The future of real estate fund financing

Fund managers, within the real estate space, are shifting the way in which they approach financing by looking beyond funding at the asset level. I'm seeing more use of subscription and NAV financing at the fund level to complement their equity capital. 

Property funds appear to be rapidly recognising that a fund level borrowing solution can be faster, cheaper and with less ‘strings attached’ to put in place versus traditional property level debt. This fund level debt can be used as a long term alternative, or more typically, as a short or medium term bridge to raising the property level debt. A lot of this sophistication is spilling over from private equity. In the PE space, funds are more familiar with subscription financing and that’s changing the conversation in parallel sectors like real estate and infrastructure funds.

For those in real estate, there’s strong demand for new funding solutions. Funds are under pressure from both competitors and investors looking for strong returns, which is reflected in their borrowing needs.

 Every stage of the fund lifecycle brings its own financing requirements which require us to think creatively to build the right solutions.

Early in the fund it’s typically tools like subscription financing, these are already widely used in the private equity space and are now spreading into real estate funds.

Later in the fund life, or for funds without investor commitments, the facilities might be with recourse to the portfolio of equity that fund owns. Putting in place the right facility at the fund level will often be more flexible, cheaper and require less admin than lending against individual assets.

These changes are exciting for us as a team. Every stage of the fund lifecycle brings its own financing requirements which require us to think creatively to build the right solutions.

I'm seeing a lot of demand from real estate funds for flexibility. We’re reaching the end of the current property cycle so, while people are still investing, they’re more selective in the funding solutions they choose and loan-to-cost ratios are dropping.

The flip side of the ageing property cycle is that more funding is going into income-producing assets. Purpose-built student accommodation and, to a lesser extent, build-to-rent, are the two where we’re seeing most activity here. Student accommodation is seeing lower exposure to Brexit-induced volatility – EU citizens make up only a small portion of the UK student population. In both

asset classes, tenants are willing to spend more on rent if it means they can get a quality offering.

The other big trend we’re seeing is for more US funds to enter the UK market. The weak pound is making assets in the UK more appealing to overseas investors. These firms are also seeing higher competition and lower yields in their home market, along with less room for asset appreciation, so they’re looking for quality investments on this side of the Atlantic. This is part of the bigger trend for a growing ‘Living’ asset class that has already emerged in the US and is now growing in the UK.

What’s not changing are the goals for funds. They’re looking to build scale: a student accommodation portfolio with 10,000 beds, for example. Portfolios of this size come with a pricing premium when funds look to sell, so there’s a real incentive to pursue this level of scale. As a result, many are taking another look at their borrowing requirements, both at the fund level and against individual assets.

In the past decade, we’ve seen a lot of change in hedging strategies for real estate investors. Pre GFC, and when the curve was inverted, the sector saw some very long-term hedging – a strategy which has unsurprisingly fallen out of favour. I’ve seen a lot of firms since going the other way and not hedging at all, but there’s plenty of room to find a middle ground between those two extremes and manage risk/reward more prudently. Property, as a lower yielding asset class, is particularly susceptible to interest rate rises as just small moves can hugely impact an investment’s internal rate of return.

We’re certainly seeing a lot of interest in hedging exchange rate exposures. Many real estate funds have a global footprint, so they’ll be investing in assets in multiple currencies. At the fund level, that often means earning profits in a different currency to that which dividends – and management fees – might be paid. For equity, currency fluctuations can therefore create undesirable net investment exposures as well as periodic cash flow exposures.

Given that cash movements impact IRR so dramatically I’m seeing more firms looking to hedge at the fund level where we can typically be more flexible than with hedges traded down at the SPV level – with appropriate credit structuring we can reduce the need for cash settlement on IR hedge unwinds or FX hedge rollovers when funds are buying and selling assets.

The final area we’re seeing interest is around inflation. With many leasing agreements exposed to changes in inflation, there’s a real demand to understand value that hedging inflation exposures can bring to equity.

For real estate funds, even where leverage is limited, hedging is incredibly important. This is especially true for firms focused on protecting cash yields. For my team, that gives us an opportunity to truly engage with clients and occasionally look beyond hedging just interest rates and FX out to commodities or even simply taking deposits. With Investec’s flexible and innovative approach to client exposures we can have a much stronger conversation about risk management for these firms.