With a growing field of lenders expanding debt availability, how to prevent the next boom from ending in bust was the key topic at our inaugural Forum event, reports Alex Catalano
Debt is flowing back into European real estate, while the lending universe has become more varied and complicated. The question now is: how can we keep the market from overheating?
A real estate credit boom seemed a distant prospect a year ago, but at Real Estate Capital’s first ever Forum last month, chairman Rupert Clarke told lenders that if they didn’t pre-plan when to turn the tap off, it would be like “cycling down a hill without any brakes”.
The Forum explored how Europe’s lenders are changing and whether the real estate industry can dial down its boom-and-
bust cycle. Moderating the first panel, on the new lending landscape, Phil Clark, Kames Capital’s head of property investment, warned: “If there is a repeat, people will ask: ‘What did you do to mitigate the mistakes?’”
Panellists said banks have bounced back and a significant group of new institutions and funds are providing debt. Competition for the larger, £100m-plus deals on shiny, core assets is now very fierce.
“In 2014 the bottom fell out of margins. Going into the deal I don’t know who the competition is any more,” said Drew Abernethy, principal of Pricoa Mortgage Capital, one of the new senior lenders. “It might be a US or UK insurance company, a syndicating bank, CMBS or a debt fund.”
In the past year, senior debt margins have halved to around 150-185 basis points. Mezzanine debt is cheaper too, as those lending it confirmed (see pp25-27.)
Margins “becoming painful”
“It is becoming quite painful,” admitted John Feeney, head of global commercial real estate lending at Lloyds Banking Group; he questioned whether some lenders were making an “appropriate” return on capital.
“We are not progressing some deals now because we think the risk is too high,” said another senior lender, Michael Acratopulo, deputy head of UK commercial real estate at Wells Fargo. Central London office prices are back to pre-crisis levels, he noted.
“If someone wants a 65% loan-to-value, interest-only, five- or seven-year loan with a relatively weak structure, depending on the building and borrower, that might expose us to too much downcycle risk,” he added.
“Lending parameters are starting to relax,” said HSBC global head of real estate finance Matt Webster. “In some markets I can understand that, in others I don’t.” The push of high prices for core assets, plus the pull of recovering markets, is leading both borrowers and lenders into secondary/value-added plays and regional locations.
Stephen Oakenfull, deputy chief executive of Redefine International, highlighted the change: “Twelve months ago it was difficult to finance secondary assets such as regional shopping centres. Now funding’s easy to find, though being a listed company helps. Banks are following investors into secondary.”
While margins are under pressure, most panellists agreed that leverage is not yet aggressive. But there is some concern that “covenant-lite” lending is gaining ground.
“It’s a very worrying trend,” said Anthony Shayle, UBS Global Asset Management’s head of global real estate, noting that covenants are early warning signs to trigger discussions with borrowers and remedial action before it’s too late. “I don’t want to be woken up one morning with a phone call or email saying, ‘Sorry, but the loan is badly under water.’”
“The market is in a better place now; the right capital is going to the right risk,” said Sam Mellor, partner at hedge fund Chenavari Investment Managers. Banks are by and large sticking to conservative senior debt, and the new cohort of alternative lenders is playing alongside them.
“You have insurers with the capacity and appetite to do very large loans and alternative lenders who can pull together a new capital stack to do a whole loan,” said Peter Denton, Starwood Capital’s head of European debt. “There are now niches: people who do different things, but even the traditional lenders have changed their spots slightly.”
Norbert Keller, who runs Helaba’s debt capital markets real estate desk, said the arrival of institutional debt investors and funds provides a greater variety of partners for the bank, a straight senior lender. This allows Helaba to underwrite bigger loans or team up with a mezzanine fund to inance deals needing more leverage than the bank can stretch to. “We can offer our clients much better solutions,” he added.
Janine McDonald, Hansteen’s director of treasury and operations, said that when the industrial specialist looked to refinance a German portfolio last year, originally funded by UniCredit, it “was hard to find new lenders”, as German banks were not keen on industrial. But a consortium including Helaba, Natixis, Pfandbriefbank and AXA REIM provided a €235m, five-year facility.
Now, different pockets of capital are looking for different loans: from fixed-rate, long-term senior debt, through whole loan to mezzanine and preferred equity. “You can tailor the risk you can accept at a price consistent with your portfolio,” said Shawn Kaufman, director of debt strategies at TIAA Henderson Real Estate.
Mezzanine makes sense
Chenavari’s Mellor concurred: “Having unleveraged debt funds taking mezzanine positions is more sensible than 20 times leveraged banks taking that position.”
Alternative lenders are increasingly seen as complementing, rather than competing with, banks. “Quite often debt fund money comes into play in deals where you need a financing that offers flexibility, perhaps for a joint venture away from the borrower’s mainstream banking facilities,” said Natalie Howard, head of real estate at Agfe.
There are question marks over the scale and longevity of the new money coming into real estate lending, but Howard said the institutions going into senior debt will not disappear tomorrow. “This money spent three years looking at the sector and we’ve had 48,000 meetings to explain what it’s all about before they moved into it. Once they’re in, they’re not going to come out.”
The new entrants are also highlighting regulatory issues; panellists agreed that it is not a level playing field, with new lenders subject to different regulatory regimes than banks, while banks, even in the Eurozone, operate under local systems. “One problem is lack of joined-upness,” said Shirley Smith, executive director at Ernst & Young.
Pricoa’s Abernethy warned against a “one-size-fits all” solution: “insurance companies, banks and other lenders have much different obligations and different sources of capital”.
Two braking systems for real estate’s boom and bust cycle
Is real estate doomed to replay regular and violent booms and busts? The Forum discussed whether a loans database and lending on “sustainable” rather than current market value would reduce the peaks and troughs, bringing stability.
Both these measures were recommended by a UK industry group and are being studied by the Bank of England. Industry opinion is divided: Standard Life head of lending Neil Odom-Haslett was “very much against” a loan database. “I see why they want it, but it’s none of their business what I do with clients.”
Other panellists were firmly in favour. Peter Denton, Starwood Capital’s head of European debt, said: “A database allows you to judge not just macro performance, but issuance, the quality of underwriting and vintages. This is important.”
Ernst & Young executive director Shirley Smith said a database would also enable banks to regulate their own businesses. “The data you need to understand real estate risks don’t fit the normal boxes on your normal loan database.”
Panellists agreed that the regulator would need to drive the setting up of a database. “The community should pay for it, not a single for-profit organisation,” argued Denton.
It was felt that non-bank lenders should be included, but the fact that new, alternative lenders have different regulators complicates the matter. “As other players enter the market, you’ve got to be aware of what is going on,” said Matt Webster, global head or real estate financing at HSBC.
Sustainable valuations — an asset’s average value through the cycle — should also replace market value as the loan-to-value basis for regulatory capital on commercial real estate lending, the Forum heard. This would break the feedback loop whereby debt exaggerates the cycle, fuelling rapidly rising values in a boom and accentuating their fall.
Europe isn’t living on borrowed time in terms of cheap gearing
How will real estate fare when the unprecedented post-crisis period of cheap interest ends?
In the US, the Federal Reserve has already started tapering off its bond-buying — quantitative easing — and the Bank of England has signalled that it soon expects to follow suit.
However, shortly before the Forum met, the European Central Bank announced that it might go in the opposite direction and beef up its quantitative easing to help the Eurozone’s stuttering economy. So don’t expect a rate rise there for five years, Sabina Kalyan, CBRE GI’s chief economist, told the Forum. “Don’t even worry about it — it’s not on the cards.”
The Eurozone is rapidly becoming a potential new Japan, she warned, citing the mix of low interest rates and low property yields, despite “awful” demographics and poor growth. “Is that what we are heading for in German and French prime real estate? Is that the new normal?”
As for the UK, whose economic recovery is gaining traction, the odds on short-term interest rates rising soon have shortened, but the increase is now expected to be more modest, “neutralising at 2.5-3% rather 4.5-5%”.
But cheapish gearing brings its own perils. “At the margin, it makes for poorer real estate investing, because you become blinded by the all-in cost of debt and what that is doing to your return, and far less focused on the fundamentals,” warned Kalyan.
John Feeney, global head of commercial real estate at Lloyds Bank, said he is seeing lending propositions where cashflow is challenged: “West End yields of 2.5% make for very tight interest coverage with quite modest leverage.” He added that Lloyds was being “very, very careful about the sponsors it backs and the cash-flow associated with the asset”.
However, for the value-adding fraternity, who can arbitrage the opportunity between what is credit-starved, slightly flawed real estate and polished, very saleable core real estate, “this is a pretty good investing environment”, said Simon Martin, head of research and strategy at Tristan Capital.
“There are plenty of buildings that are undercapitalised, trading at very high yields and you can finance them at very low rates. There is a big pick up if you can create core, or the perception of core, through capex and leasing activity.”
Specialist investors find hotels are now well worth visiting
Hospitality is an “exciting, strategic growth sector”, offering a very attractive return, but with lower volatility than others, said Mark Socker, Invesco’s senior director of hotel fund management.
There is a supply/demand imbalance and construction is very low in Europe, so “this cycle will last for a long time”.
However, it is a specialist sector. “A huge part of the ultimate success of investment is in the pre-acquisition due diligence — making sure you understand the levers that are going to give you your return,” warned Frank Croston, principal at Hamilton Hotel Partners.
“If you’re a private equity fund looking for a 15-20% internal rate of return, the hotel industry is not going to give you that unless you have a specific opportunity to create incremental value very quickly after acquisition — rebranding, repositioning, refurbishing, extending or some combination of these.”
Hotels involve aligning four interests: the brand, the management operator, the real estate owner and the lender. In the US, it is recognised that brand and management are separate skills; the brand brings in the business while the operators run the hotel.
Increasingly, said Mark Wynne Smith, global CEO of JLL’s hotels and hospitality group, the latter are third-party, “white-label” specialists – “more efficient, more nimble, super-flexible, and happy to work with you to drive real estate value.
“The key to retaining value is having maximum flexibility on assets. White label operators offer you that and you still keep the benefit of the brand.
“The good times are back for borrowers,” he added. More banks are returning to the market, often with specialist teams that understand the sector. Borrowers with stable, vanilla assets have a “considerable choice” of lenders, Wynne Smith said. “Development finance is back, but with the guarantees that have to be given and spreads of 400-500bps, it is pretty expensive.”
However, Socker said there is still “a big disconnect” in pricing between deals that involve leases and those with management contracts, with the latter commanding margins that are 80-100bps higher.
Lenders back the right projects — but at the wrong time?
Debt for development is reviving, but at the “wrong time”, according to Jim Prower, finance director of UK developer Argent.
“The right time was three years ago. On the commercial side, now is the time to be finishing a project; the letting market is hot.”
Commercial development needs speculative finance and though some banks say they will consider it, “it’s basically not there”, said William Newsom, senior director of Savills. However, for pre-let schemes, it’s a different story.
Debt funds don’t like it because it doesn’t generate cashflow, said TH Real Estate’s Christian Janssen and Standard Life’s Neil Odom-Haslett.
Residential development, on the other hand, is finding a growing roster of debt providers — Newsom’s annual survey of lenders found 57 active in the UK this year, with “plenty from the Far East following clients into the UK.”
However, they are very selective and relationship-driven. “The strength and track record of the borrower is first and foremost, followed by the asset,” said panellist Randeesh Sandhu, chief executive of Urban Exposure.
His firm lends on larger residential developments in the hotspots of central London and the home counties.
“Our biggest focus is on construction,” Sandhu said. “We want to make sure we’re backing the right developer and the project will get built.”
John Cole, head of European real estate and direct investment at US private equity firm Cain Hoy, agreed that the relationship with the borrower is the key to success: “Development requires flexibility, as things happen.”
Lenders are unwilling to finance projects without planning consent. The time and expense of getting consent is “a huge problem”, said Prower, pointing out that it took Argent five years to get permission for its London Kings Cross project.
Land lending is difficult, agreed Cole. “But deals where a developer is looking at change of use or an alternative use is established can be attractive. It gives the borrower and lender the option to go to the next phase: development finance.”
So far, most of the debt for development has focused on London. “There are some fantastic opportunities out there in the regions, but rents are at £30/sq ft tops and it’s difficult to build at that level,” said Prower. “We’re netting £30/sq ft in Manchester and it is a struggle. The regions won’t see a pick-up until rents increase.“