Real Estate for the Risk- Averse and Yield-HungryInstitutional Investors Are Warming to High-Yield Debt and Other Real Estate Strategiesby AlExIS pEtRAkIS

As alternative investments continue

to gain favor with investors, com-

mercial real estate as an asset class is

coming back into focus. Real estate’s

resiliency through the recent economic

turmoil has underscored its role as a

valuable—maybe even essential—

component of institutional portfolios.

And now today, given the current macro

environment that’s replete with confus-

ing cross currents, real estate is once

again showing its flexibility and mettle

for investors. In particular, mezzanine

debt, global REIts, and build-to-core

strategies hold great potential.

It’s easy to see why. Commercial real

estate can help investors fill any number

of roles that span the risk spectrum.

Historically, prime commercial real

estate (also known as core) has been a

favored asset class with institutional

investors, especially insurance compa-

nies and pension funds that appreciated

its long-term, liability-matching attri-

butes. Real estate has been heralded as

a potential hedge against inflation, and

it’s clear that real estate can fill a bucket

at either end of a broader barbelling

strategy. But perhaps most compelling

of all in the current environment, real

estate can offer investors secure and

attractive income at a time when there’s

a dearth of such assets.

RISK-AVERSE AND YIELD-HUNGRYYet despite the potential benefit and

multiple uses in a portfolio, many

institutions remain under-allocated

to real estate. Maybe this reflects the

slight hangover from the global financial

crisis that has colored investor attitudes.

“On the whole investors are still exhibit-

ing cautious attitudes,” confirms Jack

Chandler, head of BlackRock’s Global

Real Estate business. “Market volatility

and declining funded ratios steered many

toward the relative safety of fixed income

assets. And within the real estate asset

class, investors have demonstrated

risk aversion by focusing most of their

attention on the top tier core properties

that they deem the safest.”

Being both risk-averse and yield-hungry

is a tricky combination, to be certain.

Fortunately, there are ways for institu-

tions to address this conundrum by

looking beyond the narrow realm

Jack Chandler is head of BlackRock�s Global Real Estate business.

CuRREntSSuMMER 2012 ISSuE

MEzzANINE IN tHE MIDDLE

Mezzanine capital sits between

the first mortgage and equity.

of equity investments in core real

estate assets. Investors should weigh

the merits of other strategies and

approaches as they continue to fill

out their real estate allocation.

RISK-ADjUStED OppORtUNItIES IN MEzzANINE DEbtOpportunities in mezzanine debt—that

layer of financing sandwiched between

senior debt and common equity—may

be among the most appealing commer-

cial real estate opportunities in the

current low-yield environment.

“Speaking in the broadest terms, current

yields on real estate debt typically range

from 7% to 15%, depending on the

position within the capital stack and

the dynamics surrounding the underly-

ing collateral,” explains Robert karnes,

portfolio manager responsible for

BlackRock’s global high-yield real

estate debt investments. “But what’s

especially appealing about mezzanine

debt is the risk-adjusted nature of the

returns. the yields that investors can

capture look particularly favorable

relative to other fixed income products

like treasuries, municipal bonds, and

high-yield corporate bonds.”

Mezzanine capital offers investors some

of the appealing characteristics of both

debt and equity investments. On one

hand, mezzanine debt is cushioned

from the first loss position of real

estate equity, yet the debt investor can

still be in a position to participate in

upside appreciation, depending on the

structure of the transaction. upside

potential aside, mezzanine debt is

really about generating attractive and

steady income.

OppORtUNItY KNOcKSOne of the reasons why this strategy

is so exciting right now is the size of

the opportunity at hand, as well as

the relative quality of the opportunity.

Investors need income. Borrowers need

capital. It’s a perfect marriage. A report

by Deutsche Bank estimates that

$900 billion of commercial real estate

loans are set to mature in the uS over

the next two years alone, and another

$538 million of loans are maturing in

Europe through the end of 2013.

Many borrowers on the hook for these

maturing loans will have trouble refi-

nancing for the full amounts, given that

they were funded in a very different

economic regime when underwriting

criteria and loan-to-value ratios were

much more lax than today.

Clearly, the demand for commercial real

estate financing is ample. Yet at the same

time, traditional sources of real estate

debt, especially banks, have a diminished

appetite for lending and are shrinking

their balance sheets. Compounding

matters is the fact that the securitized

debt market is significantly less robust

than in pre-global financial crisis days.

“Who will step in to fill this lending void?”

asks Floris van Dijkum, head of Real

Estate Research and Strategy. “the

supply and demand fundamentals are

very favorable, and we believe this offers

a meaningful risk premium that reflects

the limited supply of capital as opposed

to the underlying property risk. It’s a

great time to be a lender.”

Of course mezzanine debt is not without

its risks. Investors need the ability to

gauge both economic and local market

conditions in underwriting deals. prop-

Senior Debt

B Note

Mezzanine Loan

Preferred Equity

Common Equity

First Mortgage

Equity

Mezzanine Capital

erty fundamentals still matter in risk

management, and investors need to

be able to dig into the operating details

on a deal-by-deal basis. the market

is relatively opaque and not terribly

efficient in terms of information and

capital flow. And deals must be negoti-

ated and structured with care since

there is counterparty risk associated

with enforcing loan covenants.

“A nimble manager can expose the

inefficiencies and deploy capital at ideal

parts of the capital stack,” suggests van

Dijkum. “And depending on investor

preferences, a mezzanine debt strategy

can be tilted from the more risk-averse

targeting yields in the high single-digits

all the way to the opportunistic end of

the spectrum seeking returns in the

mid-to-high teens.”

DIVERSItY AND INcOME VIA GLObAL REItsFor quick and effective deployment

of real estate capital, investors might

consider looking at listed real estate

investment trusts (REIts) and quoted

property companies. this approach

may help investors overcome the

liquidity and logistics inherent to

direct property investing.

“Global REIts offer investors an excellent

way to further diversify within a broader

real estate strategy,” says Steven Cornet,

a member of BlackRock’s real estate

equity group. “the REIt structure

continues to gain favor in Europe and

Asia, and institutions have ample

choices with regard to property type,

markets and even strategies. It’s

getting easier to fine-tune risk and

income preferences through a

portfolio of actively managed REIts.”

Although REIt investors enjoy the liquidity

and transparency that come with being

traded publicly, not to mention real-time

pricing and tax efficiency, that doesn’t

mean there isn’t an information arbitrage

opportunity. Conventional wisdom does

not always get it right in the short term.

therefore, selection becomes key, and

actively managing a portfolio of REIts

offers investors a chance to harvest

attractive income at a time when it’s

more challenging than ever to do so.

Moreover, some closed-end funds that

manage REIt portfolios funds can

employ leverage to further boost

potential income and returns, though

this also raises the risk profile.

Of course, investors need to be patient

and willing to tolerate periods when

REIts fall out of favor and trade below

underlying net asset values, sometimes

for prolonged periods. It’s also impor-

tant to note that not all strategies are

available through listed markets,

although this too is changing as REIt

structures continue gaining popularity

and have debuted in many European

and Asian markets.

Although REIts offer investors a chance

to tap alternative sources of income, any

discussion of REIts would be remiss

without mentioning that they are also a

natural fit for the beta end of the barbell.

numerous EtFs and indexing vehicles

can help investors deploy capital quickly

and with low-cost efficiency.

Floris van Dijkum is head of Real Estate Research and Strategy.

Class A asset that has the ability to kick

off strong, steady cash flow over the

long term. In reality, the investor needs

to have access to research and a much

broader set of capabilities to deliver on

such a strategy. Although challenging,

this should not be ruled out, especially

if the intent is to build a portfolio of

long-term income generating assets.

BlackRock recently helped an institu-

tional client execute just such a strategy

with the acquisition of 17 parcels totaling

2.7 acres and approximately 52,200

square feet of buildings in Hollywood,

California. the acquisition was driven

by a research view that Hollywood was

a coveted residential submarket within

the los Angeles metropolitan area,

where demand growth was favorable

and vacancy and rental rate metrics

were providing a strong tailwind.

the strategy entailed selling off the

existing tenanted buildings to reduce

the land basis, while securing entitle-

ments to construct 214 units of

Class A apartments, along with more

than 13,000 square feet of ground floor

retail and a 260-space parking garage.

that’s no small task, and as with any

development it’s not necessarily for

the timid. But for larger institutional

investors with a longer-term vision for

growing a portfolio of high-quality core

assets, this remains a viable option

worth considering. ♦

If YOU bUILD It, tHEY WILL cOMEIn an environment skewed toward risk

aversion, institutional investors have

been piling into core real estate assets

since the financial crisis. While the

liquidity crunch and general chaos in

the financial markets punished prime

property valuations in late 2008 and early

2009, the rebound was sharp. As a result,

the opportunity to acquire such assets

at reasonable discounts was fleeting.

Office properties in prime submar-

kets—london’s West End and midtown

Manhattan, as just two examples—have

returned to their pre-crisis level. High

Street retail and well-leased multifamily

properties benefitting from favorable

demographics are also generating a great

deal of interest and multiple bids.

“Cap rate compression for core assets

partly reflects the expected growth in

net operating income, as well as the

availability of financing,” van Dijkum

explains. “As a result, investors have

been willing to accept yields as low as

5% to 6%. But at current valuations,

some investors are exploring other

ways to get their hands on these

attractive assets.”

For larger investors with separate

account mandates, a more eclectic

build-to-core strategy may be appro-

priate. the concept is simple enough in

theory: acquire land or a well-located-

but-flawed asset and develop, improve

or otherwise re-tenant it to create a

MEzzANINE MINUtE

n loan type: Mezzaninen loan Size: $25 millionn loan Maturity: March 2015n Interest rate: 1M lIBOR + 700 bpsn Current Income:

7.2% (based

on 1M lIBOR

of 0.23%)n Anticipated Yield-

to-Maturity: 9.1%

(based on forward

1M lIBOR curve

Q3, 2011)444 Madison Ave. new York

CuRREntSpublished by BlackRock, Inc.

please direct story ideas, comments and questions to: Marcia Roitberg, editor telephone 850-893-8586 Facsimile 415-618-1455 marcia.roitberg@blackrock.com

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