The latest quarterly European Debt Map report released by CBRE shows lending margins remained stable on average during Q3, following months of falling pricing for prime office lending – the largest and most liquid sector in real estate debt. Borrowers, however, have experienced rising debt costs during the quarter.
Here is why, plus three other trends CBRE highlighted that we think are also important to note:
1. Rising swap rates spell more expensive debt: Despite margins remaining unchanged across most Western European countries, the total cost of senior debt has gone up across the whole of Europe in Q3 2018, rising 11 basis points to 2.28 percent. The explanation? An increase in five-year swap rates, in the face of tightening central bank monetary policy is the clearest reason. As the European Central Bank (ECB) phases out its €2.5 trillion bond-buying programme, known as quantitative easing, market expectations are that interest rates will have to rise. Rates, however, could stay low in the foreseeable future in the absence of major political or economic shocks in continental Europe. Prepare for a different scenario in the UK; a no-deal Brexit would cause a collapse in the pound and a spike in inflation – making rising rates more likely.
2. Competition is intensifying in smaller Western European markets: Lenders are increasingly struggling to achieve desired returns in the biggest and more established European real estate markets, such as Germany or France, which both show flat average prime office margins at 1 percent. This has encouraged debt providers to look to the next tier of markets, such as Portugal, Ireland, Belgium and the Netherlands. The consequence of this increased activity is a compression in loan pricing throughout 2018. Over the last quarter, Spain and Ireland were the markets within this group that experienced the most significant drop in margins; down by 55 and 25 basis points respectively.
3. UK debt is cheaper, but lenders are keeping a lid on leverage: At first sight, the UK seems to be a borrowers’ market, with margins down by 25 basis points to 1.25 percent in Q3 against the previous quarter. Falling margins have driven the total cost of debt in the country down by 13bps to 2.79 percent, offsetting the swap-rate effect explained above. While property debt in the UK is cheaper, it is not all good news for borrowers. In Q3, average loan-to-value ratios fell to 55 percent from 60 percent in Q2. This means property borrowers need to deploy more equity, which could impact their yield returns. From the lender’s point of view, lower LTVs mean further de-risking lending books, which some believe is driven more by late-cycle prudence than specific Brexit fears.
4. Lenders still have faith in Italy’s real estate: It seems Italy’s shift to populism has affected loan pricing, but not as much as many expected. In Q1 2018, typical senior margins were at 1.75 percent. But, after the formation of the populist coalition government in May, lenders reacted by increasing average loan pricing to 1.9 percent in Q2. With margins down by 10 basis points in Q3, debt providers seem to be recovering their trust in Italy. Confidence, however, is more linked to the performance of the underlying real estate sector, with debt particularly backing core assets in prime locations, rather than a reduction in scepticism about the policies of the Italian government. Indeed, in Q3, property investment volumes were their highest ever, reaching €1.6 billion, a 7 percent increase compared with the same period of 2017, according to data from Colliers International. It is an example of robust investor demand for real estate offsetting political concerns – and keeping lenders busy.
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