Senior real estate lending returns are dwindling due to tightening margins and falling interest rates. Against that backdrop, CBRE examined conditions in the mezzanine and whole loan space across Europe, to determine where, and to what extent, lenders willing to embrace risk can boost returns.
In addition to data on senior lending returns for more than 20 markets across Europe, CBRE’s European Debt Map also contains information on mezzanine pricing. It is necessary to treat data on mezzanine finance with a degree of caution, due to the smaller pool of transactions from which the data is collected compared with the senior loan market, the greater idiosyncrasy of deals, and the higher variability of the quality of underlying collateral. However, despite the caveat, the data provides interesting insight into the European mezzanine lending market.
CBRE collected margin and loan-to-value data for senior and mezzanine loans in the office and retail sectors for markets where the consultancy quotes both sets of figures. It found that senior loan LTVs were typically in the 60-65 percent range, while mezzanine LTVs were typically 75-80 percent. However, the three largest European city markets – London, Paris and Frankfurt – as well as Dublin and Milan, had lower mezzanine LTVs than other European cities.
Mezzanine loan margins were typically in the range of 6-9 percent across European markets. However, the highest margins were found in the Baltic states’ major cities – Talinn, Riga and Vilnius. The three markets were clear outliers in pricing, at more than 12 percent.
Dominic Smith, senior director, CBRE Research, adds that margins in the three largest European markets were found to be within 6-7 percent: “Given their lower LTV – and the fact that the difference between LTVs of 75 percent and 80 percent is much greater in risk terms than between 55 percent and 60 percent, it is not surprising to see that margins are at the lower end of the spectrum in Paris, Frankfurt, Dublin and London,” he says.
The most meaningful discrimination between offices and retail loans from an LTV perspective – for senior as well as mezzanine loans – was in the London market, the data showed. Both senior and mezzanine LTVs were 10 percentage points lower on retail than for office, with margins 2.5 percent higher.
CBRE went on to restrict the analysis to the office market, due to the similarity of lending terms across sectors for markets other than London. The firm used this as the basis to compare the relative contribution from the senior and mezzanine tranches to the pricing of a whole loan. It did this by calculating blended pricing across both tranches of a hypothetical whole loan. In the analysis, the senior and mezzanine contributions were expressed as cash figures, assuming an underlying asset value of 100.
The firm also factored risk indicators into the analysis; with the size of the bubble relating to the ratio of current real estate values to values at the previous peak of the market in 2007. This enabled an analysis of the extent to which mezzanine returns may be higher or lower on a risk-adjusted basis across various markets.
CBRE then analysed the relative value of senior and mezzanine in a given market by comparing the contribution of each type of debt to the return of the hypothetical whole loan. The firm plotted a line to indicate the average ratio for the sample of senior to mezzanine contribution to the return. “The further a point is away from the line towards the top left therefore reflects a market where mezzanine accounts for a more dominant share of return to the lender; conversely, one towards the bottom right indicates a market where the senior is more proportionately rewarding,” explains Smith.
Part of the whole
The analysis found that, from a pure return perspective, Oslo, London and Warsaw appear more attractive markets to senior lenders, while Copenhagen, the three smaller central and eastern European markets and, to a lesser extent, Amsterdam and Brussels, may be more alluring to mezzanine lenders. There was greater balance between senior and mezzanine contributions in Paris, Frankfurt, Milan and Dublin.
However, when risk was factored into the analysis, using LTV and the ratio of value in current to previous peaks, CBRE found Amsterdam to be the least attractive. “Underlying office values appear more stretched relative to Brussels and Copenhagen, which offer higher returns, and similar levels of return may be had in Milan, for lower LTV,” says Smith.
The markets along the trendline show uniformity in relative risk and reward, adds Smith, both within markets – considering the contributions from the two tranches – and relative to other markets. “Dublin, with its lower ratio of current to previous peak value, may be an interesting outlier,” he says.
Of the markets towards the bottom right of the chart, Oslo stood out as one where mezzanine lenders seem poorly rewarded for risk, the data showed. Although mezzanine returns are small, relative to senior returns in London and Warsaw, London has lower typical LTV and London and Warsaw both show low current capital values relative to previous peaks.
The data, says Smith, provide a glimpse of the complexities of analysing when and where to pursue a mezzanine lending strategy. “Lenders with strong borrower networks – or connections to those networks via trusted advisors – will likely find opportunities to enhance returns in all markets, at a level of risk that they are comfortable with,” he adds.