At first glance, CBRE’s European Debt Map paints a concerning picture of development lending across the continent from a risk/reward perspective.
The firm examined lending terms – margin plotted against loan-to-cost ratios – for speculative office development in 17 locations across Europe. Although one might expect margins to be higher for locations with higher LTCs, the data show that the opposite is the case.
The correlation between LTCs and margins is strongly negative at -0.69. The four markets with the highest development loan margins, of 3.5 percent or more, also have the lowest LTCs, of 60 percent or less: the UK, Ireland, Italy and Romania. Meanwhile, markets in which LTCs are 70 percent or above have margins below 3 percent. In seven out of 10 of these markets, the margins are 2.5 percent or less.
Is this a sign that the European development finance market is significantly mispriced? Probably not, argues Dominic Smith, senior director, CBRE Research, who says that individual markets are priced much more sensitively to historical market risk indicators than first impressions might suggest.
“Certainly, pockets of greater or lesser opportunity for borrower and lender exist,” explains Smith. “But when looked at in a wider historical context, many of the relationships between debt pricing and underlying market fundamentals appear fairly rational.”
To further explore the relationship between underlying market risk and development finance terms, CBRE examined nine western European markets for which it has consistent relevant data covering the period from Q4 2017 to Q1 2019. It found LTC to be closely related to the health of the underlying property markets, as far as they have seen growth in estimated rental value back to, or above, pre-global financial crisis levels. Lenders, the data show, are prepared to lend more in markets that have demonstrated the strongest recoveries.
CBRE also analysed the relationship between senior margins on prime city office developments and the prime yields now versus the lowest prime yield seen before the crisis. The data showed margins to be closely correlated with the extent to which yields have moved.
“Lenders are prepared to charge less for debt in markets where yields have recovered the most,” explains Smith. “To those whose glass is half full, the above could be argued as being pro- rather than countercyclical – lending more, at lower margins, into markets that have recovered the most since the crisis.”
However, should lenders be more cautious? To answer this question, CBRE compared LTC ratios and margins against its forecasts for capital growth in each market.
Whereas in Q4 2017 lenders were lending more, and at cheaper rates, in markets that were forecast to perform worse, this trend had corrected by Q1 2019. By the end of the quarter, CBRE found lenders were generally lending more, and at lower margins, in markets that were forecast to perform well. The firm also found lenders were lending less, and at higher margins, in markets that are forecast to underperform.
“It is to be hoped both that our forecasts are right, and that this prudence will continue,” says Smith.