Data: The relative value of real estate debt

The latest CBRE data show that real estate debt remains a smart choice in a low return world.

The second half of 2019 saw a surge in real estate investment activity across Europe, according to data compiled by real estate consultancy CBRE. The €191 billion of transactions closed in H2 2019 was 12 percent higher than the same period in 2018, and more than 50 percent more than the H1 2019 total.

“A significant amount of activity was driven by investors seeking bond-like investments in a world where the return on actual bonds has become negligible,” says Dominic Smith, senior director, CBRE Research.

With government bond yields negative in many countries, property yields – even when as low as 3 percent – can offer a significant premium.

Smith adds that senior lending against real estate offers a considerable premium in most western European markets, of around 150 basis points, rising to 200bps or more in markets including Portugal, Spain, Sweden and the UK.

CBRE delved deeper into the benefits of senior real estate lending to investors. It calculated the return that real estate debt generates over government bonds in each market, as a proportion of the premium real estate equity generates over government bonds in that market.

For example, if government bonds yield 1 percent, senior lending yields 2.5 percent and direct property yields 5 percent, the senior lending premium over government bonds would be 1.5 percent and the share of the property premium would be 40 percent. The latter figure is calculated by dividing 1.5 percent – the senior lending premium over government bonds – by the 4 percent premium direct property has over government bonds.

In this analysis, CBRE also considered prevailing loan-to-value across markets.

The analysis showed that there is a very strong correlation, 0.91, between the senior lending premium over government bonds and the share of the property risk premium enjoyed by senior lending. However, it showed there is no correlation between LTV and the share of the property risk premium enjoyed by senior lending. Some countries – such as the UK, Spain, Sweden, Portugal and Norway – offer lenders a very high share of the risk premium at a relatively low LTV.

In France, Germany and the Netherlands, for example, the trade-off is more balanced, the analysis showed.

In others, including many of the central and eastern European markets, lenders get a relatively low proportion of the property risk premium at the price of a relatively high LTV.
“For investors seeking a low risk, higher yielding alternative to government bonds, this picture may prove instructive,” says Smith.

Hotel returns

Whatever the relative story, there can be no escaping the fact that real estate lending returns, in absolute terms, are low. With this being the case, and with competition for lending against prime assets extremely strong, Smith says it is increasingly common for lenders to seek out additional margin and opportunities outside the mainstream sectors of the market.

CBRE data show that, in many countries, hotels are often the fourth largest sector of the market by transaction volume – if not the third or even second, given retail’s recent weakness. The consultancy compared lending terms for hotels with offices in 10 countries for which it has data.

The x-axis shows the extent to which prevailing LTV is lower or higher for hotels than for offices. The y-axis shows the extent to which additional margin is available from hotel lending. In this analysis, the size of the bubble represents the hotel market’s share of investment volume in 2019 – making it a measure of relative liquidity within the sector in each country.

“Some interesting trends emerge, showing arguably that in each country investors get some sort of extra something from the hotels market,” says Smith.

In Germany, Belgium and the Netherlands, the additional 20-30bps of margin available from hotel lending is proportionately high, given office margins at or below 1 percent. With the hotel lease structure in these markets making income characteristics most like that of offices, a higher premium would perhaps be an unreasonable expectation, explains Smith.

Italy, Portugal and Spain are mature markets where hotels account for a high share of the overall investment market – more than 20 percent in each in 2019. According to the analysis, Spain offers a slight additional margin for considerably lower LTV, while in Italy the reverse is true – more than 1 percent extra margin at the same LTV as offices. Portugal arguably underperforms these two comparators, offering only a little more margin at a little less LTV, but the smaller size of the economy and its reliance on tourism – making hotels a more mainstream asset class – means less differentiation arguably makes sense.

The data show that hotels in France and the UK offer intriguing opportunities. Both are liquid markets, with 7 percent and 10 percent market share and €2.5 billion and €6 billion of investment volume in 2019 respectively. But both also offer a premium relative to office lending of around 50-70bps at a LTV discount of 2.5-5 percentage points.

“Greater volatility of underlying asset income of course plays a part in this, but lenders with knowledgeable underwriting capability will not be deterred by this,” adds Smith.

Irish hotels potentially offer an even greater lending opportunity – a margin premium of 85bps and LTV discount of 10 percentage points in a relatively liquid market. Arguably, the smaller total size of the market, and the sector’s issues during the global financial crisis are driving this gap from office pricing, which nonetheless will appear attractive to many lenders.