Real estate debt: Balancing risk and reward

Bank deleveraging has created a $163 billion funding gap for commercial real estate in Europe, according to Zug-headquartered asset management firm Partners Group in a report published last month, citing DTZ data.

Alternative lenders eager to fill that gap are offering an increasingly attractive alternative to core real estate equity funds given yield compression, particularly if they are prepared to look beyond prime real estate deals.

“These real estate debt opportunities can provide investors with attractive core-like returns while providing an attractive position in the capital structure with adequate downside protection provided by equity cushions,” the report said.

A new lending landscape

The manner in which European real estate assets are financed is changing significantly, Partners believes, with a significant decline in total capital available occurring as a result of banks reducing exposure. Banks currently represent 94 percent of commercial real estate lending in Europe, meaning any retrenchment on their part will have a huge impact on overall capital provision.

Banks have become more parochial, focusing on their domestic markets or even withdrawing completely. Partners cites the example of Hypothekenbank Frankfurt in Germany, Société Générale in France, of Yorkshire Bank and Clydesadale in the UK.

This has led to the creation of the by now well-established funding gap, into which new lenders have moved. These include insurers such as AXA, Allianz and Aviva from Europe, and US groups such as TIAA CREF and Mass Mutual (via Cornerstone). Real estate debt funds have also become meaningful players.

Non-traditional lenders are forecast to grow market share in the UK from 7 percent to 15 percent over the next three years according to DTZ predictions cited by Partners. In Europe, the forecast shift is from 2 percent to 7 percent. In the US, such lenders account for 23 percent of overall CRE lending.

Lending criteria remain very selective, Partners said, with lenders focusing almost exclusively on prime properties and / or those backed by strong sponsors. There has been very limited appetite for construction loans, it added.

High loan spreads from European banks due to increased regulatory costs and higher bank funding costs, although the latter are highly divergent based on the bank’s country of domicile, how well capitalised it is, and its size and level of diversification. Partners compared the cost of buying CDS on Intesa, Italy’s largest bank, with that of Monte dei Paschi di Siena, a much smaller regional bank, and found the difference to be 260 bps (150 for Intesa, 360 bps for Monte dei Paschi, according to DTZ).

A question of fundamentals

Against a backdrop of improving fundamentals in the European real estate market on both the public and private sides, investors have seen yields on core properties in ‘safe haven’ markets compress significantly since 2010 and are now close to pre-crisis levels. The flight to the perceived quality of core markets has driven yields to near historic lows, tightening 100-150 basis points since the trough, the report said.
Partners cites the examples of 431 Oxford Street, London – sold recently for a reported net 2.9 percent yield – or 1 Rue de Ventadour in Paris, which is understood to have sold for a net initial yield of just 3.8 percent.

“The increased competition is likely to put prime returns under pressure trending towards the long term averages of 6-8 percent per annum,” the report said.

Outside of Europe’s core markets, yields have largely remained flat or grown since the financial crisis.

Margins on core properties have tightened due to increased competition, with anecdotal evidence pointing to margins of just 150-250 bps. Maximum loan-to-value ratios for core properties have also fallen to between 60 and 65 percent, with few lenders willing to go to 75 percent for core assets.

Prime properties yields are also highly correlated to interest rate changes, the report argues, whereas secondary markets are better insulated. A meaningful increase in interest rates – a question of “when”, not “if”, the report points out – would rapidly result in covenant breaches in prime deals.

A typical senior loan with a loan-to-value covenant of 75 percent on a prime asset would breach its loan-to-value covenant with just a 100 basis point rise in the interest rate, Partners said. “Conversely, a senior loan on a secondary asset does not breach the same covenant even well after a 300 basis point expansion in the interest rate”, the report added.

Mezzanine financings for prime assets are more sensitive to changes in interest rates, Partners points out, although mezzanine components in secondary property deals are, as with senior deals, more robust.

“A mezzanine loan on a prime asset breaches an LTV covenant of 85 percent with only a 50 basis point increase in interest rates, while a mezzanine loan on an asset in secondary locations does not breach the same covenant until after a 225 basis point expansion,” Partners said.

Partners’ research shows then that lending to prime assets in ‘safe haven’ markets is actually potentially more risky than it appears, given the correlation with interest rates which are likely to rise at some stage (albeit not perhaps in the immediate future). Investors in assets that are less affected by interest rate rises – such as secondary properties away from core markets – will then be in a better position as rates tick upwards. The firm is practising what it preaches too: it recently funded a senior loan at 65 percent LTV secured against a portfolio of secondary retail properties in the UK. The debt yield is 14 percent, which allows the portfolio to absorb “very significant increases in yields before the debt is impaired”, Partners said.

“In today’s environment, debt offers a safer part of capital structure which can be acquired at lower loan-to-values determined on a lower value base. Income can be secured through higher spreads available for both senior and mezzanine debt. Based on our analysis, strategies that are capable of capitalising on this opportunity through investments in floating-rate senior secured debt with strong covenants as well as mezzanine debt financing for secondary markets in Europe will be capable of achieving core-like returns for investors, albeit in more secure positions in the capital structure,” it concluded.