Alternative lenders have become a significant component of the UK real estate finance market since the global financial crisis, as tighter regulation contributed to a lower risk tolerance from commercial banks.
Meanwhile, non-bank lenders have been slower to build market share in continental Europe. But the combination of a global pandemic, regulatory changes and a more challenging economic environment are creating opportunities for private real estate debt managers in many European jurisdictions, according to Peter Hansell, who is helping to drive US-headquartered investment manager Nuveen Real Estate’s lending strategy in continental European markets.
Why do alternative lenders command a smaller market share in continental Europe than in the UK?
It is an interesting question because, ultimately, the regulatory and structural changes to the banking sector that have driven the growth of commercial real estate alternative lending in the UK have been very similar in continental Europe. Specifically, that is the increased focus of regulators on banks’ overall exposure to commercial real estate debt and increasing regulatory capital allocations against higher risk loans.
However, the UK banking sector experienced a more immediate impact of the GFC, with the effective bail out of some domestic banks resulting in the relatively quick imposition of ‘slotting’ regulation by the Prudential Regulation Authority. As higher risk commercial real estate loans became more expensive for banks in the UK to hold on balance sheets, a market opportunity for alternative lenders began to open. By contrast, Basel III regulation was not as punitive to continental European banks.
Also, the UK emerged more quickly from the GFC than many European jurisdictions, creating financing opportunities for non-bank lenders and the institutional investors that allocated to the first wave of their strategies. As one of the most lender-friendly and transparent jurisdictions in Europe, the UK was a more straightforward prospect for investors in the early part of this cycle, when real estate debt was considered an emerging asset class. An initial focus on the UK made it possible for managers to raise the third-party capital required for the sector in the UK to grow.
In many continental European markets, strong competition in the banking sector and borrowers’ traditional approach to sourcing real estate finance have made it more challenging for alternative lenders to enter certain markets. However, there is no single story for European jurisdictions.
What is changing in continental European markets?
The upcoming introduction of Basel IV regulations will have an impact on European banks similar to that of the slotting regime in the UK. Tighter regulation is forcing a greater focus on European banks’ risk profiles and their total exposure to real estate lending. It means borrowers looking for a slightly higher leveraged position or for slightly more complex capital structures are seeing opportunities to work with alternative lenders.
Institutional CRE debt investors also have a greater appetite for continental European lending strategies. They have greater understanding of private real estate debt and managers can demonstrate experience and successful lending track records outside of the UK. There is plenty of appetite for ‘mid-risk’ whole loan and mezzanine strategies, so continental European jurisdictions represent a logical expansion. This combination of borrower demand and investor appetite is supporting the growth of the sector in continental Europe.
However, there are still European jurisdictions in which competition within the banking sector is strong, making it more challenging for alternative lenders to gain market share. The scale of the opportunity, therefore, varies from jurisdiction to jurisdiction. That competition, as well as some of the legal complexities that exist, means the growth of alternative lending in some countries is slower.
How much of a role has the pandemic played in this evolution?
I do not believe the pandemic has changed the direction of travel in relation to the alternative CRE debt sector, but it has certainly been an accelerator of already ongoing change. Within the banking sector, we have clearly seen an even greater focus on managing the risk profile of future lending.
Tighter lending terms have encouraged borrowers to investigate alternative financing options to meet their specific financing needs, and often to work alongside an increasingly sophisticated broker community. There has been a great deal of education on the advantages that alternative lenders can bring to the market.
Why does growth in continental Europe make sense for your debt business?
The returns on offer in core continental European lending markets do not differ greatly from the UK. So, the real driver is the ability to follow our borrower clients as they enter new jurisdictions. Greater geographic scope also allows us to grow our loan portfolio in a logical manner. There is growing investor demand for euro-denominated strategies. To date we have expanded in Europe mainly though senior lending, but we also see good demand for the whole loans and mezzanine finance we have been providing in the UK.
What sort of borrowers are demanding such finance?
The borrower base continues to widen as alternative lenders offer a greater range of products. Demand for non-bank finance is mainly coming from borrowers operating in the core-plus and value-add space, together with those core investors seeking longer-term and fixed rates now that interest rates are rising. International private equity has been, and continues to be, one of the major users of alternative finance, but they are by no means the only source of demand. We are working with some of the larger domestic property companies in several jurisdictions, as well as high-net-worth individuals.
Alternative lenders can accommodate complex lending structures and offer a greater level of flexibility than traditional banks. That flexibility will prove particularly important as markets potentially get slightly choppier over the coming months. As alternative lenders, we can also offer a range of lending tenors, often with higher levels of leverage, as well as payment-in-kind and partial PIK options, meaning structures can be tailored to the specific business plans of a borrower on a case-by-case basis. This is particularly relevant to lending in the core-plus and value-add sectors where borrowers need flexibility to successfully execute repositioning and capex-heavy business plans.
Which continental European markets are most attractive to you?
We are seeing plenty of demand in southern Europe, including in Spain and Portugal, as well as a good range of opportunities in the Netherlands, Germany and Ireland. Those are the five markets where we see the strongest risk-adjusted relative returns.
We are also seeing opportunities emerging in both France and Italy, although we are a little more cautious on those jurisdictions for different reasons. France remains highly competitive from a lending perspective due to a strong local lending community, so opportunities tend to be fewer and relative value more difficult to find. On the other hand, Italy has a slightly different risk profile given its enforcement process, although we do see interesting opportunities from time to time.
Germany is highly competitive. Is it a difficult market to penetrate?
Yes, Germany is a highly banked market, but there are still those same downward pressures in terms of leverage within the commercial banking sector. We are seeing opportunities open up for both whole loan and mezzanine lending, particularly where borrowers are looking for higher levels of leverage which are not available from banks, or for loans against value-add business plans which are not as easily accommodated within the lending frameworks of the local banks.
German banks are increasingly accepting that, to accommodate the leverage requirements of their clients, they need to have alternative lenders with mezzanine products join them in the capital structure. It is a sign of increasing sophistication in the German market. This should create opportunities for alternative lenders in the market. But, as with all these things, it is a gradual process. It will not all happen at once.
Which sectors are most attractive?
We are relatively sector-agnostic, albeit cautious on retail. A lot of dealflow we see is for logistics and beds sectors. Although logistics yields are low, as are residential yields in markets such as Spain and the Netherlands, investing through debt provides headroom in case values soften. We also see scope in European office markets, as well as more niche sectors such as data centres and slightly more infrastructure-like real estate.
Risks yield opportunities
In the short term, inflation, accompanied by rising interest rates, will have an impact on refinancing.
According to Nuveen Real Estate’s Peter Hansell, inflation may also cause lenders to reduce advance levels depending on the view they take on financial ratios, particularly debt-service coverage ratios and debt yield.
“Another unknown is the possible impact of interest rates on cap rates and what that ultimately means for valuations and leverage levels. Of course, there is also the potential for a much talked about economic slowdown later in 2022 and into 2023,” he says.
However, Hansell believes that the headwinds facing the broader real estate market may also benefit the alternative lending sector, as, increasingly, for the institutional investors that provide the capital to the sector, alternative lending typically forms part of a broader real estate strategy for a highly income-driven investor base.
“A slowdown in capital growth should therefore mean that alternative lending will emerge as a key area of focus in the short to medium-term. Investors will progressively look to alternative lending for the strong income-driven return that the asset class offers, in combination with the downside protection that is derived through the equity buffer in combination with robust financial covenants,” he says.
“In short, alternative real estate lending will once again look very attractive relative to the value of other fixed income products and relative to direct real estate investment. It is time for careful evaluation of risk, certainly, but also a time of opportunity for further growth in the alternative lending sector.”