration of market value of the property and rental income, and therefore pays a higher return. Junior loans provide additional debt from the LTV point at which the senior loan stops (the ‘attachment point’) to the LTV point of the entire debt financing package (the ‘detachment point’). The difference between the attachment and detachment point is known as the ‘thickness’ of the junior tranche, and assuming the same detachment point, thicker tranches are able to withstand greater falls in market values before the entire junior principal is lost.

7

In Figure 9, we have presented an illustrative example of a typical whole loan financing structure and summarised (in a worked example) how a single whole loan can be split into a separate senior and junior tranches with the same combined return – but each tranche has a different risk and return profile – in order to meet the borrower’s full LTV ratio requirement.

Figure 9: An illustrative example of a typical whole loan real estate debt financing structure

Source: M&G Investments, for illustration purposes only

Whole loan€75 million notional

4% coupon

Equity

75% LTV 75% LTV

60% LTV

Senior loan€60 million notional

3% coupon

Equity

Junior loan€15 million notional

8% coupon

Annual interest:

Whole loan: €75 million x 4% = €3.0 million

Senior loan: €60 million x 3% = €1.8 million

Junior loan: €15 million x 8% = €1.2 million

Total: = €3.0 million

How to invest in real estate debtIn today’s environment, an investment manager can employ a variety of strategies to source real estate debt opportunities. Some managers favour a comprehensive approach with in-house loan origination, research, structuring, execution, and monitoring teams that deal directly with borrowers and therefore remove the requirement for banks entirely. Other managers use a less resource-intensive, syndication-based model, where the manager purchases all or part of a loan from the syndicating bank once the loan has been made to the borrower.

Once the opportunity is sourced, managers can subdivide the whole loan into senior and junior tranches themselves as discussed previously, each with different risk and return profiles, in order to most efficiently allocate risk depending on what investors require. These separate tranches can either be sold to third parties, or retained by a different pool of investors with the same manager.

In M&G’s experience, the most effective way to optimise relative value for investors is to use a comprehensive, direct origination approach, with the separate senior and junior tranches being retained by different pools of investors within M&G, such as our parent, Prudential, pension schemes and insurance companies. We outline the advantages and disadvantages of the different strategies available to managers below.

Closer origination vs. secondary purchase: While originating a loan directly with a borrower is more time and resource-intensive than purchasing a loan from a bank, it allows the lender to create a

direct relationship with the borrower and importantly ensures that a manager has full oversight and input into structuring the terms of the loan upfront. By taking a direct origination approach, a manager is able to set the price of the loan directly with the borrower instead of taking the return on the investment set by the bank that is syndicating the loan. Investors are also able to retain any origination fees available rather than these being taken by the bank.

Whole loan manager vs. dedicated senior or junior loan manager: The senior and junior tranches in a real estate whole loan are each typically sized to appeal to the risk tolerance of the different end-investors in each tranche. While a manager may only invest in either senior or junior tranches, we believe the ability to write a whole loan to meet a borrower’s full financing needs is a clear differentiating factor for the borrower and is therefore key when sourcing investments. In our experience, borrowers prefer to deal with a single lender rather than having to manage the increased execution risk that can result when dealing with multiple lenders for the separate senior and junior loans. A manager only investing in senior or junior loans may miss out on a large part of the borrower market, thereby limiting investment opportunities. A whole loan strategy can also provide investors additional value through access to better quality properties and potentially greater returns from borrowers willing to pay more for the reduced execution risk. As the real estate debt market has matured, we have seen more managers adopt a whole loan approach for this reason, with a range of strategies on offer, as discussed in Figure 10.

8

Hold to maturity vs. syndication vs. fund leverage: There are three options for how investment managers invest the capital required to finance a whole loan:

Figure 10: Whole loan considerations

Strategy Description Advantages Disadvantages

Retain senior and junior tranches

• Manager invests in senior and junior tranches for different investor pools

• Certainty of senior and junior margins from start

• No exposure to syndication or mark-to-market risk

• Requires management of the potential conflicts of interest

Syndicate senior tranche • Manager invests in the junior tranche only, and sells the senior tranche

• No conflicts of interest to manage

• Syndication risk

Fund leverage • Manager invests in the whole loan and takes out debt at fund level

• No conflicts of interest to manage

• Mark-to-market risk

Explained: Fund leverageFund leverage refers to a credit facility (or credit line) provided by a commercial bank to a real estate loan fund, and which is secured against the investments held by the fund. This provides a manager with an enhanced rate of return but the whole loan may incorporate several turns of leverage beyond what would be covered by the individual real estate loans.

The bank requires minimum headroom between the value of the fund’s real estate loans (as valued by the bank) and the outstanding balance of the credit facility. This runs the risk of introducing mark-to-market losses for an investor in the event that there is a change from book value. There are other issues with applying fund leverage;

1. If investors in the fund are required to pledge additional capital in order to repay the credit facility earlier than anticipated, the realised returns on the investment will be lower than initially expected, and

2. If there is no available capital to repay the credit facility, the manager may be forced to quickly sell illiquid real estate loans in the secondary market, which may lead to significant losses in this ‘fire sale’ scenario.

1. Hold to maturity approach with separate senior and junior investors – this strategy offers benefits to investors because the return on each loan tranche is set at the point the loan is funded. Borrowers also like the certainty of knowing who is financing the loan, not just initially but throughout the term of the loan. Importantly, a manager that intends to hold the loan to maturity rather than selling it on (via a syndication process) or applies fund leverage will need to have the processes and experience to manage any potential conflicts of interests that may arise from managing different pools of investors in the same loan transaction.

2. Syndication – this strategy relies on selling part of a loan to third parties after the initial investment has been made. While this approach reduces any potential conflicts of interest between the different sets of investors, it is subject to ‘syndication risk’ where the returns on the loan tranche that is retained by the manager could be at risk should the available returns on loan tranche being syndicated differ from the assumptions made by the manager when underwriting the original whole loan.

3. Fund leverage – some whole loan managers who wish to hold a loan to maturity, but who do not have end-investors for both senior and junior tranches, invest in the whole loan and then take out fund leverage i.e. debt at fund level, in order to increase returns. While this avoids any potential conflicts of interest, this strategy introduces mark-to-market risk (see ‘Explained: Fund leverage’ box for more detail).

M&G employs a direct origination, whole loan, hold to maturity real estate debt strategy, with different loan tranches allocated to different investors. We believe that this is the optimal way to provide the type of capital that borrowers value in the market place, and provide different groups of investors the risk and return profile they require. In our view, this gives us a pricing advantage with borrowers, allowing us to deliver better risk-adjusted returns for our investors.

ConclusionReal estate debt is an alternative investment that benefits from a number of structural features that could appeal to traditional fixed income investors looking for both investment grade and sub-investment grade debt. The changing regulatory landscape and resulting reduction in bank capital available for real estate lending in Europe has created an attractive opportunity for large-scale institutional investment into the asset class. There are multiple ways in which an investor can source real estate debt opportunities and M&G strongly believe that managers who directly originate whole loans with borrowers and retain both the senior and junior tranches in-house are best placed to deliver strong relative value opportunities for their investors.

9

10

Glossary

Attachment point The LTV at the first Euro advanced under a loan. For example, a 60-75% LTV mezzanine loan will have an attachment point of 60%

Basel III The third Basel Accord, a global, voluntary regulatory framework on bank capital adequacy, stress-testing, and market liquidity risk

Borrower The company borrowing money under the loan

Coupon The running quarterly interest paid on the loan. Comprises the reference rate (Euribor or Libor for floating-rate loans) plus the margin

Detachment point The LTV at the last Euro advanced under a loan. For example, a 60-75% LTV mezzanine loan will have a detachment point of 75%

Financial covenants Pre-determined metrics, such as LTV and interest coverage ratios, that are monitored for compliance on a quarterly basis and provide the lenders with additional control rights if levels are breached

Fund leverage A loan taken out at fund level, secured against the assets of the fund

Junior / Mezzanine loan A higher LTV loan, taking incremental risk behind the senior loan, with second ranking claim against the property and its cashflows

LTV Loan-to-value, being the ratio of the outstanding loan balance to the property value as determined in the most recent valuation

Margin / Spread The component of quarterly interest, which in addition to the reference rate (Euribor or Libor for floating-rate loans) makes up the loan coupon

Mark-to-market The interim valuation of a financial instrument to reflect any change from book value

Senior loan A loan with first ranking claim against the property and its cashflows

Syndication The selling of all or part of a loan once it has been made to the borrower

Tranching The process by which a whole loan can be split into separate senior and junior tranches

Whole loan A single, higher LTV loan, which is often subdivided into separate senior and junior tranches

M&G and real estate debt

M&G was one of the early movers in real estate debt after the global financial crisis, and key members have been investing together since the team’s inception. M&G has raised capital across both senior and junior debt strategies.

Key figures from M&G’s Real Estate Finance team:

• 21 real estate finance professionals

• Over £6.5 billion sterling equivalent (approx. £4.7 billion and €2.2 billion) invested since 2009 in over 80 transactions across 10 countries in Europe

• Over 70% of M&G loans originated with borrowers directly

• Invest on behalf of over 70 investors globally in five commingled funds and eight segregated mandates

Source: M&G Investments as at 31 March 2017. Number of employees as at 12 January 2017

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For investment professionals, Institutional Investors, and Professional Investors only. Not for onward distribution. No other persons should rely on any information contained within.

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. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and you should ensure you understand the risk profile of the products or services you plan to purchase.

This document is issued by M&G Investment Management Limited. 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. Reference in this document to individual companies is included solely for the purpose of illustration and should not be construed as a recommendation to buy or sell the same.

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 936683 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. 56536 / SEP 2017 / IM774 EDUCATIONAL_HK

Contact

www.mandg.hk

Marcel de Bruijckere +65 6349 9009 marcel.de.bruijckere@mandg.com