Currents
summer 2012 issue
Real Estate for the RiskAverse and Yield-Hungry
Institutional Investors Are Warming to High-Yield Debt and
Other Real Estate Strategies
by alexis petrakis
A
s alternative investments continue
to gain favor with investors, com-
mercial real estate as an asset class is
estate can offer investors secure and
attractive income at a time when there’s
a dearth of such assets.
coming back into focus. Real estate’s
resiliency through the recent economic
valuable—maybe even essential—
RISK-AVERSE AND
YIELD-HUNGRY
component of institutional portfolios.
Yet despite the potential benefit and
And now today, given the current macro
multiple uses in a portfolio, many
environment that’s replete with confus-
institutions remain under-allocated
turmoil has underscored its role as a
Jack Chandler is head
of BlackRock�s Global ing cross currents, real estate is once
Real Estate business. again showing its flexibility and mettle
for investors. In particular, mezzanine
debt, global REITs, and build-to-core
strategies hold great potential.
to real estate. Maybe this reflects the
slight hangover from the global financial
crisis that has colored investor attitudes.
“On the whole investors are still exhibiting cautious attitudes,” confirms Jack
It’s easy to see why. Commercial real
Chandler, head of BlackRock’s Global
estate can help investors fill any number
Real Estate business. “Market volatility
of roles that span the risk spectrum.
and declining funded ratios steered many
Historically, prime commercial real
toward the relative safety of fixed income
estate (also known as core) has been a
assets. And within the real estate asset
favored asset class with institutional
class, investors have demonstrated
investors, especially insurance compa-
risk aversion by focusing most of their
nies and pension funds that appreciated
attention on the top tier core properties
its long-term, liability-matching attri-
that they deem the safest.”
butes. Real estate has been heralded as
a potential hedge against inflation, and
it’s clear that real estate can fill a bucket
at either end of a broader barbelling
strategy. But perhaps most compelling
of all in the current environment, real
Being both risk-averse and yield-hungry
is a tricky combination, to be certain.
Fortunately, there are ways for institutions to address this conundrum by
looking beyond the narrow realm
of equity investments in core real
opportunit y knocks
estate assets. Investors should weigh
One of the reasons why this strategy
the merits of other strategies and
is so exciting right now is the size of
approaches as they continue to fill
the opportunity at hand, as well as
out their real estate allocation.
the relative quality of the opportunity.
Mezzanine in the Middle
Mezzanine capital sits between
the first mortgage and equity.
Investors need income. Borrowers need
capital. It’s a perfect marriage. A report
Senior Debt
Risk-Adjusted Opportunities by Deutsche Bank estimates that
$900 billion of commercial real estate
in Mezzanine Debt
B Note
Opportunities in mezzanine debt—that
loans are set to mature in the US over
layer of financing sandwiched between
the next two years alone, and another
senior debt and common equity—may
$538 million of loans are maturing in
be among the most appealing commer-
Europe through the end of 2013.
Preferred Equity
Many borrowers on the hook for these
Common Equity
cial real estate opportunities in the
current low-yield environment.
maturing loans will have trouble refinancing for the full amounts, given that
yields on real estate debt typically range
they were funded in a very different
from 7% to 15%, depending on the
economic regime when underwriting
position within the capital stack and
criteria and loan-to-value ratios were
the dynamics surrounding the underly-
much more lax than today.
portfolio manager responsible for
BlackRock’s global high-yield real
estate debt investments. “But what’s
especially appealing about mezzanine
debt is the risk-adjusted nature of the
returns. The yields that investors can
capture look particularly favorable
relative to other fixed income products
like Treasuries, municipal bonds, and
high-yield corporate bonds.”
Mezzanine capital offers investors some
of the appealing characteristics of both
debt and equity investments. On one
hand, mezzanine debt is cushioned
from the first loss position of real
estate equity, yet the debt investor can
still be in a position to participate in
upside appreciation, depending on the
structure of the transaction. Upside
potential aside, mezzanine debt is
really about generating attractive and
steady income.
Mezzanine
Capital
Mezzanine Loan
Equity
“Speaking in the broadest terms, current
ing collateral,” explains Robert Karnes,
First
Mortgage
Clearly, the demand for commercial real
estate financing is ample. Yet at the same
time, traditional sources of real estate
debt, especially banks, have a diminished
appetite for lending and are shrinking
their balance sheets. Compounding
matters is the fact that the securitized
debt market is significantly less robust
than in pre-global financial crisis days.
“Who will step in to fill this lending void?”
asks Floris van Dijkum, head of Real
Estate Research and Strategy. “The
supply and demand fundamentals are
very favorable, and we believe this offers
a meaningful risk premium that reflects
the limited supply of capital as opposed
to the underlying property risk. It’s a
great time to be a lender.”
Of course mezzanine debt is not without
its risks. Investors need the ability to
gauge both economic and local market
conditions in underwriting deals. Prop-
erty fundamentals still matter in risk
getting easier to fine-tune risk and
management, and investors need to
income preferences through a
be able to dig into the operating details
portfolio of actively managed REITs.”
on a deal-by-deal basis. The market
is relatively opaque and not terribly
efficient in terms of information and
capital flow. And deals must be negotiated and structured with care since
there is counterparty risk associated
with enforcing loan covenants.
Although REIT investors enjoy the liquidity
and transparency that come with being
traded publicly, not to mention real-time
pricing and tax efficiency, that doesn’t
mean there isn’t an information arbitrage
opportunity. Conventional wisdom does
not always get it right in the short term.
“A nimble manager can expose the
Therefore, selection becomes key, and
inefficiencies and deploy capital at ideal
actively managing a portfolio of REITs
parts of the capital stack,” suggests van
offers investors a chance to harvest
Dijkum. “And depending on investor
attractive income at a time when it’s
preferences, a mezzanine debt strategy
more challenging than ever to do so.
can be tilted from the more risk-averse
Moreover, some closed-end funds that
targeting yields in the high single-digits
manage REIT portfolios funds can
all the way to the opportunistic end of
employ leverage to further boost
the spectrum seeking returns in the
potential income and returns, though
mid-to-high teens.”
this also raises the risk profile.
Of course, investors need to be patient
Diversit y and Income
Via Global REITs
For quick and effective deployment
of real estate capital, investors might
consider looking at listed real estate
investment trusts (REITs) and quoted
property companies. This approach
may help investors overcome the
liquidity and logistics inherent to
direct property investing.
“Global REITs offer investors an excellent
way to further diversify within a broader
real estate strategy,” says Steven Cornet,
a member of BlackRock’s real estate
equity group. “The REIT structure
continues to gain favor in Europe and
Asia, and institutions have ample
choices with regard to property type,
markets and even strategies. It’s
and willing to tolerate periods when
REITs fall out of favor and trade below
underlying net asset values, sometimes
for prolonged periods. It’s also important to note that not all strategies are
available through listed markets,
although this too is changing as REIT
structures continue gaining popularity
and have debuted in many European
and Asian markets.
Although REITs offer investors a chance
to tap alternative sources of income, any
discussion of REITs would be remiss
without mentioning that they are also a
natural fit for the beta end of the barbell.
Numerous ETFs and indexing vehicles
can help investors deploy capital quickly
and with low-cost efficiency.
Floris van Dijkum is head
of Real Estate Research
and Strategy.
mezzanine minute
n
Loan type: Mezzanine
n
Loan Size: $25 million
n
Loan Maturity: March 2015
n
Interest rate: 1M LIBOR + 700 bps
n
Current Income:
In an environment skewed toward risk
off strong, steady cash flow over the
aversion, institutional investors have
long term. In reality, the investor needs
been piling into core real estate assets
to have access to research and a much
since the financial crisis. While the
broader set of capabilities to deliver on
liquidity crunch and general chaos in
such a strategy. Although challenging,
the financial markets punished prime
this should not be ruled out, especially
property valuations in late 2008 and early if the intent is to build a portfolio of
7.2% (based
2009, the rebound was sharp. As a result,
on 1M LIBOR
the opportunity to acquire such assets
of 0.23%)
n
If You Build It, They Will Come Class A asset that has the ability to kick
at reasonable discounts was fleeting.
Anticipated Yield-
Office properties in prime submar-
to-Maturity: 9.1%
kets—London’s West End and midtown
(based on forward
Manhattan, as just two examples—have
1M LIBOR curve
returned to their pre-crisis level. High
Q3, 2011)
444 Madison Ave.
New York
Street retail and well-leased multifamily
properties benefitting from favorable
demographics are also generating a great
deal of interest and multiple bids.
long-term income generating assets.
BlackRock recently helped an institutional client execute just such a strategy
with the acquisition of 17 parcels totaling
2.7 acres and approximately 52,200
square feet of buildings in Hollywood,
California. The acquisition was driven
by a research view that Hollywood was
a coveted residential submarket within
the Los Angeles metropolitan area,
where demand growth was favorable
“Cap rate compression for core assets
and vacancy and rental rate metrics
partly reflects the expected growth in
were providing a strong tailwind.
net operating income, as well as the
availability of financing,” van Dijkum
explains. “As a result, investors have
been willing to accept yields as low as
5% to 6%. But at current valuations,
some investors are exploring other
ways to get their hands on these
attractive assets.”
For larger investors with separate
account mandates, a more eclectic
build-to-core strategy may be appropriate. The concept is simple enough in
theory: acquire land or a well-locatedbut-flawed asset and develop, improve
or otherwise re-tenant it to create a
The strategy entailed selling off the
existing tenanted buildings to reduce
the land basis, while securing entitlements to construct 214 units of
Class A apartments, along with more
than 13,000 square feet of ground floor
retail and a 260-space parking garage.
That’s no small task, and as with any
development it’s not necessarily for
the timid. But for larger institutional
investors with a longer-term vision for
growing a portfolio of high-quality core
assets, this remains a viable option
worth considering. ♦
Currents
Published by BlackRock, Inc.
Please direct story ideas,
comments and questions to:
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