New forecast shows property debt still attractive despite fall in returns, writes Alex Catalano
CBRE is launching a new, quarterly forecast, UK Debt Prospects. The research, which Real Estate Capital will carry regularly, estimates the average returns lenders to UK commercial real estate are likely to achieve.
Dominic Smith, CBRE’s head of real estate debt analytics, says: “It answers the simple question: ‘What can I reasonably expect over my real estate horizon and how does it compare historically?’ We are trying to put real estate debt on an equal footing to real estate equity. This will help make the case for why you should lend more on real estate or invest in the debt.”
CBRE is using a combination of in-house data on loans and external information to estimate what the average annual return will be for making five-year senior and mezzanine loans over that period. It has conducted this exercise over the past 20 years and used it to show current and recent conditions in the context of the longer term.
Senior returns falling
According to CBRE, the average gross returns forecast to UK real estate senior debt fell over 2014, from 5.4% pa for the 2013-18 period to 4.1% for the 2014-19 period. This is due to a 70bps fall in interest rates (the five-year swap rate is used), a 70bps drop in margins and a 10bps fall in arrangement fees. Combined, these three factors put significant downward pressure on lenders’ returns (see fig 1 and 2).
“We are citing broad market averages,” notes Smith. However, CBRE is also able to slice these by property sector.
The risk-adjusted returns on senior debt declined more sharply, by 160bps, according to CBRE’s estimate. As well as 2014’s lower swap rate, reduced margins and the cheaper arrangement fees cited above, risk-adjusted returns look at the probability of default and expected loss, both of which increased last year.
This rise was the result of slower capital growth in the real estate collateral underlying the debt. With all-property capital growth forecast to decelerate from 5.8% pa in the 2013-18 period to 3.3% in 2014-19, the probability of a loan default rises from 1% to 4% and the annualised expected loss from 0.1% to 0.4%.
Thus, the risk-adjusted return to a five-year senior loan drops to 3.7% pa in 2014, from 5.3% in 2013.
Default risk still relatively low
“Although the probability of default has risen, it is still less than half the long-term average, so though it might look significant, the default risk is still very low by historic standards,” notes Smith.
“Crucially, the gap compared with gilt returns, at 250bps on a risk-adjusted basis, is well in excess of the long-term average of around 1%, meaning that commercial real estate debt still looks extremely attractive on a relative basis.”
Returns on mezzanine debt, here assumed to be a vanilla 65-80% loan-to-value junior tranche, fall more steeply than on senior. A 170bps decline in mezzanine margins has pushed gross returns down from 10.6% pa on 2013 debt to 8.3% in the 2014 vintage (see fig 3).
Risk-adjusted returns are more heavily hit by the slowdown in capital growth; for the higher loan-to-value ratio mezzanine tranche this leads to a 7% increase in the probability of default, to 11%, and returns fall 420bps to 5.2% pa.
Smith stresses that CBRE is making “very, very conservative” assumptions around mezzanine. “We assume that in the case of a default, the lender loses everything, but in reality, lenders and sponsors are pro-active and will take action to get money back,” he says.
CBRE estimates the gap between 2014 risk-adjusted returns on senior and mezzanine debt has shrunk to 150pbs, from the 410bps in 2013 originations (see fig 3).
“It’s not news that margins on mezz are quite a lot tighter now, but the gap shows it is still quite attractive if you believe in decent capital growth,” says Smith.
Despite returns falling for 2014 vintage debt, both senior and mezzanine still offered a healthy premium to the five-year gilt yield – 250bps for senior debt and 400bps for mezzanine, on a risk-adjusted basis (see figs 4 and 5). This is well above the long-term premium, which should continue to attract new lenders to the sector.
Stress but no meltdown
CBRE’s forecasts assume that UK real estate will not be hit by an unexpected crisis that causes property values to plummet, as they did in the aftermath of the global financial meltdown of 2008.
However, CBRE also looked at what the risk-adjusted returns on real estate lending might be in a “stress scenario” where property values fall by 25% – the same drop used in the Solvency II stress testing of insurers and similar to the 26% used by the European Central Bank when stress testing UK banks’ capital adequacy.
In this case, with much higher probability of defaults and expected loses, the risk-adjusted returns drop into negative territory: -0.5% for senior debt and -7.8% for mezzanine.
Detailed database helped build the model
“The estimates of gross senior debt returns are calculated by combining the five-year swap rate with our estimate of average, market-level margins and fees,” CBRE says of the methodology behind the debt prospects data.
“It is important to note that we are attempting to estimate what average market returns might be, not what conditions are at more rarefied extremes of the market — hence, we estimate what the average margins might be in the market, and not of super-prime City offices, for example.
“To produce a risk-adjusted return, we subtract our estimate of expected loss from gross return. For default and loss estimates
we rely on an internal model we have constructed. This combines forecasts of average UK market capital growth with historic observations of asset-level capital growth volatility — derived from our unrivalled database of historic valuations — to estimate the frequency and extent of default and consequent loss at different loan-to-value levels.”