How covid-19 is changing debt pricing

The European real estate lending market has been in a period of dislocation ever since the pandemic struck earlier this year.

As per consultancy Knight Frank’s latest Active Capital report, lenders are following different pricing strategies according to the source of their capital. While there is more stability than in the immediate aftermath of covid-19 lockdowns in March, lenders are still subject to a variety of pressures.

Here are five observations on how real estate debt is being priced in European markets.

Senior debt has a covid premium: There was an initial pricing shock in senior debt markets in March and April, due to reduced supply, as well as volatility in corporate bond spreads. One source noted senior margins were hiked by around 50 basis points for core transactions compared to pre-covid levels. Margins have since eased back, but remain around 25bps higher than before coronavirus as lenders tread cautiously.

As Knight Frank’s head of debt advisory, Lisa Attenborough, told us this week: six months have passed, lenders are realising they need to adapt to a new normal. But they need to lend on a more cautious basis.

However, LIBOR, the base rate which continues to be used in loan deals, reduced by around 75bps from January to October this year, meaning the all-in cost of senior debt for borrowers, in some cases, has reduced.

Not all debt funds are hiking margins: Mezzanine pricing is trickier to pinpoint and depends on the source of the capital the lender – typically a debt fund – is using.

Overall, debt funds’ return targets remain the same as before the crisis, meaning some have reduced leverage, in some cases from 80 percent to 70 percent but left pricing unchanged in order to achieve these same return levels.

However, there are cases of debt funds raising pricing by circa 100bps, according to Attenborough. This is typically where they are stepping into parts of the market, such as development finance, to pick up the slack left by the retreating clearing banks.

Insurers are dealing with volatility: Insurance company lenders price their lending relative to corporate bonds. An initial spike in bond spreads at the start of lockdown saw them raise property loan prices in turn. Corporate bond spreads have stabilised for now. But it is far from certain that they will stay at these current levels and more volatility is expected.

Investment banks are setting floors: Investment banks rely on the ability to syndicate debt to manage their loan exposure. Congestion in the syndication markets earlier this year severely curtailed their ability to lend. According to Knight Frank, investment banks, particularly those with UK-based lending teams, have introduced new minimum pricing floors as they manage their balance sheets cautiously.

Pricing varies by geography: From a geographic perspective, Germany, a well-capitalised debt market, has returned to competitive pricing relatively quickly. Spain, which recovered from the global financial crisis far more recently, is still noticeably volatile. Even core logistics deals in Spain are reported to be priced considerably wider than pre-covid levels. While the UK has recovered reasonably well in terms of lender appetite, the end of the Brexit transition period is looming. In already uncertain times, this is adding another layer of uncertainty into lenders’ decision-making.