This article is sponsored by Invesco Real Estate.
Many are grappling with the question of how inflation will impact Europe’s real estate lending market. Some argue that rising interest rates will result in borrowers of floating-rate debt struggling to service their loans. Others say higher rates will mean debt fund managers may be in a position to earn greater returns from new loans.
Andrew Gordon, head of European real estate debt at global investment manager Invesco Real Estate, sees rising inflation as both a challenge and an opportunity for alternative lenders. He tells Real Estate Capital Europe that real estate debt can provide an inflation hedge, and floating-rate real estate debt can be inflation-proof, if the right loans are structured on the right assets.
How does soaring inflation present a risk to non-bank lending strategies in Europe’s real estate market?
It presents risks that I would split into shorter- and longer-term risks. Short term, one consideration is about the impact on borrowers’ ability to service their debt as interest rates rise. The other short-term risk is how cost inflation is going to impact development costs and capital expenditure. Those risks are front of mind when we look at deals.
Longer-term risks, which can be harder to get to grips with, include looking at whether underlying tenants will continue to afford paying high rents. It is also important to consider the impact of rising interest rates for the potential widening in valuation yields of certain assets: if inflation takes hold, do higher interest rates start to put pressure on valuation yields on assets?
We look at the cushion between five-year swap rates – the benchmark for the market – and valuation yields. The current position provides comfort on a historical perspective and we continue to monitor this.
How are you managing inflation risk to your own strategy?
It comes down to picking the right asset, the right sectors and the right locations, because if valuation yields do come under pressure, the situation will vary across the market. Key to this is knowing the sector and the micro-location, underwriting the business plan and ensuring the borrower is capable of executing on that business plan. This is especially the case when considering whether the landlord will be able to increase rents in order to maintain interest-cover ratios if in a rising interest rate environment. Having an extensive on-the-ground platform of local experts who fully understand the assets, sectors and locations can help manage this risk.
Which real estate sectors do you see as most resistant to inflation?
The simple answer is that assets where there is robust tenant demand will be the most resilient. Ideally, this will be combined with the ability to conduct regular rent reviews so that passing rents do not fall too far out of line with market levels.
In certain jurisdictions, standard leases in some of the traditional property sectors include indexation on a regular basis. We are also keen on operating assets, such as residential, where there tends to be more structural flexibility to increase rents.
Self-storage fits the bill because they are let on short-term licences, where rents can be increased on a regular basis. Affordability is helped by the relative price inelasticity from the customer’s perspective because, once they have a self-storage unit, barriers to moving are high.
“Assets where there is robust tenant demand will be the most resilient”
We like student accommodation because, like self-storage, we are looking at short leases, with the ability to increase rents regularly. The level of demand is rising again for students, with strong application numbers for university places starting in September 2022.Sections of the residential sector are also attractive. We prefer to be where there is the broadest level of demand: where you capture people who no longer have the same amount of disposable income and want to move down into your range; and you can also capture the part of the demand where people’s incomes are growing and they can move up into your range.
Retail requires a sensible note of caution. The pandemic accelerated the trend and caused a structural shift towards online shopping. Where you can embed the two together – in-store and online shopping – then you start to see opportunities where people make the most of retail parks and retail warehouses.
Do you expect rising inflation and rates to put pressure on borrowers’ ability to service their debt?
Simply put, yes: increasing interest rates will make it harder for borrowers to pay interest. In terms of fixes, our borrowers need to take out some form of interest-rate hedging, which allows them to cap any potential rising debt service costs going forward.
It will not, however, help protect our exit risk at the end of the loan, when the asset must be able to cover debt service for a new loan at the prevailing rates. Again, the details matter. Good borrowers will be able to ensure that the right assets attract tenants who can afford to pay rents which are sufficient to service a sensible amount of debt.
Anyone would tell you that what has happened this year is gloomier than they had hoped it would be. There is the war in Ukraine, and inflation that is proving to be less transitory than expected.Our current underwriting makes a range of assumptions on what the forward interest curves are going to look like. We focus heavily on that to ensure that even in scenarios where the underlying interest rate rises quicker than expected over our loan term, that the resulting increased debt service cost remains affordable for the borrower.
How is the inflationary environment changing how you view development finance?
The big risk is the impact of inflation on the cost of development or the cost of capex. The answer is the same as it has always been, which is, where possible, to fix build costs on day one, have a sizeable contingency built into your budget, and have cost overrun guarantees in place. That is what you can do in terms of cost inflation, but you need to factor in the potential unavailability of materials.
For instance, a lot of steel comes through Ukraine; we use a lot of Russian timber; and there are certain fixtures and fittings that are in short supply. Just switching suppliers is not necessarily a solution as it can mean delays, and delays are money as far as development is concerned.
How are you talking to your investors about inflation and its impact on the lending strategy?
In one word: positively. As interest rates rise, we believe investors need to consider asset classes that can generate and maintain income in line with higher inflation.
Real estate debt is an inflation-hedged investment. Most of our loans are floating-rate loans, meaning our returns will move in line with rising interest rates. It is also positive in terms of the type of asset we look at – we focus on core assets with robust demand and with the ability to move rents on a more regular basis.
Our investors understand the underlying real estate tends to perform better in an inflationary environment and that floating-rate debt provides further inflation protection. It is one of the attractions of investing in this debt space, whether this is part of a multi-asset portfolio or for insurance firms’ Solvency II requirements.
Investors also appreciate that debt has a significant element of downside protection. Investors are fully aware of what is going on in the wider financial markets, and, within that context, we are bullish about the benefits of real estate debt and believe that European real estate debt has the potential to offer a stable yet significant return for investors as the market prepares for the possibility of higher inflationary pressures for a longer period of time.
Europe is seeing lower core inflation rates than the US
In March, the US inflation rate rose to 8.5 percent, the highest annual rate in 41 years, falling to 7 percent in April.
Andrew Gordon, who led the transfer of GAM’s $300 million commercial real estate debt finance business, including its European team and corresponding assets, across to Invesco Real Estate in late 2020, says “inflation is something US investors are having to deal with and understand in their own country.
“If anything, core underlying inflation in Europe is lower than it is in the US.”
Gordon adds that wage inflation has taken off a lot more in the US than in Europe, “so while inflation is high in Europe, it is not looking like it will be as embedded as it might be in the US.
“While we must wait to see what happens, once you look at the core inflation, it is not as scary a position as the headline makes it sound.”