Our panel of industry figures discuss the widening range of deals becoming available to Europe’s private equity and opportunistic buyers, as a growing field of lenders compete to back higher-risk assets.
Opportunistic capital is gushing into European real estate, looking to scoop up good deals while borrowing costs stay low and markets recover.
In the past 15 months, funds targeting European opportunistic and value-added real estate have raised €20.2bn of equity, while another €9.4bn has gone into European real estate debt strategies, according to PERE Research and Analytics.
Our roundtable panel discussed where private equity is finding the finance and how flexible lenders are prepared to be.
On the borrowing side were Aref Lahham, a founding partner of Orion Capital Managers, and Cameron Spry, Tristan Capital Partners’ head of investments. Roman Kogan, Deutsche Bank’s European head of origination and Christoph Wagner, director of debt strategies at TH Real Estate, gave the lenders’ perspective. Straddling the middle ground were Alan Samson, co-head of Gibson Dunn’s real estate group and Blair Lewis, chief executive officer of servicer and lender Hatfield Philips/LNR in Europe.
Serendipitously, the roundtable gathered in Carmelite Riverside, a Thameside City of London building Orion bought in 2012 and speculatively redeveloped into spanking-new offices, leased to Hachette and Gibson Dunn last year – a textbook example of an opportunistic, value-adding strategy.
Blair Lewis: “As a loan servicer selling real estate portfolios, the amount of liquidity in the market is certainly driving trading volumes, particularly on the more challenging portfolios concentrated in secondary markets and locations. Before, they wouldn’t have been able to sell at anywhere close to levels that would make sense for our noteholders – we wouldn’t do it. But now we’re shifting those assets as prices have moved up.”
Roman Kogan: The market dynamics have changed rapidly. The level of competition, of liquidity, the number of banks and other lenders that can do large deals has multiplied tremendously. Margins have come down, but at the same time, volumes have increased hugely. There is a lot more to do, but you still have to be very selective.
Aref Lahham: The speed at which capital has come back, accepted risk and is willing to price it, is amazing. In just 12 months, people are willing to finance non-performing loans in Italy and Spain, plus land and speculative developments.
After the financial crisis, lenders didn’t believe in our strategies; they didn’t believe in Spain, or in refurbishing London buildings, or shopping centres, or whatever. Now it seems everybody believes in everything again, which is amazing because it means that you can basically get debt for any strategy you want, at a cost. It’s liquefying the market.
Cameron Spry: From an equity perspective, a number of things are not 100% right today, but one thing that is right is the debt market. We’re a moderate leverage borrower – we don’t go out and take a load of mezzanine financing. The cost of our financing has come down; margins have collapsed in some respects.
Christoph Wagner: There is a lot of competition at the extremely high-quality assets end of the spectrum where German mortgage banks are fairly strong. Those assets don’t have underwriting angles and it’s where we’ve seen the biggest margin compression over the past 12-18 months.
When you move away from those assets, it really comes down to who can do the underwriting, what kind of properties they are, who’s willing to take a view on certain aspects and who’s active in the regions outside London. There’s a lot of differentiation, but overall, margins have compressed.
AL: When it comes to their home market, German pfandbrief banks are fantastic. UK clearing banks are back again and will give you great terms. They’re willing to follow you on strategies, which they weren’t before. And insurers are stepping in saying: “I’ll give you 70% loan-to-value bullet loans.” That’s a huge change. It means leverage is playing a key role in pricing, which is always dangerous, because debt is a double-edged sword.
RK: The combination of high leverage and low financing cost is a dangerous cocktail. How much equity your sponsor still has in
a particular investment throughout the life cycle of the loan is one of, if not the most, important ingredients in that financing.
Do they have enough skin in the game that they are sufficiently motivated to work out an investment that gets into trouble, especially at the point of refinancing? Or have they taken out most, if not all or more than all, of their equity and are simply sitting on an option value at maturity?
Say you’re buying something at an 8-9% net initial yield and you’re getting 70-75% loan-to-value financing at 3.5%. Just do the math. You’re going to take most of your money out over a five-year span, leaving yourself with nothing but upside and your lender with nothing but downside.
CW: We’re not seeing 85% LTV debt. Some deals are being done with lighter covenant structures, but across the board the underwriting discipline is there. We don’t see exuberance.
AL: Flexibility in covenants is not there –
it’s still very stiff. Most of the time when we’re arguing with banks it’s on covenants. You’re trying to push those barriers up so as not to fall into trouble during the loan term. A lot of risk controllers seem too stringent.
RK: We have certainly seen loan-to-value levels creep up, albeit from a very low base. However, I think there’s still a healthy amount of discipline being practised, at least on the banking side. LTV levels on debt that senior lenders are willing to hold for the long term have stabilised and I do not see much room for increase.
However, with the increased presence of debt funds, debt capital is available for most products, geographies and leverage requests now – at a price. So debt of all forms is still available; it just happens to be carved up and split up into the most appropriate home for the risk profile of that capital.
AL: I buy assets that I need to fix and just got a 75% bullet term sheet – the first since the crisis – for an asset that needs work. The new lenders are saying: “Orion is taking risk; if I take the risk below Orion and buy that business plan, I’m OK. That is more of an equity perspective.
Pfandbrief banks and UK clearers are still sticking to 50-60% LTV ratios and want all the covenants. The investment banks say: “I can sell my paper and make a margin; yes, I take a risk for a while, but I can pass it through my conduit.” They’re keeping up with us and it’s been great to do great deals.
CS: Looking at terms as a borrower, I’m intrigued as to how a debt fund generates returns for investors. Now they’re lending at 250bps over nothing. I think it’s very difficult to transmit that into a post-fee return to investors.
CW: We have the benefit of having set our targets relatively recently and with a strategy that allows flexibility to deal with different market environments.
On the senior lending side, loans with 50-60% LTVs on prime City office buildings, priced at 120-130bps, are not the space we want to be in. But for the right risk profile, we can provide very competitive pricing, especially on multi-let assets and assets with a business plan angle.
We underwrote a deal on a retail and leisure park, north of Manchester, on the basis of the property fundamentals and how it’s managed and that came with an overall interest rate of around 4% all in – for a very long-dated, 20-year term.
Our higher-yielding fund can lend at up to 75% LTV levels and hold whole loans, or syndicate senior pieces to retain the junior. On a portfolio level we’re targeting 6-7%, returns, but that’s composed of a range of returns and risk profiles across the portfolio.
CS: A lot of the money that has come into European real estate in the past 12-18 months has come either as a proxy for fixed income at the more institutional end of the market, or into the lightly staffed hedge fund/private equity/generalist asset management businesses. Much of what they seem to be buying they can leverage highly.
From our perspective, it’s a lot more difficult to invest money, but it’s certainly much easier to sell our product to the institutional market, and we’re now even selling our almost-finished product to these highly leveraged investors. From an equity perspective, it’s still a good time to invest.
AL: CMBS is also back. We’re in interesting days again.
DEVIL IS IN TERM SHEET DETAIL
Aref Lahham: Compared to pre-crisis, it takes a long time to close a loan. All the risk management installed in banks is so heavy. It’s giving flexibility to non-traditional lenders, so they win more loans. They close faster. We sometimes find it easier to take a complex deal on our credit facilities or on equity, clean it up, structure it and get it ready for a bank to take afterwards. For them it’s all clearer, neater; it’s easier than having them involved while you’re still negotiating.
Christoph Wagner: Our outlook is to get a deal done efficiently and move on to the next one. We completed a smaller deal within four to six weeks from agreeing terms to funding it.
Cameron Spry: With larger deals, we feel the need for speed. That’s why they are done by larger banks. It’s not that they are the only ones who can do them, but sponsors need that speed.
Roman Kogan: An investment bank’s competitive advantage is to provide larger ticket underwritings. If you need €500m-€1bn on a set date, say four to eight weeks from now, you have to understand that the lender needs the flexibility to manage their book, to reduce exposure, whether it’s syndication or securitisation. The market is far more focused on due diligence quality, whether on the valuation, legal or technical side, which takes time to get into an acceptable form.
Blair Lewis: You see it mostly on the continent. There’s a bit of congestion in Germany now, for example. There are so many deals on the market, €300m-plus deals, that 18 months ago wouldn’t have sold, and teams without the proper resources can’t yet deal with the sheer volumes. It’s not just because of the buyer and the bank, it’s about all of the transaction management complexities surrounding the tax advisers, lawyers, due diligence and so on. Many of the actors have not re-staffed to anywhere close to pre-crisis levels.
Alan Samson: As you’d expect after a brutal credit crunch, lenders are much more cautious. It seems like another era when, in 2007, I served up a loan document on a £500m deal that was not much more than 30 pages. It had one financial covenant: a 1.05 interest cover and no LTV.
Now the market has become more standardised; we have the Loan Market Association real estate finance facility agreement. That’s good, in that we finally have a market form, bad in that it was drafted to put the lenders in the best possible position — many follow it too slavishly without regard to a deal’s specifics, underlying collateral or reasonableness of the positions advocated.
BL: In our lending business, we are paying a lot of attention to loan agreements. I’ve spent many nights until three or four in the morning negotiating loan documents as an originator, and enforcing them in every major European jurisdiction in a non-core banking role. One thing experience has taught me is at the end of the day, what matters are fundamentals. You have to get your model straight and outline what you want across the board, and stay true to that: the underwriting, real estate and sponsorship. If you don’t get those correct, 95% of the terms you negotiated may prove irrelevant.
AS: As the market and pricing has improved and there’s more competition, lenders are becoming more flexible. But I recently worked on a loan-on loan-financing that took over a year to put to bed. That’s unusual, and it was a large and complex deal, but what took the most time was getting credit approval. We’re seeing deals where banks sign term sheets to win a mandate, often leaving open key issues, and credit is pushed off until further down the process; it either comes late in the day, on a different basis or, exceptionally, doesn’t come at all. Borrowers rightly get a bit upset and toys start being thrown out of prams.
CS: We have little interest in people who put together term sheets, then let us down at the last minute. Our business plan is to buy, fix and sell. The lenders that can move quickly on that type of deal are the ones we choose. Investment banks are a little bit more expensive, so you need a reason to use them: speed, timing, ability to complete comprehensive, building-by-building due diligence, or size of loan. Given the assets we buy, paying 5bps more isn’t the end of the world.
CYCLE IS PEDALLING FASTER
Cameron Spry: The speed at which capital is destroyed, reformed and profitably monetised is compressing. In much of Europe, the occupational cycle is elongating, but the capital cycle is very short. That is one of the big disconnects — and the big risks — in the market.
Aref Lahham: As a fund manager, when I find an opportunity or a risk, I look at how long I can remain in that space before someone who has a lower cost of capital comes in and lenders are willing to lend on it. I find I am being squeezed out of strategic sectors.
The speed is sometimes meteoric. It means we at Orion have to run consistently ahead of that capital wave, and we are running faster and faster. In Spain now, the amount of capital that is going in, bidding, and the financing and interest, is huge.
It’s a constant race to stay ahead of that wave, looking for alternative strategies, business plans with complexities. We are almost pushing lenders into different, riskier parts of the spectrum.
Roman Kogan: It’s true on the financing side as well. A short while ago, certain markets were shut for local lenders. Italy is a great example; it’s no coincidence that more CMBS 2.0 issues have come out of Italy than anywhere else. It was a market that had no local bank liquidity, but that local market has now come back very quickly and the CMBS window of opportunity, which was very open, is now less open. The same can be said for Spain, Ireland and the Netherlands. In Germany, it was never open.
MORE ASSET TRADING TO COME
Cameron Spry: In Europe, there’s still a large amount of real estate owned by people who don’t want to own it. A lot of funds have come to the end of their life; you have credit-based issues, assets that have had no capital expenditure in the past five to six years. Our fund sits in the middle, trying to remanufacture real estate into a form that suits the lower cost of capital that is trying to own it. The opportunity is still there for the next two to three years.
Blair Lewis: I agree. The assets we’re selling are in the wrong hands and need to move into the right hands: people that have money, asset management capabilities and can unlock value. The same is true in the debt arena. There are still tens of billions in the hands of hedge funds and other NPL buyers that must get refinanced, or assets will have to be sold. There is still a shift in debt in so far as putting it in the hands of people who want to hold it at a stabilised, longer-term cost of funds level.