Pricing of core UK commercial property is at or close to the top of the cycle although the market can absorb a correction, delegates at the Commercial Real Estate Finance Council Europe’s autumn conference in London heard last month.
During a discussion between lenders and borrowers, Barry Fowler, managing director, alternative income solutions at insurer Aviva Investors, said the effects of quantitative easing have helped send pricing of prime offices to an all-time high.
“If you look at QE, the premium to risk-free is still at a reasonable level. Perhaps this is a new normal unless you think inflation is going to take off and interest rates rise, which we’re seeing the start of now,” Fowler said.
“I don’t think any of us are particularly willing to bank significant levels of property valuation increase, particularly in central London, at the moment. We are mindful about the impact of where we are in the cycle overall although we’ve seen a good level of demand coming through from tenants, and that’s been helping to provide an element of growth.”
“There’s a degree of caution in the lending community,” Fowler added, “which is driven by market conditions and regulations. We’re not typically lending 75 or 80 percent loan-to-value, and you can find pockets of real growth and real opportunity if you go out into regional markets in particular. There is a differential between London and the regions and across different asset classes.”
A market correction is “inevitable”, according to Roman Kogan, head of CRE at Deutsche Bank, although he declared: “I simply don’t think there will be systemic risk across the banking sector. There will be some positions that some of us have that go sideways and they will cause a bad day here and there. But I just don’t think there is enough leverage to amplify a correction into a full-blown crash.”
Lenders including Fowler and Kogan, as well as borrowers on the panel broadly agreed that both sides are better placed to withstand a market downturn than they were during the global financial crisis.
According to Chris Bennett, director at DekaBank, lenders are more disciplined than they were in the last market peak in 2007, preferring to analyse debt capital per square foot and debt yields rather than rely on LTV.
“Lenders are smarter than the last cycle, with underwritings being more disciplined,” he said. “If you look at debt capital value and debt yield against historical levels, there is currently higher implied leverage than if one was to look solely at a headline LTV.”
Bennett pointed out that QE is not the sole influence on current investment flows, adding: “Investors’ rationale for purchasing assets varies dramatically – as we’re seeing in central London where cash-preservation is key for many. The differences in investment rationale are likely to shape the investment market over the next five years.”
However, Bennett also warned delegates: “I think we’re in danger of overlooking the potential for a reverse in capital flows. It wouldn’t take too much of a change in direction of value for conventional lenders to have less regulatory capital to lend.”
The recent rise in UK base rates and the prolonged economic uncertainty due to Brexit united borrowers and lenders on the panel in their sober market assessment although as Fowler remarked: “I don’t think anyone is hitting the panic button.” But it was clear, too, that they are responding to these headwinds while trying to judge the impact of societal change and longer-term occupier trends.
Offering a borrower’s perspective, David Marks, co-managing partner at Brockton Capital, described a “revolution going on in every sector of the real estate market” with lenders needing to adapt to a new era of shorter leases and an increasing number of real estate companies using operational platforms, such as co-working and build-to-rent, to boost returns.
“Property is, in its own right, a lagging indicator of what occurs in the real economy. But whether you look at online retail, Brexit fears or technology, we’re seeing a response across every asset class,” he said. “What were once dirty multi-let industrial units have now been rebranded as ‘urban logistics’ – achieving significant price hikes as a result of demand soaring from e-commerce and logistics businesses.”
Madeleine McDougall, global head of commercial real estate at Lloyds Banking Group, highlighted the challenge for lenders in distinguishing between a trend and certainty, and therefore establishing the downside risk of investment. “A trend is somewhere between a fad and certainty – and banks prefer certainty,” she said. “We do recognise an increasing variety of societal changes affecting demand for real estate and we are willing to support clients. Fundamentally though, we need to know where debt risk ends and equity risk begins.”
McDougall continued: “We conduct substantial risk analysis in order to become comfortable – meaning that if a trend fails to play out, any property has a clear alternative use. Co-working offices can easily be let to a single tenant just as blocks of rented apartments can be sold off.”
There was also the vexed question of development finance. Sooner or later the real estate industry will need to address long-term occupier trends via new development but right now, as borrowers and lenders on the panel all acknowledged, conditions are tough. “We’re seeing more capital flowing into our sector from UK defined-benefit pension schemes, and they’re getting their heads around investing into real estate-backed debt,” Fowler observed. “I think a natural evolution would be to bring them into the world of development funding. But I’m just thoughtful of where we are in the cycle.”
Another big issue for the conference – and indeed for the finance sector – was whether the dramatic changes in real estate will foster the continuing growth and importance of alternative lenders, and attract new players.
“I think there will be a huge wave of new lenders, some of whom may not even exist yet,” declared Marks. “If you look at some of the pent-up sovereign wealth money that is going to come out of not just Saudi Arabia but Japan and other places with an ultra-low cost of capital, the natural place it will flow to is debt.”
There was more reticence from the lenders on the panel, underlining the barriers to entry. “The number and diversity of lenders will continue to grow,” said Fowler. “But at some point we’ve got to recognise that what happens in a perfect market situation is you’ll see some consolidation – some acquisitions, some of those groups come together as they need to try and bring their cost base down again. It will keep evolving.”
In many respects, however, the advancing real estate cycle and wider changes in the industry have reinforced the age-old importance of relationship banking. On this, the borrowers and lenders were in agreement. As Lloyds’ McDougall concluded: “The lenders that survive are lenders who can deliver execution certainty, who are flexible and who can do it in a quick timeframe. The lenders who will do well are the ones that can innovate and listen to their borrowers to help them try and evolve.”
GETTING TO GRIPS WITH TECHNOLOGY
If technology is the enabling force behind the social changes and mega-trends shaping the future of the built environment, then speakers at the CREFC conference confirmed that the world of real estate finance is also feeling its impact.
Throughout the event, the importance of technology was a recurring theme, from the opening keynote speech by Tim Harford, the economist and broadcaster, to the quick-fire presentations of various new apps that promise to smooth the path of property investment.
With any discussion on developing technology and the efficiencies that follow, there are invariably fears that jobs will be lost as a consequence. In his speech, Harford suggested the impact will be a lot more nuanced. As he put it, automation and artificial intelligence may not take over jobs outright so much as certain tasks. For some, there may be little distinction between the two but a version of Harford’s thesis is already being played out in areas of real estate finance, such as mortgage lending with the likes of LendInvest.
Chief executive and co-founder Christian Faes told delegates the company is already seeing automation transform mortgage lending. Though “real underwriters” still make the credit decisions, the fact is the company is on track to lend around £1 billion per year in the next two years or so, and it will do so with fewer than 200 employees. LendInvest is competing against challenger banks that typically employ more than 1,000 people to process similar volumes.
With its online mortgage lending platform, LendInvest represents an obvious example of technology at work although at an earlier borrower/lender panel session there was some debate about the speed of change in the process of all property lending – whether technology can help get the money to the borrower swiftly when it comes to bigger transactions.
As Faes pointed out, however, the focus of the technology at LendInvest lies not just in driving efficiencies in the lending process but in providing its own investors with “very granular data”. Such analysis and management of property performance data must surely be one of the lasting benefits to borrowers and lenders, large and small.
Madeleine McDougall, global head of commercial real estate at Lloyds Banking Group, said as much when she described the use of technology as a “gamechanger” for the bank’s pioneering green lending programme.
According to David Marks, co-managing partner at Brockton Capital, technology and data management will improve occupancy as well as the energy efficiency of buildings. “There are going to be winners and losers,” he said. “Those buildings that are offering what people want and are energy-efficient and utilisation-efficient are going to be full. You’re going to see 50-60 percent occupancy in the worse buildings. It’s all about stock selection and the management of stock selection, and technology is going to play a huge role.”
With superior returns from property hard to come by right now, there is a lot of discussion in real estate about the increasing requirements of equity investors for granular data as they seek to justify investment decisions. But as both sides on the borrower/lender panel suggested, this push for performance by the asset managers should be good news for their lenders, too.
It may just turn out that the real disruptive force of technology will be to encourage greater transparency across the sector as a whole.