Political and economic instability is unlikely to derail a European real estate market awash with capital, panellists at the Commercial Real Estate Finance Council Europe’s Spring Conference, held in London in April, broadly agreed.
However, although a liquidity crunch is not expected in the foreseeable future, panellists argued that Europe’s property markets will become more difficult to navigate, with the abundance of money in equity and debt markets no guarantee to successful investment strategies.
Most capital is focused on core investing strategies, resulting in plentiful supply of senior debt, but less finance for value-add strategies, one panellist pointed out. The volume of money chasing core European property should encourage a greater focus on property market fundamentals, rather than capital values, several agreed.
“In the next five years, we will see a decoupling. There will be no single pattern when it comes to liquidity,” argued Ekaterina Avdonina, chief executive of logistics investor Delin Capital Asset Management. “Liquidity in the core space is a concern as there is the possibility of yields going lower. We are in favour of evergreen strategies in core which generate strong levels of income for the long-term.”
Trish Barrigan, senior partner at private equity real estate firm Benson Elliot, agreed with the need to focus on long-term, sustainable strategies. “Outperforming your expectation in real estate investment over the last few years has been driven not only alpha strategies, but also by smart beta; investing at the time in what were less liquid markets like Spain. That’s over. The opportunity to invest today is in being able to create alpha strategies which will deliver sustainable income.”
On the increased volumes of capital available in the private debt market, David Snelgrove, managing director at private equity firm Oaktree Capital, struck a note of caution. “There is a huge amount of private debt capital available and this is growing. Consequently, spreads are driving down in certain segments. We are also starting to see more risky lending activities such as covenant-light packages.”
Snelgrove recalled last year seeing a large light industrial mezzanine financing opportunity with leverage in the 65-75 percent area which was priced in the high single digits. “That’s now closer to mid-single digits,” he added.
“We also saw a large financing opportunity involving hotels in secondary Spain locations and its islands which was at a similar attachment point and priced around 6-7 percent. Since then, we’ve seen other examples of expanding risk appetite, for example, some people willing to provide speculative development finance on London office projects and in Spain, one fund is looking to provide up to 80 percent LTV finance on residential land in Spain. This probably bodes well for asset values in the near term.”
The high levels of liquidity in the market have affected how some borrowers use debt, panellists said. “The weight of equity capital has resulted in a shortening of our average hold period for investments,” explained Barrigan.
“Everything we do is transitional, and whereas we would typically sell on to institutional buyers after five or seven years, the hold is more like two to three years. Institutional buyers are happier to take on an element of the business plan but pay us what we believe is the end value of the scheme. That presents a challenge in how we work with lenders, who are looking for a guarantee of income over time. It can mean more expensive margins to avoid longer lock-ups,” she added.
Asked if Brexit could cause a liquidity crunch in the UK, some argue that it already has, but only in specific parts of the market, such as the £25 million-£100 million (€28 million-€113 million) size bracket.
“I think we’ve already seen the worst of the liquidity crunch that pertained to Brexit,” argued Snelgrove. “We’ve tried to sell various assets over the last few years and the depth of liquidity in those sales processes was very shallow and that’s a consistent theme across the market. One good thing about the UK is its floating exchange rate. The exchange rate is a natural form of insulation if there’s a hard Brexit.”
Although some argued that further constraints on capital are unlikely, some noted a lack of pricing direction in the UK market. Delin’s Avdonina expressed concerns about the UK. “We see risk being priced inadequately at the moment. I’m nervous about the outcome of the Brexit negotiations. Discussions about practicalities are being cut very close to the wire. We do port logistics, and the UK ports are not building customs terminals, so it’s hard to see how the country will have the ability to bring goods in, for example.”
Barrigan argued that liquidity of people, rather than capital, might prove an issue. “It will affect business and therefore occupational demand because of the impact on the movement of people. Coupled with the devaluation of sterling, how attractive is it for Europeans to be located here and participate in our economy? People we’re hiring are saying they’d rather be located in a Berlin office than London.”
Despite his view that the worst of the UK’s liquidity ‘crunch’ is over, Snelgrove added that the absence of pricing direction in the UK has led Oaktree – a firm which seeks high returns – to spend more time in Continental Europe, especially Spain. “We’ve had to focus much more on fundamentals relative to four-five years ago when buying from distressed sellers and banks on a raw capital value basis.”
“Brexit has reminded a lot of people that there are great places to live and work in Europe outside of London.”
During an on-stage discussion about risk in the European real estate lending markets at CREFC’s London event, talk drifted towards the erosion of covenants in loan deals.
“The US is relatively covenant light versus Europe, but questions pop up here on covenant-light loans,” said Rupert Gill, director in the real estate debt business at BlackRock Asset Management. “Loans in the US are more income, cashflow tracked, so there are a lot of differences.”
Chris Semones, executive director at Goldman Sachs, agreed: “It’s undoubtable that the market is heading more towards covenant-light in Europe and you’re seeing CMBS coming back with covenant-light structures.”
Covenant-light is a “hot topic” added Jason Constable, head of specialist real estate at Barclays. “We are seeing opportunities cross the desk with structures that will test lenders’ discipline and resolve. As a traditional balance sheet lender, it’s a difficult psychological barrier to get over. It will put pressure on the strength if relationship. We will work hard to preserve default covenants.”
In Europe, mezzanine lenders get asset-level security, while in the US market they typically rely on a share pledge, Semones explained. “On the senior side we wouldn’t want to entertain covenant light structures because, by definition, they are riskier asset management plans if we are doing a senior loan, but on the mezzanine side we’d be prepared to do it for the right deal. But we are laser-focused on having a clear path to enforcement.”
Asked which covenants they might be prepared to be give on, Constable commented that loan-to-value headroom is an area where sponsors can be given flexibility, through the use of an intermediate cash-trap. Semones explained that Goldman pushes for a performance test, allowing covenants to be structured to ensure a business plan is being followed.
On whether increasing levels of private debt fundraising are contributing to an asset bubble, Constable suggested it must be a contributing factor. “Some of the big Asian deals for trophy assets are bringing domestic bank debt at low pricing. The question is whether that is fuelling an asset bubble or fuelling a better-functioning syndicated debt market?”
Panellists agreed there are instances where borrowers are testing lenders’ risk parameters. “We see deals all the time where the IM will say one thing but the reality is actually very different,” said Semones. “The question it comes back to is how disciplined are you going to be as a lender? You need to be realistic and ensure loans are priced appropriately and not fool yourself that you’re lending on high quality assets if you’re not.”
Gill added: “We’ve seen deals where banks write the mezzanine loan as well as the senior and then are keeping a significant portion of the mezzanine loan on balance sheet.”
Do borrowers get what they want?
While there is plenty of debt available for investors with core assets, the supply of finance is thinner for those pursuing value-add strategies, some at CREFC’s spring conference argued.
“I’m generally happy with the terms when debt is available. The rates are fine – significantly lower than the cost of equity – which was not the case five to seven years ago,” said Michael Kovacs, founding partner of fund manager Castleforge Partners. “But that is when debt is available. There are lots of cases when it’s just not available at all.
“The traditional lenders seem to be looking for things that are straight down the fairway. If you have anything in the rough, getting leverage is significantly harder and often not even possible. That’s where alternative lenders come in; the problem is there still aren’t enough of them.”
Most lenders are focused in the senior space, agreed Lorna Brown, head of real estate debt at Legal & General Investment Management. “There is a tipping point where equity will say it’s not efficient or economic to take junior debt where it becomes dilutive to returns. There’s a lot of equity being raised, so equity deployment is important and there may not be the need to borrow as far up the capital structure.”
Anne Gales, partner with capital advisory firm Threadmark, argued: “The moment you get into transitional assets or construction, it is still incredibly difficult to get good debt. So, there is still a huge opportunity for alternative fund managers to get into that space.”
Investors struggle to allocate capital to higher-risk lending funds, Gales explained. “The institutional market in Europe is very conservative and has a lot of regulation, so to invest in mezzanine or preferred equity strategies is very challenging.”
However, Gales added, investors are gradually warming to the prospect of higher-yielding real estate debt, potentially leading to a greater availability in the market. “In the early days, for interesting non-traditional senior debt, returns were 10-12 percent net. It was incredibly attractive and people piled in. Now they have come down to 7-8 percent net, so it’s a big change, but where we are in terms of interest rates is still very interesting to look at these products,” she explained.
“There is still easily 500 basis points over other products. There is a push for the UK and Northern Europe, but also Southern Europe and a push to go a little higher on the risk curve to earn those returns.”