The past decade of private debt’s development as an asset class has been characterised by its increasing diversity, particularly in Europe’s relatively immature market. Prior to the global financial crisis of 2008-09, private debt in Europe was fairly narrow, usually focused on specialisms such as mezzanine or bridge finance. But the unique conditions created in the wake of the financial crisis have allowed private debt providers to step into territory formerly dominated by the banks and to widen their offerings to enable borrowers to completely bypass bank finance entirely. In no area is this more evident than the real estate market.
In Europe, real estate debt funds were largely unheard of prior to 2009, with banks by far the dominant players in the market. But real estate lending, which was hugely overheated in the early years of the 21st century, was one of the crucial triggers of the crisis. Banks have been forced to scale back their lending activity to try to repair their balance sheets and haven’t returned to the real estate debt market in any meaningful way.
A Bank of England financial stability report from June 2017 shows overall loan-to-value of commercial real estate loans made by banks was just 57.5 percent in the second half of 2016, compared with an average of 78.3 percent in 2006. Other Bank of England figures show commercial real estate as a percentage of banks’ balance sheets has fallen from 12 percent at the time of the financial crisis to less than 7 percent today. Despite improving financial circumstances for banks, it seems that real estate debt may be permanently off the menu.
Filling the gaps
So what has happened since the global financial crisis to plug the huge and growing funding gap the banks have left behind?
One player that has been in the European real estate debt market “before it began” is ICG-Longbow, which formed in 2006 and, at that time, was focused on acquiring real estate loans for its first fund.
Martin Wheeler, founder and co-head of real estate UK at ICG-Longbow, recalls: “We started before the crisis, and about five players entered the market alongside us between 2009 and 2011. Back then, we focused on tackling the market in a straightforward way by filling in the mezzanine gap created as the banks pulled away from the market.”
The withdrawal of the banks from lending in the immediate aftermath of the crisis is well documented, and tough new rules implemented by European regulators since then mean it was always considered unlikely that they would return in the same way as before. Indeed, with some commercial property deals being as much as 90 percent levered in the years immediately preceding the crisis, few would want that sort of risky lending to come back. But in commercial real estate, the real surprise has been that the initial withdrawal has continued.
“Banks have withdrawn more than was envisaged,” says Wheeler. “They don’t do transitional deals anymore and there are parts of the mid-market that are no longer covered either, so now the funding gap is about filling the whole gap for certain types of deals.”
This continued retrenchment by banks has meant real estate debt funds have been able to expand beyond simply servicing the risk spaces banks did not want, such as mezzanine, and allowed them to offer senior debt and whole-loan services, the real estate equivalent of unitranche.
As this issue of PDI went to press, one of the world’s largest asset managers, Amundi, launched a €500 million senior debt fund for commercial real estate focused on senior lending in club deals and syndication. Direct mandates from limited partners are also homing in on senior real estate debt, with TH Real Estate taking on a mandate last year from the Korean Teachers’ Credit Union to invest in senior opportunities across the London office market. Credit funds continue to march into territory once solely the preserve of the banking industry.
Arron Taggart, loan originator at Cheyne Capital, says his firm has been through a similar evolution since the hedge fund manager entered real estate debt in 2009, moving down the capital structure over time.
“We started off investing in mortgage-backed securities, where there were a lot of forced sales and not enough capital to go around. Then, in 2012, we moved into direct lending with unitranche development capital and mezzanine.”
Adapting to change
Cheyne has adapted its own offering not just through moving down the capital structure into less risky, low-returning debt, but also by adjusting its target deal size.
“We want to move away from the crowd a little by having larger funds that target the £50 million ($67 million-€57 million)-£100 million part of the market. There are, of course, fewer deals in that space, but there is still enough to build a business around, with less competition and better counterparty quality,” he says.
Fundraising data show that real estate debt has massively increased its depth, making investment in larger deals more viable due to the amount of capital now available to non-bank lenders in the space. Analysis of PDI data shows that from 2011, fundraising expanded rapidly, as did the number of funds in the market as more players sought to get in on the action.
In 2015, Europe-focused real estate debt funds raised $9.92 billion of capital across 21 different funds, 2016 saw much less fundraising, at just $3.85 billion, but a respectable 16 funds, indicating that smaller offerings are also thriving when it comes to fundraising activity. A further twist occurred in 2017 when a significant amount of capital was raised by relatively few funds.
This also points to another key phenomenon in the market, bifurcation.
Sam Brooks, a partner and alternative funds advisor at law firm Macfarlanes, says more established players are looking towards larger deals, which creates opportunities.
“There is bifurcation in the market, which is happening across private debt more broadly, with increasing concentration among larger managers,” he says. “This is creating opportunities for smaller and more nimble managers to do something different.”
This may not purely be driven by investor demand for more diverse risk-return profiles either, with Wheeler saying that borrower needs are also a factor when deciding what strategies to offer.
“The industry always wants to look at new ways of doing things to service our borrowers’ needs, and the borrowers are looking for new solutions to finance projects. Our goal is to match the needs of the borrower with the needs of the investor.”
In line with the broader private debt market, real estate debt funds are continuing to evolve and find the “new normal” of a world that has been transformed by the global financial crisis. A decade on from that seismic event, things continue to change and banks show little sign that they will rediscover their appetite for real estate debt.
Perhaps the most interesting thing to watch in the coming years will be how the big funds diverge from the smaller players and how managers of all types cope with a turn in the credit cycle. As in other parts of private markets, we can expect a significant change in economic fortunes to separate the best prepared managers from the rest and will see this growing market begin to consolidate.