Real estate equity investors are battening down the hatches as a combination of rising interest rates, economic recession and high levels of inflation combine to rock a market still reeling from the profound effects of the covid-19 pandemic on work and living patterns.

Figures from affiliate title PERE found fundraising for the year to the end of Q3 2022 came in at $107 billion, the lowest total for the first nine months of a year since 2013.

One of the key headaches affecting investment in real estate is a lack of financing through 2022, which is expected to continue into 2023 as tough economic conditions show little sign of abating.

According to Natalie Howard, head of real estate debt at Schroders, bank retrenchment has been a major feature of the market in the past year.

“In 2022 we’ve seen a further retrenchment by the banks in real estate lending due to a series of events,” she says.

Central banks have reduced their repo lines as their quantitative easing programmes end, leaving banks with less liquidity. In addition, a major expansion of their loan books during the covid crisis means many banks are up against the limits of their capital requirements.

Politics plays a part here too, Howard explains: “There is political pressure to support SMEs and corporates but there’s no pressure to support property companies.”

All this means most banks aren’t originating new real estate loans, which spells bad news for a business which is capital intensive and requires leverage to generate returns. Alternative lenders have an opportunity now to step into the gap left by the banks, but at present there simply aren’t enough alternative providers with sufficient capital to serve this market.

“There are just eight to 10 alternative providers operating in the European lending market today, which is not many for a €1 trillion market,” says Howard. “Around €200 billion needs to be refinanced every year so it’s a very big space with not enough lenders to fill it.”

Barriers to entry

Among the alternative real estate lenders operating in Europe today, AXA IM Alts is the largest. However, it only loaned around €2.8 billion for real estate projects in 2021 and had a total loan book worth around €11 billion at the end of Q2 2022 according to affiliate title Real Estate Capital Europe. This means there is little prospect of alternative providers being able to replace what banks used to provide in the near future.

Furthermore, according to Howard, there are few new players entering the market due to significant barriers to entry.

“There are not very many real estate debt professionals in the market and only a handful of them also have experience in asset management. It’s also a significant capital investment to build an appropriate size team to raise funds,” she explains.

Howard herself joined Schroders two years ago from specialist real estate lender DRC Capital to set up its real estate lending business. Schroders has had to commit a substantial sum to get its business off the ground and start building a book of real estate loans. The cost and manpower issues can make it difficult both for new firms launching into real estate lending and even for established direct lenders looking to set up a real estate lending arm.

However, there remains significant scope for alternative real estate lending to expand as there is appetite from institutional investors to commit more to this asset class. While much of Europe’s boom in private debt activity has been focused on direct lending to corporates in the years since the global financial crisis, a more difficult economic period and increased competition in that area of the asset class could dampen returns in the coming years. A significant global recession is expected to begin in 2023, in fact in many countries in Europe and in the US it may have already begun, and this will put pressure on consumer spending and ultimately affect cashflows of corporates and SMEs.

“Institutional investors want to diversify out of direct lending and leveraged finance,” says Howard. “We see growing interest from pension funds and insurers, though they are also keen on infrastructure debt. However, real estate debt can be particularly interesting for LPs because the huge funding gap gives alternative lenders better pricing, risk and terms.”

LP appetite

Secured lending has a track record of performing better in downturns than unsecured lending and it is this that may act as the impetus to bring more money from institutional investors into the asset class. In the relatively benign and low-yielding environment seen in the decade following the GFC, direct lending was able to offer significantly improved returns over more traditional forms of fixed income investing, vital for LPs with long-term liabilities to meet. As the economic situation has now changed, with many saying we are entering a new economic era, LPs may increasingly look towards safer investments backed by real assets.

Pricing in real estate lending is improving and so are terms, and crucially average loan to value on real estate deals has shifted in favour of lenders meaning that even if property values decline, lenders will be adequately protected by the hard asset they hold as security. LPs are also far more familiar with investing in alternative lenders than they were in 2008 and this should mean they feel comfortable branching out into new sub-asset classes within private debt.

Europe also has a lot of room for growth before it reaches the levels seen in the more developed market of the US, according to Howard.

“There is a lot more activity from alternative lenders in UK real estate where they make up about 25 percent of the market, though this is still well behind the US which is closer to 45 percent. However, in Europe it’s circa 6 percent.”

With so much potential to grow, especially in continental Europe, and an LP base that is hungry for alternatives to public market debt that can act as a defensive part of their portfolio, it is frustrating to see that alternative real estate lending is being held back by barriers to entry. But with regulatory and other business pressures limiting the ability of banks to lend, something will have to give. 

While lenders like Schroders are keen to expand their loan books in this area, constraints on manpower and the sheer time and capital required to build up a presence in this market means it is going to take time, and European real estate equity investors may face tough years ahead when it comes to financing their investments.

“We don’t expect banks to come back into the market in any significant capacity and there are very few new alternative providers coming in at the moment,” Howard says. 

“Getting to the size where alternatives could match the €200 billion of refinancing needed will take a long time.”