Fragmentation is not a bad thing when it comes to the provision of real estate debt in today’s market, comments Richard Dakin (pictured), managing director at CBRE Capital Advisors
Most mature markets in most mature economies seem to consolidate, sooner or later, into a handful of large players which between them control the vast majority of market share. Think the ‘Big Four’ accountancy firms; the dominance of Boeing and Airbus in the airline market; the ‘Big Three’ credit rating agencies – Standard & Poor’s, Moody’s and Fitch.
The trend towards oligopoly was in evidence in the pre-financial crisis European real estate debt market, but since 2007 it has gone into reverse. Diversification of the lending industry can put borrowers at an advantage, but only if they are able to make comparisons across the wealth of debt sources they are faced with.
It is not long ago that the debt markets seemed to be following the well-trodden path towards oligopoly. Take the UK as an example; the share of new lending accounted for by the largest 12 lenders was almost 80 percent in the immediate aftermath of the global financial crisis, up from around 70 percent in the late 1990s, according to De Montfort University research.
However, this proportion has fallen by a quarter, to around 60 percent today. In other words, twice as much lending (40 percent of the total) is now done by entities outside the largest 12 organisations than was the case a decade ago. This is a market that is rapidly fragmenting into one made up of a range of diverse lenders with varying goals, rather than consolidating into a small, homogeneous set of large outfits with similar strategies.
Borrowers should welcome the shift away from oligarchy. Such markets can be anti-competitive, with dominant firms being price-setters and consumers price-takers. In a situation of pure(r) competition, the reverse is true; consumers – in this case borrowers – are in a more dominant position, meaning that it is the suppliers – in this case the lenders – which are more likely to be price-takers.
In practice, though, it may not be so easy for borrowers to establish a strong position. Choice is a curse as well as a blessing; to secure the best terms available, borrowers now need to scour a huge number of potential lending partners. Data from Preqin show that over the three years from 2014 to 2016, 40 different managers raised a combined €40 billion for deployment in European debt markets.
Added to incumbent banks and existing alternative lenders, CBRE estimates that there are now more than 200 active lenders across Europe. So, while such competition will deliver favourable terms for borrowers prepared to sift through all available options, it is practically impossible for the thousands of individual borrowers out there to dedicate the time to do so.
In a fragmented lending market, price discovery is the challenge for borrowers. An investor’s internal rate of return (IRR) is hit by a total cost of debt and lower loan-to-value ratio. A base case of a total cost of debt of 2.5 percent and a 55 percent LTV – broadly where CBRE’s European Debt Map suggests benchmark pricing was for London office investment in Q2 2017 – produces an IRR of 8.9 percent, given assumptions around capital growth. This IRR can be improved to 9.2 percent given 25 basis points cheaper debt; 9.7 percent given an additional 5 percent of leverage, or 10.1 percent with both.
The impact on an investor’s IRR from securing either favourable or poor debt terms demonstrates why debt advisory firms have emerged to help borrowers navigate the market.
Ultimately, the benefits of a diverse market come down to how transparent that market is. The debt space has never been the most open of markets and is, in many ways, decades behind even the wider property market, which, although opaque by the standards of equities, at least has public databases of deals and an embedded culture of sharing performance data and benchmarking.
In a fragmented lending market, data, such as the European Debt Map, can provide borrowers and lenders with greater clarity – allowing both sides to compare debt terms across the continent.