UK ROUNDTABLE: Opportunity amid regulatory Armageddon

The UK private equity real estate market is treading water amid a torrent of regulation capable of ‘destroying the industry’. Apart from that, opportunistic real estate investment in England is showing increasing signs of life. PERE Magazine June 2011 issue.

There’s a “torrent of regulation” set to hit the UK.

So says a concerned Stuart Jenkin, director of fund management at UK private equity real estate firm Frogmore, one of three participants in PERE’s UK-focused roundtable this year. Jenkin, like the roundtable’s other two participants – Harin Thaker, head of real estate finance international at Deutsche Pfandbriefbank, and Dean Hodcroft, head of real estate for Europe, Middle East, India and Africa at Ernst & Young – fears real estate fund managers and some of their investors are facing a flood of proposed regulation aimed at restricting the risky exploits of managers in financial sectors other than real estate.

Jenkin explains: “The way these things seem to be coming at us, it appears we’re being pushed into a set of ‘one size fits all’ solutions. These are primarily focused at banks, insurance companies and big hedge funds but, through the wording, we’re being caught.”

The Alternative Investment Fund Managers (AIFM) directive, Solvency II, Basel III, the Bribery Act  – each of these were scrutinised to a greater or lesser extent over the course of the almost two-hour roundtable, which took place on the 21st floor of London’s iconic 30 St Mary Axe building, known worldwide as ‘the Gherkin’.  It is unusual for an event such as this to focus so much on regulation, but the severity of the situation demanded the attention.
AIFM was the market’s initial major concern, with Hodcroft comparing the first iteration of the European Union directive designed to create a Europe-wide fund marketing system to using a “sledgehammer to crack a nut.” Today, however, EMIR is at the crest of an incoming wave of threatening regulation.

The threat from EMIR

We really should relay the seriousness of this, as it has the capacity to destroy the industry
Dean Hodcroft, E&Y

Despite sounding like a Middle Eastern prince, there is nothing noble or privileged about EMIR as far as the private real estate universe is concerned. The European Market Infrastructure Regulation (EMIR) is a piece of regulation introduced by the European Commission last September that, if enforced in its current iteration, would see real estate investment firms forced to make derivatives trades via a central counterparty and not privately or over-the-counter as they currently are done. The amount of capital that would need to be sidelined to facilitate such trades is slated to be 5 percent or more of a platform’s notional principal, plus a further variation margin where a derivative’s fair value is negative. This capital would be posted in case of counterparty default.

The argument goes that an obligation to set aside such capital actually undermines the whole purpose of hedging by property firms to achieve optimal cash flow stability. Added to that, the illiquidity inherent in real estate investing makes it particularly hard for property businesses to comply with margin calls. Estimates already have surfaced of the regulation potentially taking approximately €65 billion out of the economy. “That is so significant,” reflects Thaker, shaking his head.

While there is no specific private equity real estate lobbying group, real estate bodies including the British Property Federation (BPF) and the European Association for Investors in Non-Listed Real Estate Vehicles (INREV) have been striving to have real estate funds ring-fenced from the reaches of the regulation. Hodcroft is keen to see even more action taken.

PERE parrots a quote from a prior interview on EMIR, where the regulation was likened to “financial Armageddon,” and Hodcroft says such strong language is no overstatement. “We really should relay the seriousness of this, as it has the capacity to destroy the industry. It is complete nonsense when the security already is there in the bricks and mortar itself,” he says of the regulation’s central premise.

The way these things seem to be coming at us, it appears we’re being pushed into a set of ‘one size fits all’ solutions. These are primarily focused at banks, insurance companies and big hedge funds but, through the wording, we’re being caught
Stuart Jenkin, Frogmore

At press time, proposed amendments to EMIR were being considered, including the carving out of real estate-focused businesses, by the Economic and Monetary Affairs Committee of the European Parliament (EP) ahead of a vote on the 24 May. The result of that vote would reflect the EP’s position on the regulation. Running concurrent to that, the European Council (EC) also was determining its position ahead of a vote scheduled for 17 May. Following these separate shows of hands, a trialogue was expected to ensue between the EP, the EC and the president of the European Council to thrash out a mutually agreeable draft. After that, detail would be finalised during a stage called ‘Level II,’ with implementation expected by the end of 2012.

Hodcroft warns: “Let’s say the worst-case scenario happens and this ruling goes through. Those suddenly needing to fund such collateral don’t have such big piles of cash. What do they do? They can’t borrow it because, by definition, that wouldn’t solve the problem. They probably would have to sell assets, which impacts market values. I’m an optimist by nature, but such a downward spiral would be unstoppable.”

Jenkin interjects: “It’s not as though someone is saying ‘We’re after the guys in real estate because they use swaps.’ Still, it could trigger a massive default in the market, which is something our team already is considering.”
EMIR’s potentially devastating arrival should not diminish the importance of other incoming regulation. AIFM is further down the line that EMIR – it has reached Level II stages already, although it will not be implemented until May 2013 at the earliest for European fund managers and 2015 for non-European managers. Unlike EMIR, some initial concerns about AIFM have been ironed out, although others remain.

Of specific worry is the wording of the definition of leverage. “We know what leverage means at the asset level, but not what it means when you start to go up the corporate chain,” Jenkin confesses. He also is concerned about what the regulation’s ‘document custodian’ proposals will entail: “Again, this is treating us like a hedge fund. We use registered title with land certificates; these are not the same as stocks or bonds.”

Solvency II, an updated set of regulatory requirements for insurance firms operating in the EU scheduled to come into effect in January 2013, brings further trepidation. Jenkin sees minimum capital requirements for insurance companies investing in real estate, currently slated to be 25 percent, as “over the top.” Fearful that the regulation becomes a “Trojan horse” capable of spreading an inappropriately risky perception of the asset class, he says: “We start there, but what about the European pension funds? Suddenly, our institutional friends that like real estate for diversity are discouraged from investing.”

Similarly, more stringent capital requirements face the banking sector through the well-publicized Basel III regulation, adding to the list of concerns. Also scheduled for implementation in 2013, Basel III would saddle lenders with more conservative financing capabilities.

The art of the covenant

In the current market, it is slightly more challenging for firms like us who operate higher up the risk curve and aren’t buying core assets

Stuart Jenkin, Frogmore

In the face of the oncoming regulatory landslide, Deutsche Pfandbriefbank’s Thaker nonetheless predicts a more productive time for the bank’s lending programme, in the near future at least. Thaker, who is responsible for originating new loans, says the bank has “retrenched” from non-core European markets to focus on Western Europe, the Nordics and selectively in Spain, and it is capable and keen to lend up to €8 billion per year.  He admits, however, that activity over the past year or so has not matched the lender’s aspirations: “Either it is because vendors have changed their minds or we lose a deal to rival banks, not on margins but on covenant settings.”
Indeed, Deutsche Pfandbriefbank is applying greater scrutiny to areas such as interest service covenants. Though rivals are doing likewise, Thaker says the bank’s more stringent underwriting assumptions are leading to some deals going elsewhere. He offers a hypothetical example to further explore the thinking: “Let’s assume we are lending at a margin of 200 basis points. Today’s five-year swap rate is 300 basis points, so we’re looking at 500 basis points all-in. In five years’ time, with an increase in interest rates, it is 700 basis points. Perhaps add 200 basis points more for amortisation to kick in, so really we’re talking about 900 basis points. But what if another bank has worked it out at 800 basis points? Which bank wins the deal? Today, it is not all on pricing but rather how forward-looking a bank is.”

As far as Deutsche Pfandbriefbank is concerned, debt at loan-to-value ratios between 60 percent and 65 percent is readily available, typically on five-year terms. Speculative development is off the table, but development is not although “it must be in the right location and for the right sponsor,” Thaker insists, adding, “We are very careful about that.” Margins for the bank differ from project to project, but Deutsche Pfandbriefbank charges between 190 and 210 basis points at 60 percent LTV and approximately 240 basis points at 65 percent LTV.

Hodcroft and Jenkin agree that those figures are fairly standard in the current market.  “Those are typical terms we hear in the market, but it’s about getting the right transaction to match them,” Jenkin chimes in. “In the current market, it is slightly more challenging for firms like us who operate higher up the risk curve and aren’t buying core assets.”

Frogmore has been selective in its capital outlays over recent years. Last year, Jenkin says, the firm saw £19 billion of deals, only two of which met its criteria. “It has been difficult to get happy with what was happening in the market, particularly immediately after we came out of recession,” he recollects. Primarily, he is concerned about the lack of “lifeblood,” or tenant health, in many of the deals he considers. “Submarket after submarket, we can’t get happy with the property fundamentals of a lot that we see,” he adds.


It’s one of those interesting times when home players generally cannot buy in their own market
Stuart Jenkin, Frogmore

Using capital from its Frogmore Real Estate Partners II fund, which closed on just less than £200 million in 2009, Frogmore acquired the shell of a 79-unit luxury apartment development on The Strand in Central London through a joint venture with UK homebuilder Galliard Homes from Spanish bank BBVA. It also bought a data centre in Enfield, north of London. Of that deal, a sub-market in itself, Frogmore bought the asset entirely with equity and will seek debt after the project has stabilised.

Thaker admits Deutsche Pfandbriefbank would struggle to finance such assets, explaining that the specialisation of the real estate asset class makes it potentially tricky to underwrite. “Who would run the building in the absence of the current borrower not being able to fulfill its obligations?” he asks. Jenkin agrees that it is a specialised area where, like a shopping centre, the operator needs to provide considerable services to the tenants. To that end, Frogmore has teamed up with a data centre specialist to ensure that happens.

Capital pursuits

Specialist markets aside, UK real estate investment activity is somewhat polarised currently towards London and the UK’s Southeast, with many of the country’s regions still stagnant at best. According to the latest research by Jones Lang LaSalle, direct commercial real estate investment in the UK reached £8 billion in the first quarter of 2011, down 18 percent on the fourth quarter of 2010 but up 41 percent on the first quarter of 2010. Within that £8bn, “transactions were particularly focused on the central London office sector due to its ‘safe haven’ status and the strong occupational market fundamentals,” the report stated, adding that investment volumes in the city would stay limited because of tight supply rather than a lack of pursuit.

Just last month, PERE interviewed Samsung Fire and Marine Insurance, Korea’s largest non-life insurance firm, on its desire to invest internationally. Unsurprisingly, London was among its top targets. Seeking returns of between 6 percent and 6.5 percent from core properties with long-term leases, the Korean insurer is not alone. “They would struggle,” Hodcroft suggests, adding that yields for such properties have dipped lower now.

Indeed, the wall of capital chasing such limited property is constructed predominantly by international investors. Added to the Koreans are Canadian, Chinese and Middle Eastern investors, among others. As Jenkin points out: “It’s one of those interesting times when home players generally cannot buy in their own market.” London has seen this before, he adds. “I remember when the Japanese came in and bought big time. That drove yields to 4.5 percent, forcing UK funds to back off. The Germans have done likewise.”

Hodcroft says many of these investors will remain on the market sidelines frustrated, stressing that more flexibility and innovation is needed for those looking for extra value in London. “You have to be imaginative,” he says, noting that satellite business districts such as Stratford, Vauxhall or Battersea could make interesting longer-term plays.
Hodcroft emphasises his belief that the growth of mini-business districts will happen in London and that the capital may start to grow outwards towards the M25 (a ringroad motorway around the city) in terms of its attractiveness to investors. That said, he notes that successful investment outside London and the Southeast will continue to be very challenging until values materially re-set.

I call it the four stages of grief: first comes denial, then there’s anger and then acceptance. The final stage is you move on and get things done
Dean Hodcroft, E&Y

Hodcroft does predict, however, the forthcoming government budget may provide an indication of when that happens and expects favorable outcomes from an ongoing consultation paper on REITs and the introduction of new enterprise zones (where developments benefit from various tax breaks). He says: “These should give fresh impetus to UK investment and development across the country and are very welcome proposed reforms.”
Certain private equity firms already are hip to this, and that has been reflected in some of the UK’s biggest deals in 2011 so far. In January, The Blackstone Group acquired a 33-acre office park at Chiswick Park for £480 million. The New York private equity and real estate giant also reportedly was a bidder on the larger Green Park office park in Reading, west of London, losing out to Oxford Properties, the real estate arm of the Ontario Municipal Employees Retirement System. At press time, Oxford had been selected as preferred bidder for the 180-acre park in a deal valued at £415 million.

Indeed, some of the biggest deals in UK property this year have or are involving opportunistic capital managers. In addition to Blackstone’s capture of Chiswick Park, London-based Delancey snapped up London’s Plantation Place in a deal valued at £460 million via the ownership of a note in a CMBS structure. The ongoing sale of Project Monaco, a £1.6 billion loan book, by the Royal Bank of Scotland is another deal to have lured private equity’s finest. At press time, Blackstone, Lone Star Funds, Starwood Capital Group and Westbrook Partners had been shortlisted to buy the book in a deal widely considered to be the first litmus test of the UK banking sector’s appetite to scale down its property holdings in the aftermath of the global financial crisis.

Such transactions could be viewed as somewhat meaningful for the UK private equity real estate sector, given the various forces constraining the high returns it is accustomed to or expects. According to the Investment Property Databank’s UK Quarterly Property Index, commercial property returns fell to 2.3 percent in the first quarter of 2011, growth it described as “sedated” even if reflective of values recovering 19.9 percent since June 2009. IPD traditionally focuses on lower-risk properties, but its findings help indicate what is happening further up the risk curve.

A murky future

When asked what next year’s agenda will look like, the participants initially seem tongue-tied. No slight on their professional credentials, but gazing through a crystal ball to predict the future is becoming increasingly challenging given how interconnected the global economy is today.

“Everything is global,” says Jenkin. “Recent history has proven to us that we are more susceptible to global shocks than ever before.” Pointing to events like Japan’s earthquake near Sendai, the civil war in Libya and the various democratic uprisings in the Middle East – each of which has had a reverberating effect on the economies of countries, including the UK – it is easy to agree that real estate clairvoyance is a near impossible task.
Jenkin opts instead to compare today to the past: “This feels like 1995 to me, but on a much larger scale. We had the 1990 crash, then a bounce in the market as prices looked cheap and thereafter there was little activity as the economy hadn’t really recovered.” Hijacking the analogy, Hodcroft adds: “I call it the four stages of grief: first comes denial, then there’s anger and then acceptance. The final stage is you move on and get things done.”
The UK property market has nearly dusted itself off and is readying to get going again. If the wave of regulation coming doesn’t derail the effort, the omens are looking more positive, but that’s a big if. What is discussed at next year’s event will no doubt shed some light on that, but there’s a long time to go between now and then.

Three of a kind

This year’s roundtable participants were asked for their thoughts on three large UK deals, all involving private equity real estate firms, that have commanded headlines in the first half of 2011

Blackstone’s purchase of Chiswick Park

What it is
: A 1.1 million-square-foot office park comprising 12 buildings west of London
What happened: In March, The Blackstone Group acquired the park from a joint venture comprising fund managers Schroder Property, Aberdeen Property Investors and Stanhope in a deal valued at £480 million.
Why it is important: Other than marking Blackstone’s first UK investment in 15 months, the deal also was the catalyst for the creation of the first CMBS transaction in the UK since the credit crunch. The deal was financed with a £360 million loan from Deutsche Bank, which was then securitized and sold to investors.

What roundtable participants said:
I hope this means the re-emergence of more liquidity via the CMBS market. If this is the start of things to come, then I’m pleased, but it is probably too early to tell. I’m keeping my fingers crossed.
Thaker: Banks that can exit through CMBS definitely have an upper hand over banks that cannot because no one wants to underwrite such big deals single-handedly.
Hodcroft: For me, this brings up the question of how much property out there is actually ‘plain vanilla’ securitisable because it needs to be something damn good – well tenanted and low risk.

The ongoing sale of ‘Project Monaco’ by the Royal Bank of Scotland
What it is:
A UK legacy loan book with a par value of approximately £1.6 billion.
What happened: At press time, RBS had shortlisted four private equity real estate bidders – The Blackstone Group, Lone Star Funds, Starwood Capital Group and Westbrook Partners – ahead of a final decision expected later this month.
Why it is important: Ever since the credit crunch, private equity real estate firms have been waiting for the UK’s main real estate lenders (RBS, Lloyds Banking Group and Barclays Capital) to offload large portions of their loan books. While by no means gargantuan, ‘Project Monaco’ is far bigger than anything to have been offered for sale previously.
What roundtable participants said:
This is fascinating, as we’ve all been waiting to see what the major lenders are going to do. The question is whether this is the start of some big strategic sales programme.
Thaker: I think this may be a starting position for them. This is an example of a bank looking into its basement to work out what it actually has and splitting its core holdings from its non-core holdings.
Hodcroft: Bidders are not going to necessarily want everything in there, and they are likely going to want [new] debt [to buy it]. Of course, RBS wants to deleverage, but I don’t think they believe they can sell it without putting in some vendor financing. We’re talking about a £1.6 billion book after all, and that’s a big deal. In fact, it’s the biggest thing happening in the market right now.

Delancey’s acquisition of Plantation Place
What it is:
A 550,000-square-foot office building in the City of London
What happened: Bought in 2006 for £525 million by Invista Foundation Property Trust and Stobart Group, the building’s value has since dropped, breaching the loan-to-value covenant of its securitised debt. That breach enabled London-based Delancey, one of the CMBS noteholders, to buy Invista and Stobart out, assume the debt and correct the LTV breach in a deal valued at £460 million.
Why it is important: Whether deliberate or not, Delancey effectively pulled off a ‘loan to own’ strategy rarely utilised in the UK, although more common in the US.
What roundtable participants said:
Jenkin: To recognise an opportunity to secure an asset like that is fantastic – my hat’s off to them. We have seen a lot of junior loans being offered around the market. They can be very complicated, but the historical knowledge will have been helpful.
Hodcroft: In the UK, it can be very hard to force your way through the security to the underlying asset.

The participants

Dean Hodcroft
Partner and head of real estate for Europe, the Middle East, India and Africa
Ernst & Young

Hodcroft has been with Ernst & Young for 23 years, during which time he has focused largely on advising public and private companies, public sector bodies and large corporate occupiers, as well as opportunity funds, on their real estate transactions and issues. His team – an approximately 4,000-strong unit spread across Europe, the Middle East, India and Africa – is engaged in providing a wide gamut of advisory services in areas from restructurings and administration to tax audits. Ernst & Young’s real estate clients include corporate occupiers, listed companies and, of course, private equity real estate funds.

Stuart Jenkin
Director of fund management

Jenkin is the director of fund management for Frogmore and has been with the firm through its different corporate guises since September 1997. He joined the UK private equity real estate firm from Siemens Properties, where he spent 18 months as managing director for its more than 6 million-square-foot portfolio. He joined Siemens in 1996 from Provident Mutual Life Assurance, one of the UK’s most active real estate institutions, where he worked since 1982. Before that, he worked for Abbey Life Assurance.

Harin Thaker
Head of real estate finance international
Deutsche Pfandbriefbank

Thaker has spent more than 18 years at Deutsche Pfandbriefbank and its predecessor, Hypo Real Estate, which was nationalised in the wake of the credit crunch and re-emerged in 2009 under its new name. Thaker’s remit centers on repositioning the lender as a potent force in today’s real estate finance sector. The bank, which manages approximately €125 billion of assets, currently has a lending capability of about $8 billion per year to finance real estate assets across its target markets in Western Europe and the Nordics. Much of its activity, however, will be focused on the UK.