Given the capital-intensive nature of real estate investment, it is critical to assess and monitor the functioning of the debt capital markets to anticipate where equity markets are heading.
Most new bank lending activity is currently on hold as lenders pause to assess internal exposures and the potential for the repricing of risk, although previously committed deals are completing – albeit with some margin flexibility where possible. Traditional market participants have been negatively impacted through existing portfolios as they are assessing potential losses and increased costs. Some are stuck with unrealised syndications swelling balance sheets.
While the cost of capital for banks is up about 50-100 basis points, it remains to be seen to what extent this will be passed on to real estate borrowers as new transactional evidence – post the covid-19 pandemic – on both the debt and equity side remains on hold.
Positive leverage permits a geared purchaser to bid a higher price – assuming all else is equal on underwriting assumptions and required rate of return. Should the pricing of debt no longer be accretive to leveraged buyers, the unlevered underbidders’ pricing may reflect a marked reduction in property value.
This oversimplification admittedly masks the reality of the real estate market as highly geared property investors traditionally have also targeted higher levels of return, so would incorporate more aggressive underwriting assumptions along with a higher cost of capital. By contrast, low-levered and equity-only buyers have traditionally come from more conservative institutional capital sources that benefit from a lower required rate of return. In turn, these dynamics act as a counterbalance to narrow the end pricing gap, but it remains that it is normally the highly levered buyer that can afford to pay a higher price and be the winning bidder.
In the current market context, increasingly of greater importance than price is availability of financing. For those lenders not riddled with balance sheet concerns the focus will shift toward underlying sector prospects and asset quality. Both the debt and equity markets have found consensus around the epicentre of disruption being the hotel and retail segments. This is where distress may emerge despite a more accommodative banking sector compared to the post-global financial crisis period.
It is critical to keep a close eye on what is occurring in the debt capital markets
Meanwhile, residential and industrial properties are expected to remain more insulated due to the essentiality and underlying demand-side tailwinds remaining intact. The more limited availability of debt capital by source of finance, combined with more stringent asset characteristics – in terms of sector, asset quality, location and other factors – for those active lenders, will likely drive a starker variation in equity valuations as not all markets will reopen with debt financing available, regardless of the aforementioned pricing element.
Beyond the issue of pricing and lender preferences for exposure, size is also a key stumbling block for the debt capital markets. For financings in excess of €100 million-€150 million that traditionally rely on a syndication, the limited capacity of the banking sector to fill this void is leading to an acute shortage of debt capital for large scale assets and, or portfolio transactions. This may provide cash-rich equity investors or alternative lenders with an opportunity to take advantage of a situation where competing levered buyers are out of the market, with the wider capital market dislocations providing a short window of opportunity to secure high-quality assets with limited competition.
For equity investors navigating the current market turmoil, it is critical to keep a close eye on debt capital markets as adjustments in this portion of the capital stack will have a direct consequence on where, and, at what price, the levered buyer will be able to transact. Pricing of the debt piece is likely to see margins widening – which may be counterbalanced by declines in the reference rates.
But, perhaps more importantly, availability of debt capital is likely to be more focused. The US market is experiencing a more rapid adjustment than Europe, but what is becoming clear on both sides of the Atlantic is active lenders are more discriminating on the underlying sector and locations they are willing to lend on.
Furthermore, a number of lenders are increasingly sensitive to loan size. All of which provides some insight on where price discovery and liquidity are likely to first emerge as investment opportunities up and down the capital stack.