2020 continues to be a challenging year. The investment outlook remains cloudy, as many economies have started to recover only slowly from the economic paralysis caused by the COVID-19 epidemic. Nevertheless, stock markets have rebounded sharply, driven by massive fiscal and monetary stimulus. Equity valuation levels have reached record highs, offering only limited upside potential for investors. At the same time, traditional fixed income areas remain unattractive, given the persisting low interest rate environment. Therefore, investors continue to explore new, innovative investment opportunities that offer more attractive risk-adjusted returns.

For conservative investors, private debt remains the asset class with the most attractive risk-reward profile. The direct lending area continues to benefit from the lack of funding by traditional banks to small and medium-sized enterprises. Numerous private lending funds have been launched in the aftermath of the Great Financial Crisis to fill the funding vacuum that was caused by stricter banking regulations. The growth of the private debt area has been spectacular. According to the leading alternative information provider Preqin, assets under management have grown consistently each year and, as of June 2019, reached a record of $812bn. The BlackRock Investment Institute estimates annual gross returns of 10.4% for the direct lending asset class in the next seven year, based on data as of 13 April, 2020. Only private equity has a higher expected return (10.8% per year). However, while private debt returns are relatively stable, private equity interquartile returns range from -1.8% to +24.8%, which implies a completely different risk profile.

Private debt includes a wide range of strategies with different risk-return characteristics. Some areas, such as venture debt, subordinated loans and mezzanine are not without risk. Conservative investors should focus on opportunities in the senior-secured lending area where they benefit from the strongest protection. The UK real estate bridge lending market is one of the most attractive niches that perfectly illustrates the attractiveness of private lending. Real estate bridge loans are short-term loans, fully backed by the value of a property. The UK is by far the biggest bridging market in Europe with a well-established legal framework and strong lender protection. According to the Association of Short Term Lenders (ASTL), the UK bridging loan books grew 19.7% to GBP 4.5 billion in 2019, which is more than the combined market size of all other European countries. At the same time, the UK bridging market is less crowded than the US market, offering higher yields and lower default rates. Average monthly interest rates are close to 0.9% per month, or more than 11% annualized, a sharp contrast to the Bank of England’s key bank rate that was reduced to a record low of 0.1% during the COVID-19 epidemic.

What are the reasons real estate developers are willing to pay such high rates? The short answer is the lack of funding by traditional banks. It is not surprising that in a recently conducted survey by Ernst & Young, the key consideration when choosing a bridge lender, is the speed of execution. The most important purpose for bridge loans are refurbishment projects with a relatively short duration. Another reason is an acquisition bridge to complete the necessary down payment within 30 days after purchasing a property at an auction. Developers might also seek bridge funding to start a development before replacing the bridge loan with a cheaper construction loan or mortgage by a bank. Sometimes, a partial construction or a certain level of pre-sales help to get a more favorable long-term bank loan, which more than offsets the temporary high rates for a bridge.

Investors also benefit from the short duration of the bridge loans with clear exit strategies. The average loan duration is only 9 to 12 months. More importantly, bridge loans are fully secured by the value of the property that exceeds the loan size significantly. In the UK, the average loan-to-value (LTV) is around 60%. This means that even if property prices drop 40%, there would be no impairment. Importantly, investors can count on best-in-class valuation companies that ensure a fair, current appraisal of the properties. Interestingly, property prices, especially on the low- and middle-class residential segments outside London, have remained very stable, even after Brexit and during the Covid-19 recession. This is mainly because of the severe housing deficit that has existed for many years, as the supply of new housing has not met the rising demand from population growth.

The Great Financial Crisis was the main catalyst for the rise of the private debt market, as private investors and fund managers started to seize the opportunity to replace traditional banks in providing the much-needed funding to small and medium-sized enterprises. The impressive growth of the UK bridging market is an excellent example of this trend. Investors can take advantage of this attractive investment opportunity via the Katch Real Estate Lending Fund that offers high transparency and superior risk-adjusted returns, compared to other asset classes.

Column by Pascal Rohner, CIO at Katch Investments