Borrowers and banks debate measures needed to sustain debt market revival, writes Lauren Parr
The continuing recovery of the UK real estate finance market was a clear theme throughout the Commercial Real Estate Finance Council Europe’s two-day autumn conference, held at Clifford Chance’s Canary Wharf office this month.
Borrowers appear to be holding more of the cards; banks are getting more comfortable about lending outside core locations on prime property; work-outs are reaching resolution; CMBS issuance is getting back to 2003 levels; and growth is coming through in the economy.
CREFC Europe’s chairman, Peter Denton, urged the market “to ingrain the lessons of the past few years and not to lose them”, suggesting the market has passed the point of urgent ‘fire fighting’.
Discussion of the Vision report, which explores how to avoid property lending threatening financial stability in the future, further underlined a forward-looking focus (see below).
The market may be heading in the right direction, but the feeling was that this isn’t being taken for granted. Denton said in his introduction to day two: “We are at a pivotal point; not far enough removed from the crash to forget the worst, but in a new market where we can apply those lessons.”
During a session on borrowers in Europe, speakers from the likes of Ares, Benson Elliot, Hines and Quintain reported abundant liquidity for core property and even for some value-added assets.
Benson Elliot chief financial officer Ken MacNaughton said he had received up to 20 positive responses or term sheets for some deals, illustrating how strongly liquidity has returned to the debt markets.
“Three years ago we would have had two or three offers, and one would have been just a means of getting on the page for the future. Now we’re getting 12, 15 or 20 positive responses that we can narrow down to a strong shortlist.”
Importantly, leverage remains low and borrowers are diversifying their lender base. They feel it is important to develop new relationships and “give people a look”, according to Hines’ UK finance director Ian Brown, in light of traditional banks’ retreat from lending in the past two years.
Calibrating debt and equity
Besides spreading risk, borrowers are focused on making themselves more desirable. MacNaughton added: “A key focus is the right calibration between debt and equity, so that we can quickly progress initial asset management initiatives – and then we can talk to lenders about more attractive terms than had we financed at closing.” However, when it comes to refinancing, the relationship between borrowers and lenders can be strained.
Mike Pashley, Ares Management’s European chief financial officer, said it was frustrating “when your debt is given to a work-out team within the bank, or a servicer, that you don’t have a relationship with; ‘dialogue’ then becomes a series of ultimatums – it’s been tough.”
His experience has been particularly troubled, since the firm hadn’t been told by its bank that one of its loans was in a portfolio that is up for sale. “Banks have to realise there’s a situation where relationships need to be dealt with,” he insisted.
During a session on lending in Europe, a strong message from banks entering the run-up to the end of this year and into 2014 was that they are open to underwriting bigger deals and will look to distribute debt.
Certain French banks were reported to be back in the market after having retreated from the UK. If anything, there could be too many property lenders and not enough deals to go round now, but that would balance out over time, said Gad Caspy, Deutsche Bank’s head of commercial real estate. Pricing has fallen to 175-200 basis points for core London deals, while the cost of borrowing remains at an all-time low.
But banks’ return on capital requirements mean pricing cannot tighten much further. Charles Balch, Deutsche Pfandbriefbank’s head of real estate finance international, felt the market is set for a “normalisation” period.
Worries about the Eurozone have receded since last year and the UK economy shows signs of improvement. The data is stronger, with GDP figures of 0.7% in Q2 and 0.8% in Q3. This is no “false dawn” like in previous years, insisted keynote speaker Simon Wells, HSBC’s chief UK economist. What’s more, interest rates are likely to stay low until the end of 2015.
Lenders and borrowers gaining confidence
Against this backdrop, both lenders and borrowers feel more confident about doing business. “Investors have got comfortable with moving away from the UK and Germany and into Spain and Italy selectively over the past two quarters,” noted Caspy.
However, according to Hines’ Brown, there is still room for further liquidity in the Irish market. He would like to see more lenders there after recently securing six term sheets “at a struggle”.
Insurers’ entrance to the property lending market on a large scale has been the biggest impact for Hines. The firm secured £170m last year from a single insurer. Yet borrowers highlighted the new challenges brought in dealing with insurers: namely fixed-rate deals and prepayment penalties.
Despite insurers’ lack of flexibility, owing to their requirement to maintain yields, delegates overwhelmingly felt they would become a bigger part of the financing market, accounting for 10-30% of lending. Drew Abernethy, principal at Pricoa Mortgage Capital, said insurers are not driven by the same motives as banks, in that “the culture is taking long-term views
and not placing a lot of confidence in where the market is today”. Cash flows, rather than values, are insurance firms’ key focus.
But they are not necessarily more conservative than other lenders. MetLife managing director Paul Wilson said while the company preferred core deals, it had taken B notes in the UK and mezzanine in the US. “Though most of our deals have been at 50-65% loan-to-value, we could go higher, and that’s about being paid for it. We do like to see income coming through.”
With the economy’s swift rebound now reflected in debt financing as well as equity markets, speakers voiced doubts about the sustainability of this pace. “There’s a long way to go to a boom/bust scenario, but when you hear the phrase ‘paradigm shift’ twice in a week, it’s time to sell!” joked Denton. Balch’s insight into lending margins in the Netherlands was telling: “We’re seeing quotes on certain asset types starting to hit figures below where we’re pricing the UK at.”
Economy still needs rebalancing
HSBC’s Wells said the UK recovery is largely fuelled by consumers saving less, not wage growth – real wages have fallen for four years – and at some point this “has to stop”. The market needed to be careful not to just ride the wave and lose sight of the goal of rebalancing the economy to be more manufacturing-driven, he added.“
“Growth may slow a little next year. The UK needs to focus on the quality as well as the quantity of growth. Debt-fuelled or housing-led growth isn’t sustainable.” Eurozone concerns have not vanished, Wells said. “It still worries me immensely. France faces a real challenge to get public finances under control [while] Germany is still too reliant on export-driven growth.”
However, Wells admitted he had been pleasantly surprised at how stable the Eurozone has been this year, even if “Europe still needs to sort out its banking system.”
Regulatory issues, such as slotting, still loom large, confessed one senior UK banker. John Feeney, global head of corporate real estate at Lloyds, warned: “There is a deceptive calm in the banking sector right now, with flush liquidity. But much of what European banks have got is unprofitable; it has got to change.”
IPF provides Vision for making property cycle a smoother ride
The central discussion on the first day of the conference concerned A vision for real estate finance in the UK, a report that makes proposals about how to avoid commercial property lending threatening financial stability in the future.
Sponsored by the Investment Property Forum, the ideas are the work of a small group of individuals acting in their personal capacity.
“The purpose is to try and moderate the amplitude of the peaks and troughs,” said Phil Clark, Kames Capital’s head of property investment. Clark outlined the proposals alongside Matt Webster, global head of real estate finance at HSBC, and CREFC’s new chief executive, Peter Cosmetatos.
Delegates found the report’s proposals for a loan database and to link regulatory capital requirements to long-term sustainable valuations for property lending most noteworthy.
Clark said incomplete knowledge of real estate loans in aggregate had been a big problem and the market had “incomplete knowledge of where we were in the real estate cycle, so where the real risks were”.
For that reason, the report recommends setting up a real estate loan database, an expert advisory panel and some kind of accredited real estate lending qualification.
Cosmetatos said sustainable valuations would “provide an additional reference point, giving context for market value against the cycle and allowing regulatory capital rules to work in a more risk-sensitive and counter-cyclical way.” The idea was not to get rid of Red Book market valuations, he added.
Webster said such implementation would constrain the amount lent when the market is going up, “and when it is coming down, should give an incentive to lend”.
Other proposals concern regulation regarding diversity of lenders, with the aim of reducing barriers to market entry. The key note speaker after the Vision panel, Oliver Burrows from the financial stability directorate at the Bank of England, agreed that “being able to diversify the lending supply” sounded “sensible”.
Burrows, speaking in a personal capacity on the topic ‘Experience from the crisis and options for reducing systemic risk’, acknowledged that several of the Vision proposals were “interesting”. The Bank of England’s financial policy committee (FPC) has powers to make proposals and direct others to make changes, which he pointed out are a key option for reducing systemic risk.
Countercyclical capital buffers allow capital requirements to be raised and there can also be specific sector requirements, which “allow the FPC to raise capital requirements against commercial property”, Burrows said. “It is not going to be an easy job – it’s hard to understand the market, especially with limited data.”
He said while some boom and bust is part of the market, “an alternative approach is to consider changing the cyclical nature through structural reform”, and noted that the report’s long-term sustainable value proposal was interesting.
Keeping it simple may help maintain CMBS revival
So far this year there has been €7.7bn of CMBS issuance in 10 deals, with three more in the pipeline. This is on track to match 2003 levels, reflecting the trend in the US, where there is more momentum in the capital markets. “This could be a natural progression back to a healthy market,” said Ravi Joseph, managing partner of servicing firm Mount Street.
Transaction volumes next year could reach €10bn-€15bn, predicted panellist Nassar Hussain of Brookland Partners, although the delegates’ majority view was a less optimistic €5bn-10bn. Hussain, however, correctly forecast this year’s level at a previous conference, when 80% of the audience thought he was too bullish.
But there was a feeling that more needed to be done to simplify structures if the market were to keep growing and more investors to step in. Robert Marshall, head of ABS credit research at M&G, denied that a “meaningful step forward [had been made] in the simplification of structures. We need to stop being too clever; we need to put together deals to attract new investors.”
The debate reflected the view that many aspects of CMBS structuring still need ironing out, although Luka Miodragovic, an investment analyst at BlackRock, did praise the ease with which he was able to obtain information on this year’s Debussy CMBS. “[It] was a pleasure to work on,” he said. Caroline Philips, managing director at Wells Fargo, voiced concern about problems created by pushing for greater disclosure in new deals under CMBS 2.0.
“It’s a sensitive area involving issues of confidentiality,” she said. “I worry that borrowers will be put off using securitisation due to the increased public disclosure. There would need to be a clear cost benefit to borrowers from using securitisation.” She would also like to see tapered servicing fees, split between primary and special servicers, “where you do not have an economic disincentive to save the loan before default”.
One area of the market in which there has been progress is CMBS restructuring. Delegates were surprised that outstanding note maturities for next year were only €645m, far lower than the €5bn-plus they had thought when polled. This shows “we’ve dealt with a lot to date,” said Andrew Petersen, a partner at law firm K&L Gates.
“The initial couple of years was painful to watch, with standstill after standstill,” Miodragovic recalled. Servicers are now taking action, although there was discussion about whether they should be awarded more power – the right to enforce, for example. “I’m all for greater servicer discretion; it’s good for transactions,” Miodragovic said. Capita director Jim O’Leary thought it was possible for one party to assume the role of both servicer and trustee in order to cut costs.
The role of valuations in legacy CMBS deals was aired in a discussion chaired by LBBW’s senior manager, Craig Prosser. “Lack of updated valuations through the crisis meant we had to look at deals from scratch, from the bottom up,” said Fitch managing director Euan Gatfield.
“We have developed an autonomous set of property assumptions that doesn’t rely on reported values, but instead on long-term trends visible in historical data on rents and yields. It is not that valuers are wrong, but simply that they are answering a different question to the one debt investors should be asking.” Fitch’s approach has similarities with the long-term sustainable valuation recommendation in the Vision report.
Situs managing director Hugo Raworth agreed that “the application of valuations” was key. He said he had seen special assumptions in legacy deal valuations, for example valuing on the basis of an acquisition of the assets in a special purpose vehicle – thereby reducing stamp duty and increasing the value – in circumstances that were not appropriate.
Commenting on the Vision report’s long- term sustainable valuation proposal, Nick Knight, executive director, valuation advisory services at CBRE, recognised the importance from a lending perspective of trying to understand how an asset will perform over the life of a loan. “It may go some way to help. I would probably favour a more regular (Red Book) valuation regime,” he concluded.