This article is sponsored by Schroders Capital
What impact do current macroeconomic factors have on the real estate debt market?
The macro environment is now characterised by high inflation, rising interest rates and slowing economic growth. This challenging environment has had a significant impact on the real estate debt market. Real estate values have fallen, lenders and especially the banks are less willing to make new loans and where capital is available it is at lower loan to values and at higher cost, a result of increased base rates and higher lending margins.
It has become difficult therefore for borrowers to find capital and as such, the macro challenges of the last 12 months have created a lender-friendly environment in which the quality of transactions in terms of leverage, returns and borrower and asset quality have all improved for lenders.
As such, the challenges of the last 12 months have created a very attractive time for investors to get exposure to secured credit, where lenders have the experience to underwrite the real estate assets.
What characteristics should LPs be looking for in their debt allocations, and how can real estate cater to these needs?
Most LPs have exposure to private credit through a corporate direct lending programme which they have built out post-GFC. These portfolios have generally performed well, supported by the low interest rate and central bank supported liquidity regime of 2009-21.
As the economic regime changes, many LPs are stress testing their portfolios for the new environment and ensuring their private debt portfolios are well diversified.
LPs are often looking to add the following characteristics to their portfolios:
1) Inflation protection
Real estate debt offers the potential for inflation-linked cashflows from floating rate debt, and (partial) inflation hedging if the value of the underlying collateral increases.
2) Downside protection
Real assets are backed by physical collateral, providing the basis for high recovery rates.
3) Shorter/diversified duration
Real estate loans are typically three to five years.
Real estate debt is a €1 trillion market in Europe, and many investors are simply diversifying in to a significant market place to which they’ve been historically underallocated.
What change can LPs expect to see in their real estate debt allocations throughout 2023?
We leverage the knowledge of our European real estate business to support our underwriting and form a view on an asset-by-asset basis.
We’re agnostic on sectors given we believe that lenders often overlook transactions simply because the sector is out of vogue, missing the opportunity to generate strong risk-adjusted returns. That said, we would expect capital across the market to continue to be attracted to the following areas given underlying fundamentals and a challenging and inflationary macro environment:
- Life sciences.
- Build to rent.
Given the current economic climate, how should return expectations be managed for 2023?
It’s important to differentiate between existing loan books and new loans originated today.
For existing loan books, we anticipate challenges for borrowers when looking to refinance. Assets purchased or financed in 2017-18 may find that there are valuation declines, that there is less liquidity to re-finance and that they may need to inject equity or look for junior debt facilities.
Newly originated loans have the potential to benefit from these same trends, providing investors with returns with lower leverage, and benefiting from a very illiquid market in which the capital provided can generate attractive risk adjusted returns.
We see the move from bank lending to alternative lenders as a structural change, but the macro challenges of the last 12 months have created a tactical exposure for investors to gain access to the asset class at enhanced returns.
The ability to service debt in rising rate environments is always a key concern. How vulnerable are lenders to increases in the cost of real estate debt financing?
All prudent lenders will ensure their interest rates are hedged on their loan facilities to make sure that risk is mitigated, and they usually do that via a swap or a cap.
Across the market there will be transactions where lenders and sponsors were not as prudent as they could have been. This will, as ever, be a problem which is particularly acute in higher leverage loans.
The other side of that question is recession, which is expected to be protracted. How severe do we expect the downturn to be, and – as a relatively new asset class – what can we expect from real estate debt?
Any prudent lender is going to underwrite sustainable values through the cycles, so we are certainly haircutting values 20 to 30 percent and we have already seen valuation declines which reflect a significant portion of that decline. The quoted REIT market is a good sense check against asset values.
As a sustainable lender, we also need to make sure we are underwriting the environmental risk, because as we see environmental legislation becoming tighter and more demanding on real estate it’s imperative that we make sure we are not originating a loan today which will be unable to comply when new sets of regulations come in to force. That’s a real focus for real estate lenders.
The other thing is lending to sponsors you feel comfortable with and that have the expertise, track record and capital to step in and provide support.
Has the backdrop affected your tilt more towards property or structure risk?
Each loan that we originate will have a robust loan structure with a full suite of covenants and we will look to mitigate risk through the structure we implement. As lenders, we are glass-half-empty people always focused on the downside.
How does the intensifying focus on the sustainability profile of assets alter return expectations?
As a sustainable lender, we screen out a whole series of transactions that don’t comply with the hurdles that we set ourselves for sustainability. By default, that means we avoid lending on properties that are likely to become obsolete as a result of their environmental credentials.
In addition to that, sustainable lenders are also able to influence borrower behaviours and drive expenditure and improvement on those properties.
From a lenders perspective we do not see an alteration in return expectations due to sustainability initiatives.