Debt expected to remain ‘plentiful’, despite political and economic risks

With interest rates set to stay lower for longer and bond yields in many European countries in negative territory, debt for real estate is expected to remain plentiful in 2020 – albeit with important conditions, according to industry leaders.

More than half of the 905 respondents to Emerging Trends in Real Estate: Europe 2020, the annual survey published on 6 November by consultancy firm PwC and real estate industry body the Urban Land Institute, believe that the availability of debt for refinancing or new investment in 2020 will be in line with 2019. Some 28 percent of respondents anticipate the supply of debt increasing in the next 12 months.

In terms of where debt will come from, survey respondents expect the long-term shift away from banks towards debt funds and institutional lenders such as pension funds and insurers to continue. More than 70 percent believe alternative lending platforms will increase their activity in the next 12 months, more than three times the 22 percent who expect banks to lend more.

Yet among the more detailed interviews carried out with lenders and borrowers, there is little evidence of complacency about the risks inherent in a late-cycle market when there is a fine balance between economic growth and the effects of monetary policy. Central banks’ moves to maintain or cut base rates are clearly seen as a big boost for real estate investment, but not yet for the underlying economies. The threat of a global recession, escalating trade tensions between the US and China, and continuing uncertainty over Brexit are all clouding sentiment. “Our risk requirements have become more stringent in these times and it is hard to find business as a senior, conservative real estate lender,” says one German banker.

On the borrower side, a director of a UK real estate investment trust is similarly cautious: “The biggest issue overhanging the business is political risk. In response, we are keeping financial leverage low.”

With pricing high for existing assets, investors seem willing to look to development to find higher returns. However, survey respondents believe it is more likely there will be a much larger increase in equity than debt for development, reflecting the willingness of institutional investors to adopt a build-to-core strategy and the pullback of traditional lenders from development finance.

A significant industry concern for 2020 is the cost of construction – rising labour and material costs have added to the risks associated with development, particularly in Germany, where economic concerns are most acute.

One pan-European debt fund manager expresses concern about the volume of develop-to-core projects: “You can create a story about Brexit, but it is easy to build in Germany, so some markets could get overbuilt pretty quickly. If we have a downturn, there could be a lot of space that is not needed.”

At the same time, the growing popularity of alternative and residential real estate, which has been charted by the survey for several years, shows no sign of easing. Interviewees point out that, with commercial values high almost across the board, sectors with demographic support, such as rented residential, are increasingly attractive. This thesis is spreading beyond the equity sphere and into debt where, until recently, lenders had been more reticent about exposure to assets outside mainstream real estate. But more than 40 percent of respondents believe the biggest increase in availability of senior debt in 2020 will be in niche sectors.

“We have had a development finance mandate for a while, which is continuing to grow for anything with a bed,” one fund manager says.

That does not mean offices and logistics have been sidelined by debt providers. Lenders are continuing to back high-value assets in a benign interest rate environment that has caused yields to compress or remain flat in core markets. But the possibility of a downturn is influencing lenders’ strategies when it comes to lending on core assets. One bank director sums up the mood among traditional lenders: “We know we are a long way into the current cycle. No one knows what interest rates will be in five years and that makes us nervous, cautious, and we are not willing to take a punt. You need to be aware of cycles and you make sure you are in the best assets, well connected to public transport.”

“If we have a downturn, there could be a lot of space that is not needed”

Pan-European debt fund manager

Alas, retail does not fall into the “best assets” category, at least for 2020. Survey respondents were not asked specifically about the sector, but interviewees report that lenders are far less willing to lend on shopping centres and retail parks, particularly in the UK, where the sector is facing precipitous falls in both income and capital values.

“We are very cautious on retail, and we would only lend to clients who are already active in the sector, and only on high street units,” says one banker, speaking on a pan-European basis. “We are not lending on shopping centres or retail in the regions.”

“A lot of lending institutions have redlined retail, and that makes it harder to wade in,” says a UK advisor.

One debt fund manager adds: “For UK retail, I think 2020 will be a big year in terms of lenders dealing with problems. The Bank of England is talking to banks and asking them to look at their books, to address whether there are real problems there. A lot of big property companies are conducting reviews at the behest of the banks.”