Inflation has replaced covid-19 as the main source of angst in Europe’s real estate finance market. Already on the rise in 2021 due to pandemic-related supply constraints, it is soaring following Russia’s invasion of Ukraine. “The market is coming to terms with the fact that inflation may be more permanent than transitory,” says Claus Skrumsager, head of North Haven Secured Private Credit Fund at the asset management arm of US bank Morgan Stanley.
Key metrics point to this new paradigm. UK inflation reached 9 percent in April, from 5.5 percent in January. In the EU, it increased from 5.6 percent to 8.1 percent in the same period.
To counter the rising cost of living, central bankers are unwinding more than a decade of loose monetary policy, with an end to quantitative easing and increases in interest rates. Furthermore, with no end in sight to the conflict in Ukraine, economic growth prospects look dire. In May, the European Commission slashed its growth forecast for 2022 to 2.7 percent, from 4 percent. The threat of recession, and stagflation, hangs over Europe.
All this comes as Europe’s real estate industry rebounds from covid. Consultant CBRE reported €359 billion of investment in Europe in 2021, up 25 percent from 2020. Lending was also up. London’s Bayes Business School revealed new UK origination of £49.7 billion (€59.4 billion) in 2021 – up 48 percent from 2020. As the buoyant property industry comes up against volatile macroeconomic conditions, lenders are being forced to balance these opposing conditions.
The Bank of England’s prediction in May for where the UK inflation rate will rise in 2022
“The headlines sound staggering, but the story for our market is more nuanced,” argues Andy McDonald, head of real estate finance for the UK arm of banking group HSBC. “Our house view is that the Bank of England rate will hit 1.5 percent this year and stabilise around 2.5 percent. These are still relatively low rates in the scheme of things.”
McDonald says the sector has been “drinking from the cup of low rates” for years and acknowledges even a moderate rise will have an impact. “Whenever the cost of anything goes up fourfold, it is a shock. Our asset class will not be immune to these headwinds, particularly when cap rates in certain asset classes have contracted so substantially in recent years.”
Borrowers are still seeking financing, which they continue to view as accretive to their investments, but are concerned about increases in base rates, liquidity costs and a low-growth environment. This has led to more conversations about the value of hedges.
“We have endless calls with clients about hedging,” says Francesca Galante, co-founder of pan-European debt advisory firm First Growth Real Estate. “Some borrowers ask if the forward curve has priced inflation in too much, and some believe the ECB will not be as hawkish as it is indicating. But most are saying ‘let’s hedge’. There is a healthy debate among borrowers. Taking the contrarian view and declining to hedge is a big statement right now though.”
With uncertain conditions ahead, Galante has also seen greater borrower demand for longer-term, fixed-rate loans as sponsors aim to lock in today’s market terms with the anticipation of both hedging and liquidity costs possibly increasing.
Expectations of higher rates have already fed into SONIA, Euribor and swap rates, leading to higher priced debt in the industry. “In addition, if liquidity costs for banks increase due to their underlying cost of funding rising, banks’ loan margins need to be higher,” says Galante. “It means a narrowing of the difference between bank debt margins and the margins offered by debt funds, which have already been raised at a certain return level.”
The European Commission’s growth rate prediction for 2022 for the EU, revised down
As head of debt and value-add equity strategies in Europe for Chicago-headquartered LaSalle Investment Management, Michael Zerda has both a lender and borrower outlook on the market.
On the borrowing side, his team sourced more than £400 million of debt in April to finance two UK outlet centres. “A dozen interested parties came forward,” recalls Zerda. “Many were banks looking to price the loan from a capital markets perspective. We decided to go with a ‘balance sheet style’ lender, due to possible near-term disruption in the capital markets. It proved to be the right call.”
Zerda notes the economic climate has already had several effects on lenders. Investment banks that securitise or syndicate their loans – as well as alternative lenders funded with back leverage – have had to adjust to financial market volatility.
“We have seen some traditional banks retrenching to their home markets or away from certain risk profiles, such as development risk. Some, but not all, have either increased pricing or reduced the amount of leverage they will provide,” says Zerda.
On the rise
A specific threat posed to real estate financiers by inflation is rising construction costs. Those with existing development loans face the risk of cost and time overruns on sponsors’ projects. Those considering lending against new schemes, meanwhile, face the challenge of calculating the likely cost element when deciding leverage.
“On the equity side of our business,” says Skrumsager, “we have seen construction costs go up as much as 60 percent in the past 18 months. There is no doubt we will see pain in the development space.”
Skrumsager says there is still liquidity for development projects, but borrowers face tighter lending terms. “Importantly, loan structures are also tightening. We will see lenders demand equity goes into deals first rather than alongside debt. Lenders will also demand cost overrun guarantees from sponsors and more checks around sponsor liquidity. In a higher-rate environment, lenders will want a higher stabilised ICR [interest coverage ratio], meaning a lower entry LTC [loan-to-cost].”
Zerda says inflation is already impacting the development financing market. “We have seen development starts put on hold, which hopefully takes some inflationary pressure out of the market. We’ve also seen banks more cautious about construction and some even pull wholesale out of development finance.”
Not all bankers are negative on development lending. Christian Schmid, real estate director at Germany’s Helaba, says factors including location must be considered when making investments in development projects. He points to a project – the Central Business Tower in the bank’s home city of Frankfurt – which Helaba is not only financing, but is also developing on its own land, which he describes as “one of the best locations in the city”.
“I feel comfortable with that,” says Schmid. “I believe such a location will find its market. The challenge is not to let it too early to benefit from rental growth.”
Development aside, debate rages as to whether standing real estate stock represents a hedge to inflation. In a March 2021 research paper, manager DWS said US commercial property prices exhibited a strong correlation to inflation, particularly in the 1970s and early 1980s. However, with costs rising sharply, some believe affordability issues will hit sectors unevenly.
“Contractually, most cashflows in loan collateral will have some sort of inflation link. But you need to look under the hood,” says Skrumsager. “For example, third-party logistics companies operate on very tight margins, so, can that sector really absorb a higher rent burden? Will build-to-rent residential tenants be able to afford higher rents, given purchasing power erosion? Or will affordable housing schemes prove a less cyclical proposition than super-expensive flats?
“It’s one thing to have an inflation-linked income stream on paper, but another when tenants are not prepared to pay rent rises. In nine out of 10 cases, there is some sort of negotiated outcome. But we’re in completely new territory here, and some of these increases will be significant.”
Debt specialists argue a forensic analysis of potential loan collateral is essential. Lenders are urged to give attention to whether assets are correctly positioned within their markets. “As a lender, we look for collateral where the revenue growth can support cost inflation,” says LaSalle’s Zerda. “We are focused on industries and asset types where income will outpace capital or operational expenditure growth.”
Lorcain Egan, head of lending in Europe for Starwood Capital, says the US private equity firm has been thinking for some time about how investments will hold up in an inflationary environment. “Last year, we thought the recovery from covid would come with some inflationary aspect,” he says. “Quantitative easing peaked in 2020, with $18 trillion of negative-yielding debt in the world. It was a signal we would have to think about inflation, because all that debt would need to find its way back into the system.”
He explains Starwood’s decision in March 2021 to provide a £1.8 billion loan to mega-manager Blackstone was written with rising inflation in mind. The loan, made alongside fellow non-bank lenders Apollo Global Management and Blackstone’s own debt business, Blackstone Real Estate Debt Strategies, was to finance the UK holiday property platform Bourne Leisure. “Parts of the hospitality sector look a good place to be in an inflationary environment,” says Egan. “Operational real estate where revenues and income rapidly adjust to inflation is attractive.”
Egan goes so far as to argue inflation is not necessarily a negative for lenders if investments are selected wisely. “For us, it’s a 50-50.”
End of an era
A major impact of inflation on the real estate lending market is rising rates, as central bankers counter rising costs by pulling policy levers. The extent of rate rises remains an unknown, but most believe a gradual end to the era of cheap debt is happening. The Bank of England base rate was 1 percent at the time of writing, after four consecutive increases, and the ECB is expected to raise rates three times this year.
Jim Blakemore, head of debt at manager BentallGreenOak, does not expect to see dramatic rate rises. “The scope for rate rises is not what it was in the 1970s. A 20 percent increase to mortgage rates in the UK would be catastrophic. The world is in a dramatically different place, and there is a lot more debt out there. Central bankers have the ability to exert influence through relatively small changes.”
While some fear the impact on borrowers’ ability to service higher debt costs, most executives who commented for this article do not foresee widespread distress.
“A lot of our clients have interest rate risk mitigation strategies, so in the near term I don’t see wholesale stress on ICRs,” says HSBC’s McDonald. “Will it increase scrutiny of lenders around refinancing events? Sure. But since the global financial crisis, notwithstanding the yield environment, there is enough buffer in client cashflow to withstand a hike of 150 basis points. We aren’t looking at a cliff edge event here by any stretch of the imagination.”
Clarence Dixon, global head of loan services for property services firm CBRE, says lenders are factoring future rate rises into their underwriting now. “There is an anticipation that interest rates will continue to rise, so it is being built into underwriting now. Lenders do not want to be caught on the back foot. They are modelling out how their cost of capital will increase.”
The impact of rising rates will affect lenders according to their funding sources and the risk-return profile they are seeking. North Haven’s Skrumsager says his organisation’s model has been to target attractive risk-adjusted returns in the senior, moderately leveraged, investment-grade lending market. “We have stayed away from very tight, sub-200-basis-points logistics financings, for example, as tight valuation yields can easily break a loan when stressed.
“But if there is a repricing in this area, such as stabilised prime residential and logistics, which has been aggressively financed by banks, we might see more sensible pricing from our perspective. It might become a proposition for us. But we would need to be very cautious, as higher rates have an impact on the cost of hedging, valuations and reasonable exit debt yield assumptions, requiring more conservative underwriting.”
Egan sees rising rates as a positive for a lender like Starwood, which provides loans against transitional real estate and seeks higher returns. “We find it tougher to keep generating great risk-adjusted returns when rates are getting lower and lower,” he says. “We love cashflow, so low rates put a strain on our underwriting in certain sectors. Our team generated outsized returns in a low-interest-rate environment and that definitely wasn’t easy. When rates are very low, driven by central bank quantitative easing, the normal economic cycle can get out of kilter.
“We want, as a business, to take advantage of this economic cycle. We doubled our loan book last year – we created some of our best risk-adjusted returns. So H1 2022 is close to our best six months. For Starwood European Real Estate Finance, our London listed fund, the most important point is that 78 percent of our portfolio is floating rate loans, so our returns increased, all at a conservative 61 percent overall LTV.”
The end of easing unlikely to dampen investor interest
According to Sabina Reeves, chief economist and head of insights and intelligence for manager CBRE Investment Management, the unwinding of quantitative easing makes investor commitments to real estate, and real estate debt, that bit less attractive. “The property yield is still above the bond yield, but the premium is narrower,” she explains. “It was abnormally high.”
Another stress on capital flows to real estate is if institutional investors find they are overallocated to the sector. “We’re in the midst of a bond sell-off that we haven’t seen for many years, so multi-asset investors, as bonds and equities take a hit, may find themselves overallocated to real estate.”
However, despite headwinds, Reeves believes real estate equity and debt strategies will remain attractive to investors. “If real estate fundamentals remain strong, and rental growth is frothy, investors will seek access. But the ability for real assets to act as an inflation hedge varies wildly by type of asset. Managers need to choose the right type of real estate carefully.”
She adds that the diversification on offer through real estate strategies, including the range of credit risks on offer, makes the sector an interesting prospect. “Because real assets are heterogeneous, you can find the protection you need if you want it. It varies from a pure bond to a pure equity, depending on where you are in the capital stack.”
A major risk on lenders’ minds is the threat of rising rates contributing to a fall in real estate equity values. As borrowing gets more expensive, buyers are less likely to view the cash-on-cash return from an asset as justifying the investment. The prospect of falling values means lenders may become exposed to higher LTV ratios in existing deals and are likely to become more conservative on leverage for new loans.
“If interest rates increase, and the value of assets goes down, yields must increase to make real estate a better investment than government bonds,” says Helaba’s Schmid. “I don’t expect this scenario in the next 12 months because there is so much liquidity. But if interest rates rise too fast, there will be a rapid change, because values have stayed for too long at their current levels.”
Skrumsager already sees evidence of yields bottoming out in parts of the market: “It is early days, but in April and May, in the secondary logistics market for example, we’ve seen cases where yields moved from 3.5 percent to 4 percent in Benelux, and from 3 percent to 3.25 percent in France. But valuations always lag, so we as a lender focus more on cashflows.”
The risk of declining equity values could lead to greater caution among lenders, potentially resulting in lower leverage on offer to borrowers, at higher margins. Some expect lending strategies to become more specialised as debt providers home in on preferred sectors. Lenders are also forced to consider the impact of slow growth in European economies just as the recovery from covid was getting underway. The longer the conflict in Ukraine continues, the worse Europe’s economic growth prospects look, and the more likely recession becomes. But lenders argue they will continue to provide finance in European markets, albeit with sponsor and asset selection at the front of their minds.
For bank lenders, managing extensive existing borrower relationships will be a priority. Helaba’s Schmid says that, although new business was lower in 2021 than in the previous year, the bank’s real estate portfolio grew due to fewer clients making early repayments on loans. “The question we are asking internally is: how can we be more selective in our financing deals, but also service our existing client base?”
Schmid believes a focus on quality loans is more important than ever. “We should imagine the days of everyone making a hell of a lot of money from real estate might be over, but quality still survives.” He foresees a situation where the difference between winners and losers in the market will be based on “the location and quality of the asset, but also by what sponsors have done to add value, rather than sitting on a plot of land and expecting it to generate income”.
Others argue that a focus on financing value-add projects – despite concerns about rising costs – will make sense in testing economic times as sponsors strive to deliver appropriate stock to their target markets, with sustainability a priority. “For anything with a refurbishment or value-add aspect to it, you need to stress test the deal a lot,” says BentallGreenOak’s Blakemore. “But there is a need to upgrade real estate, especially in the office and retail segments, to make it more relevant in today’s world.”
Although their outlooks on European real estate financing conditions differ, the debt specialists who spoke to Real Estate Capital Europe acknowledged there are uncertain times ahead. All indicated they remain eager to do deals, albeit while considering a new range of risks.
“It’s a more difficult world,” says Blakemore. “As well as inflation and rising rates, there is also ESG to think about, the remaining effects of covid and emerging sectors. There is change everywhere, and it makes it all more challenging. But plenty of investors out there believe hard assets are a good place to be in an inflationary environment. That bodes well for real estate.”
Rising rates will test loan book quality
Lenders argue conservative underwriting during this cycle will stand loan books in good stead through a period of interest rate rises. However, Nicole Lux, lead author of the Bayes Business School UK lending report, sees difficulties in this cycle not with loan-to-value ratios, but with income coverage ratios.
Bayes’ December 2021 survey showed 38 percent of the UK loan market was fully floating rate. Assuming a 50-basis-points rate rise, interest coverage ratios will drop from a current 1.3x to 1.6x range to what Lux called “critical levels” of 1.2x to 1.5x, resulting in a rise in covenant breaches.
“I think it is more of a concern than some think right now,” she says. “Unless real estate yields start to move upwards, things will be difficult for owners of some assets, and while some costs can be passed on to tenants in higher rents, if they cannot afford the new rent level, there is no extra income to collect.”
However, one senior loan servicing industry figure says widespread distress does not look imminent. Clarence Dixon, head of loan services at CBRE, periodically applies a 10 percent haircut to the leverage of the $340 billion of loans his team manages to test how stressed it becomes. “It is minimal. Let’s give credit where it is due – lenders’ good underwriting,” he says.
Paul Lloyd, managing partner and chief executive of London-based credit management firm Mount Street is also yet to see stress across the loans the firm manages. But he says there is gathering concern in parts of the market. “There has been prolific lending in recent years, and some question how well all loans were underwritten. With all the problems going on in the world, there could be issues with some loans.
“Everyone dismissed the prospect of payment default. While the odd small company going bust is unlikely to have a dramatic impact on a large portfolio, if several implode at once then this could indeed lead to an eventual loan payment default. Lenders can kick the problem down the road if they have enough income coming in, but they need to consider their eventual exit. So, people are hiring companies like Mount Street as back-up servicers to do more surveillance on their loans than ever before.”