Navigating real estate debt funds

This article was co-written by Gaultier Saussine, Partner, KPMG Luxembourg.

In the ever-shifting landscape of investment opportunities, debt investments stand out as versatile instruments catering to a myriad of investors. Amid soaring inflation and interest rates, some asset managers are considering leveraging the distressed sales of real estate assets by acquiring debt, rather than directly investing in these assets.

Additionally, given the ever-changing nature of real estate lending, opportunities may arise around refinancing existing debts, with traditional banks less eager to risk exposure during tumultuous times.

In our recent article about private debt, we noted this situation has given rise to one of the most extraordinary times for private credit investors across our 20-year track record. It’s phenomenal to have nearly all credit structures at floating rate in a climbing rate environment, as long as the right businesses are lent to. 

Real estate debt funds typically invest in loans backed by real estate properties, providing a steady income stream through interest payments. Generally, Those mortgage-backed securities or loans secured by a Luxembourg law share pledge acquired by the debt fund or in which the debt fund participates are held through Luxembourg taxable companies, such as Luxembourg standard companies or securization vehicles. These Luxembourg investment vehicles afterwards can potentially enforce the mortgage or share pledge and hold the real estate assets or shares without any additional tay leakage in Luxembourg. This allows for a tax neutral investment structure.

Real estate debt funds are attractive propositions for investors seeking stable returns with lower volatility. They also offer more security than equity investments, as lenders often have priority in case of default. They’re a way of taking part in the real estate market while minimizing some of the risks of property ownership.

However, these funds can be sensitive to interest rate changes. When interest rates rise — which seems less likely at this point of the cycle — borrowing costs for real estate projects can follow suit, affecting these investments’ profitability. Investors should be aware of these funds’ exposure to interest rate fluctuations and consider how this may affect their overall performance.

On the other hand, real estate debt funds have many positive features. For starters, the investments are subordinated and offer a regular interest yield. And as a backup in a worst-case scenario, such as default or financial difficulties, these funds can take over and manage the underlying assets, thereby creating additional value.

Investing in debt funds is an appealing strategy if you’re seeking higher yields, as investments through debt can match private equity returns while outperforming real estate property results. Typically, the loan-to-value (LTV) ratio will have a significant cushion, while you additionally benefit from a larger yield from the interests paid.

In recent years, we’ve seen significant bond issuances by various real-estate players in Europe to invest in pan-European markets.

These public debt instruments are structured to receive the loan receivables directly. This means the public entities are regulated by various authorities and must extensively report on their key transactions to the market. However, it’s important to note they generally provide lower yields than private debt instruments.

This isn’t to say private market players don’t accurately report to the market — they do. However, they’re usually unregulated, and their yields are often higher. 

Finding the right property company to invest in is essential to a real estate asset manager’s success — after all, they’re investing in companies also managed by another property manager. Striking the right balance between relying on these companies and own involvement is therefore crucial. Initially, this may prove more challenging for traditional real estate players, but we’re here to help and advise you accordingly.

Commercial real estate (CRE) offers attractive opportunities for real estate debt funds, with investments profiles that differ from residential properties due to longer lease terms and potential for rent increases. CRE debt funds enable investors to engage with the real estate market, capitalizing on economic cycles affecting commercial spaces, such as shifts in demand for office or logistics properties. 

While green finance is still facing hurdles to its implementation, the wide dissemination of ESG initiatives may also generate other ESG-lending opportunities for projects with mid-to-long-term environmental benefits.

New market forces are reshaping real estate finance, introducing efficiencies through blockchain, smart contracts, and data analytics. These innovations aid in faster loan processing, enhanced property management, and improved investment decision-making by analyzing market trends and identifying potential risks. As technology continues to evolve, real estate debt funds that adapt can gain a competitive advantage, ensuring better asset valuation and fund performance.

Real estate debt funds are an appealing alternative to traditional real estate funds, providing both steady returns and an additional layer of security.

Selecting the right debt fund managers is key to achieving a successful target investment strategy and a higher yield overall, which is what investors are ultimately looking for.