RE Debt special: Forging new paths

Since 2010, the proportion of outstanding UK real estate debt secured against property in Central London has almost doubled at the expense of the rest of the country, according to the latest De Montfort Commercial Property Lending Report. And this has happened over the same period as non-bank lenders have increased their market share in the amount of loans originated in the real estate industry.

The conclusion is clear: non-bank lenders such as real estate debt funds and insurance companies favour Central London. And it is likely that this trend will continue, as advisory firm Savills predicts that the proportion of loans originated by non-banks will make up almost a third of the market by the end of this year.

Lynn Gilbert, head of M&G Investment’s senior real estate debt strategies, said that the firm does not specifically seek out opportunities in the capital. “We try to look outside the M25, but we can only follow the borrowers. The lot sizes are smaller.”

In 2014, M&G provided £238 million of financing for the property development firm the Northern Trust Group in a rare instance of a real estate debt deal hitting nine figures outside of the capital.

To be successful at sourcing deals in the regions requires a good working knowledge of the area. Many debt funds operate on a pan-European basis meaning a detailed knowledge of smaller cities is beyond them. And this is perhaps a reflection of investor attitude, as LPs tend to approach diversification on a nation-by-nation basis, rather than by region.

Additionally, large deal sizes are difficult to come by outside of London. Martin Wheeler, co-head of ICG-Longbow, a firm with a long history of investing in real estate outside of London, says “that there is more volume of deals in the regions and better risk-adjusted returns because the underlying property tends to not be overinflated.”

But it is banks, he says, that are the primary competition in the market and, with branches operating across the entire country, they have the advantage with regards to knowledge of the local area.

Paul House, managing partner of Venn Partners, says that around 30 percent of the firm’s real estate debt portfolio is focused outside of London. He says that opportunities are available because cities such as Manchester and Bristol are reporting growth. “Deal sizes are smaller and the amount of transactional volume is not as high as London, but there are opportunities and the debt market is not overly competitive within those markets. Manchester and Bristol are doing well. Liverpool was a more challenging market several years ago but has also improved.”

The North-South divide is a well-documented issue within British politics. Cities such as Manchester, Liverpool, Leeds and Newcastle were built on large manufacturing industries. But since the advent of de-industrialisation, many have struggled to recover, reporting a number of socio-economic issues, most notably long-term unemployment.

The government attempted to rectify this imbalance with the launch of the British Business Bank (BBB) in 2013. The BBB was a response to the banks’ retreat from lending to small and medium-sized enterprises following the introduction of reforms following the global financial crisis and to help stimulate growth across the regions.

The BBB primarily works with private debt funds when channelling its resources to the market. In April, it launched a £400 million debt tender for the Northern Powerhouse Investment Fund with mandates to target investment in the North and help redress the divide.

While many may see a big difference between the regions and London in the scale and quality of assets, lenders simply look at the fundamentals.

Peter Hobbs, managing director at advisory firm bfinance, says that “lenders are more focused on the credit worthiness of the borrower, the quality of the cashflows, conventional credit risk metrics such as LTVs and DSCRs rather than the ‘trophy’ nature of buildings”.

In this respect, the regions may appear more attractive to lenders as they tend to be higher yielding while still having assets with good credit and long leases. Hobbs says that “pricing in London has become very aggressive as yields have been compressed to historic lows. For those lenders looking to generate high single-digit returns they need to take on various forms of risk, whether higher LTVs, weaker credit or more transitory assets, and one way to control this risk might be to increase exposure to the regions”.

While they may have attractions, Hobbs warns that the regions are not immune to property market downturns. “As we have seen from previous downturns, the value declines in those cities tend to affect those cities as badly as London and the fact that these markets are illiquid should only further enhance those concerns”.

At the time of writing, Britain was heading into the final week of campaigning in the EU referendum vote and experts from a wide range of institutions, both international and domestic, warned of a negative economic impact if a Brexit occurred. The former Prime Minister Gordon Brown warned that a departure from the EU would affect cities across the UK. Labour leaders of a number of city councils signed a letter noting that a vote to remain was a “vote for prosperity and progress”, while a vote to leave was one for “serious economic danger”.

A number of other macroeconomic issues also threaten the steady growth of the regional cities even if the UK votes to remain. The year started out with an unexpected downturn in China’s economy and a drop in oil prices and it is unclear how the global economy will develop over the next year.

The UK economy has been chugging along at between 2 and 3 percent over the last three years, with London grabbing the biggest slice of the pie. But while the space for real estate debt funds to originate loans is growing, it may be investors’ thirst for higher yields that ultimately drives them out of the M25 to source deals in the regions.