The property cycle will continue for the foreseeable future in Europe, although it is more difficult to read than previous iterations, argued panellists at the Loan Markets Association’s Real Estate Finance Conference, held in London in May.
Whereas the UK’s position in the cycle could historically be gauged in relation to conditions in the US and Continental Europe, the current market is characterised by divergence between real estate sectors, panellists argued.
“There isn’t one cycle; there can be multiple cycles within the same city,” said Russell Gould, Citi’s co-head of CRE finance for the EMEA region, adding: “We’re certainly late-cycle in certain markets.”
Sentiment is mixed across UK sectors, with offices “finely balanced”, retail slowing and logistics growing, explained Madeleine McDougall, global head of CRE finance at Lloyds Banking Group: “Office vacancy rates are below 5 percent in London and 2 percent in some regional cities and unemployment is at its lowest for years.”
Threats to the office sector include potential interest rate rises as well as the increasing concentration of occupier take-up across London, such as from co-working giant WeWork. The volume of overseas capital from one jurisdiction – China – is also a concern, although McDougall summed up the office sector as “definitely toppy, but stable”.
Retail was described as “tightening”: “There are very few transactions and M&A activity has stopped,” McDougall argued, pointing to abandoned buy-outs such as Hammerson and Intu. Meanwhile, Logistics remains strong, with further rental growth forecast.
The house view of US-based MetLife Investment Management, explained Paul Wilson, a London-based managing director with the firm, is the economic cycle has two to three years to run in the US, with the UK and Europe a year or two behind. “The equity side has slowed down a bit, but the debt side is very, very healthy,” Wilson said. “There are big appetites to lend.”
While parts of the equity market are teetering at the top of the cycle, panellists agreed the outlook for debt is more stable. “It doesn’t feel late cycle in the debt space,” said Citi’s Gould. “Yes, pricing has tightened and there are occasions where covenant-light structures have been seen, but we haven’t seen leverage go crazy and pricing is holding up on the whole.”
Banks have remained disciplined in their loan terms, partly due to regulatory pressure, but also due to bankers’ memories of the financial crisis, argued Michael Shields, a member of ING Real Estate Finance’s global management team: “The debt funds have been a little more aggressive than they need to be, maybe because they are in competition with each other, but banks have stuck to their loan-to-value levels, so the risk in the market is on the equity side.”
Shields views the imminent Basel IV banking regulations as a concern for the debt market. “We aren’t seeing the market react yet, but as implementation gets closer and banks start to think about their models, there could be an impact on pricing,” he suggested.
The next downturn, when it comes, will be less severe and shorter than the last, the lenders agreed, although there was discussion about increased elements of risk being taken in the market.
“Equity has found replicating the returns generated in recent years to be difficult without gearing up or taking on more risk,” commented Neil Odom-Haslett, head of commercial real estate debt at Aberdeen Standard Investments. Senior lenders, he continued, have remained disciplined on loan-to-value, although he noted seeing an increase in risk appetite from mezzanine lenders. “In some cases, senior debt funds have geared up their funds in order to enhance their returns and similarly this now becoming a common practice amongst the mezzanine lenders,” he said.
Senior lenders are also introducing an element of risk into portfolios. “I’m focusing a little more on value-add situations,” said ING’s Shields, “because we need some upside potential. The US is two years in front of us and there is some softening in US markets, so why would you want to do an office deal with long-term leasing but no upside?”
Aside from lending risk, panellists admitted to seeing covenant-light deals in the market, albeit sparsely. “It’s happening,” said McDougall, “not as standard, but I’ve seen in 2018 a couple of deals where there are covenants so loose they don’t have teeth.”
Odom-Haslett added: “We’ve seen mezzanine positions behind some of our senior debt which have no covenants aside from maturity date.”
ING’s Shields argued covenant-light is not widespread. While some US sponsors might expect more lenient covenants in line with their market standard, he added, certain covenants are necessary if a loan is to be sold into the European syndication market.
Demand for UK property from Chinese and Hong Kong buyers has dipped, possibly due to Chinese capital controls and a narrowing of the currency differential due to sterling’s rebound since the EU referendum in 2016, panellists said.
Lloyds’ McDougall argued that Brexit has been priced into the market as a downside risk, meaning a softer-than-anticipated Brexit would fuel greater demand from global investors. Korean and Middle Eastern investors have gradually returned, she said, although US investors remain averse to the UK: “They see it as too much of a risk and like the growth they see in Continental Europe.”
Citi’s Gould agreed Continental Europe is attracting increased volumes of capital: “Large parts of Europe have well-banked investment markets. Investors are looking at territories such as Spain and Italy, which are earlier in their cycles.”
Greece, Gould continued, is beginning to attract interest from non-performing loan buyers. While the Italian market remains difficult to access, Spain is attracting most investor activity, including for pools of loans as well as hard assets.
The increased supply of debt has led to pricing converging across Europe, bringing margins across peripheral markets in line with core parts of the continent, Shields added. The risk, he explained, is that liquidity is likely to dry up in some Southern and Eastern European markets once the cycle turns.
“There’s a potential liquidity issue in some markets and people are ignoring it,” warned Shields.