Unlocking Opportunities: Private Real Estate Debt for LGPS

As LGPS pools seek to optimise returns while managing risk for partner funds, private real estate debt offers a compelling blend of predictable income, capital stability, and diversification. The retreat of traditional banks from segments of the lending market has expanded opportunities for institutional investors, allowing LGPS funds to access a broader range of risk-return profiles.

With valuations stabilising and interest rates supporting attractive yields, now is a timely moment to consider or expand allocations. Crucially, this aligns with the goals of the Mansion House Compact, which encourages greater investment in productive finance—including private credit and real assets—to support long-term returns and UK economic growth.

As pools seek to optimize returns without taking excessive risk, private real estate debt represents a prudent allocation that balances predictable income, stability of returns, and diversification benefits. Investment opportunities in real estate have diversified as traditional banks have retreated from certain segments of the lending market. This shift provides investors with a broader range of risk return exposures. We see now as an opportune moment to open or add to an allocation in real estate debt as valuations have stabilised and interest rates are supportive.

Private real estate debt as a source of diversification for LGPS Portfolios

Private real estate debt has emerged as a potentially strategic asset class for LGPS investors, offering a compelling combination of predictable income with inflation sensitivity (important in the context of high inflation and uncapped liabilities), as well as stability of returns, and diversification benefits. Within the spectrum of real estate investment opportunities, private real estate debt provides a distinctive profile, less correlated with traditional equity and fixed income whilst providing predictable cash flows. The cash flows are derived from the underlying, robustly structured loans, often secured by high-quality real estate assets, providing a consistent and reliable source of income. This income stream is also attractive in comparison to corporate bonds, with private real estate senior loan margins averaging 305 basis points (bps) in 2024 whilst the spread on BBB-rated corporate bonds was 160 bps¹.

Moreover, the relatively lower volatility of private real estate debt, compared with equity investments, enables LGPS pools to manage downside risks effectively for their partner clients. Figure 1 demonstrates how the addition of real estate debt to an LGPS portfolio improves the efficient frontier with a sharpe ratio second only to European Infrastructure Equity.

These characteristics demonstrate how private real estate debt can play a positive role by aligning with an LGPS pools’ maturing private markets program and aid partner funds in their portfolio objectives.

In Figure 1, we have constructed a portfolio and efficient frontier (light blue line) consisting of the average LGPS asset allocation. On a separate frontier we have included a maximum 10% allocation to European real estate debt. The inclusion of this asset results in an expanded frontier (dark blue line) which improves the risk adjusted return potential of the overall portfolio. All private markets assets are capped to 5% above their current allocation.

Market dynamics

The European real estate market has undergone significant transformation in recent years, shaped by evolving macroeconomic conditions, regulatory developments, and changing investor preferences. More recently, post-pandemic stabilisation in valuations and lower interest rates in the Eurozone should encourage both lending activity and increase liquidity in the market.

Specifically lower interest rates have increased the capitalisation rate spread – a useful measure when comparing investment opportunities across different regions. Europe’s capitalisation rate (the ratio of net operating income to the property’s purchase price) has recovered and, with reduced benchmark interest rates, the spread is expanding, shown in Figure 2. This indicates a higher risk return profile in comparison to other regions where the spread is pointing to a more modest investment outlook.

In approaching how to invest in private real estate debt, the rise of alternative lenders has provided a variety of debt instruments to the LGPS, from senior whole loans to mezzanine debt, allowing pools and funds to tailor their exposure. The dynamic of having alternative lenders has allowed for more flexible negotiations and customised transactions that better meet diverse market conditions.

Alternative lenders and institutional investors can align their objectives by structuring deals to accommodate individual risk tolerances. The alignment with LGPS pools goals also allow for an environment of stable, predictable income with manageable risk and creates a synergy with alternative lenders to create a more balanced environment for real estate overall.

Asset types and their appeal to LGPS pools and their partner funds

As mentioned above, within private real estate debt a wide spectrum of instruments are available, each with distinct characteristics and risk-return profiles. Senior loans are typically the most secure form of financing, backed by the underlying real estate collateral and carrying first priority in the event of default. This makes senior loans an attractive option for those seeking stable, lower-risk returns.

Mezzanine debt, by contrast, sits between senior debt and equity in the capital stack. While it entails greater risk, it also offers higher yields, reflecting the subordinate position in repayment priority. This instrument appeals to LGPS pools seeking enhanced income without direct exposure to equity, providing a middle ground between security and return potential. Whole loans provide a higher loan-to-value (LTV) ratio than senior loans but still have first-ranking security over the underlying assets. Whole loans are therefore expected to have higher returns though still provide a stable cash flow.

Risk management and due diligence

While private real estate debt offers many benefits to LGPS pools and clients, it also requires rigorous risk management. Because of this, investors more broadly have typically partnered with experienced asset managers and conducted thorough due diligence to mitigate these risks effectively. One area which particularly benefits from a partnership approach is the loan structuring itself, including covenants and prepayment penalties, as expertise here has a direct bearing on return profiles.

In structuring, the critical aspect lies in understanding what is available across various markets and identifying what should be avoided. Without experience enforcing loans in different jurisdictions, it remains difficult to anticipate potential pitfalls and therefore challenging to establish absolute requirements. One illustrative example is Italy, where past challenges have highlighted potential complications, leading to the adoption of a structure offering alternative enforcement routes, including a contractual mechanism to directly manage the underlying properties.

Experience in both the financing and management of real estate is fundamental in examining each borrower’s credit worthiness, including evaluating the loan-to-value ratio attached to the loan. Local expertise is also crucial to assess the quality of the collateral. The sourcing of many real estate loans is reliant on local expertise covering not just location, condition and idiosyncratic market fundamentals but also an in-depth understanding of regional laws and lease structuring. An on-the-ground presence is arguably key for value preservation.

A typical lender may prioritise the credit metrics of a loan, and while these are significant, it must always be remembered that the loan is secured by a property regardless of what the credit metrics might indicate. Repayment depends on the liquidity and marketability of the asset when the time for sale arises. As the LGPS market well knows, local market dynamics cannot be adequately assessed from a distance, in several instances initial reviews of loans with strong credit metrics have been followed by feedback from local teams indicating a lack of buyers for specific lot size in a particular location thus raising concerns about a successful exit. Having direct engagement with the market is therefore fundamental for maximising the chances of a favourable outcome.

Outlook and strategic considerations

Looking ahead, the European private real estate market is poised for continued evolution. Alternative lenders are likely to expand their presence, providing innovative financing structures and increasingly flexible solutions that mirror developments in the US market. One potential example of this is the use of back leverage, taking on additional debt to finance further investment, which is more widely used in the US.

Reflecting on the potential size of opportunities within the European real estate debt market, the European market is relatively small compared to that of the US. Alternative lenders in Europe have 10% of market share compared to in the US where the proportion is over 40%. This highlights the considerable potential for further expansion of alternative lenders within the European market which has an estimated size of €2.0tr^.2.

Conclusion

European private real estate debt represents a compelling investment opportunity for LGPS Pools and their partner funds, in a world where predictable income is required to satisfy cashflow needs, stable returns, and portfolio diversification to allow potential to protect hard won funding levels. By understanding the evolving market dynamics, leveraging new regulatory frameworks, and applying robust risk management, LGPS Funds can in the process enhance their cashflow generation to pay pensioners and generate attractive risk-adjusted returns for members. As the market continues to evolve, LGPS pools who engage thoughtfully and strategically with the asset class are well positioned to benefit.

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