This article is sponsored by FAP Invest.
When assessing risks across European debt markets, most property financiers – from direct institutional lenders via debt funds to alternative capital providers, as well as banks – look at a relatively static key figure: the loan-to-value ratio. An LTV cap determines whether the lender commits capital to a financing opportunity or not.
LTV is in fact used as an equivalent measure to expected returns. A differentiation between jurisdictions, submarkets and asset classes is usually not incorporated into the analysis. But is the default risk of a transaction with a 70 percent LTV in the UK really the same as one with the same parameters in Germany? And how do office loans fare against residential loans, at the same LTV?
Issues with the LTV
The common practice of strict adherence to LTV and interest rates as the key determining factors in the selection of real estate-backed loans can lead to, at best, lenders missing out on debt opportunities, and, at worst, a considerable misallocation of capital. With this approach, countries like Germany and France are often underweight in a loan portfolio as lower LTV limits often result in return targets not being met. At the same time, the UK and Spain are often overrepresented as – supposedly – conservative LTV caps still produce attractive returns.
“Strict adherence to LTV and interest rates as the key determining factors in the selection of real estate-backed loans can lead to a considerable misallocation
Taking Germany as an example, international investors have a very positive outlook on the country’s real estate debt market, as it is underpinned by Europe’s largest economy, and a high-performing one to boot. Market access is easy, and the political framework is seen as stable and predictable.
And yet, Germany is often underweighted within pan-European lending mandates. Lenders point out that interest rates are unattractive for senior loans – a situation created by the competitive German banks with their unrivalled refinancing opportunities – and that returns for mezzanine loans only become interesting with LTVs north of the 80 percent mark.
International capital providers in particular have identified a lack of attractive junior lending opportunities with LTVs between 50 and 75 percent in Germany. Because of this, they move into other jurisdictions where LTV ratios remain within their self-imposed margins, to reach target returns. But does this rationale guarantee the security they expect?
The LTV-driven assessment does not take into account that, while knowing the price of the property at the time of the financing, it is unclear how the property value will develop over the loan period. Predicting the recoverability of the underlying security is a challenge that is often underestimated. Another issue that is usually not examined in the risk assessment is the differing quality of valuations in various countries.
Guidelines on how to calculate the market value of a given property follow a global standard, as defined by the Royal Institution of Chartered Surveyors. So, the basis for valuation is virtually the same across the world; the ‘V’ in LTV should be easily comparable. But valuers can only map out the market according to their own experience and the data that is available to them.
Coming back to Germany, the market is a relatively opaque one. “The parties agreed not to disclose the purchase price” is a common phrase in press releases on transactions, not to mention the omittance of initial yield or other relevant details such as remaining lease terms or even tenants. Data only becomes available with a considerable time lag, so valuations are usually six to 12 months behind the market cycle. If there is an uptick of 5 percent in capital values over one year, a significant financing gap emerges. The UK is a lot more transparent, so valuations are closer to the actual market than in Germany.
What this ultimately means is that a loan with a 70 percent LTV has a higher risk of default in the UK than it has in Germany. The same equity tranche does not equate to the same amount of security. Adjusted for risk, a 70 percent LTV in the UK should correspond to an 80 to 90 percent LTV in Germany. Looking at returns within that bracket, the German real estate private debt market suddenly becomes just as attractive as international counterparts.
Lenders can incorporate these factors into their risk assessments by adopting market index solutions, which measure asset value growth as part of the loan indexation. This method provides an indication of how the valuation of the underlying property is likely to change during the life of the loan. It also provides a more accurate basis for the evaluation of the risk-return structure in target markets, as well as a consistent method for comparing real estate across borders and with other investments such as corporate bonds.
Asset value growth as part of loan indexation
Working with MSCI, we examined two attractive, but very different, European debt markets.
Together with Sebastian Gläsner, executive director at MSCI, a global provider of indices and analysis tools for the financial industry, we analysed MSCI data on the change in real estate valuations across two core European markets between 2002 and 2021. We found interesting implications for risk assessment, which support our evaluation of risk in specific submarkets.
We took Germany and the UK as examples, since they represent two highly attractive and competitive but very different European debt markets. With a ready availability of transaction data and a focus on the capital city of London, the UK is a transparent and established hub for international capital coming into Europe. It is often the first point of call for investors interested in establishing a foothold on the continent. Germany, on the other hand, consists of several strong regional markets, buoyed by its famous small- and medium-sized enterprises, which need more in-depth local know-how to penetrate effectively.
Example A: Office building at 80% LTV
Taking a given LTV of 80 percent on an office building loan, the expected loss per year amounts to 93 basis points in the UK. If the office is located in Germany, that value falls to just 39bps.
Example B: Residential building at 36bps
Turning the example around and taking a set expected loss per year at 36bps, this corresponds to an LTV of 85 percent on a loan for a residential building in the UK. In Germany, the same risk budget allows for an LTV of 89 percent.
Mapping the risk exposure
The red line represents LTV levels across different jurisdictions and asset classes – UK office and residential and German office and residential – which correspond to a maximum expected loss of 36bps per year. The difference is more pronounced in the office sector. The same risk exposure allows for an LTV of 79 percent in the financing of an office building in Germany, but only for an LTV of 65 percent in the UK. The assumptions about the expected loss are based on MSCI Real Estate’s confidential data on direct real estate investment. The company recorded a market value volume of well over $2 trillion in 2021, on which its assessments are based. The evaluation is based on assumptions FAP has implemented together with MSCI, including different amortisation scenarios and a table that converts credit ratings into an expected loss in basis points per annum.