Eastdil Secured on why borrowers and lenders are having to get creative

Global investors are starved for yield. Around half of developed nations’ sovereign bonds return less than 1 percent, with expectations for only moderate inflation across the eurozone in the foreseeable future.

Real estate remains attractive on a relative-value basis and global investor allocations to property will continue to grow. The velocity and direction of foreign investment into European markets has, at times, also been spurred by foreign exchange movements relative to local currency, driven in cases by political factors and focused on gateway European cities.

The subsequent high volumes of domestic and foreign capital deployed into European real estate have pushed yields down across major asset classes, forcing investors to work harder to identify suitable opportunities. Against this backdrop, the search for yield has required lateral thinking on behalf of investors and lenders. Many are adopting new investment strategies designed to broaden the return profile of investment portfolios and loan books.

For some market participants, the search for yield has encouraged expansion into new geographies, while many others are focusing less on the traditional mainstream property sectors, such as city centre offices and high street retail. Instead, they are deploying capital into those alternative real estate sectors supported by strong underlying fundamentals such as changes in demographics and consumer habits, including urbanisation and e-commerce.

In certain asset classes, this has meant understanding emerging business models. For example, traditional office investors, influenced by the expansion of WeWork and other collaborative working competitors, have invested in serviced office assets. Some have gone a step further to build out operating companies, in a bid to capture the potential revenue surplus generated from the business model. Lender attitudes are changing as a result.

Historically, debt providers have been more reticent to finance properties such as serviced office assets due to concerns about short leases and weak end-user covenants. As sponsors and debt advisors articulate a convincing case for transactions, underpinned by a strong investment thesis and proven operational expertise, lenders have become more willing to engage on transactions. To counterbalance the relative newness of such sectors and the typically shorter leases they feature, lenders have rightly maintained focus on the underlying real estate and its location. As sector-specific data become more readily available, we anticipate increased financial liquidity in emerging sectors such as co-working.

Meanwhile, some investors are shifting their attention to different parts of the distribution chain. A clear example can be seen in the European logistics sector, where lender interest remains strong, due to favourable underlying fundamentals driven by the growth of e-commerce. During the last year, investors and lenders have moved across the value chain from big-box or third-party logistics, to ‘last-mile’ urban logistics, attracted by the strength of infill locations and income durability.

Many of these assets, historically used for traditional industrial purposes, have been repurposed for fulfilment use, based on their proximity to urban locations. For lenders, there is increased leasing risk, associated with the fact many of these assets require intense asset management to sustain and grow capital value. This risk is offset by factors such as the growth of online retail, the scarcity of well-located supply, strong rental growth and higher debt yields.

The search for defensive and durable cashflow has also led investors and lenders into other alternative asset classes such as student housing, healthcare and the private rental residential/build-to-rent sector. Overall, during the past three years, investment activity in UK alternative sectors has totalled £45 billion (€50 billion) – around a quarter of total real estate investment volume, with a similar trend in Continental Europe.

From a lender perspective, alternative asset classes represent appealing opportunities to lend defensively while improving overall loan book pricing. We increasingly see alternative property types represent a larger part of pipelines and expect the trend to continue in the coming years. However, it is imperative lenders understand the operating risks these asset-backed businesses carry.

BROADER HORIZONS

Increasingly, investors look at real estate as a series of underlying income streams, priced in relation to differing costs of capital, durability of cashflow and overall leverage. For example, in the UK, we see increased interest in fee/leasehold bifurcation strategies with long-dated asset buy-back options, through which property owners sell their freehold subject to a ground lease, while retaining the leasehold. These strategies capture arbitrage opportunities between cap rates and cashflow. The sale of a super senior income strip priced lower than the asset yield, creates additional equity value. These strategies have been well-received by lenders, subject to underlying asset/sponsor quality and an acceptable ground lease.

As the real estate cycle and industry have evolved, market participants have looked to broaden their horizons. For example, as asset managers look to grow assets under management and leverage their infrastructure, we have seen opportunistic managers shift their strategies down the risk curve to introduce value-add, core-plus and even core strategies, with lenders following suit.

The desire to move across the risk spectrum has also led to considerable M&A activity in the real estate asset management sector. In 2018, we have seen a US insurance company purchase a significant stake in a pan-European, multi-strategy equity investment manager, as well as a European investment manager buy a minority interest in a European lending platform.

Another defining factor of the market is the shift of investor capital into debt strategies. Certain equity managers have also built out lending platforms as they diversify their business models and capture new streams of revenue.

Looking forward, we are encouraged by the overall health of European real estate and the financing markets. While there are concerns about the continued strength of the global economy and the potential impact of geopolitical events, capital continues to flow into European real estate from outside the region and within.

High property values will continue to embolden investors and lenders alike to creatively deploy capital into lateral opportunities across geographies, sectors, investment structures and risk profiles. With demand for real estate and the availability of debt both likely to remain high, investors and lenders will look to new strategies to deliver higher returns.

This article was sponsored by Eastdil Secured.