This article is sponsored by M&G Investments.
Why have you continued to finance offices amid such uncertainty for the sector?
The office sector is not without its challenges, which relate primarily to changes in working patterns and how that might impact occupier demand and asset values. In our view, it is important to follow occupier demand because, ultimately, investors will go where the occupiers go, and the debt and equity will follow.
Stock selection is key, therefore. It is about picking the right asset – an office building where people fundamentally want to go and work, which needs to be accessible, have amenities on site, be close to other amenities, and, certainly, needs to have green credentials.
We continue to see good demand from occupiers for those products. If you look at take-up in central London since covid, it has been weighted towards those best-in-class buildings. And we have seen office rents get to record levels, seemingly contradicting the often-negative sentiment about the market. There is an undersupply of this type of office, so we are pretty relaxed about financing that type of property.
A key 2022 deal was your £79 million (€89 million) financing to revamp a London office scheme. Is refurbishment where you see the opportunity in offices?
We think the opportunity is in green buildings, with ESG credentials, amenities and accessibility. In 2020, in the middle of covid, we did two big office deals, lending over £600 million secured against two existing buildings. The assets had long income and were high quality, with BREEAM ‘Excellent’ certification. That is one type of investment we are happy to make.
The second is a refurbishment or development type, where you are delivering a product into the market which meets the occupier’s current expectations. Occupier requirements have become more specific over the past two or three years through covid. If you are financing a refurbishment or development today, it allows you to provide an office building which should tick all the boxes for the modern occupier.
How have financing conditions changed in the European office market in the past year?
For offices, it has become more challenging. For modern buildings with long leases to strong tenants in gateway cities across Europe, there continues to be liquidity to finance those assets. Pricing has moved out and LTVs have come down a bit – it depends very much on whether the valuation has been rebased and by how much.
If you take Berlin, for example, prime office yields were under 3 percent pre-covid; now, they are closer to 3.75 percent. Likewise, City of London yields are around 100 basis points wider today than they were 12 months ago.
If valuations have been properly rebased, we are seeing leverage levels broadly unchanged for the best assets. There has certainly been, on the lending side, a flight to quality.
Across the market there still seems to be a lag between where valuations are and where we think the clearing price actually is. So, when we are asked to finance a particular asset and are told its loan-to-value is 55 percent, if the valuation has not been rebased we might conclude in the current market that LTV is going to be more like 65 percent and so we have to price it accordingly.
For offices, we are starting to see more values rebasing; we are starting to see transaction evidence coming through. That makes it easier to say where yields have moved to, to get a clearer picture of what the true value is, and lenders are more willing to lend against that.
Do those challenges reflect the wider real estate financing market?
I think so. Since covid, there has been a change in how people live and that is impacting real estate. It has accelerated the shift in retail to online, which has implications for all retail asset classes: shopping centres suffered; out-of-town retail warehousing performed fairly well; and the high street entirely depends on which town or city you are in.
We have seen how that shift online accelerates the growth of the logistics market. We have seen people working from home and the impact that has had on the office market. So, there has been a knock-on effect in pretty much every asset class.
Fundamentally, it comes down to where the value of the asset you are lending against is and how sustainable your income is going forward, which are always the questions you ask yourself as a lender. For much of the past decade, we have been asking these questions in what has been a quite benign environment, with relatively low inflation and non-existent interest rates.
In the past 12 months, however, we are asking ourselves the same questions in an inflationary environment, with higher interest rates and the cost of living crisis, while the UK seems to be on the cusp of recession every other quarter. It is a very different environment, so we have to pay extra special attention to those considerations.
Beyond office opportunities, which other sectors are attractive in the current market?
Purpose-built student accommodation and the private rented sector will continue to be an attractive and defensive debt investment off rebased values. There continues to be an imbalanced supply/demand dynamic which favours the provider of high-quality product.
If you are looking for more risk and return, then we see a big opportunity at the moment in refurbishment and construction. That is one part of the market where liquidity seems to be drying up because lenders are increasingly concerned about the impacts of cost inflation and increased insolvency risk in the construction supply chain.
As a consequence, lenders seem to be pulling back from construction and refurbishment finance. That is where we think there is going to be a real opportunity to lend at attractive returns.
As a non-bank lender, how are you adjusting your lending strategy to suit market conditions?
We are not adjusting it per se, but we are more mindful of the risks in the market and ensuring we have a rebased valuation and we understand the NOI better. The fundamentals of real estate, sponsor expertise, credible business plan and equity at risk remain the same.
What do you see as the main threats and opportunities in the European real estate sector in 2023?
Macro events, rather than market specifics. This includes the inflationary environment, the situation in Ukraine, and tightening monetary policy across Europe and the UK. All of these create uncertainty which has translated into lower investment volumes across Europe. Investors are pausing for thought.
For debt funds, there is actually a great opportunity. The banking market has not dried up completely but there seems to be less liquidity and many of the debt funds do not have the same constraints that some bank lenders might have. When there is less liquidity in the market, opportunities increase for alternative lenders to make some attractive investments.
As real estate values come down, the amount of debt an asset can support will reduce and that is creating a funding gap to existing loan balances due for refinance. And that is a particular area where opportunities exist for lenders such as us.