Real estate debt versus equity: stick or twist?

As European real estate enters into a recovery phase, there is growing curiosity about what this means for real estate debt. David Renshaw, Manging Director and Co-Head of European Real Estate Debt Strategies recently spoke with IPE Real Assets about the continuing demand for debt and observed that the impact of US tariffs on global markets is a clear sign that macro volatility isn’t letting up anytime soon.

While debt can be a good place to hide during market downturns, when the market recovers, rising asset values benefit equity investors. As the European property market reaches the tail end of its value correction and a new real estate cycle approaches, investors should, in theory, start moving away from debt to favour more traditional real estate equity investments that provide the benefits of capital gain as well as income returns. But are they doing so?

“I don’t believe investors are adjusting their allocations,” says Dale Lattanzio, managing partner of DRC Savills Investment Management, which recently closed a new European whole-loan fund.“The defensive characteristics of commercial real estate debt – for example, equity cushion, covenant protection – remain highly valued by investors in fluctuating markets, where equity returns are less certain.”

Other institutional debt fund managers agree. Gregor Bamert, head of real estate debt at Aviva Investors, says he is seeing “increasing investor interest in real estate debt as an attractive diversifier to other areas of private credit”. Dan Riches, head of real estate finance at M&G, says his firm is “reporting interest from across the world” for its debt products.

M&G was one of the first asset managers to set up a real estate debt business back in 2009 to complement its property equity investments. Since then, the asset class has experienced explosive growth, driven by several factors, including the search for higher returns in a low interest-rate environment – with the added benefit of asset-backed downside protection – and general retrenchment by banks due to stricter regulations.

“The consistent message I am hearing from investors today,” says Riches, “is that they now recognise real estate debt as a separate asset class in its own right, and they all see real estate debt as an asset that complements real estate equity structures. So, there has been a real shift in perception over the past decade whereby real estate debt has become part of investors’ broader real estate allocations.”

As such, real estate debt is expected to continue to play a growing role in investors’ portfolio allocations and even more so against a backdrop of market volatility and lingering uncertainty.
Confidence returning

“Confidence is returning to the equity market with many investors calling the bottom of the real estate cycle, but ‘tariff-gate’ and the impact on global markets demonstrates that macro volatility shows no signs of slowing down,” says David Renshaw, co-head of Fiera Real Estate Debt Strategies. “With this in mind, investors will continue to look for diversification strategies providing income and, crucially, security across the real estate capital stack.”

But where are returns today for real estate debt? Asset managers seem to agree that, despite interest rates trending downward, investing in debt still provides appealing risk-adjusted returns compared with other fixed-income strategies, private credit or real estate equity investments. “Risk-adjusted returns for debt have expanded,” says Martin Farinola, head of real estate debt strategies at Delancey, a UK real estate fund manager that entered the sector in 2021. “Margins for some asset classes remain sticky, leverage levels modest, and asset quality on pipeline deals seems to have improved.”

Cyril Hoyaux, head of real estate debt strategies at asset manager AEW, notes the asset class is now benefiting from a larger “illiquidity premium” compared with 12-18 months ago. The illiquidity premium is a key measure of the attractiveness of real estate debt as it tells investors the excess return historically provided by private markets in excess of public markets in exchange for reduced liquidity.

“Today this premium has grown wider to around 150-200bps, making investing in private real estate debt more satisfying within the fixed-income asset class,” Hoyaux explains.

The group is preparing to launch a new debt strategy, joining the ranks of Nuveen, Generali, BGO, Cheyne Capital, Schroders and DWS – to mention a few other managers currently marketing new products. “We are in the fundraising process and expect to have €1bn to deploy in the sector over the next few years, including capital we have available now from other strategies,” he says.

Decent returns
In terms of real estate debt returns, Hoyaux adds: “Typically, for a senior loan with an LTV of 60%,we would ask for a 200-250bps margin over the three-month Euribor rate, which all-in-all comes to around 450-500bps. This return can go up to 700-900bps if back-leverage is introduced, or it can even reach two digits if we extend a unitranche loan and/or add a tranche of subordinated debt. This is a very decent internal rate of return with the benefit of a 30-40% equity cushion.”

Christian Janssen, who runs Nuveen Real Estate’s debt business in Europe, expects to do morelending this year, particularly for its core-plus debt strategy. “I’ve been in the debt business for over25 years and my personal view is that the sector has seldom been this interesting from a risk-adjusted and an absolute return perspective.” he says.

Market activity will continue to be driven by loan refinancing's rather than new loans, experts say. This is largely a result of a huge funding gap emerging in loans issued over the past few years as a result of lower underlying property values and the increase in interest rates reducing the debt capacity for a given property. It was further compounded by short-term loan extensions requested by landlords to deal with market illiquidity in the recent past.

“For a loan issued in 2022, for instance, underlying property values have since come down by 20-25%, so it makes sense for the owner to refinance the loan and wait for the transactional market to recover before putting the asset back on the market,” says Riches.

He is confident that real estate debt will continue to represent a strong investment proposition, particularly in the face of increasing geopolitical risks and persisting macro uncertainty. “There is an increased perception that real estate values are at the bottom, but it remains difficult to predict with accuracy what is going to happen,” Riches says.

“Real estate transaction volumes were the lowest in a decade in 2023 and only saw a minor uptick in activity in 2024. We think the continuing low volumes of trades are driven in part by uncertainty around the potential for capital growth,” he continues.

“Senior loans provide investors with returns of 6-9% without the need for capital growth or rental growth. These returns are similar to what investors might have expected to receive historically from core equity, but in a debt strategy in which underlying property values can go down up to 40%and credit investors still sustain full returns. This makes for a very compelling investment proposition.”