This article is sponsored by Schroders, and supported by Deutsche Finance International, EQT Exeter, Knight Frank Capital Advisory, and Mount Street.

As the dust settles on the covid-19 pandemic, the European real estate debt market has emerged with an expanded need for alternative finance. Banks, still the dominant source of finance in Europe, have continued to retrench from parts of the market, as covid and now a series of geopolitical and macroeconomic upheavals have increased risk.

Market observers say this has further mapped out fertile territory for a rapidly expanding cadre of debt fund managers who see an opportunity to harness the surge of capital seeking a defensive way to invest in real estate.

Held in late April, the Real Estate Capital Europe roundtable brought together a group of private real estate professionals from firms across the industry to discuss the evolving role of alternative lenders and how they will grapple with the two burning issues of the day: rapidly rising inflation and the urgent need to create real estate fit for a net-zero carbon future.

Asset manager Schroders, playing host to the discussion at its London office, is a relatively recent entrant to the European real estate lending market. Natalie Howard, recruited by the firm in 2020 as head of real estate debt with a brief to ramp up its credit offering, says there is plenty of scope for expansion. She estimates that alternative lenders make up only 20 percent of the UK real estate debt market, and 6 percent in continental Europe. In the much more mature US private debt market, the figure is 40 percent. Howard believes that Europe could eventually reach 30 percent.

Howard identifies a series of factors pushing banks to withdraw from real estate lending: concern that they might have to retain capital to cover pandemic-related defaults as government support for businesses is withdrawn; the winding down of quantitative easing by the European Central Bank; and the looming introduction of Basel IV regulations, which will tighten standards for credit risk. “European banks were very active up until covid,” Howard says. “They will still compete in some areas, but as soon as you move away from the absolute cookie-cutter perfect deal, there’s very little financing available. The funding gap is huge and alternative lenders are moving in to fill it.”

Mainstay lenders

At the roundtable, borrowers were represented by two investment managers: EQT Exeter and Deutsche Finance International. Both say they are utilising credit from alternative lenders with increasing frequency.

“There has been a definite shift,” says Nisha Raghavan, EQT Exeter’s chief financial officer for Europe and Asia-Pacific. “Up until the pandemic, banks were our mainstay lenders. Today, we still reach out to them as the first port of call. But with yields being so low and the inflation pressures coming through, we need to improve leverage, and we need lenders that understand complex real estate and are able to commit faster and give us a much smoother decision-making process. That’s where the alternative lenders really shine.”

“Because many of them are also equity investors, alternative lenders often have a deeper understanding of business plans”

Farrah Brown
Knight Frank

In some markets, traditional lenders are still keen to back more favourable sectors, such as logistics and residential, notes Gavin Neilan, chief investment officer at DFI. “But for strategies like development and repositioning, and unloved sectors like retail, the alternative lenders perform a very important function.”

Alternative lenders have made strong headway in geographies underserved by banks, says Farrah Brown, a partner in Knight Frank’s capital advisory team. “In Southern Europe – Italy, Spain and Portugal – yields are higher and provide attractive returns to debt investors, so debt funds are more active in those jurisdictions. And traditional lenders in those markets have retrenched more than in countries like France and Germany.”

Brown specialises in marrying borrowers with lenders. For some segments, alternative lenders can be a better match for private equity buyers, she suggests. “Because many of them are also equity investors, alternative lenders often have a deeper understanding of business plans. That is particularly true of sectors where the pandemic has accelerated change, like life sciences, as well as niche residential sectors, data centres and self-storage. They have a better grasp of the story when it comes to providing credit, and that enables the borrower to secure finance and get the deal done more quickly, which is vital in today’s market.”

As head of asset diligence at loan servicer Mount Street, Jim Gott is well placed to observe the way in which the composition of the European debt fund market is changing. “In the last two weeks, we have had two or three different companies [come to us] that wanted to start their own debt platform, and are looking at outsourcing middle- and back-office functions. They are commonly equity managers that want to get into debt. Often, they have spotted a niche and want to build a fund around that. A lot of the deals that alternative lenders are doing are value-add and development, which is partly driven by the need to upgrade the energy efficiency of assets.”

Illiquidity premium

There is no shortage of capital available to back those new entrants, says Howard. “Pension funds and insurance companies have a big exposure in fixed income and a raft of investment-grade corporate bonds yielding anything from 50 to 100 basis points. By allocating some of that fixed-income money to investment-grade real estate debt, they are sacrificing liquidity to get 200bps. They have doubled their return for an equivalent risk level, while also having asset security. That illiquidity premium is very attractive to fixed-income investors, so they are moving into private real estate credit.”

“We need lenders that understand complex real estate and are able to commit faster”

Nisha Raghavan
EQT Exeter

Alternative lenders are now playing across the debt capital stack, encroaching on the traditional lenders’ territory while filling in the gaps left by their aversion to risk, claims Howard. “The big insurance companies are all playing in the bank space, doing investment-grade lending on core stabilised assets at 50 to 55 percent loan-to-value at 150 to 250 [basis points] over SONIA in the UK, or 100 to 200 over Euribor on the continent.

“In addition to that, funds cover everything away from the bank market, such as stretched-senior whole loans to development funding, which is almost rarer than hens’ teeth now. We will see a number of new entrants coming into the market over the next five to 10 years. And it will not always be a high-yielding strategy.”

Historically, debt funds have played at the high-yielding end of the credit market, offering mezzanine debt and lending against higher-risk assets and strategies. But the influx of fixed-income money into the space has wrought a transformation, argues Howard. “Alternative lenders are working out that if they have fixed-income money, then they can compete directly with the banks. The vast majority of the money in alternative lending now is actually playing in the same market as the banks, which is 80 percent of the real estate debt market. That is where investors can get the volume and scale.

“In a high-yielding strategy, you might have 20 investors in the fund, each putting in a €20 million or €30 million ticket, like they would in a real estate equity fund. But in a low-yielding strategy, you will have investors putting in hundreds of millions because fixed-income allocations are much bigger.”

Low-yielding debt strategies also benefit from not being forced to deploy within a limited time window, observes DFI’s Neilan. “The opportunity to lend mezzanine finance at the price that you want to lend is very cyclical, whereas the main demand is for whole loan or senior loan debt – that is a structural opportunity.”

Scanning the horizon

Roundtable participants identify the biggest challenges for the alternative lending industry in Europe.

Farrah Brown: Hedging costs are increasing, in particular interest rate caps, which is generally how debt fund borrowers hedge. This results in debt funds’ cost of debt being less attractive to borrowers, which could make it difficult for debt funds to deploy capital. It is unlikely they will loosen their hedging requirements.

Jim Gott: So many new debt funds are being created that the biggest pressure on alternative lenders over the next two years will be increased competition for both deals and staff. It is a growing industry and there is a relatively small pool of debt specialists.

Natalie Howard: The risk posed by the declining value of the equity within assets as a result of factors such as higher costs and increased obsolescence. As a lender, you manage that risk by adopting a more cautious mindset: lending less and charging more.

Gavin Neilan: In the short run, there is a huge challenge and opportunity around ESG and the net-zero carbon objective. In the medium to long term, decentralised finance will create a lot of disruption, as well as product innovation, which will impact right across the financial industry including lending and investing.

Nisha Raghavan: Inflationary pressures on development costs, interest rate rises and the wider stagflation risks in the economy.

Inflationary environment

As debt funds continue to grow and cement their place in the market, they will face the challenge of managing the risks posed by an inflationary environment. While floating-rate investment-grade loans provide an element of protection for investors from interest rate increases, asset prices will come under pressure as yields increase.

“If the risk-free rate is rising, and real estate has to command a premium to the risk-free rate, you are going to have declining values,” says Howard.

While that predicted pricing adjustment has yet to filter through to equity markets, lenders have already begun to factor it into their underwriting, says Neilan. He notes that debt markets, like equity markets, which bounced back strongly as the pandemic threat dissipated, have begun to see increased pricing and a reduction in leverage.

“Equity markets have not repriced much. But debt has gotten more expensive”

Gavin Neilan

“Equity markets have not repriced much,” says Neilan. “But debt has got more expensive. To do deals at the moment, the collective players have to make an adjustment – maybe the lender takes a little bit less margin, maybe the equity investor takes a little bit less return. When pricing shifts one way or the other, that is going to change that dynamic for both parties.”

To manage the risk of declining values, lenders will have to build in a bigger cushion into their underwriting, predicts Howard. “Part of the argument for being in the debt part of the capital stack is that you are underwriting assets at depressed values. We underwrite everything on sustainable yields, which are substantially wider than current valuations. For instance, we will probably never lend on a logistics building because cap rates are so low that when we apply a sustainable yield, we can only lend about 20 percent of LTV. Nobody wants that.”

As lenders go further up the risk curve, their capability to assess asset-level real estate risk and the quality of the borrower will become increasingly crucial, she adds.

Mount Street’s Gott also believes that evaluating sponsor risk will become a more important consideration. “Lenders will allow borrowers a wider scope if they are comfortable with them as a sponsor. It is a slightly different way of looking at risk,” he says.

Raghavan says EQT Exeter is among the growing cohort of managers exploring the options for taking portfolio financing for platforms as a means of managing increased real estate risk. She explains such finance is increasingly available from alternative lenders as well as banks. “It locks in financing for the portfolio, which gives us security and certainty, so we do not have to look for financing on a deal-by-deal basis.”

According to Howard, another consequence of the current worsening economic climate could be that bank lenders are likely to be deterred from providing loan-on-loan financing to enable debt funds, which some managers have used to maximise their lending potential and boost returns. “I think very shortly the traditional banks will realise that loan-on-loan financing for real estate debt portfolios is a bad idea. In a market where you have inflationary pressure, rising interest rates and declining real estate values, that is when those loans start to go wrong.”

Alternative lenders lead ESG charge

Asset managers are better placed than banks to provide green lending, argue participants.

While European banks have trumpeted their green lending programmes, alternative lenders have been at the forefront of translating laudable goals into concrete action, argue the roundtable participants.

Asset managers active in the lending space cannot afford to be greenwashing, says Schroders’ Natalie Howard, noting that her firm employs around 48 ESG professionals. “You’ll see a similar story in other big asset managers: you have to have a framework, it has to comply; you have to be up to speed with the changing regulations.”

The requirement for investment managers to comply with the European Sustainable Finance Disclosure Regulation has already raised the bar for the industry, says EQT Exeter’s Nisha Raghavan. “SFDR provides the framework and standardisation. We need to comply with it anyway to raise equity and to support our organisation’s ESG ambitions, but every bank has a different framework. There is no standardisation or cohesion.”

Alternative lenders already have a strong grasp of the mechanisms required to make green loan conditions meaningful, adds Mount Street’s Jim Gott. “Debt funds are better at understanding and applying key performance indicators and ratchets than banks. Ratchets have to go down as well as up, and unless you apply them in a rigorous way, they don’t work.”

Banks do have some potential advantages when it comes to green lending, observes Knight Frank’s Farrah Brown. “They can price in margin ratchets more easily than debt funds, which are generally driven by a target IRR.”

The private real estate sector deserves credit for its response to the challenge presented by the net-zero goal and its adoption of better ESG practices, says DFI’s Gavin Neilan. “The industry is adapting quickly, and a substantial amount of investment is going in from lenders, investors, operators and advisers to really try and understand the issues and ensure that they are dealt with appropriately.”

Net-zero goal

The participants are acutely aware of the scale of the challenge posed by the need to decarbonise Europe’s real estate. Howard characterises it as the “ESG freight train trundling towards us” and notes that “real estate is the one sector that impacts the net-zero goal more than any other”.

“By providing funding for ESG capex, [lenders] can reduce stranded asset risk and make returns along the way”

Jim Gott
Mount Street

With that challenge comes opportunity, however, and the participants agree that non-bank lenders have the potential to play a leading role in providing the finance necessary for the sustainability upgrade of Europe’s real estate due to their focus on financing transitional real estate.

“ESG will drive the need for a massive expansion in transitional equity and transitional debt for repositioning and repurposing,” says Neilan. “Some research talks about 80 percent of offices being obsolete by 2030 if they don’t get repositioned to meet current occupier requirements and stricter energy efficiency regulations.

“It looks easier to tick the ESG boxes by knocking a building down and developing something that meets all the green certifications, but there is a huge amount of embodied carbon lost in doing that. It is impossible to get to net-zero carbon by just developing new assets, so there is a strong case for repurposing and repositioning. It is really important that planners, lenders and equity investors are in relative lockstep around that.”

The market has already reached the point where the availability of debt finance from alternative lenders is dependent on the deal’s ESG characteristics, says Brown.

“The asset has to be a green asset already or the business plan has to set out how it will become a green asset,” she adds. “Borrowers will not get a better rate. They will just have access to finance that a non-performing asset, or an asset that will not become sustainable, will not have.”

Participants agree that alternative lenders’ ability to underwrite transitional property also puts them in a position to provide finance for the repurposing of assets that run the risk of obsolescence.

“The funding gap is huge and alternative lenders are moving in to fill it”

Natalie Howard

The risk of widespread stranded assets in the office sector may be less than feared because the response to the decarbonisation challenge within the real estate industry has been encouraging, argues Gott. “The feedback we are getting from lenders is that by providing funding for ESG capex and turning a subprime asset into a prime one, they can reduce stranded asset risk and make returns along the way. That has to be a team effort for it to work, however, with the lender, the equity and ideally the tenant involved as well.”

Raghavan adds: “There is a lot of new technology coming in, which will be helpful in repositioning assets so that they become more mainstream.”

The participants agree that for debt funds, successful participation in the greening of the sector depends on making sure that their underwriting assumptions around capex are correct, and that they have built in enough contingency to account for potential cost inflation.

Across the European real estate credit market as a whole, the opportunity for alternative lenders is evident. But in an unsettled business environment, caution will continue to be their watchword when underwriting transactions of all kinds.

Meet the panel

Farrah Brown
Partner, Knight Frank Capital Advisory

Brown focuses on Knight Frank’s debt advisory business, sourcing and managing debt across Europe and across all sectors: office, retail, mixed use, logistics and student accommodation. She joined the firm in 2021 after spending 15 years at Nuveen Real Estate, where she was head of treasury for Europe and Asia-Pacific.

Jim Gott
Head of asset diligence, Mount Street

Investment services provider Mount Street services loans amounting to around €112 billion in Europe, the US and Australia. Gott joined the firm in 2020 to establish its asset diligence business. His role involves assisting clients with asset risk management at origination or acquisition and during the investment period.

Natalie Howard
Head of real estate debt, Schroders

Howard was recruited by Schroders in 2020 to build the asset manager’s real estate debt platform offering lending to institutional investors across the capital stack. She has more than 30 years’ experience in balance sheet lending and debt capital markets, with previous employers including DRC Capital, AgFe, Lehman Brothers and Barclays Capital.

Gavin Neilan
Founding partner and chief investment officer, Deutsche Finance International

Neilan is a co-founder of DFI, a pan-European private equity real estate firm with more than €3 billion in AUM. The business, which has raised a series of value-add and opportunistic closed-end funds, is part of Deutsche Finance Group, a global investment manager with €9.6 billion in AUM.

Nisha Raghavan
Global chief operating officer, chief financial officer for Europe and Asia-Pacific, EQT Exeter

Raghavan joined EQT Partners in June 2016 as CFO and since 2021 has been global COO of EQT Exeter. EQT Exeter was formed through a combination of EQT Real Estate and Exeter Property Group. The firm manages approximately €15 billion of real estate assets, of which around €7 billion is in Europe.