We’re all familiar with CBRE’s estimate that around €960bn of European commercial real estate debt is outstanding. Around half is due for repayment before 2014, requiring new capital sources to refinance or repay a wall of maturing debt – just as banks lower or eliminate their commercial real estate debt exposure.
The huge capital demands arising from this growing funding gap have caused Europe’s debt markets to evolve, with mezzanine debt funds appearing about three years ago and the development of senior debt funds apparently the next step.
However, Morgan Stanley estimates that the €200bn these alternative sources will provide is far less than the sector’s anticipated €700bn near- term capital requirement. Also, lending so far by mezzanine debt funds suggests most of this capital will be limited to investments in prime assets.
Insurance companies’ property allocations have been small in the past, with banks providing 96% of real estate debt, but insurers are increasing their real estate debt exposure. Pension funds, meanwhile, allocate a relatively small portion of their at least €3trn of European investments to real estate, from 3% in the UK to 9% in Germany.
However, property debt investments can fit very well with insurers’ and pension funds’ needs, as they look for long-term, fixed income investments. Real estate can easily be structured as a fixed-income investment. The insurance market is already being tapped in Europe; for example, the German schuldschein, typically an investment product for insurers, has been adapted for property.
In the US, insurance companies are estimated to be responsible for 20% of debt capital on commercial real estate, while US pension funds allocate an average 8-10% to real estate. The US is having a far better credit market recovery for commercial property than Europe, even enjoying a revival in its CMBS market, where insurance companies and pension funds are active investors. This recovery is largely down to the large variety of alternative sources for debt capital in the US.
Until now, Europe has had the luxury of not needing to consider other real estate debt capital sources, as banks were always open. Because most debt capital has been structured for banks’ balance sheets, it is short-term and at floating rates.
To re-gear the European market, some important changes are needed with respect to the structure and terms of debt capital, to encourage investment from other sources. In particular, European borrowers will need to grow comfortable with long-dated loans. Given today’s low interest rates, this is probably the best time for the market to get borrowers to agree to such a change.
Borrowers will also need to adapt to yield compensation for early repayment. Typically, this can be negotiated; for example, it may be possible to agree on yield compensation for a prepayment during the first several years, with lesser penalties as the loan term progresses.
This needs further development between borrowers and lenders, as happened in US markets. Borrowers will need to accept the risk of interest rate changes – a situation that effectively exists anyway when borrowers take on an interest-rate swap and attempt to prepay a loan in mid-period, to refinance at a lower interest rate.
Lenders will also have to make concessions. Borrowers will want flexibility to sell properties, particularly if they are asked to make a long-term loan commitment, and will not want yield penalties to obstruct their ability to manage their investment holdings.
Structures will have to be developed to relax change-of-control provisions and permit borrowers to cause a property sale without triggering a loan prepayment. This would create ‘staple financing’ when the property is sold – another arrangement already accomplished in US transactions.
In the end, Europe needs to expand the available markets for commercial real estate debt capital. Water always finds its way; hopefully, that rule also holds true for capital.