European Real Estate Debt: Why Now?
Against a backdrop of decades-high inflation and rising rates, real estate debt is worth considering—especially given the potential for attractive returns, duration risk mitigation, and diversification.
Highlights:
- While real estate debt is not a substitute for real estate equity investments, it is highly complementary.
- There are a number of reasons to increase an allocation to real estate debt, including the potential for attractive returns.
- Floating-rate real estate loans mitigate duration risk—a perennial challenge for fixed income investors.
- On a risk-adjusted basis, real estate debt and equity assets have historically outperformed the major publicly traded asset classes.
- European property debt, in particular, offers powerful diversification benefits for investors.
- Increasing regulation and a pandemic-induced property-refinancing backlog have created a considerable opportunity for non-bank lenders.
Real Estate Debt & Equity: A Complementary Mix
Strategic property investors—those looking to maximize risk-adjusted returns in the long term—can benefit from an allocation to both debt and equity real estate through the cycle. In particular, fine-tuning investors’ preferred blend, depending on the phase of the property cycle, might be worth considering. For instance, real estate debt exposure can be built up through the top of the cycle, forgoing frothy peak equity returns but limiting the inevitable downside to come. Meanwhile, exposure to real estate equity can be increased during the recovery phase at the bottom of the cycle, when return expectations are rising.
The optimal property debt allocation will depend on the individual investor’s investment objectives including target returns and risk tolerance. The basic principles of investment diversification suggest a minimum and therefore meaningful property debt allocation for the “average” investor to begin at around 15%–20%. That could rise to over 50% for the most risk intolerant long-term capital sources. Real estate debt is not a substitute for real estate equity investments—rather, it is highly complementary.
The Inflationary Environment
High inflation will likely continue in the coming months. Against this backdrop, the U.S. Federal Reserve (Fed), which has set the global interest rate climate for capital markets, is currently in an aggressive tightening phase to attempt to wrestle inflation back under control—almost irrespective of the consequences for growth, in our view. Risks of a global recession are therefore rising, but especially in Europe because of the continent’s additional high dependency on energy from Russia. While the European Central Bank’s (ECB) monetary tightening has lagged behind the Fed, the central bank recently ended an eight-year era of negative interest rates at their July 2022 meeting, hiking for the first time in over a decade and increasing their deposit rate by 50 basis points (bps) to 0 bps.
