Lesley Lanefelt
Head of Nordic Investments, Velo Capital

"Value-add debt capital will play a key role in the coming years"

Our Head of Nordics at Velo Capital just had a column published in Real Estate Capital Europe. In the column, she challenges the perception that 'value-add' debt funds are an expensive source of capital, arguing that a more holistic view, considering the entire capital structure, of financing is needed. Read the full piece below.
Lesley Lanefelt
Head of Nordic Investments, Velo Capital
Thought Leadership piece
It is not uncommon to hear that ‘value-add’ debt funds providing higher levels of leverage are a relatively expensive source of capital – and are even unaffordable for low-yielding assets. This view is usually based on a comparison of debt fund coupons and the debt yield, which can be viewed as the maximum cost of debt an asset can service at a given leverage point. If the debt coupon is higher than the debt yield, the debt must be too expensive. Case closed? Not exactly.
The comparison is logical, if not overly simplistic. While debt yield is certainly an important metric, what value-add debt fund financing can offer is much more nuanced.
There are instances where the coupon is higher than the debt yield of an underlying asset, implying that it will not be possible to fully service the interest. But a more thoughtful approach demonstrates viability. Interest shortfalls can be solved with payment-in-kind or accrued interest, or look-back fees at exit, for example. Asset quality, location, usage, tenant credit worthiness, sponsorship and sustainability credentials all come into play. Value-add debt funds are not unequivocally bound by minimum interest coverage ratio considerations and can therefore be more creative – without compromising on discipline or risk management.
We recently received a request for a 50–65 percent loan-to-value mezzanine loan against a low-yielding residential asset in Stockholm, with low leverage senior bank financing in place. While predominantly paid current, we were prepared to accept a PIK element based on the asset’s quality, location, and sustainability credentials, as well as the local supply and demand characteristics, which supported near zero vacancy risk and solid rental growth. Given the potential for rents to increase, odds are we would be naturally de-levered on such an asset – but if not, the indicated leverage still represented an acceptable risk given the overall resilience of the investment. Bottom line, this asset could ‘afford’ mezzanine financing, even if not all interest would be paid current.
Debt fund financing is relevant for a broader spectrum of projects today than ever before, from top-up mezzanine facilities behind low leverage senior and bridge-to-a-better-market (re)financings to transitional and development projects. Across all these investments, we find sponsors focus disproportionately on the coupon as the barometer of affordability when in fact a more holistic view is required. Financing costs need to be considered in the context of the entire capital structure, looking at the weighted average cost of capital and how this increases or decreases depending on the proportion attributed to senior, mezzanine and equity funding.
While the cost of capital for whole and mezzanine loans is higher than traditional senior financing, these loans typically provide 15–25 percent more leverage resulting in a more cost-effective capital structure. Sponsors that best utilise what debt funds offer are the ones that understand that total leverage and the relative cost of capital are the main drivers of returns, not absolute coupon.
When it comes to the green transition, understanding how to best use value-add debt fund financing quickly becomes mission critical. Despite the pressure to enhance the sustainability credentials of existing stock there is not nearly enough capital active in this space. Brown-to-green projects are part of our core investment strategy because we think the combination of value uplift and a more liquid, de-risked end product in short supply represents an attractive investment proposition. Structuring these projects, however, takes specialist credit and underwriting knowledge.
As Basel IV takes effect traditional bank financing will only become more restricted in Europe, in particular in the value-add space. While not a replacement for bank financing, value-add debt funds are important in preserving well-functioning, liquid real estate markets. The first step to best utilising value-add debt fund financing, however, is to understand the accretive nature of the capital they provide.
/Lesley Lanefelt, Head of Nordic Investments, Velo Capital – one of Urban Partners' three investment strategies