The bottom of the cycle, when capital values have rebased and market recovery is evident, can be the best time to enter the real estate market as an investor. This is particularly the case for direct investors. Acquiring assets at discounts to intrinsic value that provide both attractive rental income and capital value appreciation can result in the best investment vintages.

While debt investments do not typically benefit directly from positive capital value growth in the form of enhanced returns, they benefit indirectly as this results in loan-to-value metrics (LTVs) reducing over the course of the loan. For example, Nuveen Real Estate Research analysis using CBRE Europe Prime Capital Value index shows three-year loans originated at the bottom of the cycle during the Global Financial Crisis at 70% LTV would have matured with LTVs at circa 55-60% LTV as asset values increased over that period. This is even more apparent for 70% LTV loans with five-year maturities as they will have reduced the exit LTV to close to 40%. Real estate debt investments can take advantage of this effect without paying extra for the improving return-vs-risk profile. Levered debt strategies stand out at this point in the cycle as the elevated return and risk characteristics become asymmetric over the loan term.

Explaining levered debt

Traditional real estate loan capital structures typically comprise equity and debt components. The equity component is the asset owners’ contribution, while the debt component is the loan secured against the asset. Levered debt structures are different. The equity component remains the asset owner’s contribution, but the loan component is split into back-leverage (which is a loan from a bank to the debt fund) and fund equity (which is debt fund cash). The debt fund providing the loan is now no longer financing the entire loan from its own cash. It uses an additional bank loan as contribution to the loan it provides to the asset owner. This frees up capital for the debt fund to hold more loans and enhances returns as the debt fund is capturing the same level of loan interest payments (minus finance costs payable on the bank loan) with less debt fund cash.

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