In the third instalment of our review of Real Estate Capital’s 2019 interviews, below are abridged versions of our discussions with the head of real estate debt at insurer Rothesay Life, fast becoming a key player in European property lending markets, and the head of capital markets at M7 Real Estate, a leading European borrower.
Harish Haridas, head of commercial real estate debt, Rothesay Life
In March, we published our interview with the head of the property debt strategy at the specialist insurance company Rothesay Life. The company had recently closed a mega-financing of Goldman Sachs’ new London HQ. Harish Haridas explained why the company was getting involved in real estate debt. Read the full interview here.
It is a sign of the times that one of the largest loans to be closed in the European commercial real estate market so far this year was done entirely by an insurance company many would be forgiven for not having heard of.
Rothesay Life insures defined benefit pension payments for corporates and other insurance companies. In January, it closed a coveted financing mandate with a £689 million (€780 million) loan to South Korea’s National Pension Service to fund the sale-and-leaseback of Goldman Sachs’ European HQ at Plumtree Court in the UK capital.
It was the type of loan that, once upon a time, would be almost guaranteed to have gone to a club of commercial banks. With a five-year term, a loan-to-value ratio below 60 percent and a margin understood to be below 150 basis points, it was done on terms most obviously associated with the banking sector. However, Europe’s real estate lending market has its most diverse set of participants ever and it perhaps should not have come as a surprise that an insurer, which plans to keep the loan entirely on balance sheet, single-handedly took on the debt mandate.
From its offices in the Leadenhall Building, the London tower better known as the Cheesegrater, Rothesay Life has been quietly building a real estate loan portfolio since 2015, when it stepped into the market to provide a £220 million financing of motorway service areas in the south of England. Harish Haridas, who joined as head of commercial real estate debt in 2016, used to be a banker, working on pan-European CMBS issuance for Morgan Stanley from 2005, before a stint at Royal Bank of Scotland from 2010 working on deleveraging the bank’s exposure to continental European commercial property.
Around £1 billion of annual commercial real estate lending can be expected from Rothesay Life, Haridas says, although this will fluctuate depending on the volume of liabilities the firm needs to match and the quality of loans available. He recalls an early conversation with his management when the former banker asked about his annual target. “I was told the target is not to originate a certain volume, it was to be in the flow. The aim was to screen as many of the transactions taking place, but invest only when the right one came along,” he says.
The watch-and-wait mindset does not always come naturally to former bankers, he admits. “When you are living with risk over the long term, as insurance companies do, you need to live it very comfortably. When people join a company like this from the banks, they want to do deals.”
“The most obvious investment class for insurers is corporate bonds, due to the size of the market and the exchange-based nature of investing in these assets,” he says, “but Rothesay has avoided an overly large exposure to corporate bonds in favour of hard assets. Within the wider private debt market, commercial real estate provides a good risk-reward balance. If you lend at 60 percent LTV, the chances of loss, particularly on a prime asset, are relatively low. You can’t buy and sell a real estate loan on a screen like you can with corporate bonds, but we are able to put a little less reliance on liquidity, given the longer-term nature of our capital.”
Regulation of the insurance sector is another major driver of property debt activity. “Regulation is a critical driver of our investing strategy,” says Haridas. “At the present moment, we only do senior property lending, with no equity or mezzanine positions in our book. There will be periods of time when we have to be patient. For example, we haven’t done a real estate loan in the US for a year because the pricing was too tight. We financed Nike’s flagship store in New York in August 2016, because the UK had shut up shop after the Brexit vote and the US was competitive. We lent at around 200bps, but by Q3 2018, a similar loan would have priced at around 125bps.”
Real estate debt, however, has maintained its relative value premium to more liquid assets, Haridas explains: “Illiquid real estate credit should provide a premium to corporate bonds of the same tenor because of the smaller number of participants and the time and resources invested in structuring and negotiating CRE loans. This was recently evident in the US where the sharp correction in the US corporate bond market was followed by an equally sharp correction in CMBS spreads.”
Talk turns to the prospect of rising interest rates. While they usually indicate improved economic activity and therefore higher real estate rents, stagflation – a combination of economic stagnation and inflation – can worry those active in the real estate market.
“In most UK and European markets, CRE yields are at or above their historic risk premiums to the underlying government bonds and hence provide some element of buffer to rising interest rates,” Haridas says. “However, the fact that in some markets, CRE yields on an absolute basis are at historic lows is a cause of concern and therefore we focus on ensuring that our debt yields are at levels above historic highs seen in past downturns.”
Looking forward, insurance companies have a role to play as part of a diverse and conservative property lending market. Insurance capital, the former banker explains, is a natural source of financing for illiquid assets like commercial properties. “In the 1970s, apparently insurers had significant presence in the UK’s property lending market, then banks gradually stepped in and took 90 percent of market share. Things are gradually coming full circle.”
Hugh Fraser, head of capital markets for M7 Real Estate
In March, we spoke to M7’s Hugh Fraser to get a borrower’s perspective on the debt market for multi-let real estate in regions across Europe. Read the full interview here.
Real Estate Capital: What do you look for from a lender?
Hugh Fraser: They need to get our sector and the granularity of the assets we buy. Lots of people don’t like grubby regional real estate – we love it. We hate locking cash in an account to make the lender feel comfortable it will be spent on capex. We have so much surplus cash in our vehicles that we ask lenders to be flexible on how we fund our capex programme. Also, loan-to-value covenants need to provide some breathing space; in a loan with 60 percent LTV, I wouldn’t want to see a cash sweep set anywhere lower than 72.5 percent, for instance.
REC: Are covenants shifting in borrowers’ favour?
HF: Maybe for the biggest players like Blackstone, but I do not see a relaxing of covenants in M7 facilities. We do not push for light covenants, because covenants at the right level can create good discipline. I certainly don’t see a shift towards covenant-light.
REC: What could lenders do better?
HF: Many banks could be more transparent upfront about what they can and cannot finance, rather than waiting until they issue indicative terms. A lot of banks are still poor about being open and honest about what they can do, because they want to maintain the pretence that they are open to all types of financing when they are not.
REC: Where is pricing in your part of the market?
HF: It varies significantly by country. In Denmark, we are borrowing at 55 percent LTV and paying 80-100bps, because lending is funded through the efficient Danish bond market. In our biggest markets, Germany and the Netherlands, pricing from the investment banks for the type of product we buy has not changed dramatically in five years; it is in the region of 325bps, while the UK is between 250bps and 300bps.
REC: Is Europe a liquid debt market?
HF: In some countries, the terms you get can depend on the day of the week you turn up. Debt for our sector cannot be described as a liquid market. Prime, core real estate is entirely different. For regional real estate, it is usually possible to source finance, but it is not truly liquid if it comes from the same few lenders.