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Q&A: Francesca Galante of First Growth Real Estate

First Growth’s co-founder on navigating Europe’s real estate debt markets during the covid-19 pandemic.

This article is sponsored by First Growth Real Estate

The team at pan-European real estate debt advisor First Growth Real Estate returned to its offices in London, Paris, Milan and Madrid in June, after what partner and co-founder Francesca Galante describes as an “intense” lockdown period, balancing work and homelife.

Since covid-19 hit Europe, she explains, the team have been kept busy negotiating loan extensions and covenant waivers for clients affected by the pandemic, as well as assisting borrowers in their searches for new finance, and keeping in contact with debt and equity providers during a highly uncertain period for the market.

Here, Galante shares her observations on real estate debt market conditions during the crisis.

How has covid-19 affected the continental European real estate debt market?

Francesca Galante
Francesca Galante

There has been a large reduction in liquidity, especially in Italy, Spain and other peripheral markets, but also in France and the UK. Lenders are busy dealing with covenant waivers and restructuring requests from existing borrowers. As corporates experience liquidity issues, it leads to reduced rent recoveries by landlords, and therefore lower levels of debt service.

As a result, lenders’ credit committees are more cautious about new commitments, especially in hospitality and retail, but also for offices, where the sustainability of rent and upcoming lease breaks are being heavily scrutinised.

But we do not expect a major liquidity crunch, assuming of course there are no further lockdowns. Banks are capitalised and most debt funds have dry powder. European Central Bank refinancing measures will support the euro area financial system by providing a liquidity backstop. In addition, the EU’s €750 billion covid recovery plan shows unprecedented support for the economy.

“Distressed deals are yet to come through”

Which types of lenders remain active?

Commercial banks are open for business, selectively. But they are balance sheet lenders, so have capacity constraints. Cashflow strength has become critical to them and they are shying away from large deals in favour of loans they can fully hold, or share between a few banks, which means deals need approval from multiple credit committees. They are also favouring their domestic markets, partly due to governmental pressure.

International investment banks are in wait-and-see mode because their loan exits via syndication or securitisation are more difficult. Certain debt funds are taking an opportunistic approach and are actively chasing distressed deals where an emergency capital injection is needed, or secondary trades at deep discounts.

In general, lenders are shifting their focus to core assets, owned by existing borrowers. Lenders have closed the valve for asset classes harshly impacted by the crisis and where the route to normality remains uncertain.

How are your borrower clients reacting to the crisis?

Sponsors are retrenching to less risky transactions, just like they did in 2009. However, aside from the few putting all deals on hold until the dust settles, most are keen to deploy capital and explore opportunities. They are targeting higher returns for the same risk they were taking pre-crisis. Borrowers are clearly thinking about the risk of asset values dropping, and so are reluctant to take on high leverage.

Asset managers are putting sales on hold, especially for retail and hospitality, and so are considering refinancing, to release equity and protect their returns over longer hold periods. In distressed situations, some are testing the water for discounted payoff deals, which some banks are receptive to.

How have lending terms changed due to covid-19?

We have seen some deals close during the crisis. Due to the difficulty in assessing property values, lenders are cautious on loan-to-value, and are requesting additional collateral and interest reserves. They are questioning how values are impacted by covid, despite a lack of transactions. For core transactions, lenders are repricing margins, due to an increase in their internal cost of capital. Those lenders that need to syndicate are including a pricing buffer to protect themselves against higher syndication margins.

Funds with a locked-in cost of capital are also increasing margins to follow the overall repricing trend. Those that use loan-on-loan funding to boost returns are significantly increasing their margins, because such finance has dried up. Overall, repricing is likely to continue. As banks increase the risk rating of new loans, they will need to retain more capital, leading to increased margins.

Covenants are difficult to set, because it is so hard to predict how values will change in the next few years. Lenders are building in additional cash reserves as buffers and are requesting more frequent valuations. There is also more focus on security packages, ongoing amortisation to de-risk loans for lenders over time, and covenant-lite loans are no longer available.

Which European markets have been most affected by lockdowns?

Italy, Spain, Portugal and Greece. With a high proportion of employment in leisure and hospitality, the lockdown hit Italy hard. Several international lenders have put a hold on new business. In Spain, small and mid-size domestic lenders put all new financings on hold during the state of emergency, while foreign lenders such as French and German banks have been very selective. Where banks were previously providing 60 percent loan-to-value ratios, this will now be more like 50 percent, while pricing has likely increased by around 100 basis points for core transactions. The universe of value-add lenders has shrunk dramatically.

Smaller and more peripheral markets such as Portugal and Greece are reliant on domestic lenders as international capital almost entirely retreated.

Will we see a wave of distressed deals?

Most European countries have set up emergency measures to support corporates, including state-guaranteed loans. Distressed deals are yet to come through as real estate lenders have been willing to act reasonably and in a cooperative way with borrowers. However, more distress is inevitable as lenders cannot accommodate the liquidity issues of their borrowers beyond a certain point.

Will we see a new wave of non-performing loan sales?

Banks have put deleveraging plans on hold while they await better market conditions. The bid-ask spread is too wide. However, a few sale processes have been announced in Italy, Spain and France. In the medium-term, we expect non-performing loans to increase significantly, but not to the extent that they create a systemic risk for the industry, or a retrenching from new business by banks.

Most state support guarantees were targeted to performing situations, further increasing the gap between performing and non-performing situations and discounting values of NPLs and unlikely-to-pay loans.