Whenever the real estate market has been disrupted – cyclically or structurally – there is invariably a flight to safety for both equity and debt capital. But the economic recovery from covid-19 looks much different from what has gone previously. The pandemic has reinforced or accelerated emerging real estate trends. This means that what constitutes a safe or risky investment is more open to question than ever.
Against this unknown, Real Estate Capital asked leading property debt market participants where they see the opportunities, risks and challenges. The over-riding sentiment is one of cautious optimism and highly selective investment, but also eagerness to do business.
“I don’t think you should ever underestimate the human element – people want to do deals,” says Mark Bladon, head of real estate at Investec, the London and Johannesburg-headquartered bank. “They have not been able to get out on site and suddenly they are being set free. I expect to see a real spike in turnover of deals. What slightly concerns me is once that initial exuberance comes down there may be a small decline in asset values as the reality of high government debt, or tax rises, takes hold.”
Covid has also reinforced the environmental, social and governance agenda, which means the industry is thinking for the long as well as the short term.
“It is a huge opportunity for investors and lenders alike in this coming cycle to ensure they adopt sustainable business principles,” says Bill Sexton, EMEA president of loan asset manager Trimont Real Estate Advisors. “A lot of this is about the repurposing of real estate, as we come out of this terrible pandemic. We all have a duty to act collaboratively to ensure that ESG measures continue to be implemented. There is now enough diversity in our capital markets to enable us to do that.”
In this report, we examine where lenders with varying appetites for risk see their role in what the industry hopes will be the recovery phase after the economic shock of the coronavirus.
Where most debt capital is targeted
The future of the workplace and how it affects the office sector are arguably the most fascinating unknowns in real estate, as many corporate occupiers continue to focus more on managing through the pandemic than making long-term decisions.
With economic recovery still uncertain, some real estate lenders – including the German banks – have reverted to what they regard as core, low-risk real estate: the long-lease office. In some respects, they are making hay while the sun shines because, as the industry leaders interviewed by Real Estate Capital suggest, the definition of best-in-class offices is changing and is subject to wider and increasingly stringent lending criteria.
Recent deals show senior lenders are eager to lend against the market’s trophy assets. In March, LBBW and ING led the successful completion of a £400 million (€461 million), five-year refinancing of 110 Bishopsgate, a 459,000-square-foot office tower in the City of London. The following month, German lender Helaba underwrote a senior loan to finance the circa €700 million purchase of the Silberturm office tower in Frankfurt.
The problem is that trophy assets are few and far between. And as Gilles Polet, head of real estate finance EMEA at French bank BNP Paribas, points out, there remain significant concerns about the office sector overall. “On the equity side, you hear a lot about how people will want to go back to the office, and there will be more amenities. This is one story,” he says. “The other, very brutal one is that at least 25 or 30 percent of the demand will disappear, and that will have a systemic impact on the market. But where will be the final call between these two dimensions? It is hard to guess. What is sure is that the quality of the property in its local environment, with high environmental standards, will be key.”
Aviva Investors, the investment manager of UK insurer Aviva, has written senior loans for UK offices over the past year. Barry Fowler, managing director, alternative income, acknowledges there will be winners and losers in the sector: “But if a building is being used for collaboration and idea generation, has the right mix of sustainability features, if it is in the right location, if it has got the right wellbeing focus, then that is something we would certainly see as being core and the kind of office that will survive long-term.”
Covid and the core
German lender DekaBank is well known for financing prime offices in core locations. But Chris Bennett, who heads its London branch, believes the impact of the pandemic on core offices will be profound. As he puts it, ongoing occupational relevance and sustainability criteria are “undoubtedly going to be key drivers of investment performance”, as well as the ability to reconfigure to provide flexible space, greater focus on health and wellbeing, and reasonable walk-time to a transport hub. He adds that “competitive tension from occupiers” for the very best assets could prompt rental growth in the medium term.
Meanwhile, secondary office stock is likely to suffer from greater volatility of income and ultimately lower demand – effectively producing a two-tier market. As most industry players agree, the risk of obsolescence in this sector is higher now than it was pre-pandemic.
In comparison with offices, there is relatively little debate around residential and logistics. For 2021 and beyond, the flight to safety for many lenders will mean ‘beds and sheds’. The arguments in favour were well-rehearsed long before covid but are even more compelling now, albeit for different reasons: logistics growth on the back of surging online retail sales, with residential as a strong defensive play given the hugely favourable supply/demand dynamics in many European cities.
A unifying factor is the stability of their income – highly sought after in a tentative economic recovery. The debt and equity capital interests appear truly aligned in what some call the ‘new core’. As Bertrand Carrez, head of real estate debt at French asset manager Amundi, says: “The relative weight of those sectors is increasing, but more as the result of the market shift itself than as a shift of our own strategies.”
The ‘new core’ is also a big part of Barings Real Estate’s plan for markets as diverse as the Nordics, the Netherlands, Germany, the UK, Italy, France and Spain. “Fundamentals for these sectors are strong,” says Sam Mellor, Barings’ head of Europe and Asia-Pacific real estate debt. “Key risks are likely to be around indiscriminate pricing between best-in-class and the rest as the weight of capital exceeds the available investment universe in some markets.”
This weight of capital has raised some concerns about the risk of an asset price bubble in core logistics markets. Even a firm supporter of the sector like Mellor acknowledges there is “potentially not enough price differential based on tenant quality”, with some logistics operators running on “very tight margins” while “specific locations are very contract-dependent”.
Even so, the capital deployed into core real estate is gathering momentum, and this is having an impact on debt pricing. As many of our sources say, a core return is now under 100 basis points and only really attractive to the major banks.
“It is widely agreed that, after the [onset of the] pandemic, margins went out, depending on where you were on the risk spectrum, anywhere from 20 to 200bps as a very rough range for the same leverage or even lower leverage at the start of the pandemic,” says Omega Poole, partner, head of debt advisory at London-based law firm Mishcon de Reya.
“We are starting to see quite competitive pricing for so-called hotter asset classes at lower LTVs. Once you get into the higher risk part of the capital stack, my sense is there is less of an appetite for lenders to be competitive because there is still a fair amount of uncertainty.”
Ben Eppley, who heads Apollo Global Management’s European property lending business, adds: “There is definitely competition among sponsors and among lenders, and we have seen the effect of that over the last year where, in like-for-like deals, the spreads have reduced not insubstantially. So, the sectors where you are seeing a lot of capital – logistics, multifamily – yields are coming in.”
“We are starting to see quite competitive pricing for so-called hotter asset classes at lower LTVs”
Mishcon de Reya
Lisa Attenborough, head of Knight Frank’s debt advisory team, says the property consultancy has obtained debt financing terms for logistics assets at all-in rates of 1.5-1.8 percent in Spain, the Netherlands and Germany. She adds: “LTVs have rebased from where they were 12 months ago, and senior lenders are probably comfortable around 55 percent, with the exception of core assets in core sectors.”
From a borrower’s perspective, Duco Mook, head of treasury and debt financing at CBRE Global Investors, believes there has been a positive change in sentiment towards core offices since early 2021: “It means in practice, in my view, that an international lender would focus on the top 20, 30 cities across Europe, at central business district locations. Would they finance on a 60, 65 LTV like pre-covid? No, probably not. LTVs have tightened, so nowadays 50, 55 is the maximum for bullet loans.”
Not always aligned
Away from the established markets, there are signs the interests of investors and lenders are not completely aligned. Data centres and life sciences are clearly niche real estate sectors in terms of volume of capital deployed. But they have thrived under the spotlight of the pandemic and have a strong structural growth story that has won enthusiastic support from equity investors.
Data centres are judged to have the best investment prospects of all property types in 2021 in PwC and the Urban Land Institute’s annual Emerging Trends in Real Estate survey of nearly 1,000 European industry leaders. However, the survey is heavily weighted to borrowers and advisors, and our own sources indicate greater caution among lenders. As Mellor says: “If nothing else is certain, the increased creation and usage of data seem certain. But data centres require more of a curve of understanding and technical knowledge, which has perhaps made them less accessible and potentially under-invested.”
European lenders’ lack of experience with life sciences as a property type is also an issue. Mishcon de Reya’s Poole says lenders can see the “macro-economic rationale” for life sciences. “Lenders are excited about the newer asset classes that have been trending from an equity perspective,” she adds. “But as ever, there is caution if they feel they don’t have the in-house expertise to underwrite them properly.”
It is notable that most lender support is coming from firms, like Apollo, that have exposure to life sciences in the US, where it is a more established sub-sector. Apollo has a pipeline of upcoming deals in Europe and, says Eppley: “We think that for the right asset, life sciences properties can be core, core-plus.”