Cautious optimism declared in ‘reshaping’ lending market


Lauren Parr reports from the Commercial Real Estate Finance Council’s Spring Conference

The real estate finance market is beginning to find its feet and new ways of doing things are emerging, five years on from the global financial crisis. From debt fund IPOs and new CMBS issuance, to more distant potential vehicles such as MREITs, the Commercial Real Estate Finance Council Europe’s Spring Conference explored the new reality of the financing market in Europe.

While many panellists tempered their comments with caution, and the keynote speaker, Deutsche Bank economist Dr Thomas Mayer, painted a dismal picture of the European Monetary Union, there was optimism too. Morgan Stanley property equities analyst Bart Gysens said an investor had told him that today’s market felt “a bit like 2005… My colleagues are holding doors open for me, and asking how my weekend was – and they didn’t do that in 2008, or 2009, or even 2010/11!”

Held at K&L Gates’ London office on 24 and 25 April, just days before Bank of America Merrill Lynch launched its €1.07bn Taurus 2013 GMF 1 CMBS, BoAML director Gregory Clerc told delegates many more banks were looking at CMBS again. He sees a “significant increase of commitment from banks that closed their businesses looking at reopening. I wouldn’t be surprised if they don’t start rebuilding platforms.” In terms of investors in new issues, one speaker also noted: “JP Morgan is not the only one out there trying to invest in commercial real estate debt product.” The US bank bought about 75% of the last new CMBS issued, Florentia, which closed in September.

“Higher lending margins should provide opportunities for new entrants… development margins in central London are attractive, and development finance to the right project could offer an interesting risk-reward profile” Bart Gysens, Morgan Stanley

The Taurus securitisation is a re-securisation of a €1.03bn CMBS loan that was split between Windermere IX and Deco 14 before being refinanced by BoAML in February. Secured against Gagfah’s German multi-family Woba portfolio, it is the first new issuance European CMBS of 2013 (see News).

“We’ve seen a shift of ABS investors (who also buy residential mortgage-backed securities) to German multi-family CMBS, because people will always pay their rent,” Clerc said, explaining the attraction for investors in German multi-family debt securities. However, Cairn Capital’s Birju Shah, said he believed demand for real estate debt capital markets products “definitely goes beyond German multifamily”.

Clerc said marketing to investors is now very different. Banks try to get investors committed earlier than before and deals are being pre-placed. And the rating process is more “painful”, in that it is more stringent.

K&L Gates’ Sean Crosky: “the market is not evolving fast enough to deal with bond maturities”

Active management needed to tackle maturing debt problem

With €21.5bn of CMBS loans maturing in 2013, this year was expected to be the peak of funding pressure. But the “ticking time bomb” has been somewhat defused by the restructuring of €9.1bn of these, and the repayment of €0.7bn so far this year according to Fitch Ratings’ figures.

There is still €19.8bn for servicers to contend with though – 30% of outstanding loans by balance. “It is important that the active management of the loan starts early,” said Matthias Schlüter, Hatfield Philips managing director. “Currently, transfer events [of loans from primary to special servicing] are way too late.”

One issue raised at the conference was the approach of CMBS final note maturities. Volumes spike at about €13bn in 2016 and 2017, said Fitch’s managing director and session moderator Euan Gatfield.

“There are still a couple of years until it gets lively but it takes a couple of years to work out loans, especially outside the UK,” said Gatfield. Some 80% of the €10.1bn of loans that are overdue are outside the UK.

Yet “the market is not evolving fast enough to deal with bond maturities” pointed out lawyer Sean Crosky of K&L Gates. “Bond maturities are a game changer,” he insisted. “Up until legal maturities, it’s about recovery. After that, it’s about loss minimisation.”

In light of looming note maturities, Paul Lloyd, managing partner of Mount Street, said he found it “worrying” that loan extensions continue to happen. “We’ve got to try to ensure we don’t have fire sales near the tail period,” he said. But Schlüter said he no longer saw extensions happening without “a clearly defined end goal”.

More prospects down the line

Another of the panellists in the session gauging the prospects for new debt issuance, Deutsche Bank’s Bhavesh Patel, acknowledged “two or three” new securitisations of old deals in the pipeline “and a few more down the line”. He felt the prospect of new assets being securitised was still “relatively low in the short-term”, at least until late this year or early next.

bart-gynsenHigher lending margins should provide opportunities for new entrants… development margins in central London are attractive, and development finance to the right project could offer an interesting risk-reward profile” Bart Gysens, Morgan Stanley

The pipeline deals are thought to include a second €700m CMBS by Gagfah, which will partially refinance the maturing €2.08bn German Residential Funding deal; Toys R Us’s £263m Debussy DTC CMBS; Deutsche Bank’s £400m re-securitisation of Blackstone’s Chiswick Park; and Deutsche Annington’s “mini GRAND” CMBS to meet part or all of its €700m refinancing target for 2014.

Matching investors to products was the name of the game for banks now, Clerc said, which made it a “more exciting time”. He pointed out that there have been three unrated bonds placed in France, all designed for French insurance companies, featuring relatively low LTVs, unrated and fixed-rate. Tishman Speyer issued a seven-year bond; a hotel deal called Project Verdi was another; while the third was a residential portfolio secured on the credit of tenant EDF (see more).

Clerc’s BoAML colleague, CMBS analyst Mark Nichol, also highlighted that quoted property company Intu recently established an SPV which issued long-term, fixed-rate bonds and borrowed five-year, floating rate money that rank pari passu. Nichol pointed out the similarity with a structure set up back in 2004 by Land Securities.

Re-couponed deals

Birju Shah agreed there has been “a definite increase in demand for fixed rate rather than floating rated bonds”. He expects the four or five treasury desks and money managers that are active CMBS investors to continue to buy into deals considered candidates to be “re-couponed”, such as the recently restructured LoRDS or GRAND CMBS. With few new deals to buy into, buying into “re-couponed” deals “has been the story of the last nine months”, he said, a trend he expected to continue for at least 12 months.

birgu-shahThere has been a definite increase in demand for fixed rate rather than floating rated bonds. Buying into ‘re-couponed’ deals has been the story of the last nine months” Birju Shah, Cairn Capital

The need for CMBS and for other new sources of debt capital was as urgent as ever, most speakers agreed. On the one hand, banks cannot be the force they once were, having issued about 95% of the €2.5 trillion real estate debt out there in Europe. They face enormous structural pressure in having to hold more capital on balance sheet, and are about a quarter of the way through their €350bn-€600bn run down according to Fitch Ratings.

Neil Hasson, head of real estate lending at Macquarie Group, was doubtful that loan sales will speed up. “Banks in a low interest-rate environment are able to hold on to loans… I don’t sense an increase in urgency.

It’s not as if something has happened or is going to happen tomorrow [to change that].” Jan Janssen of BoAML pointed out that trading banks can mark down loans, as have some others like Lloyds. “But if other banks mark one loan down they have to mark down another 100 and they simply couldn’t bear the losses. So they have to slowly, slowly wear them off.”

In a discussion called “The Alternative Financiers”, panellists believed sales of large NPL portfolios would continue, though as one loan buyer pointed out “the dead deal costs are painful”. Jordi Goetstouwers of Lone Star said they are a necessity for the sellers. “It’s still the least bad way to move a lot in a relatively short time”.

Even if banks wanted to resume active new lending, it is not profitable for them all. Morgan Stanley estimates that changes in regulation mean that commercial real estate lending has gone from a double-digit return-on-equity business to a low single-digit return-on-equity activity for tier one banks, “while for tier two banks with a higher cost of funding, returns are now negative on average, all else being equal”, Gysens explained.

In banks’ favour, however, is the fact that real estate borrowers can afford higher borrowing spreads as long as interest rates stay low. As such, loans can be re-priced “which allows banks to gradually work their way out of this”, while higher lending margins should provide opportunities for new entrants in commercial real estate lending, added Gysens. Furthermore, development margins in central London “are increasingly attractive, and development finance to the right project could offer an interesting risk-reward profile”.

North American money is flowing into European debt opportunities, according to panellists who discussed “The European versus the US market”. “People are buying into a sustained weakness in European bank lending,” said James Wright of Agfe.

Matthew Webster, global head of real estate at HSBC, thought the US and Canadian lenders setting up in Europe would provide liquidity – they can price competitively relative to banks and do not face the same regulatory controls.

Structural differences

However, there are structural differences in North American lending practices which may not transfer easily to Europe. First and foremost, borrowers here are accustomed to shorter term floating rate finance, while the North American institutions looking to provide senior debt are used to longer-dated, fixed-rate structures. “There needs to be a change in the way people finance themselves. Demand for long-dated finance needs to grow significantly for it to be a big opportunity here,” said Wright.

Overall, Gysens forecasted a reduction of up to €700bn of mainly debt capital over the next five years to be replaced by only €200bn of debt and equity coming from new entrants. REITs will not recapitalise the market alone, but their contribution could be up to €25bn. The number of private equity firms seeking to increase their allocation to real estate debt over the next 12 months has also multiplied three-fold, while sovereign wealth funds continue to go after good quality real estate.

Insurance companies will make up a significant part of the new money, said Gysens. Morgan Stanley estimated that they face a 40% fall in earnings between now and 2018 owing to low bond yields and tight credit spreads, and will reshuffle their portfolio allocations accordingly.

As insurers are more likely to originate debt than buy secondary loans though, the building up of platforms means any material increase in real estate lending could come “at a glacial pace”, Gysens said.

The discussion turned to whether new funds can fill the debt gap and if borrowers will embrace them. Blackstone’s Robert Harper said yes: “There’s an opportunity for new debt funds to come into Europe and find deals. There are buckets of capital that will find a home and grow over time.” But he said borrowers needed to trust new lenders in terms of certainty and execution, preferably to know them personally.

Kennedy Wilson’s managing director Fiona D’Silva predicted: “It’s going to be a very busy few years and funds have an important role, wherever in the capital structure they play.” Lone Star’s Goetstouwers said no one should resent the increasing competition. “There was a hole to be filled. A few years ago we were complaining there wasn’t any money and the guys are there now. As in any market with new entrants there will be a shake out.”

Panellists felt mortgage REITs were unlikely to play a part in replacing capital for real estate, at least in the short term, because the Treasury and UK regulators have bigger fish to fry, and MREITs are not a political priority. But Marion Cane, Ernst & Young director of tax, said: “Discussions Ernst & Young have had with interested parties indicate the size of the market could be €10bn-€25bn over time, not to be sniffed at as an additional source of funding.”

What have emerged as a viable source of new lending to UK real estate are listed debt funds, which give investors the comfort of a regulated investment with associated transparency and corporate governance, according to Ravi Anand, head of corporate finance at Dexion Capital, which helped Starwood put together its £229m IPO at the end of last year.

Investor meetings

But the process and effort involved in an IPO isn’t simple and it isn’t cheap. It took 152 investor meetings to pull off Starwood’s listing of its debt fund Starwood European Real Estate Finance, and Starwood’s senior managing director, Jeff Dishner, posed a question to the panel he chaired on “IPOs – A Future Trend?”: “Is there a way to make it easier?”

Tim Mitchell, director at Investec Bank, who worked with IGC Longbow on its £105m IPO of a senior debt fund last January, noted that some prefer the private equity route. “Getting comfortable with having a public face can be a bridge too far,” he noted. And investors are still being educated about a new market, he added.

James Wright:
James Wright:
“People are buying into a sustained weakness in European bank lending”

With a market capitalisation of under £500m in three funds – DRC Capital also has a listed property debt fund for mezzanine loans – the scale remains small compared to the amount of refinancings needed. Mark James, managing director at Jefferies International, which also advised on Starwood’s IPO, noted that “new issues are harder to execute than follow-ons”. Once a fund can point to its track record, investors are easier to convince.

In the conference wrap-up, Renshaw Bay’s Christian Janssen returned to Gysens’ 2005 anecdote: “We’re nowhere near 2005 when it comes to the debt position as far as availability, leverage, pricing and liquidity goes”. The lending market now is characterised instead by “low leverage, and something of a herding mentality chasing nicer assets” he said. There is “nowhere near enough debt capital available; the banking sector is retreating still”. However, the new and most importantly, diverse, lenders meant that “the reshaping of the market is very encouraging”.

‘Most mezz lenders accept they are going to be fully subordinated’

CREFC Europe’s guidelines on intercreditor agreements will be published in a few weeks and mezzanine lending trends were discussed in a panel chaired by Allen & Overy’s Christian Lambie.

The previous norm, fuelled by the securitisation boom in 2005-2007 whereby A and B note structures were “stamped out as if from metal sheets” as Lambie put it, has gone. Then, said Duncan Elley, a director at mezzanine lender Chenavari Investment Managers, structures were driven by the securitising banks “securitising the A piece, keeping the B piece and making sure they had some nice rights”. Now, “most mezz lenders accept they are going to be fully subordinated”.

Current issues between senior and mezzanine lenders and borrowers include separately enforceable share security and cure rights. The concept of permitted acquirers is catching on, said Lambie, rather than senior lenders wanting to stick with change of control covenants.

“Cure and buy-out rights are very strong comfort blankets that will be tested over the next few years,” said Elley, pointing out that we’ve yet to see examples of the new round of loans running into problems. “If the value breaks in the mezz, the senior gets out whole and it’s nice to know you have something in your back pocket and could buy the senior out and manage the asset.”

One clear trend is more blurring of senior and mezzanine, as some senior lenders are now prepared to look at higher LTVs. So is senior pushing into the post-credit crunch mezzanine territory and is that in turn squeezing mezzanine out altogether or into preferred equity? Lambie asked.

Philip Moore, of mezzanine lender DRC Capital, said some senior lenders, such as pfandbrief banks, are constrained in terms of LTVs. “We and our competitors have been able to invest our first funds” he said, but he agreed that things were changing. “In 2009/10 when this new market started you either did senior or junior. Now it is getting more stratified and sophisticated; some are doing higher senior, some conservative junior… the market is getting more mature, more interesting”.

He said DRC Capital’s fund had done both mezzanine, with a full shared security package where, as Lambie pointed out, the advantage is “as debt you can step in ahead of unsecured creditors”, as well as preferred equity investing. Lambie said he knew of one deal where the senior lender wouldn’t accept any mezz so a mezz lender came in as pref equity. Moore said that in deals “where we have limited or no rights we take a more conservative approach on underwriting”.