For a Few Basis Points More…

Financial markets play a key role in allocating capital in a modern economy. The theory goes that the market will seek to match the right form and cost of capital to the opportunity presented to it. Part of this process might involve distributing the different parts of the capital structure to the investors best suited to take that particular risk reward mixture. The split between debt and equity being the most obvious example of this.

In the real estate debt world the use of back leverage to enhance returns is an example of this risk distribution process and has become a distinguishing feature of many investment products that are seeking investor capital in todays market place.

Of course, at the heart of this risk distribution process is the reality that different types of investors think about risk differently and can therefore accept a different return. The question then for investors must be, am I being adequately compensated for the risk I am taking, and do I understand the risk I am taking.

In finance the use of leverage to enhance returns is certainly not a new concept, but its penetration into the European real estate debt market is relatively young. Tightening bank capital rules and higher return seeking investment capital have combined to grow its use significantly. For the leverage provider it’s a capital efficient way to deploy at scale, without having to originate and own loans directly.

For the funds employing leverage it allows them to boost returns to meet the double digit target returns they have promised their investors. For investors considering new allocations to real estate debt and the choice between levered and non levered funds, there are a number of points to consider.

• Fundamentally, is the extra return being generated by the use of leverage adequate compensation for the extra risk factors that its use brings. Whilst the different position in the capital stack is easier to observe (you are not the senior lender anymore) not all leverage is created equal, and hence we would encourage investors to ensure they understand any maturity mismatching risks, and in particular liquidity risks that may be introduced to the fund as a result of mark to market provisions and credit support given to the leverage provider.
• Pace of deployment and quantum of return is also a consideration. Funds that use leverage must originate a larger volume of loans in order to deploy their investor’s capital. Is this feasible and over what time frame? We observe that pricing competition for larger loans is intensifying as a result of the smaller number of transactions being targeted by leveraged funds.
• Does the investment manager have experience in managing leveraged strategies? Real estate is a cyclical asset and how the manager chooses to use leverage at different points in the cycle will have a meaningful impact on returns.

My fellow panellist at the Debt Funds conference in Germany, summed up the question of leverage brilliantly, by invoking those famous words… ‘The Good, The Bad and the Ugly.’, mirroring the essence of this article. Namely that it can be good or bad depending on how it is used. Investors would be well advised to consider all implications of its use in order to judge whether their investment will be good, bad or ugly!

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