FEATURE: Spread’em!

Seeing an opportunity created by the pullback of large banks in Europe, opportunistic-style real estate firms are becoming senior loan providers. PERE magazine, March 2012 issue

Wander into the office of virtually any private equity real estate fund manager in London for a meeting, and it won’t take long before ‘debt’ is mentioned. It is one of a million issues the modern-day fund manager has to grapple with in Europe, but it also is fairly high up the list of challenges. 

One American company with a strong Europe presence recently noted that the difficulty in financing real estate deals with an element of risk lies not in getting mezzanine debt, but in obtaining the senior debt in the first place. Indeed, for many months, there has been a better supply of mezzanine loans from alternative lenders such as M&G Investments, Pramerica Real Estate Investors and Duet Group. However, the problematic piece tends to be the first part of the loan, which can represent some 60 percent to 70 percent of the value of the property. 

Spotting this senior finance gap, experienced opportunistic real estate investors well versed in buying assets with an element of risk are now turning into senior real estate lenders. One good example would be New York’s Fortress Investment Group, which recently hired Cyril Courbage, the former London-based managing director at Deutsche Bank responsible for European commercial real estate large loan banking and nonperforming loan principal activities. The appointment of Courbage reportedly is part-and-parcel of a plan to raise a European senior debt fund. Meanwhile, Starwood Capital, another US firm that was rumoured to have courted Courbage, also reportedly is eyeing a $1 billion-plus senior debt fund. 

In Continental Europe, examples can be found as well. Just last month, it emerged that Paris-based La Française Real Estate Managers was preparing the launch a €300 million senior debt fund focusing on the French property market. The fund manager is majority owned by Crédit Mutuel Nord Europe, a retail bank that reportedly is in talks to take over a senior team specialised in debt and senior loan originations with a view to be fully operational in the second half of the year. If plans to raise a fund like this – and those of Starwood and Fortress – work out, it will equate to the opening up of a fresh source of senior property loans. 


Natale Giostra, head of UK and EMEA debt advisory at CBRE, has noticed the trend. “Lots of people are starting to talk about it, and I know that some fund managers are speaking with investors,” he says. “Some are trying to gauge the appetite of investors for putting some money into senior debt funds, and I think they will succeed.”

In speaking with one US real estate professional that has operated in Europe for an American private equity real estate firm but preferred not to be identified, it is quite apparent that there always has been a big difference between the US lending environment vis-à-vis Europe.  “The US traditionally has been financed on a senior basis through the capital markets, whereas Europe traditionally has financed itself through the bank market,” he says. “Here you have a well-told story about contraction, which is creating all sorts of opportunity for alternative lenders to come into the space.”

The reason why firms such as Fortress and Starwood have become interested is equally clear. Once lending margins – the difference between the interest the firm could charge a borrower and the prevailing rate each traditional bank borrows from each other – reach 500, 600 or even 700 basis points over that interbank rate, as they currently are in the UK for a lot of particularly non-prime assets and even some higher-quality assets, that is a big chance to make a handsome profit.

Even for London assets that are deemed to have risk attached to them, potential purchasers already are seeing lenders quoting interest rates of 8 percent to 9 percent. Those lenders are more ‘alternative-type’ real estate finance sources than traditional banks. 

According to one party interested in acquiring such London assets with a degree of risk: “I think you are going to see hedge funds and firms such as Starwood and Fortress in that lending space rather than the more crowded mezzanine market, where quite frankly, in a 2 percent lending environment, not many people want to borrow at 12 percent to 14 percent.” Most of the situations involving such mezzanine debt, he notes, tend to centre on recapitalisations where there was a need to “plug holes” in order to attract senior loans.   

In England, groups such as Fortress or Starwood effectively could operate similar to Deutsche Bank. The assumption of real estate professionals here is that such firms would underwrite a loan at around 600 or 700 basis points over the interbank rate and then finance that loan either at the fund level or on an aggregate portfolio basis. Alternatively, they might syndicate pieces of the senior loan to investors that do not possess the capability to originate loans themselves but are looking for that ‘spread’, or profit between the borrowing and lending rate.

Needless to say, when the market for financing European opportunistic deals was functioning well a few years ago, margins were closer to 200 to 250 basis points above the interbank lending rate, so it wasn’t particularly attractive to firms such as Fortress or Starwood to lend. Now, however, potential buyers are finding themselves borrowing at 700 basis points above the interbank rate because there is so little traditional funding available for higher-risk real estate assets. Loan providers that are lending on those terms could easily generate returns equivalent to the lower end of the opportunistic spectrum.

Time lag 

Given that Europe generally is seen to be at least two years behind the US in its real estate recovery, it is worth noting that Europe is just catching up with how the financing market played out across the pond. If one examines how firms such as Starwood approached the US lending market as an opportunity, one can see parallels. 

Starwood Property Trust, which Starwood Capital launched as a REIT in the US in August 2009, was originally raised to be a mezzanine fund. However, the firm discovered as it worked within the industry that the more attractive way to operate was to originate the whole loan. The company financed the senior part of the loan either through securitisation or lines of credit that were open to the wider company. 

At the moment, alternative sources of senior loans cannot come soon enough for many opportunity funds. That is because the lack of finance is causing a competitive disadvantage to them. 

PERE spoke with one London-based professional that could afford to buy assets with just equity and no debt. That buyer has noticed the absence of competing bids from opportunity funds for assets with risky elements to them. He points out that, if opportunity funds in general are struggling to finance a risk-bearing asset, why not be tempted to make loans to gain almost opportunistic-type returns from an asset-backed investment with a senior claim over the property should the borrower default.

The good news is that opportunistic fund managers looking to make direct property deals are beginning to see asset prices reduce to such a level where they can entertain financing a 7, 8 or 9 percent rate of interest from alternative sources. For example, when Lone Star Funds agreed to buy a £900 million real estate loan portfolio from Lloyds Banking Group, it reportedly agreed to a £300 million financing from Citigroup and Royal Bank of Canada priced at 600 basis points over the three-month London Interbank Offer Rate, which has been hovering around 1 percent.

Every little helps

The downward motion of prices, however, simply has not yet been of sufficient scale to offset the problem of securing debt in the first place. CBRE’s Giostra notes that deals have been financed when the underlying assets are good, but he agrees that it is not easy for those wishing to buy higher risk/reward property. “The market is polarised,” he says. “If you buy core, ‘defensive-type’ assets, then you attract lenders. If you buy tertiary properties, it is very difficult. There is almost no debt capital for this type of property.”

Of the alternative lenders, Giostra notes that insurance companies had entered the market, but he was quick to point out that, like any newcomer, they would be focusing first on the lower end of the risk spectrum. “They are not going to finance every single property, so they will be selective,” he adds.

Ric Lewis, whose firm Tristan Capital Partners co-manages the European Property Investors Special Opportunities fund, agrees that the banking market has changed. “For the first time in a bunch of years, the banks are looking and saying, ‘I want to figure out whether I want to do the deal and whether I like the sponsor.’ If they don’t like one or the other, they don’t do it,” he says. “Plus, they have changed their pricing.” 

Lewis offers the example of an empty building in Scotland with a three-year master lease. The deal went to the lender’s investment committee, where “they said: ‘Look, as a bank we have been involved with this firm eight times in the past, and it has delivered on every business plan. They think they’ve found value with the asset, so we will finance them.” 

Of course, for every firm finding some success in financing such deals, there are a whole lot that are struggling. Given that some alternative lending sources are entering the market, it means the upcoming period of time will be one to watch in European private equity real estate. 

If these alternative lending sources at around €1 billion each can really become effective in providing large amounts of capital, it is going to be a long-term positive factor. Anything that makes opportunity funds less dependent on the whims of traditional lending sources is a good thing.