This article is sponsored by Drooms
Through its role as a provider of digital data-rooms for real estate transactions, including financing transactions, Drooms has a vantage point on European market activity. Rosanna Woods, managing director for the UK and Benelux at the firm, says cross-border transactions, including the financing side of them, are increasingly challenged.
What challenges are cross-border real estate transactions facing today?
Currently, it is difficult to get large cross-border transactions over the line. We have seen a number of planned deals going on hold while the participants adapt their approach, and sell assets off in smaller packages or individually. These are highly complex deals, subject to all kinds of legal and technical issues, and in a time of uncertainty that makes them increasingly difficult to close, particularly in the absence of common standards.
With 27 countries and 24 official languages, cross-border business relations in the EU can be complicated. The implementation of new regulation, much of it related to ESG, is happening at a different pace across various countries, which can lead to delays and legal uncertainty. Buyers and sellers need to understand which minimum standards apply in one country, but not in another, so that for each market they are identifying the right price point.
On the debt side, there is a growing disparity in the approach of risk-off German financiers, compared with US and UK lenders. Meanwhile in cross-border transactions the respective parties sometimes have different approaches to due diligence processes.
Then there are macroeconomic challenges around rising interest rates and inflation, and fluctuating exchange rates. The war in Ukraine has also had a chilling effect on some cross-border deals because buyers are re-evaluating the risk profile of assets in Eastern Europe. The silver lining for transaction volumes could be that a lot of capital has been raised by managers that are waiting for signs of distress to deploy it.
How much of an issue is debt supply to the cross-border investment market?
Cross-border transactions always become difficult if the target market is not sufficiently transparent, is not perceived as legally secure, or is too small without enough comparable market data available. Decisions about whether to lend frequently depend on the source of lenders’ capital, whether it is from the US, Europe or elsewhere, and they can be comfortable with some markets, but not with others. Our clients tell us that debt funds and banks are still lending, with German banks continuing to offer the most competitive terms on a risk-adjusted basis.
However, the supply of debt has essentially reduced as a result of leverage coming in. Where lenders may have been at 60 percent LTV before, they are now more likely to be at 50-55 percent. The larger the deal, the more competitive the landscape. The US investment banks are still very active in the market, especially if there is a syndication play or a chance to securitise or sell down.
Are lenders’ and borrowers’ approaches to due diligence changing?
We are entering a new and more complex world for dealmaking. The combination of rising construction costs, rising interest rates, rising inflation and the unknown direction in rent trends inevitably leads to a new risk assessment. To get deals done, lenders and investors are working together to find creative ways to put in place different belts and braces to make sure that the downside is protected, using approaches like cash traps, dilution agreements and bridge loans from sellers. At the moment, the bigger and more sophisticated players are in the best position to play these cards and get large cross-border transactions over the finishing line.
Which sectors do you see as particularly challenging for cross-border transactions?
In recent years, we have seen a lot of cross-border logistics platform sales. But achievable prices and turnover are changing considerably in the sector as development costs are rising, and it will take some time until the parties’ purchase price expectations have come closer to a consensus again. Retail is still an issue, as is hospitality, but the latter is making a comeback post-covid. The pandemic was a very difficult time to dispose of cross-border hotel portfolios, but we are beginning to see more platforms changing hands. There is also a lot of refinancing activity for multinational portfolios currently as owners restructure in response to rising interest rates and higher construction costs.
How big of a challenge is data security?
Regulatory requirements are still fundamentally different across European countries, so establishing a common standard is crucial, and ideally that should be the highest possible. Failing to take data security seriously can potentially be very damaging. Recently, a European housing company was issued with a double-digit million euro fine by GDPR for its lax approach to handling data. According to an analysis by DLA Piper, fines issued for GDPR violations across the EU increased almost sevenfold from January 2021 to January 2022, to nearly €1.1 billion. There is also the risk of reputational damage.
Digitisation in the real estate sector was accelerated by the pandemic, but more people working remotely also led to more potential cybersecurity vulnerabilities. Real estate companies really do need to up their data protection game because, through their tenancy relationships especially, they have millions of pieces of personal information at their disposal. It is vitally important to partner with companies and providers that have a high degree of security in their setup, and to use smart, secure digital platforms to share information. For example, in a data room, everything is protected through watermarks and permission structures and audited so that you can see every click.
What is your outlook for cross-border European real estate business?
The euro region has almost fully recovered from the effects of the pandemic, but the Ukraine war is a setback. Further economic upheavals, such as a recession, are to be expected and depending on how long high inflation lasts, effects on the real estate market are also to be feared. Savills research suggests that in 2022 we should expect to see cross-border investments increase by 2 to 5 percent. The outlook is hard to predict, but the fourth quarter of 2022 will set the tone for what 2023 looks like.
How can some of these challenges be overcome?
More common standards would be helpful. For instance, Drooms developed the gif Data Room Index, a common due diligence standard which is now recognised throughout Europe. Due diligence is a key part of completing a deal successfully, and it is important to ensure a standardised form of information flow and review for all parties involved.
One of the key factors for the success of international transactions is the availability of all relevant documents, and making them accessible to all parties involved, anytime, anywhere. This requires a single source of truth, a generally valid database that can be relied upon by all stakeholders involved in a transaction. Digital and collaborative platforms are the best way to provide that, as they ensure networked, secure and effective collaboration across time zones. They also enable the management and structuring of documents, so that the seller can always update documents and potential investors have insight into all available information.
Where such solutions also have an integrated translation tool, it helps to overcome language barriers, while preventing any potential security leak that might be caused by interfacing with external applications. Having complete data also supports the identification of advantages and weaknesses with regard to ESG guidelines, and the creation of meaningful ESG reports. At this point in time, secure, digital solutions are mandatory to be able to overcome the many challenges of deal making in a cross-border situation.
Information ecosystem supports sustainability
Storing, organising and accessing ESG data is increasingly crucial for closing cross-border transactions.
Are deal participants in large, cross-border transactions providing adequate ESG data?
Not always, but the trend is clearly upwards. There are few investors who do not have ESG on the agenda, and the quality of data available during the due diligence process is increasingly important. The level of detail required depends on the ESG strategies and the ambition of the different stakeholders.
But it is clear that vendors are putting more effort into collecting and disclosing ESG data on metrics such as energy performance, green building certificates, green lease clauses and on-site renewable energy production.
How is ESG data being used in the financing of such deals?
Lenders often assess opportunities by commissioning third-party due diligence reports, which now includes an increasing amount of data on ESG factors sent to them, particularly as their appetite for financing green buildings is growing. In the light of increasing regulatory requirements such as the EU Taxonomy regulation and Green Bond Standard, and to avoid allegations of greenwashing, banks and other lenders need to make any green financing subject to binding conditions. Their fulfilment must be confirmed based on ESG information, which requires a reliable and up-to-date database of factors such as energy performance and building in-use certificates.
How can data rooms be used to optimise ESG data?
We need a common, transnational standard for ESG data, similar to the gif Data Room index, so that you can say that all the documentation is there to establish the ESG standing of each asset. Market participants face significant challenges in meeting regulatory requirements on reporting and investor disclosure. For example, mandatory disclosures under SFDR require that various documents be collected and reviewed, to disclose any exposure of properties to fossil fuels. For large portfolios, that would be almost impossible without centralised storage in data rooms.
In the future, stricter transparency requirements will not only require permanent data collection and storage over the entire real estate lifecycle, but also the linking of data rooms to an ecosystem of other systems. This would provide access to up-to-date data on anything that relates to ESG when you need it.