When the Alternative Credit Council recently predicted that the global private debt market will be worth in excess of $1 trillion by the end of 2020, some might have called the claim a little audacious.
Only seven years ago, less than £1 in every £10 lent in the UK came from an alternative lender.
Today, alternative lenders account for more than a quarter of the total UK lending market. It isn’t a fad, it is the new status quo.
A summer survey of over 550 European institutional investors said that private debt would be one of their favoured investment asset classes in the next three years. The conditions for alternative credit’s growth in the UK property market specifically couldn’t have been better.
It has come at a time when property finance from mainstream or high street banks is severely restricted. The banks that provided loans before 2008 have only returned to narrow parts of the property finance market, and with less than convincing enthusiasm. Cue thousands of creditworthy small and medium-sized property investment and development companies struggling to source the finance they need to finance their assets and grow their businesses.
Add to that the sheer volume of outstanding loans that are due to mature and will require refinancing.
Take, for instance, the commercial real estate market. In Europe alone, there are an estimated €500bn of loans due to refinance in the next four years. Without the traditional lenders there to offer new loans, alternative lenders have a big gap to fill.
But it’s the surge in interest from a widening global pool of investors that’s putting this alternative investment option so firmly on the map.
The appetite from institutions like pension funds and insurers has ramped up exponentially. One of the UK’s largest pension funds, RPMI Railpen, announced this summer that it is boosting its direct lending allocation (on behalf of its 350,000 UK railway industry pension holders) to as much as £4bn.
The constant hunt for yield is, unsurprisingly, a predominant driver to private debt. In this lower-for-longer interest rate environment, the search for income is a perennial preoccupation for investors. Plus, with equities at high valuations, new equity issues underperforming, and bond yields hitting historic lows, private debt has become the light at the end of the tunnel for yield-hungry allocators.
But what, beyond yield, is putting property debt investment so firmly on the radar of our pension funds and insurers?
Simply put, property equity investments are not as attractive as they once were. We’re observing a marked shift among investors from direct property equity investments to the private debt route.
As this extended economic cycle continues, the capacity for growth in property investments is tailing off. Furthermore, with yields in most sectors at all-time lows and rental growth prospects for the residential and commercial sectors also being relatively limited (according to the Office for National Statistics, rents grew by just 1.3 per cent in the year to October, while CBRE reports that commercial rents are flat), the outlook for returns from property is modest.
When these are compared with the returns generated by property debt positions, property debt investment looks really attractive on a risk-adjusted basis.
Pension funds and insurers are also influenced by how short-term property debt investing can be, adding greater liquidity to their portfolios.
Your traditional direct property equity position might last as long as a decade to defend against cyclical downturns in capital values and to offset high transaction costs. Even in institutional property investment funds, the minimum hold will be for no less than seven years. But shorter-term direct lending permits more flexibility; investors recoup their capital and recycle it sooner as opportunities and markets evolve.
Perhaps the most impactful — and exciting — driver is what institutional investors like about direct lenders’ evolving models.
The faceless bank mortgage or the transactional approach of a hedge fund or private equity lender are fast losing favour. Direct lenders and property finance borrowers are striking up a new, more sustainable way of working: a more specialist, relationship-managed experience that complements both parties’ goals.
Borrowers get finance on terms that work for them, and direct lenders achieve astonishingly high repeat borrower rates and lower than average arrears rates: testaments to a formula of lending that really works, and provides confident signals to investors that the credit quality is high.
However, we’re not there yet. Dutch non-bank lenders have been shaking up their mortgage market for years, and the Netherlands is home to myriad tales of how direct lending has transformed institutional investing.
But at a time when every investment decision counts, it’s encouraging to see the diversification and ambition of UK pension managers to try the alternative. More often than not, it’s better than the norm.