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CREFC Europe: Shining a light on back funding

The financing behind European real estate debt funds is both a bright spot and a dark corner of the real estate debt market, finds CREFC Europe's CEO, Peter Cosmetatos.

Peter Cosmetatos of CREFC
Peter Cosmetatos, CREFC Europe

When the global financial crisis struck nearly 15 years ago, we discovered how little anyone knew about the amount, quality and location of real estate risk in the financial sector – even though most of it was in highly regulated banks. Since the GFC, the real estate finance market in the UK (and more patchily in continental Europe) has seen a big expansion in non-bank lending. As banks, including CMBS lenders, pulled back, largely under regulatory pressure, the gap was filled by other sources of capital, drawn by the risk/return of real estate debt in a low yield world.

Non-bank lenders have proven more long-lasting than the opportunistic, short-lived phenomenon some expected. As they consolidated their presence in the market, their capital structure has evolved. Firms that initially only deployed equity raised from their investors now commonly add fund-level leverage to increase their firepower, compete in the lending market and deliver promised returns. There are various models for this, ranging from loan-on-loan to warehouse lines and repo finance widely used in the US.

Those forms of ‘back funding’ have some interesting characteristics:

  • By increasing the capital available to non-bank lenders and reducing their blended cost of capital, back funding helps ensure a flow of reasonably priced credit to those parts of the market that banks are no longer committed to serving. Debt fund leverage thus structurally supports the supply of credit to the whole real estate market.
  • In economic terms, the back funder and the debt fund can replicate a senior/mezzanine split.
  • Unlike a true senior lender, the back funder does not get mortgage security, but it typically enjoys a lighter capital and compliance burden than for direct real estate lending.
  • For firms that have reduced their direct real estate lending for regulatory or commercial reasons, lending to debt funds offers diversified real estate exposure.
  • Back funding is opaque. In all likelihood, neither the end borrower nor financial regulators will know about it. It is also invisible to studies such as Bayes Business School’s commercial real estate lending report, which sees a senior loan advanced by a debt fund, but not the participation of a bank or other back funder, or the slicing of risk that allows.

The evolution of Europe’s real estate lending market to include leveraged non-bank lenders makes a lot of sense. Although the pandemic did not excessively stress this model, a property crash might – and the opacity of this corner of the market feels problematic.

In trying to make post-GFC UK oversight of real estate risk in the financial system smarter, the Vision report, published in 2014 by a cross-industry group, called above all for comprehensive, robust and timely data. The European Systemic Risk Board has also consistently acknowledged real estate “data gaps” in recent years.

But while regulators do have a better handle on real estate risk in the banks, they have not kept pace with a changing market. That is not a good thing. A future property crash will surely reveal problems, and regulators rarely do their best work when they are caught by surprise.