Residential finance: The European opportunity

Continental European markets offer developers and lenders opportunities to back residential projects, writes Lauren Parr.

European residential markets have gained substantial momentum over the past few years owing to a strong economic performance in several countries. Increasing house prices and supply/demand imbalances mean residential construction has picked up across the region. Even countries hit severely by the financial crisis such as Spain and the Netherlands have seen a significant uptick in activity.

“The sector is growing on the back of success seen in cities where there is a particular undersupply of stock driving an increase in rents,” says Jos Tromp, head of EMEA research at CBRE.

The solid performance of Europe’s residential markets is accompanied by growing demand from institutional investors which are attracted by the prospects of stable returns,
as well as the increasing liquidity of many emerging build-to-rent multi-family markets in Europe.

“We’re typically seeing liquidity driven by Germany and the smaller markets of the Nordics, as well as places like the Netherlands. The rest of Europe is only starting to see a bit of a sector appearing,” says Tromp.

There are substantial differences in the profiles of the institutional residential markets in Europe and these are largely dictated by local housing culture. For example, the Dutch market has large social housing stock whereas Germany is known for its renting culture. Taxation varies from market to market; in Germany, investors can deduct certain costs when renting out apartments, for instance. There are also differing market trends at play in individual markets.

“Capital goes in cycles. As a core investor, you wouldn’t have invested in Spain during the crisis; in the Netherlands, a lot of mortgages were underwater for a long time; now we have Brexit, there is a question mark over residential prices in London and the UK,” says Tromp.

“People need to feel comfortable and as this confidence is in place in most of Europe, core capital is increasingly looking to invest in the sector, with increased appetite to consider development in order to build scale,” he adds.

With favourable conditions expected to persist in the medium-to-long term, the search for investable product will continue, resulting in rising rents and prices across Europe.

Germany leads the way 

“The opportunity set is greatest in Germany owing to the size of the market, liquidity, funding and strong fundamentals,” says Joseph DeLeo, senior partner at London-based private equity real estate firm Benson Elliot.

Germany is experiencing a housing shortage in all metropolitan areas, driven by growing urbanisation of the population. It has an attractive operating environment in terms of upward pressure on rents, while investments are easily financeable.

On the investment side, margins are very competitive at around 100 basis points, having come in over the past 12 to 18 months. Construction finance can be up to 200bps on average. Loan-to-value levels remain at 65 percent to 75 percent.

Benson Elliot’s strategy is focused on finding undermanaged apartment buildings it can improve, before selling after a couple of years. The depth of liquidity in the market makes it an easy sector to exit.

“What’s changed for us in the last eight years since we’ve been active in the sector is that it’s become a lot more difficult to get the yield we need to generate the type of returns we expect, so we’re looking at opportunities on the development side. If we can build to 125-300bps development yield above buying existing product we think it makes sense,” says DeLeo.

The company took a big position in Berlin in 2016, when it committed to build 750 units valued more than €300 million on a plot behind the city’s main train station. The deal was financed by UniCredit and Berlin Hyp.

“Asian buyers are fuelling demand for apartments in Berlin and Frankfurt, both of which are attracting talent and their populations are rising,” says Thomas Zabel, head of residential development for Germany at JLL. “That has created a positive outlook for German residential developers looking for development finance from domestic banks.”

Banks have also become more open to financing micro-apartments aimed at young professionals since last year. “There is a growing need for smaller units because apartment prices are increasing in core cities. Before now it was viewed as ‘special financing’, however, the fact margins are very tight means banks are open to greater risk-taking,” says Martin Büber-Monath, responsible for Patrizia’s financing activities.

Ireland’s tight supply

Ireland’s supply/demand imbalance is well publicised, with around 37,500 homes required nationally over the next five years – 15,000 per year in the Dublin area. However, only around 5,400 were completed nationally in 2016 according to Goodbody Stockbrokers.

“The market experienced a very deep housing crisis as a result of which house prices dropped by more than 50 percent. There has been very little output of units and delivery is well behind what is needed,” says Tim MacMahon, director of development and residential capital markets at CBRE in Ireland.

A significant increase is expected in 2017, with Goodbody forecasting approximately 10,000 unit deliveries, albeit still less than a third of the forecast demand. The greater Dublin area alone will account for about 70 percent of this.

“There has been a shift in sentiment in terms of people choosing to rent. Dublin has a large transient population while the economic backdrop is strong,” says MacMahon.

“From a finance point of view, you have substantial availability of equity and bank debt for the funding of building new homes and mortgages for end product,” notes Paul McDonnell, head of property finance at Bank of Ireland.

Significantly, about 12 months ago, Ireland’s central bank relaxed prudential regulation which determines the level of capital lenders must hold, and the government introduced a Help-to-Buy scheme for end-users. These changes, combined with an improving economy and increased supply of new homes, have led to improved demand in the housing market.

Bank of Ireland has committed a further €1billion of funding for construction and development specifically – a figure that has grown from €250 million in 2014. The lender’s greatest level of production involves Dublin-based starter homes, although there is also emerging demand for middle- and higher-priced units.

Smaller schemes, or where there is a significant element of land, are often financed by alternative lenders, which have made an entrance in the market in the last two years, although the debt in these instances is considerably more expensive than traditional bank debt, often as much as 8 percent to 10 percent margins, plus fees.

Dutch demand

The Dutch residential investment market is performing strongly due to high occupier demand. This is driven by population growth in the major cities, a reduction of government subsidies of owner-occupier mortgages and housing associations being forced to refocus purely on low-income households. Investment volumes have risen to €3 billion a year since 2014, from €1 billion before that according to CBRE.

“Initially, the majority of transactions in the market involved existing properties which was partly driven by portfolios divested from social housing corporations. In the current market, however, developments also play a major role,” says Robert-Jan Peters, head of CBRE’s debt advisory business in the Netherlands.

In September, OVG sealed the sale of its Valley development in Amsterdam to private investor RJB Group. The 75,000 square metres mixed-use building will include apartments, offices, a sky bar, restaurants, shops and cultural facilities, regenerating the urban district of Zuidas.

“A number of institutions have partnered with local developers because there is an acute shortage of new investment stock in the pipeline. Some are trying to get ahead of the game, even though it may not be their natural niche,” says Peters. This allows them to create the quality of underlying product that allows them to bid aggressively.

Appetite for residential financing is extremely high, from both local and international wholesale banks, as well as Pfandbrief banks and insurance companies.

The lending market has become increasingly more competitive over the past 15 to 18 months, with most international lenders looking for volumes of at least €50 million at 60 percent LTV on an interest-only basis. Pricing ranges from 110-115bps.

“We see leverage moving up and amortisation becoming negligible quite quickly. Deals are being won by lenders on price, with the odd lender that has lost out on a couple of deals coming in with a knock-out bid,” Peters says.

There has also been an erosion of terms and conditions – for example, prepayment protection has slowly become more borrower-friendly with prepayment penalties reduced.
The historic characteristics of the Dutch residential market including The Netherlands’ rent control mechanism means portfolios are often rented out below market rates. “The asset class provides stable, long-term income, but if tenants leave you are often able to deliver a very strong investment return. Current valuations are tight but income is not expected to come down,” says Peters.

DIFFICULT MARKETS TO CRACK

Other European markets offer investment and lending opportunities, although they can be difficult to penetrate owing to the dominance of local investors and lenders.

From a liquidity point of view, the Nordics is one of the most favoured markets by institutional investors. “In Finland, the investor universe for residential is a lot higher than the potential universe in commercial real estate. Pension fund investors typically from the Nordics and the Netherlands have had a long history investing in that market, driving the development of the segment. However, with a large volume of global capital available to invest in the residential sector, this is starting to change a bit,” says CBRE’s Tromp.

Stockholm offers a very liquid institutional residential investment market, but a low return environment. For example, pbb Deutsche Pfandbriefbank recently provided a SEK 1.44 billion (€141 million) loan to Heimstaden Bostad for the financing of four newly built and two refurbished residential properties in the city.

“It’s difficult for global capital to get a substantial allocation to a residential market without taking development risk; it’s far more local than commercial real estate and far less transparent which means it’s an advantage to understand local market conditions,” Tromp says.

Copenhagen is experiencing a housing shortage but Benson Elliot has struggled to find enough returns as the market is still dominated by local pension funds. “Norwegian and Swedish investors with a long-term view are happy to generate a 3 percent yield. We can’t compete development-wise,” says Benson Elliot’s DeLeo.

The French market is heavily dominated by local institutions willing to bid aggressively on French property while the general population prefers to own rather than rent, “so you don’t have a big rental market to begin with”, DeLeo says. Meanwhile, home-ownership in some of the central and eastern European markets is close to 100 percent, limiting liquidity in those PRS markets thus far.

As such, much of the capital eyeing Europe’s residential markets currently is sticking to the region’s western markets where effective deployment is a more straightforward affair.