This article was sponsored by AQ Partners.
Q. How is the changing role of the banking industry creating opportunities for alternative lenders?
Cristina García-Peri: The crisis took its toll on the regulatory restrictions towards capital adequacy and risk management, as well as in terms of the restructuring and concentration process in several European markets. This has been particularly the case in Iberia, where we have gone from almost 60 bank entities actively competing in the market before 2008, with an extremely deep and wide syndication market for corporate and real estate financings, to an industry where only a handful of entities are truly active in lending in the real estate business.
Additionally, banks have been forced to operate in a low interest rate environment for quite some years now, which is eroding profitability. All these are factors that play a role in the way they approach the lending business in general, and real estate lending is also part of this transformation.
This is clearly creating an opportunity for the alternative lending industry.
Daniel Herrero: Historically, it has been obvious that debt funds were poised to expand their share in the financing market in Europe in general, not only in real estate. Simply by looking at more developed markets like the US and the alternative lending share in that market, it has always been something to expect. But the restructuring of the banking system in Iberia and other European economies during the crisis has accelerated that process in several aspects.
Jaime Martínez: There are structural changes that are here to stay, like the concentration among banks, reducing significantly the supply, and also the overall change in risk appetite and policies. The change in risk appetite creates opportunities: it opens the door to mezzanine investors to complement bank debt in the acquisitions of assets where banks are less comfortable; and it creates an opportunity for bridge lenders to cover the gap that banks leave when they are unable to provide financing for development or certain transitional situations.
When you look at the non-structural aspects, there is one area in Iberia worth mentioning, which is the acquisition of debt portfolios from bank balance sheets by large distressed investors. These portfolios involve the acquisition of assets or debt refinancing which cannot be done through traditional bank debt. Traditional banks do not finance the acquisition of this type of asset, nor do they refinance NPL loans. And this is clearly an opportunity for mid-size debt funds that will be around for the foreseeable future.
Q. Then, is there competition between banks and real estate debt funds?
JM: Generally speaking, there isn’t. Alternative lenders like AQ Partners will usually cover a financing gap in transitional situations: in situations where bank financing is not available, because the asset, sponsor or project does not fulfil bank requirements. Additionally, you will see us complementing bank financing with subordinated debt.
DH: Our intention is not to compete against banks, but rather co-operate with them and complement their business.
CGP: I would add that there is a space with lower risk returns where insurers or pension funds can provide financing, which will compete with that of bank lenders, offering longer tenors with non-amortising structures and more flexible guarantees.
Q. With increasing competition among debt funds, how do you think investors can differentiate themselves?
CGP: There are over a dozen debt funds active in the Iberian market. However, very few of these have local teams with origination and execution capacity, and an even lower number of those have the real estate underwriting expertise that is needed.
We are talking about being familiar with market practices. Things as simple as being able to structure transactions with documentation in Spanish or Portuguese can be a differentiating factor that facilitates significantly your ability to source and execute deals.
Additionally, many of the larger international investors that look at Iberia as part of a pan-European strategy do not look at tickets below €50 million, and the reality is that some of the most attractive risk-return opportunities will occur within tickets below that level.
JM: Worth noting is that many investors have statutory or self-imposed restrictions with regards to the structure of the financings they can pursue. For example, several international investors can only operate with certain governing law standards, or certain types of securities but not others.
DH: I think it is important to be flexible and able to execute transactions with the security and the structures that fit best for each situation. Sometimes a first mortgage over an asset is the right thing, and sometimes it is not; or there is an alternative that works equally well and fits better the needs or the interests of the borrower, and the flexibility of the lender could be the difference between reaching an agreement for a deal or not.
Q. Do returns have anything to do with how competitive debt funds are?
JM: Not necessarily. Lenders with lower return thresholds can afford to provide financings at lower costs, and this makes their life easier. But you always have to look at the risk of the transaction and ensure you are not mispricing it.
CGP: But the reality is that if you look at the institutions that generally make up the LP base of real estate debt funds and the return requirements that they have, you can quickly infer that real estate debt fund managers need to focus mainly on opportunities with net IRRs in at least the high single digits. In addition, we are beginning to see investors that can include leverage in their loan portfolios. This creates an artificially higher return level, which allows them to provide their LPs with mid-double-digit net returns, while they lend at mid-to-high single digits.
DH: In any case, leaving loan portfolio leverage aside, I think it is generally quite difficult to see alternative financing for value-add, restructuring or opportunistic projects at costs below the high-single-digit level. The ability to differentiate yourself with creativity and flexibility and the ability to source opportunistic off-market transactions are far more critical when it comes to maximising returns.
Q. What do you think about the cycle at the moment and the prospects it creates for alternative lenders?
CGP: We have seen five years since the last cycle turn in 2014. In that period, valuations have seen a significant increase across asset classes, so we are cautious. We believe real estate direct lending is always a good complement to any real estate portfolio as it sits at a lower risk level of the balance sheet, and in this part of the cycle, direct lending can actually offer better risk adjusted returns than equity. n