CG Capital Europe: Iberia finds its place in the sun

This article is sponsored by CG Capital Europe

Broiling macroeconomic turmoil and high inflation have proven to be a double whammy for European real estate markets over the past 12 months. Just as investors and managers alike had hoped for some post-pandemic respite from the woes that the global health crisis caused, rising interest rates have made traditional lenders even more cautious while the cost of debt continues to climb.  

Borrowers may be feeling the pressure, and the refinancing gap is only likely to widen, but the economic backdrop is also creating notable opportunities for alternative lenders willing to step in. Javier Beltrán, CEO at real estate and infrastructure investment bank CG Capital Europe, discusses these themes as well as the rapidly changing real estate capital market on the Iberian Peninsula.

How has the financing environment impacted traditional lenders and private debt opportunities in the region over the past year?  

Broadly speaking, the current environment has increased the risk aversion of traditional lenders, making them more restrictive and selective with regard to certain asset classes and projects, as well as to borrower and tenant profiles. This approach is the outcome of a tougher economic outlook, decreasing valuations and increasing concerns over interest coverage capacity across all segments. The current environment has triggered opportunities for alternative debt lenders, for senior debt, whole loans and mezzanine facilities. Also, LTV ratios have shrunk by 5-10 percent on average across all real estate asset classes. 

It is also important to point out that private debt has evolved substantially in the past two years. We see more and more debt funds filling the gap in terms of pricing that existed previously between the traditional and alternative lender. This is creating an increasingly competitive European debt market.

Of course, the decision between one lender or another will depend on the risk appetite of the borrower, the specific project, the investment profile and the purpose of the debt. In some cases, traditional bank debt will be more suitable while other situations call for private debt.

How does the Iberian market compare with other European markets in terms of real estate investment, interest rates and the overall financing market? 

Traditionally, Iberia has taken a longer time to correct valuations and assume repricing that has been caused, this time, by the increase in interest rates. Both Spain and Portugal show more positive macroeconomic metrics than their peers, especially in terms of inflation and economic growth expectations. 

In certain markets and asset classes, especially in Portugal, yields were also less heated than in other European countries. All of the above has caused an adjustment in the market that has been more volume-driven than price-driven, and probably more gradual than in the rest of Europe.

In terms of the financing market, Iberia has traditionally been a predominantly banking market. In recent years, this has progressively been changing and is a new reality that is here to stay. There is also still much room for increasing sophistication in terms of financing decisions and structures. Another clear example is how scarce mezzanine-preferred equity tranches are compared to other European countries, such as Germany or the UK. In order to evolve in this aspect, a change in habits of both borrowers and senior lenders will still be needed. 

How do you see the steady rise in Euro Interbank Offered Rate (EURIBOR) screen rates shaping the market, and do you expect that they will fall any time soon?  

The strongest interest rate increase cycle ever registered since the euro area was founded has translated into a more challenging environment for the investment market. 

Firstly, it has triggered a correction in valuations that we are still observing and, in addition, a considerable tightening of financing conditions for both acquisitions and recapitalisations throughout the region. 

The past 18 months have been characterised by uncertainty about inflation control and the peak of the interest rate hike. This period has seen certain levers and financing strategies become particularly relevant. For example, defining the optimal financing structure and hedging strategy have become key for investors and have helped to mitigate exposure to financing risks and to optimise investment returns.

In any case, in the last few months we are starting to see a progressive stabilisation of the macroeconomic situation. Although there may still be a further hike in interest rates, it is likely to be much more contained than the previous ones, and the forward rate curves are now inverted. They point to a decline in medium- and long-term rates. I believe that we will not return to a zero- or a negative-rate scenario and we will have to live in a normalised situation with benchmark EURIBOR rates in the 250-350 basis point range.

How is rising borrower default risk influencing distressed opportunities?  

There is a higher risk perception, including borrower and tenant default risk and write-downs in valuations. This is not just a perception, but a reality and a real risk that both lenders and borrowers need to be cautious about. As in any down phase of the cycle, opportunistic investors are on the lookout, and in recent months we are seeing many players looking for distressed opportunities.

While there are bound to be some opportunities in the coming months, we believe there are stark differences from past downturns that will mean that they will not be as numerous. 

For example, leverage levels are now much more conservative and traditional lenders’ exposure to real estate sector is much lower. This factor, together with the increasing competition in the European financing market, leads us to believe that we are in a phase in which we will see a higher number of refinancing deals. Lenders could prove to be more willing to negotiate instead of taking on a troubled commercial real estate asset and having to manage it or try to sell it in today’s market.

Given the current economic backdrop, how important is the role of debt adviser in bringing together lenders and borrowers? 

Nowadays, optimal debt structuring and financing raising processes are much more complex and are taking longer than before. We are truly experiencing a more demanding and complex financing market where there is an increasing need for deep knowledge about optimal capital structures for each particular deal, individual lenders and their criteria. This is especially true as obtaining new financing, particularly optimal debt structure for each deal, has become much more complex. 

These challenges even magnify if financing is being targeted for assets without a large proven track record and for new real estate developments which are not pre-let or pre-sold, implying a commercialisation risk that many traditional banks are not willing to take. Knowing alternative lenders and capital sources, and what their requirements are, can prove invaluable in structuring new debt across the capital stack.

Having deep know-how of corporate finance, as well as local real estate sectors, is key to structure and raise optimal debt. At a moment when agility in investment decision-making is another key factor and debt raising processes are mandatorily extended, certain key principles are becoming increasingly relevant. Those include in-depth corporate finance and local real estate knowledge, implementation of innovative financing formulae, tailor-made solutions, perseverance and privileged access to lenders, including banks and debt funds.

How do you see tightening of the real estate debt market playing out in Europe?  

We will likely continue to see complexity and restrictions in the foreseeable future. Tightened financing conditions are resulting in higher lending margins, providing more appealing risk-adjusted returns for senior and junior debt. 

Tightening on financial conditions has led debt margins to expand in the first half of 2023, in parallel with EURIBOR rate increases. Margins for ‘weaker’ assets, as well as for the more risky investments, have increased considerably.

The reduction in investment volumes may be restricting the origination of new acquisition financings, but it is certainly not shortening refinancing and capex financing transactions. 

As the slowdown in transaction volume continues and higher risk aversion from lenders prevails, there will be greater need for higher equity requirements, suggesting we should not expect the investment market in new assets to fully come back to normal life before the end of this year. 

How should investors think about optimising their capital stack as an additional alternative to asset divestment?

The main consequence of asset valuation adjustment is the misalignment between bid and ask, which, except for certain players and asset classes, is still not being completely matched. This has led to a fall in investment volume and a decline in the liquidity of certain real estate assets.

The current situation in the investment and financing market has largely been brought about by factors that were difficult to foresee a few years ago. As a result, many investors’ business plans envisaged yield levels for divestment that are currently unattainable, making it extremely difficult to meet the required investment returns.

Although for some investors and deals, this is not a feasible option, an alternative in which we are increasingly working to mitigate the previously mentioned situation of diminished returns is the extension of investment horizons while awaiting a more favourable scenario for divestments. 

In the interim, alternative formulas should be implemented to boost investment returns, such as recapitalisation of assets, allowing some value creation to crystallise through a dividend.