This article is sponsored by Apollo Global Management.
As the worst effects of the covid-19 pandemic recede, the real estate market has adjusted to accommodate new ways of living and working. This has presented opportunities in so-called ‘new economy real estate’ – those sectors that have emerged as a result of changed habits and lifestyles, and with potential for growth to meet tenants’ new demands.
Ben Eppley, a partner at US-headquartered alternative asset manager Apollo Global Management, believes there is substantial scope for non-bank lenders like Apollo to finance such real estate. Apollo’s commercial real estate debt platform had approximately $40 billion of assets under management as of 31 March 2022, and, since its formation in 2009, has invested more than $61 billion of capital into commercial real estate loans and securities, $13.3 billion of which has been in Europe since 2014.
Eppley spoke to Real Estate Capital Europe about where he sees the opportunities to take advantage of the new normal, and why the last two years have sharpened his sense of risk.
Which property sectors in Europe do you consider to be new economy real estate?
In the new economy space that we are looking at on behalf of the sponsors we finance, we have focused on warehouse and logistics properties, particularly anything benefiting from last-mile distribution, e-commerce and omnichannel retailing. The valuation for these assets has increased dramatically, and alongside that we are seeing rapid increases in rents because it is such a supply-constrained market relative to tenant demand. This has been a longer-term trend, but the pandemic accelerated things; with people ordering things online because they were stuck at home, demand for these assets was turbocharged.
We also spend a lot of time looking at the life sciences sector, such as lab space, research and development space, and offices tied to biotech and research. Again, this is an area where growth in Europe was accelerated by the pandemic. In certain markets, we saw the growth of knowledge centres between educational institutions and the private sector – in the UK as well as in Germany, the Netherlands and elsewhere – to develop new biotechnologies and work on other scientific endeavours.
One prominent example is vaccine development, and this has expanded to other areas of research and development. That sort of space has very specific property requirements, which, coupled with the limited supply, has increased the appetite among both tenants and institutional investors.
We have also lent against different types of residential projects, including PRS, for-sale residential and student housing. I think that is partly a function again of the pandemic where people spent so much more time at home. In many of the newer residential schemes, we see space for home offices and other amenities to accommodate the hybrid work model many companies have adopted.
How liquid are Europe’s real estate lending markets for new economy real estate?
Most of the new economy real estate attracts significant interest from debt providers. Logistics is clearly a very liquid asset class. In life sciences, the opportunities have been scarce, but they are picking up. Because of the relative lack of supply, real estate investors have been building new projects and portfolios, so we have also seen a pipeline of development deals that need construction financing.
With residential, for example, we have seen a lot of construction activity over the last few years as a function of the fact that it did not really exist in appropriate quantities and forms beforehand. Lenders have appetite for all these different types of strategies.
But in spite of this liquidity in the debt capital markets over the past few years, one key evolution we have seen among lenders is that the spaces in which people compete are so much more fragmented. Prior to covid-19, many lenders – even different types of lenders, whether banks or alternatives or funds – tended to converge; there was a lot of overlap among lenders looking across property types, geographies and business plans.
Today, we are seeing many divergent views on risk and where different types of lenders want to play. Even within the same genre of lender, there are very different ideas and risk appetites. Everyone is making a slightly different prediction of the future. Recent rate rises, inflationary pressures, quantitative tightening and macroeconomic trends are exacerbating this.
The benefit that we have as an alternative lender is our capital is very flexible: we can make senior loans, whole loans, mezzanine loans and preferred equity. That means we access various types of deals across the capital structure, and we can pick and choose which ones we like relative to others. This tends to set us apart from more mono-strategy lenders that may have one cost of capital or narrow guidelines around what they can pursue.
Emerging residential concepts are proving popular with alternative lenders. Where do you see growth?
In many markets, there is a lack of new supply of residential in all its forms, whether it is for sale or for rent, or student housing. I think that is the primary driver – there is a historical and ongoing lack of development in places people want to live. Over the last few years, a lot of developers and real estate investors have been trying to solve that issue by accessing or developing the residential market in different geographies – although regulations, zoning and planning laws are playing into that supply/demand dynamic.
We want to be able to underwrite a project from the bottom up where we really believe in the real estate fundamentals of a scheme. We are really focused on that granular underwriting so we are protected, and, to do that, we want to back high-quality sponsors that we believe can deliver. We recently provided senior financing for a project called Embassy Boulevard, a 467-home rental scheme in Nine Elms in London. We like the regeneration of that particular location as there is a lot of infrastructure going in there and we see the rental space as a new economy sector in the UK.
Where do you see opportunities for non-bank lenders in the competitive logistics space?
For non-bank lenders, there have been two primary areas of focus. The first is transitional or construction lending with heavy capex requirements – often against logistics or residential, as noted above, sometimes on a portfolio basis, because logistics can be built relatively quickly. We have also seen a lot of office redevelopment and construction focused on creating highly sustainable and amenitised working environments.
The second area of focus is financing facilities for aggregation or hybrid strategies, including facilities where we are financing some standing assets, albeit ones which might require some leasing and some ground-up construction, all within one facility. We have provided both aggregation and hybrid facilities in the UK and on a pan-European basis. That gives the sponsor the flexibility to bring in additional properties over time and across multiple jurisdictions, and those deals are typically €100 million or more.
How has the pandemic changed how you evaluate potential financing deals, from a property-use perspective?
We are much more aware of acute disruption now and how quickly different variables can shift. The last two years have been a stark reminder that; for example, in hotels, your cashflow does not necessarily go to zero – it can be negative. Or when you have a development budget that you thought you could use to set a fixed-price contract and, all of a sudden, costs are 15 or 20 percent higher.
What it has done is to sharpen our underwriting: we are stressing our variables to much more extreme scenarios, and stress testing whether a deal can withstand them. That has included things like inflation, energy costs, labour or materials cost, supply-chain disruption and so on.
When we are underwriting new deals, we want to know if sponsors have a plan to hedge energy costs for a period of time, and what the local labour market looks like. Those things had been seemingly predictable for a period of time, but are now suddenly much more volatile. On the revenue side, we are more conscious now of tenants perhaps not being as financially secure as we would have thought, and we are prepared for revenue to fluctuate accordingly.
Does taking development financing risk make sense in emerging and in-demand sectors?
When you fund development, you are taking a forward view on construction costs, on interest rates, and on the real estate market fundamentals at the time and in the future. So right now, I think it is increasingly difficult to underwrite a development loan without being confident as a lender in your downside protection. I think the various things we are dealing with at the moment are going to limit development and land purchases going forward for a period of time.
That said, as long as rental growth can outpace inflation and finance costs, then it still makes sense to develop; logistics is one example where that has recently been the case. I do not have a crystal ball, but I could see a scenario where that relationship inverts and it becomes less economical.
Do you see scope in financing traditional sectors such as offices in situations where assets are being repositioned for a post-pandemic economy?
We are trying to focus on best-in-class, sustainable offices in the best locations, either redevelopments or repositioning, or new build offices, because we think that tenants will ultimately be attracted to the best buildings with sustainable systems and attractive amenities. In some ways, financing a refurbishment is more ESG-friendly than financing ground-up construction because you can retain all the embedded carbon in the building.
A good example of that is 81 Newgate Street, which we financed, and which is going to be converted to an ESG-compliant, highly sustainable trophy office building. It has the nice combination of being an outstanding asset and being in a great location to begin with. Those sort of buildings will be a focus going forwards.
Backing a logistics portfolio
Apollo has provided European manager M7 Real Estate with a series of loans for several portfolios of retail warehouse properties in the UK.
The first loan totalling £167.8 million (€197 million) was originated and upsized in October 2020 for the acquisition of nine retail warehouse assets totalling one million square feet, mostly located in Greater London and the Southeast. In autumn 2021, Apollo provided a £157 million, five-year floating-rate senior loan secured by an additional portfolio of nine retail warehouse properties covering 1.2 million square feet.
“We have created a strong partnership with M7 in connection with financing their retail warehouse strategy,” says Apollo’s Ben Eppley. “M7 was an early mover in the retail warehouse sector and their thesis has proven to be correct, as values have continued to increase and other large sponsors have entered the market.”