Annual Review: real estate

From the United States to Europe and onto Asia the growth of real estate debt funds has seemed inexorable over the past decade and showed few signs of slowing in 2015.

Of 150 new lenders to have entered the real estate finance market over the past three years, 60 percent were non-bank – namely debt, private equity and special opportunity funds – according to Savills’ Property Financing 2015 report.

This growth is reflected in market share. In Britain, De Montfort University’s UK Commercial Property Lending Market report found that the banks’ slice of the overall market has fallen from a peak of 72 percent to 49 percent of a £165.2 billion ($239 billion; €213 billion) pie at the end of 2014. Non-bank lenders have expanded to 6.5 percent over the same period. In terms of origination, which surged 51 percent to £45.5 billion in 2014, UK banks and building societies still provide the biggest chunk (39 percent), but insurers and other non-bank lenders account for a healthy 25 percent.

In the face of aggressive competition this advance was felt to be slowing in early 2015, but received a helping hand in the second half of the year when macro headwinds started blowing.

China’s equity market volatility, fears over emerging economies’ growth and falling commodity prices, were unevenly felt within real estate financing markets, but weighed more heavily on traditional lenders.

Many of these institutions had hit their full-year lending targets by the third quarter so went “risk off” in the final quarter. This also resulted in the pressure being taken off contracting margins, albeit temporarily.

According to Cushman & Wakefield’s European Lending Trends report last month, average senior loan margins last year were 138bps in Paris, 139bps in Frankfurt – where LTV’s are typically higher than the UK – and 157bps in London, but were conservatively estimated to have moved out 25bps in the UK in Q4.

Those lending mezzanine said the shift was more dramatic, with loans written for 7 percent to 9 percent in the summer moving out by 100bps by year-end.

Clark Coffee, head of Tyndaris Real Estate, which invests in mezzanine and preferred equity in Europe, believes this could continue. “We anticipate the recent volatility in commodities and equity markets to reduce the risk appetite of traditional lenders and financial institutions in the first half of 2016. This should create new pockets of opportunity for alternative lenders such as us,” he says.

It is this higher-yielding debt space where the majority of private debt managers are targeting the best risk-adjusted returns.

Initially, due to the disruption and illiquidity in European markets, mezzanine funds were able to achieve their target returns at a very attractive risk profile. However, as liquidity returned, managers have had to become more creative in terms of how they deliver their returns.

Some have chosen to maintain their return profiles by accepting increased risk, which can come in the form of higher LTV points, more transitional collateral and/or by way of balance sheet tools, such as senior syndication and leverage. Other managers have worked to reduce investors’ return expectations and hold their risk levels neutral. This is seen as a natural progression of the mezzanine market from generalist to specialised managers, some targeting high-risk segments and others focusing on lower-risk areas of the opportunity set.

This evolution mirrors that of the private debt universe in the US, which emerged on the back of the savings and loan crisis of the 1990s.

Debt strategy specialisation, such as focusing on the private rented sector or smaller loan sizes for example, could also emerge this year, according to Nassar Hussain, founder of debt restructuring specialist and mezzanine lender, Brookland Partners.

In fact, it is already happening. Last month, M&G Investments said it was considering raising a development finance fund after investing £2.2 billion in European CRE senior and junior debt in 2015.

“If you are playing in the market today you have to be prepared to be flexible in terms of how you lend because the market is shifting,” Hussain says.

And investors are willing to continue to support managers demanding a wider remit judging by the capital raises in 2015 and those expected this year.


Despite rapid progress, the European market is still some way off the more balanced landscape prevalent in the US, where just under half of all real estate finance in a $2.9 trillion market is provided by alternative sources.

And the US model is far more firmly entrenched: the trend for the last 50 years shows that the banking sector accounts for just over half of all real estate lending. CRE debt funds account for approximately 30 percent of this, cementing their position in the wake of the financial crisis when blue-chip players such as Blackstone and Starwood emerged as market leaders. However, this old guard was shaken-up in April when General Electric announced it would exit the bulk of its lending business, GE Capital, including a $26.5 billion sale of most of its real estate assets and loans.

Ryan Krauch, a principal at Mesa West Capital, a privately held portfolio lender with a capital base of more than $3.5 billion, calls GE’s “overnight disappearance” a “game-changer”.

“It is one of the most significant things to happen in the real estate lending business since the global financial crisis and created a lot of opportunity for people in our business,” he says.

GE’s decision has not dampened enthusiasm for the asset class with investors turning to the sector globally in droves in the scramble for yield.

Krauch explains the US market rationale: “Investors need current income in a low interest rate environment, which is hard to find through traditional fixed-income investments. And they need downside protection in a late-cycle investment market, and that is hard to find in a low-cap rate environment. This creates a natural demand for real estate debt which has the ability to solve both problems.”

It is not only investors desperate for yield. Lenders have moved into new asset types, such as secondary and tertiary markets, while in Europe they have bifurcated into specialist and generalist managers.

However, the “underserved middle market”, that is assets under $50 million, could be a big growth area, according to Robert Brown, a managing director at JCR Capital which operates in this space.

He reasons that volatility in the capital markets as seen in the US and Europe in the second half of 2015 can create a sweet-spot for smaller-ticket lenders.

“If you look at the upcoming wave of CMBS maturities – some $114.6 billion this year – a lot of the big institutional deals have been sold, refinanced or restructured. But if you are a small owner-operator who borrowed CMBS 10 years ago you still have to repay your loan and there is not enough capital focused on that space. If you look at the amount of transactions in that middle space it is exponential in terms of number of deals.”


Compared with the US, the real estate finance shadow banking industry in Asia is in its infancy, with Japan and Australia the most established markets.

Real estate-related debt investments in the region, assuming a rough guide of about 50 percent LTV ratio, totalled around $64 billion last year – about level with 2014’s total in dollar terms, but an overall increase when measured in local currencies, according to JLL.

Banks reign supreme and competition between them is fierce. PwC’s Emerging Trends in Real Estate Asia Pacific 2016 report said that “together with proceeds from pre-sales, bank debt remains the dominant source of financing for Asian real estate”.

However, with additional expenses piled on banks by Basel III capital requirements, insurance companies in particular have started entering Asia-Pacific with MetLife, Prudential and Manulife among others having recently deployed capital, or seeking to do so.

There are also a dozen or so alternative asset management firms focused on credit and special situations investing in Asia, carving out a niche in real estate.

One of these is SSG Capital Management led by managing partner and chief investment officer Edwin Wong, who points to structural gaps in emerging markets such as India and China.

In India – one of the emerging markets hardest hit by a stricter regulatory regime – lending growth fell from 33 percent in 2005-08 to 10 percent in 2011-14.

“In India we continue to see a prolonged slowdown in the real estate sector creating funding needs for corporates, so we will lend for growth but also provide rescue financing,” he says.

“Banks will also not lend against land for development in the emerging markets, so private debt is benefitting from that.”

In China, developers have been reliant on the country’s $18 billion bond market to raise finance as banks became more conservative in recent years, but with the booming bond market falling victim to equity market turmoil there is an opportunity – not without risk Wong acknowledges – for debt funds to fill the breach here too.