With UK debt terms now increasingly cheap and flexible, our expert UK roundtable panel assesses the opportunities and challenges for borrowers and investors in a fiercely competitive market.
Investment flows into UK real estate are unabated, with more than £34bn recorded in the first half of 2015 – up £10bn on the same period last year, according to Property Data.
That activity has driven demand for finance. But it has also spurred lenders into providing more flexible, bespoke and competitive terms.
For borrowers, debt is cheap and the issue is sourcing the right lender and deploying their debt and equity capital towards the right asset in the right place and at the right price.
Our roundtable panel of property experts discussed how 2015 has unfolded so far, a year that saw a general election in the UK, and where the opportunities and the risks lie ahead. On the lending side were Paul Dittmann, head of senior commercial mortgage finance at M&G Real Estate, and Colin Sanders, chief executive of specialist lender Omni Capital.
Simon Marriott, head of UK real estate at investment manager Valad Europe, and Ed Daubeney, head of debt advisory at agent DTZ, gave the borrowers’ perspective.
The roundtable gathered at DTZ’s Old Broad Street headquarters in the City of London. The agent recently announced a merger with rival Cushman & Wakefield to create the second largest property agency in the world – a sign of confidence in the commercial real estate market.
SIMON MARRIOTT: We had a really busy start to the year. A lot of portfolios came to market, including quite a few cross-border portfolios. The market definitely slowed down three weeks before the election: there was a big “woah, let’s just hang back and see how this pans out”.
Labour Party leader Ed Miliband talking about rent regulation in the residential sector… that was not clever. But after the election result it started to pick up again. In the UK, the market doesn’t really shut down during the Summer, although it gets quieter. I sense that the final quarter of this year is going to be really busy, with lots and lots of product coming to the market.
PAUL DITTMAN: I agree with Simon’s assessment of the market absolutely. We were very busy before the election. We had our best spring ever and I would say there was a lull before the election around mid-April. Now, without question, we are drinking from a fire hose. Transactions are flooding into our gates here – size-wise, it’s huge.
COLIN SANDERS: It’s picked up significantly after the election in the London residential market. But it’s very specific to the area and that could be different from one end of a street to the other. If a developer has selected the location well and the product is high quality and well-presented, they’re still selling at massive premiums to international buyers.
EDWARD DAUBENEY: From a banking perspective, I don’t think anybody really stopped lending before the election. But there was a bit of a pause and then on the day of the election result there was a sigh of relief, I suspect throughout the entire property industry in the UK.
SM: From an investor’s view, people have got a lot of assets to sell and they think “there’s a weight of capital coming from North America or Asia that’s going to pay inflated prices because of the increased pressure to invest”.
We are really selective. Out of the last four deals we’ve completed, we weren’t the highest bidder, but they came back to us. Maybe the competition has been a bit aggressive on the underwriting or they hadn’t seen the physical asset. We do all that at the beginning of the process, so we’re very robust. We try to bid with all of our approvals in place and even though we are a leveraged player we always close with equity for speed.
ED: Over the past few years since the recession it’s been important for buyers to complete all equity to compete – especially in London. Actually, this is beginning to change now, especially regionally. From a borrower’s perspective you can tell there’s more liquidity now in the banking market and more certainty.
Buyers are prepared to complete out of cash, knowing in the background credit has been approved (or is close to being approved in some cases) prior to them exchanging and they’ll exchange based on that. A few years ago you wouldn’t have done that because clients would be saying: “No way are we doing that, we want it signed and we’re doing a simultaneous exchange and completion.” So borrowers are much more confident with the banking market.
PD: That’s definitely the case. We are seeing some buyers who will buy first with equity and then want to know, can we close the loan near the date, or two weeks later? Rather than buying fully with equity first and then going out two months later and doing the debt.
So, that’s changed a bit and that’s been to our advantage, as we have a very tight credit process. It’s not a meeting once a week, it’s ad hoc, so we win deals because we can move at speed and we don’t have a big bureaucracy behind us.
CS: Omni benefits from some of this because often our borrowers’ finance will be put together by a private bank at a particularly fine rate, but it isn’t done in time, and we’ll provide a bridge to get through that initial period, typically a couple of months.
Often our clients end up needing those whole two months or more. So that’s the type of facility we provide through our bridging finance product and we’re seeing a lot of that. I don’t think that’s likely to change soon, not from where I’m sitting.
PD: There are several new alternative lenders out there. Back in 2006 it was all banks. It was either CMBS and/or it was banks. In the US, it’s half banks, a quarter CMBS and a quarter insurance or alternative lenders. It’s starting to get like that here. Alternative lenders don’t benefit from the loss-leader concept, where real estate loans are just the driver for the swap guys. In 2006, some banks or investment banks were doing deals with 50-75bps margins because the swap was making millions, and that’s not really happening anymore.
SM: We have two or three banking partners, as well as other banks coming to us, some of which may replace existing banks in a pool. We will generally pitch to two or maybe three of our banking partners at a time.
Relationships still important
SM: Relationship lending is extremely important to us. That way, we know who to partner with and we can go back again and again. They know how we cut the deal, we know how they analyse the deal, how their credit processes work. That gives us comfort. It gives us more security around the deal execution and that is really valuable.
We decided early on to have a broad, inclusive lender group: UK lenders, pfandbrief-style banks, some institutions. That’s our set and we’re comfortable with them.
ED: I have clients contact me and say: “Look, we’ve never borrowed from such-and-such bank.” They say: “We want to build a relationship with them. We’ve got our other connections, but we do want to spread our bank exposure.” When we discuss previous relationships, they say: “My bank was such-and-such. That was such a strong relationship – until they pulled the plug in the downturn.” So clients are a lot more careful about their exposure.
CS: From a different perspective, we often issue indicative terms of funding support to assist a developer making a bid to purchase a site or scheme. Often they fail because they’re relying on our debt funding. That’s nothing to do with what we’re offering; it’s just that the vendor has often got a buyer in an equity position, which will always win in a bidding process.
PD: If we give a letter and also indicate this is a repeat experience with this borrower, that adds a lot of credibility. We’ve closed deals in two weeks, from term sheets to signing – not funding – but completed the due diligence, signed the loan documents and everything.
We have a good conversion rate when we send out a term sheet. I think we convert about half of those from when we send out a term sheet to actually winning the deal.
But we look at a lot of deals before getting to the term sheet stage; we have to kiss several frogs to find that prince of a deal. And there are still deals that don’t make sense. We are seeing more portfolio trades with a mixture of asset quality. This was similar to some 2006-07 trades, where the challenging assets were mixed with jewels, but no matter how much lipstick you put on the pig, it’s still a pig, so asset selection and intelligent research are a priority for us.
SM: We are seeing groups of assets being marketed as portfolios, but they aren’t really portfolios: there’s no sector or regional theme. Rather, they are collections of assets, some of which we like, some of which we wouldn’t want to own.
You hear people say you can get 75% leverage on this, that debt will get cheaper or that we’re in an equivalent yield market now – equivalent yield is a term we’re hearing a lot now, and that can be worrying. The implication is that rental growth is back across the board, that it’s a given.
People are making purchasing decisions based on assumed future rents in the hope that rents will carry on rising. This market is inexorably moving to a point where there is an insatiable appetite from capital for assets. You only have to look at the successes of some of the recent fund raisings.
Change in debt metrics
PD: We look at the all-in cost for senior debt, but the make-up of all-in cost has been changing in the past few years. In 2013, the five-year swap rate was 90 basis points; in summer 2014 it was 220bps. In 2013, average margins were circa 300bps over the 90bps and in 2014 they were at circa 180-200bps, which is where they are today.
The overall senior debt borrowing rate was averaging 4% in 2013 and 2014; today it’s closer to 3.5-3.75% as the five-year swap has come down to circa 165bps.
It seems that some German banks lending in Germany, which make the cheapest loans, aren’t pricing credit, but pricing the opportunity cost of not investing their deposits – especially when the bank deposits rate is -75bps or -50bps. They may need to make a loan so they can add 75bps or 100bps. It’s not really a credit call, it’s more: “I’ve got to get this money invested, whatever it takes as long as it’s above Libor.”
ED: With slotting, there are situations where it makes it harder for UK clearing banks to compete on pricing. If you have a UK bank competing with a German lender on a prime central London office building, there is only one winner. I believe there are lending deals in London now where a new low on margins is going to be set.
SM: On the equity side, it’s also a yield compression story. Sector wise, there are still opportunities for the more hands-on, value-adding strategies. The logistics market is like the new retail for me. Look at it now: it’s at sub-5% yields for really prime stuff, whereas it was at 7% only two years ago.
PD: I think yields are still going to go down for some markets. Equity aside, look at London. Who are your investors and what’s the relative comparison? What do the Hong Kong guys that are coming over here think? That we’re at the very start of the stage. The equity we see today is becoming more deep and plentiful and possibly we’re going to see multiples of more new equity coming through – and where do you go in the world to invest it?
Yields are 2.5-3% on prime Fifth Avenue, New York retail. Some of those retail boxes are a hundred thousand per sq ft. I mean, is that normal? Is that where we’re going? So, we’re getting back to 2007 total yield compression. Not only in London, but also starting in the regions. At some point it will revert to a new normal, but it’s hard to say where that level is, given that long-term rates are expected to stay low and other relative investments are low yielding.
ED: Not wishing to sound too negative, but I was thinking about what could cause a downturn this time round? Is it going to end up being an occupier-led issue? There’s actually quite a lot of development now; are investors going to overdo it?
However, in London, rents are projected to grow well into 2018, which is positive. It’s very interesting seeing how rents have increased in places like Kings Cross, Farringdon and Clerkenwell. Last time it was a banking-led recession; it won’t happen in this cycle, because banks are being more prudent with their underwriting.
Equity takes the risk
ED: Yes, you can get 80-85% leverage with some mezzanine, but generally it’s the equity that’s taking more risk this time. Recently DTZ published its second European Lending Survey, where over half of lenders considered the biggest risk for the lending markets to be the weight of capital now being deployed.
SM: You don’t want to lose your discipline. You don’t want to be forced by pressure in the market to go to places where you’re uncomfortable. Our experience has shown that sometimes it’s not so bad if you’re not the highest bidder, because people realise you’ve done your due diligence and they come back to you. We’re looking to use the team in a more creative and opportunistic way: to find the sector that’s a bit underpriced or where we can put the capital to work better. So, we’re definitely remobilising our development capabilities.
PD: We’ve seen many opportunities in the UK in the past 18 months. We’ve lent all over Western Europe. Where we are scoring is we’re writing whole loans – we’re not syndicating. Our borrowers look us in the eye and say: “Okay, we know you’re going to be there at the end of the day.”
I think people are willing to pay extra to know we’re there and we get back to clients really quickly on deals we like. We’ll send terms in two or three days and say: “This is where we are, let us know if you need a term sheet,” and then move on to the next transaction. It’s just sifting through a lot of stuff and we’re closing a lot of deals. We get a lot of repeat business because of the smoothness of it.
CS: We intend to continue with our core bridging product in prime London and the South East. But in the regions, our niche is to support medium-sized developers with multi-unit schemes ranging from £5m to £20m. I see that continuing through 2015 and 2016 for us. I’d expect us to do £250m of development business in the next 12-18 months. For the size of the business we are, that’s good progress and we believe it is very achievable.
ED: It’s good to have greater availability of development finance – it’s interesting work. From an adviser/broker view it’s a fantastic market because of the breadth of debt out there. Most opportunities can be priced: it could be two-over, it could be eight-fixed, depending on the risk. This wasn’t readily available 12-18 months ago. n
LIFE BEYOND PRIME LONDON RESI
Colin sanders: The consensus is that prime central London property has become a bit toppy, so we’ve been quite conservative with new lending in that area. We’re seeing more action in zones two and three and in the regions, where we’re much more comfortable in going to higher levels of leverage, which for us is at the higher end of the 80% mark.
We can’t compete on price, so it’s always going to be how far up the curve we can go. We’re happy to do that in some of the regions, London zones two or three and some of the Crossrail hotspots. We’re happy to do those because we can see where the end position is going to be.
We don’t like to back single units, but we are doing quite a few multi-unit schemes, where the scheme provides entry-level flats with sales prices of £220,000-£250,000, because we can see there’s an active market for that. We can see people can afford it; it’s an investment market as well, so you know they’re going to sell. So, some of the gross development values surrounding places like Chelmsford and Croydon have provided great upside for developers.
However, we’re very cautious about some of the values that are being bandied around in London. We don’t offer development funding in that high-end, super-prime market, although we’ve done — and continue to do — a lot of bridging loans in prime
central London. Our risk appetite has been fairly cautious and at low loan-to-value levels, and represents very short-term risk – usually say six to eight months. I feel comfortable about that.