As Real Estate Capital celebrates its 10th anniversary, Daniel Cunningham looks at how Europe’s real estate finance industry has changed since coverage began. Across a series of features, which will be published this week, we will take a look back through the archives at a fascinating decade for the market.
A lot of capital was flowing into the European real estate industry back in 2007.
The tax-efficient REIT regime was established in the UK that year, with the potential for a new wave of corporate finance activity. The UK was at the forefront of the property derivatives market, which granted investors indirect exposure to the sector through new financial instruments.
In the debt world, US-style CMBS had taken off in Europe around 2003, with Barclays Capital putting the volume of issuance in 2006 at €65.3 billion, double the previous year. Mezzanine debt products were being offered by banks to edge borrowings up the capital stack. In short, a lot of money was at work in European real estate, funnelled through increasingly complicated debt and equity structures.
It was at the peak of the last market that this publication was launched, to cast light on the complex finance underpinning real estate’s boom. Since then, it has covered arguably the most turbulent, yet fascinating, decade in the history of the property debt markets.
The publication was founded in 2007 under the name EG Capital, at the time a sister title of UK weekly Estates Gazette and spearheaded by launch editor Jane Roberts, who would be editor until 2015. The title’s mission statement was spelled out in Roberts’ first Editor’s Letter: “Our aim is to bring together in one place as much detailed information as possible about financing real estate. Every month we will describe and analyse the structures and innovations being used to raise capital for property.”
As the credit crunch of 2007 forced a contraction in lending and the ensuing global financial crisis of 2008 exposed the real estate bubble created by years of unbridled lending, the title was at the forefront of coverage of the fallout. CMBS restructurings, loan work-outs, debt portfolio sales and opportunistic investment filled the pages instead of capital-raisings and lending deals.
By 2009, when the title became independent and was renamed Real Estate Capital, the European property finance story was one of gradual recovery, as the bankers re-emerged into the alternative lending space to provide debt in an illiquid market. In 2014, PEI Media acquired the title, beginning a new stage in its history.
Then and now
The market that Real Estate Capital monitors has been transformed in the past decade. “It’s more transparent,” suggests Max Sinclair, head of Wells Fargo’s UK commercial real estate division, and formerly Eurohypo’s UK property head. “Although we are not yet as transparent as the US, we are working in an environment where communication is instantaneous and there is far more real-time information than we used to have, including news alerts.”
In contrast to the US, where the prevalence of securitisation brings transparency, European property finance remains a secretive world. However, a gradual shift in the client base investing in real estate has made the market more open, Sinclair adds: “10 years ago, there was much more bank lending to private individuals, but the bank market is much more institutional today.”
Hugh Fraser, former real estate banker and since 2009 the head of capital markets at M7 Real Estate, remembers a time when long lunches were the order of the day in the industry. “Our Covent Garden location was a perfect place to be when the crisis hit,” he jokes.
“Ten years on, with the life of being a banker but a distant memory, it feels good to be a borrower,” he adds. “Back in 2009, when we set up M7, I would leave messages for 20-plus lenders and only Nationwide and WestImmo would return my calls. Today, most of the 20 return the call.”
While few dispute that the global financial crisis forced real estate finance to transform, one former property banker turned debt fund manager argues that the space has been in a state of change for at least 20 years.
“There’s no question that the last 10 years has been a decade of tremendous change, but I’d argue that the previous 10 years saw as much change, in a different way,” says Peter Denton, formerly of Starwood, BNP Paribas and WestImmo, and now CFO of social housing provider The Hyde Group.
“From 1997 to 2007 one of the big themes was lending through new products such as securitisation,” Denton continues, “I started lending in 1998 at Deutsche Bank and was one of the first to provide mezzanine debt. Those types of product were highly innovative. In the last 10 years the theme has not been the products, but who lends you the money.”
“Structured finance,” Denton adds, “has become a dirty phrase, whereas before 2004 it was a badge of honour.”
Critics of the financial services sector, which grew in the years preceding the global financial crisis, decry it for becoming too large, too complicated and too bonus-driven. Defenders of the pre-crisis property finance market argue that the financial innovations that emerged between the late 1990s and early 2000s supported the institutionalisation of the real estate market and its transition to becoming an asset class.
“There were a lot of positives that created ways of achieving things,” says Denton, “but when a mentality is created in which risk is sold on, and when that is combined with incredibly high compensation, it changes the lending mind-set for the worse.”
A major point of difference between 2007 and 2017 is that the CMBS market is virtually closed, leading lenders to either lend on balance sheet or share risk through the syndication market. In the debt fund space, alternative lenders often have their own money invested, creating an alignment of interest.
Financial regulation in the wake of the crisis has become a source of intense debate. Within the real estate finance sector, few dispute the need for regulation, though opinions differ as to how it ought to be implemented. In the UK, the ‘slotting’ regime has had an impact on clearing banks’ lending appetite. So-called Basel IV regulation looks set to bring uniformity to the continental European banks’ methods of allocating risk. In the insurance sector, Solvency II has clipped institutional investors’ wings.
“Regulators are not deliberately aiming to stop the property cycle occurring; they are trying to ensure that a crash would not be of systemic importance,” says Denton. “Within reason, I don’t see a problem with lenders taking risks. The problem is that, historically, those risks impacted everyone because they exposed our banks.”
The diversification of the European lending market is a key point of difference between 2007 and 2017 – one the crisis prompted. During the last market peak, banks dominated the scene across Europe. Banks are still the largest lenders, but an array of alternative capital sources – insurers, debt funds, hedge funds, even property companies – are providing debt beyond the banks’ risk parameters.
“It will continue to be a bank-dominated market because banks can make high returns from real estate lending, compared with other sources of revenue and because borrowers like the flexibility that five-year floating-rate debt can give them,” says Sinclair. “The debt funds and insurers have a big role to play, but with a certain type of client or asset. Their cost of capital is more suited to seven to 12 year-term debt and longer term investors.”
Diversification has led to the notion of debt advisors becoming more accepted in Europe, to intermediate between sponsors and the array of lenders seeking to provide loans. “You don’t simply knock on the door of a clearing bank or investment bank anymore,” says one source.
M7’s Fraser says that, back in 2009 when he began borrowing for the firm, debt was typically offered at 65 percent LTV for 100 basis points upfront, a 260bps margin and 250bps annual amortisation. “The truth is that today it is probably exactly the same, unless you are doing big tickets, which helps get tighter pricing than this level. Obviously the ‘V’ in LTV has changed significantly, but our sector is popular today because of the strong income returns it produces,” he says.
The defining difference between the market in 2007 and 2017 is leverage. At the height of the last cycle, senior banks were issuing debt at 80 percent to 85 percent loan-to-value. This time around, senior lenders are capping their lending at around 65 percent. Junior debt can be sourced to supplement bank debt, and some alternative lenders have made a business providing whole loans in the region of 80 percent LTV, but, crucially, that risk is off the banks’ balance sheets. The volume of equity at play in the market, as a result of the low-interest-rate environment encouraging managers to put money to work in alternative asset classes, has also curtailed the use of debt.
“People have realised that when the music stops, higher leverage can crush you in a bad market,” says Denton.
An area of concern is that prime property values have spiked, meaning that 60 percent LTV could become much higher leverage in the event of a downturn. Sinclair, however, argues that the market’s leverage is far more sensible than in the last cycle: “Lenders have lent against assets with good revenue, so if values were to fall, debt can be serviced through periods of temporary decline.”
Indeed, Sinclair argues that a prudent approach by lenders ought to be a focus on debt yield – as is the case in the US market – with interest cover ratio a less relevant measure in the low-interest-rate environment. Whether or not such tests are increasingly adopted, Denton argues that property stress analysis is similar today to the late 1990s, and vastly different from 2007: “Between 2003 and 2007, that got lost,” he says.
Over the next few days, the story of European real estate finance from 2007 to 2017 will be told through a retrospective look at Real Estate Capital’s coverage. The markets appear very different at the beginning and the end of the decade, but keeping history in mind is always wise.