Lending into London’s commercial real estate market can generate higher returns, at lower risk, than other major European cities such as Paris and Berlin, CBRE’s latest analysis of European property debt markets shows.
The consultancy’s latest iteration of its European Debt Map, updated to capture lending terms from Q4 2017, reveals that returns vary considerably across the continent’s markets. Although there are pockets where typical lending terms appear stretched, average deal terms generally reflect strong returns and continued lender caution, the research shows.
London and Rome are shown to command higher returns than competing markets. Senior margins in the UK and Italy offer a premium of 40 basis points and 65bps over France, respectively. Compared with Germany, lenders doing business in the UK can expect a maximum premium of 50bps, while pricing in Italy can be as much as 75bps higher.
Lending returns – expressed as margin and arrangement fee, plus the five-year swap rate – vary, although patterns emerge when comparing senior lending on prime capital city office investments. Of the larger investment markets, London generates returns of 2.65 percent and Rome 2.22 percent, while returns in Berlin and Paris stand at 1.42 percent and 2.22 percent, respectively.
At the same time, key measures of lending risk, such as average interest cover ratio and debt yield versus medium-term property yield, show that London and Rome can offer comparably safer conditions to debt providers, based purely on those criteria.
“We are not saying that every deal in London is low risk at high return, compared with every deal in Paris,” explains Dominic Smith, CBRE’s head of real estate debt analytics. “Our latest research offers a general snapshot for lending markets across Europe.”
The report, which has been extended in scope from senior lending to include mezzanine and whole lending across office, retail and logistics sectors, does not take into consideration factors such as macro-economic risk, market scale, liquidity and regulatory conditions. Rather, it offers an analysis of key lending terms to create an overall picture of conditions across European markets.
Outside the largest markets, some of Western Europe’s highest returns are found in Dublin (2.72 percent), Madrid (2.52 percent) and Lisbon (2.42 percent). The Central and Eastern European region, as might be expected of less liquid emerging markets, commands the continent’s highest returns, with Bucharest and Warsaw at circa 5 percent, Prague at around 4 percent and Budapest and Bratislava at approximately 3 percent.
On the risk side, CBRE analysed the risk of default on interest payments – by examining income cover ratios – and the risk of capital loss in the event of a loan-to-value default – by looking at average debt yield across markets.
Lending standards generally remain disciplined, despite fierce competition. “Having deployed €6 billion of real estate lending in Continental Europe since June 2016, we have seen first-hand the strength of competition for all deals,” says Marco Rampin, head of debt and structured finance for continental Europe at CBRE.
“But lenders remain cautious on underwriting criteria,” he adds. “It’s true that some banks have shown willingness to increase loan-to-values to secure a deal because of competition, but they remain prudent.”
Interest cover ratios on senior loans secured by prime capital city offices, for instance, are uniformly high. Based on this measure, lending across all cities appears low-risk – a reflection of the lower cost of debt, especially due to interest rates, and often moderate LTV levels – supporting the argument that lending has remained disciplined so far in this cycle. In Europe, eight cities have an ICR of 3 or above, including Berlin (3.64), Paris (3.29) and Rome (3). Indeed, in this analysis, London has comparably lower income coverage on an average basis, at 2.36. Interest cover is typically lowest in Warsaw (1.47), Prague (1.70) and Oslo (1.74).
On the capital values side, lenders continue to closely monitor debt yields, to measure the percentage return they can receive if the borrower defaults and the lender forecloses the property. A higher debt yield indicates greater downside protection for the lender. Seven cities have a debt yield below 6 percent, including Berlin (5 percent) and Paris (5.12 percent).
“Lenders are increasingly considering debt yield. Generally, they don’t do deals for less than 5 percent debt yield,” Rampin notes.
Debt yield, however, may not be enough to adequately judge relative risk across markets, CBRE notes, with underlying property yields higher in certain markets. Comparing the debt yield to more than one property yield – the current yield, the 10-year medium average yield or the 20-year average – reveals that, in certain markets, lenders could be exposing themselves to more risk than is generally being talked about in the market.
In Berlin and Vienna, for instance, the current debt yield is within 50bps of the medium- and long-term average property yield. In these markets, yield need only move to slightly above average levels for lenders to be at risk of capital loss. It is in this analysis that London emerges as the city with most cushion between the debt yield and historic average property yields, with current debt yields at 213bps and 165bps above the medium- and long-term average property yield respectively.
Although risks have increased in some markets, the lending European market is in “rude health”, Smith argues.