Defensive Senior Debt Strategies in a Zero Yield Environment

In the low yield environment investors currently face, real estate debt can provide the income that has been lost from other asset classes.

Executive Summary

The low returns world we currently live in has presented significant challenges for institutional investors. As yields on high quality sovereign and corporate bonds stay persistently low, and even negative, pension deficits are increasing, endowments are struggling and sovereign wealth funds are struggling to generate their target returns. We strongly believe that real estate debt may provide a potentially compelling solution for institutional investors looking to make new allocations under these circumstances. As we will outline, Aalto’s conservative approach seeks to mimic the risk profile of conventional investment grade securities, whilst providing a potentially superior return stream to that which investors have become accustomed to from traditional liquid investment grade bonds.

Aalto first entered the real estate debt markets in early 2010, when both the European and US markets were dislocated following the Global Financial Crisis (‘GFC’). Today, these same areas are characterised by a diverse group of lenders, including banks, asset managers and other institutional investors. There is also considerable divergence between opportunities in different geographies, and across different types of real estate assets. Across both the US and Europe, vast changes in financial regulation over the past few years are having a material impact on bank lenders’ lending appetite in the market, thus creating dispersion in certain real estate assets or market segments.

Real estate markets have broadly improved over the last 3-4 years (i.e. assets have become more expensive). At Aalto, we have responded by steadily reducing our risk appetite to help ensure that our real estate debt investments provide our investors with a margin of safety should the market environment change in coming years. In practice, this has meant focusing on defensive direct loans with lower loan-to-value ratios, strong equity sponsors and ongoing maintenance covenants. Our investment focus revolves around sourcing loans backed by quality core and core+ real estate assets, and in targeting a portfolio level average loan margin of 300-400bps over LIBOR with moderate upfront lender fees. Our lending is mainly focused on floating rate and relatively short duration opportunities for our pension fund clients and more weighted towards long-dated fixed rate loans for our insurance clients.

Key Facts

  • We believe real estate loans are attractive in the current market environment:
    • Senior loans, secured by quality real estate assets that can be underwritten in detail
    • Floating rate with short duration
    • Large market with ample potential opportunities – USD 2.9 trillion in the US and EUR 1.1 trillion in Europe1
  • Aalto’s focus is aligned with these areas:
    • Geographic focus on US, Europe and UK
    • In terms of capital structure we look for senior secured debt at 50-60% LTV
    • We lend to institutional borrowers backed by what we perceive to be high quality real estate
    • Our portfolio seeks a material yield pickup to traded corporate debt of comparable credit quality
    • The portfolio’s yield profile is complimentary with direct real estate investment

 

1. CBRE and Morgan Stanley Research.