The opportunity in European commercial real estate debt

Transcription

1 The opportunity in European commercial real estate debt

2 Executive summary The European commercial real estate (CRE) debt market has changed dramatically since the global financial crisis of (GFC), with a combination of factors leading to a reduction of bank capital available for borrowers. This in turn has provided an opportunity for institutional, non-bank capital to enter the market in scale to meet borrower demand. Today, non-bank capital comprises 6.5% (c. 117 billion) of the European CRE debt market, compared to only 1% (c. 14 billion) in 28. Interestingly, when compared to market composition in Asia and North America, where non-bank capital accounts for around 2% of the CRE debt market, it is clear that there remains significant scope for increased institutional investment in European CRE debt. In the aftermath of the GFC, CRE debt providers risk aversion and return requirements increased dramatically as capital was withdrawn from the market, leading to a reduction in loan-to-value (LTV) ratios and an increase in loan margins. While the lending market has subsequently recovered, LTV levels and loan spreads remain considerably more attractive when compared to pre-gfc levels. Today s market offers an attractive investment proposition for CRE debt investment characterised by good relative value when compared to alternative investments with a similar risk profile. An investment in CRE loans can deliver stable cashflows due to its fixed income nature, while giving investors the downside buffer to prevailing asset values inherent in a debt investment and providing security backed by physical assets. This hard-asset security, coupled with bespoke, transaction-specific, documentation, and loan covenants that act as early warning signs in the event of poor real estate performance, can help mitigate capital loss. An investment in CRE debt can also offer potential capital efficiencies for investors subject to Solvency II. CRE debt investment offers compelling features for investors in both investment grade and sub-investment grade assets. The ability to split a single CRE loan into separate senior and junior portions creates CRE debt product for both types of investor within the same transaction, and enables the optimal allocation of risk and return of the CRE whole loan. Senior, investment grade, loans currently offer margins of 2-25 basis points (bps) over a reference rate such as Libor, with junior loan margins of 8-12 bps. Platforms for investing in CRE debt can be structured in a variety of ways, with key decisions relating to how investments are sourced, whether any portion will be syndicated or held to maturity, and whether to invest in investment grade, or sub-investment grade CRE debt. M&G strongly believes that the most efficient way to optimise risk and return for investors is to directly originate whole loans with borrowers, hold these loans to maturity, and offer investors both investment grade and sub-investment grade investment participations within the same transaction. This paper explores the key features of CRE loans, the evolution of the lending market post-gfc, the reasons why the investment proposition for CRE debt is attractive today, and the advantages and disadvantages of the different options for CRE lending platforms.

3 3 Contents Commercial real estate debt explained 4 The market for European commercial real estate debt investing 6 The investment case for commercial real estate debt 8 How to invest in commercial real estate debt 9 Conclusion 1 Glossary 11

4 4 Commercial real estate debt explained Commercial real estate (CRE) debt is used to refer to private loans secured against commercial property. CRE debt can be secured against a variety of commercial property types, with common examples being offices, shopping centres, industrial and logistics units, hotels, private residential rented properties, and student accommodation. These loans are typically advanced to special purpose vehicles, which are companies that have been set up with the sole purpose of owning property and usually have no other assets or liabilities. CRE debt investments typically comprise loans as opposed to bonds. There are some key differences between loans and bonds that investors should bear in mind when making investment decisions: Collateral package Liquidity Number of investing parties Loans Bonds Conclusion Generally benefit from dedicated collateral (e.g. a first ranking mortgage on a physical property). Illiquid instruments with limited ability to trade positions in a secondary market. One or few given lack of secondary market. Often unsecured credit obligations of an issuer with no dedicated collateral. Highly liquid instruments with a large, active, secondary market. Many due to active secondary trading of bonds. In a default scenario, investors in loans benefit from specific, ring-fenced collateral, which is used to repay all secured creditors before senior unsecured creditors. Loans offer an illiquidity premium to compensate investors. The relationship between lender and borrower is far closer for loans than for bonds. Typical CRE borrowing structure The lenders will usually take out a registered mortgage over the property which gives them a first legal charge against the physical asset, ensuring that the loan ranks ahead of any other creditor of the borrowing company. Loans are typically non-recourse, which means that lenders are solely reliant on the property for both scheduled interest payments and the repayment of loan principal at maturity. Interest is paid from the rental income received by the property, and loan principal is repaid either through a refinancing or sale of the property, with no additional guarantee from, or recourse to, the ultimate sponsor of the borrowing company. Loans are often quoted as a percentage of the underlying property value, with this metric defined as the loan-to-value (LTV) ratio. The higher the LTV, the higher the risk in the loan, as the underlying property can withstand less value decline before the loan starts to incur principal losses. Interest on the loan is usually paid quarterly by the borrowing company from the rental income it receives from tenants of the property. Interest can be fixed or floating rate depending on the specifics of the loan, but floating-rate loans are generally hedged (often through an interest rate cap) to ensure that the rental streams generated by the property are able to continue to pay loan interest even in a rising reference rate environment. The ratio of net rental income (after operating expenses of the property) to interest due under the loan is called the interest coverage ratio (ICR). The higher the ICR, the more protected the loan s interest payments, which means the property can withstand larger falls in rental income before the loan defaults and interest is no longer paid in full. Figure 1: A typical CRE borrowing structure Sponsor entity Holding company Property company Property CRE loan Underwriting analysis While the LTV is the most commonly used risk metric in CRE debt investing, more sophisticated lenders will undertake a far more rigorous cashflow and market analysis, and not rely on LTV as the only measure of risk. This further analysis is crucial to understanding key transaction risks because the volatility of property value varies significantly between different assets. Commercial real estate by its nature is a cyclical asset class and therefore it is important to adjust LTVs upwards or downwards based on the expected volatility in value of the property being financed, in order to withstand changing market conditions through an economic cycle. Generally, investors value predictability of cashflow so properties that benefit from long-term, contractual income from tenants with high credit-worthiness will typically exhibit far less volatility in value than transitional assets that require reletting or capital improvement works to be undertaken. Prudent lenders will therefore undertake extensive due diligence on a property s cashflow predictability and sustainability, which includes both an analysis of any current, contracted income and importantly, the ability to replace income on an ongoing basis. Scenario analysis using bespoke, underwriting inputs can be carried out to model the CRE loan under a variety of downside scenarios, and the impact of this assessed. Consequently, an investment grade CRE loan against a headquarters building of an A-rated tenant with a 25-year lease may provide leverage up to 7% LTV, whereas an investment grade CRE loan against a hotel in a coastal resort that relies heavily on summer tourism for the majority of its income may only provide leverage up to 4% LTV.

5 5 Financial covenants The LTV and ICR ratios are examples of two key credit metrics that are not only analysed at the point of advancing the loan, but importantly are continuously monitored throughout the term of the loan, and can be tested through financial covenants. The type and level of financial covenants are set at the beginning of the transaction and serve to provide the lender with early warning signs of any deterioration of property value or income, and provide the lender with certain additional rights to ensure value protection. These covenants are tested against ongoing performance, typically by annual revaluations of the properties and quarterly cashflow statements. Importantly, financial covenants are set at levels which should allow both full interest payment and full recovery of the loan principal in the event of enforcement and sale of the property. Financial covenant packages typically include both cash sweep and default covenants. A breach of a cash sweep covenant occurs after a modest deterioration in value or income, the consequence of which is to use any cashflow after payment of interest to amortise the loan or to be held in a lender-controlled escrow account. A cash sweep covenant breach does not constitute a default of the loan. The default covenants are breached after a greater deterioration in value or income occurs, at which point the borrower usually has the right to repay enough of the loan to satisfy the covenant breach, failing which the lenders have the right to assert more control over the operations of the property or even force a sale in order to try to recover the outstanding loan balance. Figure 2 shows a typical financial covenant package for a 7% LTV CRE debt investment with a 1.45x initial ICR. Figure 2: Example of a typical financial covenant package and headroom from initial levels Typical whole loan financial covenant package Initial level Cash sweep level Default level LTV 7% 75% 8% ICR 1.45x 1.35x 1.25x Source: M&G Investments, for illustration purposes only Types of CRE debt Depending on the risk appetite and business plan of the borrower, LTV requests in the European CRE market can often be as high as 7-8%, with the borrower seeking to use leverage to amplify the equity returns for the property owner. At these LTV levels, a fall in property values in excess of 2-3% would result in capital loss for the lender, which makes the loan too high risk for a traditional investment grade credit investor, who in today s market will typically lend up to 6-65% LTV. However, this depends heavily on the specific characteristics of the underlying property as discussed previously. The market solves this problem by topping up the senior loan with a subordinated junior loan to reach the total financing need. This can be done either with separate senior and junior loans provided by separate parties, or instead by one party providing a single, whole loan for the full 7-8% LTV, which is then subdivided into separate senior and junior tranches. The senior loan created by this tranching process has a first ranking claim against the property and its cashflows, and the junior loan (also referred to as a mezzanine loan) has a second ranking charge against both the property and its cashflows after the senior loan. The junior loan, which takes the incremental LTV portion is a higher risk investment than the senior, investment grade loan, as it can withstand less deterioration of market value and income, and therefore pays a higher return. Junior loans provide additional debt from the LTV point at which the senior loan stops (the attachment point ) to the LTV point of the entire debt financing package (the detachment point ). The difference between the attachment and detachment point is known as the thickness of the junior tranche, and assuming the same detachment point, thicker tranches are able to withstand greater falls in market values before the entire junior principal is lost. In Figure 3, we have presented an illustrative example of a typical whole loan CRE debt financing structure and summarised (in a worked example) how a single whole loan can be split into a separate senior and junior tranches with the same combined return, but each with different risk and return profiles in order to meet the borrower s LTV requirement. Figure 3: An illustrative example of a typical whole loan CRE debt financing structure Equity Equity Whole loan 75 million notional 4% coupon 75% LTV Junior loan 75% LTV 15 million notional 8% coupon 6% LTV Senior loan 6 million notional 3% coupon Annual interest: Whole loan: 75 million x 4% = 3. million Source: M&G Investments, for illustration purposes only Senior loan: 6 million x 3% = 1.8 million Junior loan: 15 million x 8% = 1.2 million Total: = 3. million

6 6 The market for European CRE debt investing The changing landscape for non-bank lenders Since the onset of the GFC, the European CRE debt market has undergone fundamental changes, with banks facing increased capital requirements under new regulations such as Basel III. While banks remain the dominant players in CRE lending, holding 7% of outstanding CRE debt at the end of 215 (see Figure 4), the ongoing disintermediation of the market has seen non-bank lenders increasingly looking to fill the void left by banks that have either reduced their activities or withdrawn from the market completely. At the end of 215, non-bank lenders in Europe had grown to represent 6.5% ( 117 billion) of the CRE debt market, compared to only 1% ( 14 billion) in 28. Despite this rapid expansion, European non-bank lenders still account for a significantly lower market share compared to their counterparts in Asia and North America, which held approximately 2% of CRE loans in their markets at the end of 215, suggesting there remains space for non-bank lenders to continue to grow within Europe. Figure 4: Non-bank lenders are becoming an increasingly large portion of the CRE loan market The change in composition of global CRE markets 28 vs North America Europe Asia Pacific Banks CMBS Non-bank Bonds Source: Cushman & Wakefield December 215. CMBS = commercial mortgage-backed securities Current conditions ripe for investment While lending criteria has been tightened since the GFC, demand for CRE debt has remained strong. This has created opportunities for alternative lenders to source investments offering attractive risk-return profiles. As one of Europe s core markets, the UK benefits from strong real estate fundamentals and a lender-friendly legal framework. In 215, UK commercial property lending hit a six-year high, up 19% year on year, according to findings from De Montfort University. Importantly, a quarter of this lending was financed by non-bank lenders compared to no meaningful participation between 27 and 211 (see Figure 5). There has been a marked shift from the lending landscape prior to the GFC, when lending criteria were more lax; LTV ratios were typically high, margins low, and property valuations at peak levels. By contrast, market dynamics at present are generally characterised by more conservative valuations with CRE debt offering higher returns at lower LTV levels than before the crisis. Figure 5: Non-bank lenders now a larger portion of the UK CRE debt origination market Composition of UK CRE debt origination market % % 23% 25% 25% 18% 85% % Source: De Montfort University Mid-Year 216 Commercial Property Lending Report While the sharp pullback in LTV ratios reflected a broader trend of post-crisis deleveraging and de-risking, loan margins tend to vary depending on the supply of available capital and perceived credit risk of individual investments. Therefore, as banks reduced lending activity during the crisis, margins rose to compensate for higher credit risk and lower overall availability of debt capital. The market appears to have reached a point in the cycle where credit standards have stabilised at new normal levels, with LTVs considerably lower and margins considerably higher than pre-crisis levels. In an historical context, CRE lending currently offers significantly improved relative value than at any stage during the ten-year period leading up to the GFC. As Figure 6 shows, in the UK, average senior CRE debt margins have stabilised around 2-25 bps, almost double their pre-crisis levels, while LTV ratios remain significantly below the levels seen previously. Figure 6: Higher CRE debt returns at lower risk levels than pre-gfc UK senior CRE debt LTV by property type LTV 85% 8% 75% 7% 65% 6% 55% 75% UK senior CRE debt margin by property type Margin (bps) % 82% H1 216 Banks Non-bank H1 16 Prime office Prime retail Secondary office Secondary retail H1 16 Prime office Prime retail Secondary office Secondary retail Source: De Montfort University Mid-Year 216 Commercial Property Lending Report

7 7 The picture is similar throughout the rest of Europe LTV levels are still low in an historical context and far below the peak seen in 27. Further, overall lending volumes remain below pre-crisis levels and the opportunity for non-bank lenders remains strong as traditional bank lenders have less capacity to refinance maturing loans. Importantly, the increase in bank regulation post-gfc means it is unlikely that banks lending criteria will return to pre-crisis levels as initiatives, such as Basel III, make it far more capital-intensive for banks to provide high LTV loans. Capturing the investment opportunity Europe s CRE debt market presents a compelling opportunity for investors as there is a significant requirement for CRE debt finance in the market, and alternative lenders, such as asset managers, are in a good position to capture these opportunities. The two users of CRE debt finance can be categorised as: i) purchasers of commercial real estate requiring acquisition finance; and ii) existing owners of commercial real estate looking to replace existing financing. The amount of new debt issued for acquisition financing has increased substantially in recent years due to the higher turnover of the investment market and the greater use of debt (on average) per transaction. As Figure 7 shows, the proportion of CRE acquisitions financed by debt has steadily grown since the GFC, with CBRE, a leading commercial property and real estate services advisory company, estimating that 46% of 254 billion of European CRE investment in 216 was financed by debt. Assuming this reliance on debt finance continues, the market opportunity going forward should remain compelling. In addition to new acquisition financing, lenders can also take advantage of the opportunity to refinance existing debt. As shown in Figure 8, approximately 52 billion of CRE debt in Europe is expected to mature, and therefore need refinancing, in the next three years. As CRE loans in Europe typically have a term between three and seven years, borrowers would need to refinance loans on a rolling basis should they wish to retain ownership of the properties. Therefore we expect a significant portion of debt advanced during 217 to be added to and increase the debt maturity profile for 22 / 224. Figure 7: Debt has played an increasing role in CRE acquisition financing since 29 European CRE acquisitions and proportion funded by debt billion % 57% 58% 61% Amount of debt used to finance CRE acquisitions ( billion) Value of CRE acquisitions ( billion) % of acquisition volume debt financed (RHS) Source: CBRE European Commercial Real Estate Finance 217 Update 64% 66% 73% 49% 37% 37% 37% Figure 8: A healthy pipeline of potential deals to be refinanced over the coming years Maturity profile of European CRE loans ( billion) billion % 4% 44% 47% 46% % of debt used in CRE acquisitions RoE Iberia France Germany UK Source: CBRE European Commercial Real Estate Finance 217 Update. RoE = Rest of Europe

8 8 The investment case for CRE debt In our opinion, CRE debt investments provide a number of compelling investment features and we believe there is a strong case to include an allocation to CRE debt as part of a wider fixed income portfolio. In particular, investors allocating to CRE debt benefit from the following attractive investment characteristics: 1) Strong relative value when compared to other investments with similar risk profiles 2) Stable cashflows for institutional investors seeking regular income 3) Security package of dedicated, hard-asset, collateral 4) Bespoke transaction documentation with a deal-by-deal financial covenant package to provide early alerts for investors 5) More efficient workout process for dealing with troubled loans compared with corporate bonds 6) Potential for improved capital efficiency for insurance companies under Solvency II vs. other core fixed income assets Strong relative value: For both senior and junior CRE debt investors, the relative value proposition is attractive. Senior CRE debt investments, when compared to corporate bonds with a similar credit rating, have consistently offered increased returns over the past five years, as evidenced in Figures 9 and 1. This increase in returns is primarily due to the illiquidity premium for holding a CRE debt investment, and compensates the investor for the risk of not being able to quickly sell the position in a secondary market. For institutional investors looking to hold investments to maturity, and not trade positions in a secondary market, it can provide an attractive increase to returns. Junior CRE debt returns are especially attractive in flat or falling markets when compared to levered equity CRE returns, such as value-add CRE equity and opportunistic CRE equity returns, due to the fixed nature of junior loan returns within a range of property value changes (see Figure 11). Stable cashflows: CRE debt is a fixed income investment benefiting from a pre-determined schedule of interest and principal payments, which is attractive for investors looking for steady cashflow. Nevertheless, borrowers always have the right to repay their loan at any time, so to mitigate this risk of prepayment, loans often benefit from prepayment penalties in the event the borrower decides to repay the loan early. The prepayment penalties can vary from a fixed percentage of the loan amount, which usually declines the longer the loan is outstanding, to full make whole / spens protection, whereby the borrower must pay the difference between the outstanding loan notional and the present value of the remaining loan cashflows at the prevailing government bond yield, subject to a floor of zero. Security against dedicated collateral: The recovery of a CRE loan is dependent on the value of ring-fenced, physical property, which is unlike corporate bonds, where recovery is generally more dependent on the management of a business as a going-concern. Importantly, as CRE debt investments are loans, not bonds, they benefit from the security, and other investment characteristics of a loan outlined previously. Bespoke transaction documentation and covenant package: The terms of any particular CRE loan are usually heavily negotiated between borrower and lender. CRE debt is a private asset class, and while standardised industry documentation is encouraged and regularly used, the key contractual terms of each deal are customised to ensure the investment reflects the specific risks of the underlying Figure 9: UK senior CRE debt investments offer higher returns than corporate bonds UK senior CRE loan margins vs. corporate bond spreads Bps Bps % 15% 1% 5% % -5% -1% -15% -2% H1 216 Senior CRE debt margin (all sector average) A rated corporate debt spread BBB rated corporate spread Source: De Montfort University Mid-Year 216 Commercial Property Lending Report (Senior CRE debt margin), BofA Merrill Lynch (BBB and A rated GBP corporate 3-5 year asset swap spread) Figure 1: UK senior CRE debt premium UK senior CRE loan spread premium vs. corporate bonds Potential gross IRR H1 216 Spread premium* vs A corporate debt Spread premium* vs BBB corporate debt Source: BofA Merrill Lynch (BBB and A rated corporate 3-5 year asset swap spread) *UK senior CRE debt spread premium calculated as the difference between the equally weighted average of CRE debt margins from the De Montfort University report and the BofA Merrill Lynch 3-5 year BBB and A rated GBP corporate asset swap spreads Figure 11: Junior CRE debt can outperform equity in flat and falling markets Returns on junior CRE debt and select equity strategies in a range of market conditions -25% -2% -15% -1% -5% % 5% 1% 15% 2% Mezzanine Value-add equity Opportunistic equity Change in property value during hold period Source: M&G Investments, for illustrative purposes only. IRR = internal rate of return

9 9 property and the business plan of the borrower. Part of the bilateral negotiations will focus on the type, and level, of financial covenants that will be included in the documentation. More efficient workout process when dealing with troubled loans: When compared to a listed corporate bond, which will often be held by a significant number of different investors, the fact that CRE loans are typically held by one or few investors means that CRE lenders can negotiate directly with the borrower. This should lead to a more streamlined workout process in the event of a loan default. Capital efficiency under Solvency II: Insurance companies using a standard model can potentially benefit from the hard asset collateral under the CRE loan to attract a reduced capital charge compared to alternative fixed income investments. Insurance companies using an internal model can potentially use a manager rating of the CRE loan to assess capital requirements. In addition, bespoke reporting and specific portfolio scenario analysis can be provided to meet regulatory obligations. How to invest in CRE debt In today s environment, an investment manager can employ a variety of strategies to source CRE debt opportunities. Some managers favour a comprehensive approach with in-house origination, research, structuring, execution, and monitoring teams that deal directly with borrowers and therefore remove the requirement for intermediaries. Other managers use a less resource-intensive, syndication-based model, purchasing loans from banks once the terms have already been negotiated and the loan is in place. Once the opportunity is sourced, managers can subdivide the whole loan into senior and junior tranches themselves, each with different risk and return profiles, in order to most efficiently allocate risk to investors. These separate tranches can either be sold to third parties, or retained by a different pool of investors with the same manager. In M&G s experience, the most effective way to optimise relative value for investors is to use a comprehensive, direct origination approach, with the separate senior and junior tranches being retained by different pools of investors. The advantages and disadvantages of the different strategies are outlined below. Origination vs. secondary purchase: While a direct origination approach is more time and resource-intensive than purchasing a secondary position, it allows the lender to create a direct relationship with the borrower and importantly ensures full manager oversight and input into loan structuring and transaction documentation. Further, a direct origination strategy allows the manager to set the price of the loan directly with the borrower instead of taking the return on the investment set by the syndicating bank. Investors are also able to retain any origination fees paid by the borrower rather than these being taken by the intermediary bank. Whole loan manager vs. dedicated senior or junior loan manager: The senior and junior tranches in a CRE whole loan are each typically sized to appeal to the risk tolerance of the different end-investors in each tranche. While a manager may only invest in either senior or junior tranches, we believe the ability to fund a whole loan is a clear differentiating factor when sourcing investments. In our experience, borrowers prefer to deal with a single party rather than having to manage the increased execution risk inherent in dealing with the multiple parties required to obtain separate senior and junior loans. A manager only investing in senior or junior loans may miss out on a large part of the borrower market, thereby limiting investment opportunities. A whole loan strategy can also provide investors additional value by providing access to both better quality properties and potentially greater returns from borrowers willing to pay more for reduced execution risk. As the CRE debt market has matured, we have seen more managers adopt a whole loan approach for this reason, with a range of strategies being deployed to access the whole loan borrower market, as discussed next. Hold to maturity vs. syndicate vs. fund leverage: Assuming that managers decide that CRE whole loans provide the best relative value lending opportunities, there are three primary options for how managers source the capital required to advance a whole loan: 1) Hold to maturity with separate senior and junior investors this strategy offers benefits to investors because the return on each tranche is set at the point the loan is funded. It is also well-received by borrowers, who like the certainty of knowing who their counterparty is, not just initially but throughout the term of the loan. However, this strategy requires a manager who has the processes and experience to manage any potential conflicts of interests that may arise from managing multiple tranches within the same capital structure 2) Fund leverage some whole loan managers who wish to hold a loan to maturity, but who do not have end-investors for both senior and junior tranches, take out fund leverage in order to increase returns. While this avoids any potential conflicts of interest, this strategy introduces mark-to-market risk 3) Senior syndication a strategy that relies on selling tranches of a loan to third parties after the investment has been made also reduces any potential conflicts of interest, but instead takes on syndication risk, which can result in significantly lower-than-expected returns for the retained tranche if the syndication assumptions made by the manager are incorrect Explained: Fund leverage Fund leverage refers to a credit facility advanced by a commercial bank to a CRE loan fund, and which is secured against the investments held by the fund. This credit facility is priced below the interest rate of the individual CRE whole loans, thereby providing the investors with an enhanced rate of return more akin to a junior CRE loan investment. The commercial bank requires a minimum value buffer between the bank s own appraisal of the value of the fund s CRE loans and the outstanding balance of the credit facility. This creates mark-to-market risk, whereby investors in the fund might be obliged to repay the credit facility earlier than anticipated creating two potential issues: 1) If investors in the fund advance additional capital to repay the credit facility, the realised returns on the investment will be lower than initially expected 2) If there are no available investor commitments to repay the credit facility, the manager may be forced to quickly sell illiquid CRE loans in the secondary market, which may lead to significant losses in such a fire sale scenario

10 1 The worked example below further explores the sensitivity of returns on the junior tranche to the size and price of the senior tranche under a syndication strategy. In-depth: Risks in a senior syndication strategy A CRE debt manager makes a 7% LTV whole loan at 265 bps margin, with the intention of holding the junior tranche and syndicating the senior tranche The underwritten margin on the junior tranche is 1,11 bps assuming the senior tranche can be sold at 65% LTV at 2 bps After funding the whole loan, if the senior tranche is syndicated at a 2 bps higher margin (22 bps) and 2% lower LTV (63%) than the underwritten levels the junior tranche margin can be reduced by 44 bps to 67 bps Syndicating at 4 bps higher margin and 5% lower LTV can reduce the junior tranche margin by 695 bps to 415 bps Junior returns under a range of senior syndication assumptions Senior LTV Senior margin (bps) % 1, % % % % % Figure 12: CRE whole loan considerations Strategy Description Advantages Disadvantages Retain senior and junior tranches Manager invests in senior and junior tranches for different investor pools Certainty of senior and junior margins from start No exposure to syndication or mark-to-market risk No conflicts of interest to manage Requires management of the potential conflicts of interest Syndicate senior tranche Manager invests in the junior tranche only, and sells the senior tranche Manager invests in the whole loan and takes out debt at fund level Syndication risk Fund leverage No conflicts of interest to manage Mark-to-market risk M&G employs a direct origination, whole loan, hold to maturity CRE debt strategy, with different loan tranches allocated to different investors. We believe this is the optimal way to provide the type of capital borrowers value in the market place, and provide different groups of investors the risk and return profile they require. In our view, this gives us a pricing advantage with borrowers, allowing us to deliver better risk-adjusted returns for our investors. Conclusion CRE debt is an alternative investment that benefits from a number of structural features that could appeal to traditional fixed income investors looking for both investment grade and sub-investment grade debt. The changing regulatory landscape and resulting reduction in bank capital available for CRE lending in Europe has created an attractive opportunity for large-scale institutional investment into the asset class. There are multiple ways in which an investor can source CRE debt opportunities and M&G strongly believe that managers who directly originate whole loans with borrowers and retain both the senior and junior tranches in-house are best placed to deliver strong relative value opportunities for their investors.

11 11 Glossary Attachment point Basel III Borrower Coupon CRE Detachment point Financial covenants Fund leverage ICR Junior / Mezzanine loan LTV Opportunistic CRE equity Margin / Spread Mark-to-market Senior loan Special purpose vehicles Sponsor Syndication Tranching Value-add CRE equity Whole loan The LTV at the first Euro advanced under a loan. For example, a 6-75% LTV mezzanine loan will have an attachment point of 6% The third Basel Accord, a global, voluntary regulatory framework on bank capital adequacy, stress-testing, and market liquidity risk The company borrowing money under the loan The running quarterly interest paid on the loan. Comprises the reference rate (Euribor or Libor for floating-rate loans) plus the margin Commercial real estate The LTV at the last Euro advanced under a loan. For example, a 6-75% LTV mezzanine loan will have a detachment point of 75% Pre-determined metrics, such as LTV and ICR, that are monitored for compliance on a quarterly basis and provide the lenders with additional control rights if levels are breached A loan taken out at fund level, secured against the assets of the fund Interest coverage ratio, being the ratio of the net rental income of the property to loan interest A higher LTV loan, taking incremental risk behind the senior loan, with second ranking claim against the property and its cashflows Loan-to-value, being the ratio of the outstanding loan balance to the property value as determined in the most recent valuation An investment strategy targeting underperforming or undermanaged assets, or ad-hoc investment opportunities that offer the potential for high returns. This strategy typically involves the use of leverage and targets higher risk and return objectives than both a core and a value-add real estate investor The component of quarterly interest, which in addition to the reference rate (Euribor or Libor for floating-rate loans) makes up the loan coupon The interim valuation of a financial instrument to reflect any change from book value A loan with first ranking claim against the property and its cashflows A subsidiary company with a financing structure and legal status that makes it unaffected by any potential bankruptcy of the ultimate corporate entity that owns it The ultimate owner of the borrower The selling of all or part of a loan once it has been made to the borrower The process by which a whole loan can be split into separate senior and junior tranches An investment strategy which aims to generate returns by increasing the cashflow generated by an asset. This strategy typically involves the use of leverage, and targets higher risk and return objectives than a core real estate investor A single, higher LTV loan, which is often subdivided into separate senior and junior tranches

12 M&G and real estate debt M&G was one of the early movers in real estate debt after the GFC, and key members have been investing together since the team s inception. M&G has raised capital across both senior and junior debt strategies. Key figures from M&G s Real Estate Finance team: 2 real estate finance professionals Over US$7.7 billion (approx. 4.6 billion and 2.2 billion) invested since 29 in over 7 transactions across 1 countries in Europe Over 7% of M&G loans originated with borrowers directly Invest on behalf of over 7 investors globally across commingled funds and segregated mandates Source: M&G Investments as at 3 September 216. Total invested amount as at 1 November 216. Number of employees as at 12 January 217 Contact Real Estate Finance Investor Relations team: Huaiyuan Lu +44 () huaiyuan.lu@mandg.co.uk Hong Kong distribution team: Marcel de Bruijckere marcel.de.bruijckere@mandg.com institutional.clients@mandg.co.uk For Professional Investors only. Not for onward distribution. No other persons should rely on any information contained within. The distribution of this document does not constitute an offer or solicitation. Past performance is not a guide to future performance. The value of investments can fall as well as rise. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and you should ensure you understand the risk profile of the products or services you plan to purchase. This document is issued by M&G Investment Management Limited. The services and products provided by M&G Investment Management Limited are available only to investors who come within the category of the Professional Client as defined in the Financial Conduct Authority s Handbook. They are not available to individual investors, who should not rely on this communication. Information given in this document has been obtained from, or based upon, sources believed by us to be reliable and accurate although M&G does not accept liability for the accuracy of the contents. M&G does not offer investment advice or make recommendations regarding investments. Opinions are subject to change without notice. Reference in this document to individual companies is included solely for the purpose of illustration and should not be construed as a recommendation to buy or sell the same. M&G Investments is a business name of M&G Investment Management Limited and is used by other companies within the Prudential Group. M&G Investment Management Limited is registered in England and Wales under number with its registered office at Laurence Pountney Hill, London EC4R HH. M&G Investment Management Limited is authorised and regulated by the Financial Conduct Authority / MAR 217 / 1239 (773MC) HONG KONG