This article is sponsored by CBRE Investment Management, and supported by Conduit Real Estate, BBS Capital and Catella Residential Investment Management
Partner, Conduit Real Estate
Managing director, BBS Capital
Chief investment officer and co-head, EMEA credit strategies, CBRE Investment Management
Head of debt finance, Catella Residential Investment Management
What constitutes a mid-market loan in the European commercial real estate market? That is the opening question facing the four participants in Real Estate Capital Europe’s mid-market roundtable discussion, held in London in July.
Loan size is the obvious starting point: £10 million (€11.7 million) to £50 million, says the lender at the table, Alexandra Lanni, co-head of EMEA credit strategies at CBRE Investment Management, who says the market’s larger lending institutions focus on loans above that size band.
For some mid-market-focused lenders, the upper end of the ticket size has reduced somewhat, Lanni notes: “In the past it has been more like £75 million. But when market conditions get more testing, underwrite sizing comes down.”
It is an opinion shared by the borrower taking part – Didier Beltai-Menth, head of debt finance at Berlin-headquartered manager Catella Residential Investment Management – who says a range of €15 million to €75 million has been supplanted by one of €15 million to €50 million. That upper limit is defined by the size of loan that lenders feel comfortable keeping on their books, he says, without the need to syndicate. And lenders are becoming more risk-averse.
“Before, the lending market was driven by the origination team. But in the last four or five years it is driven by the risk teams. We used to call a lender and get their view on a loan within five minutes. Now, it takes two or three weeks while they make certain they will be able to underwrite holding the loan.”
Jonathan Jay, a partner at London-based adviser Conduit Real Estate, says sponsor trends shape the mid-market. “The mid-market, it could be argued, is a function of borrowers’ activity within these loan parameters. Historically, big private equity funds dominated the space. But as they raised, and looked to deploy, gargantuan pools of capital, their place in the mid-market was superseded for the most part by property companies, family offices and so on.”
More recently, Jay has seen a return of private equity firms to the mid-market. “A lot of these PE firms have begun investing thematically, which involves doing aggregation strategies necessitating smaller deals, so by default some PE firms’ business plans now involve incremental, piecemeal acquisitions. Often these strategies are supported by larger facilities, but a coterie of lenders – predominantly challenger banks – have stepped into this vacuum to support bolt-on acquisitions.”
Adam Buchler, managing director of adviser BBS Capital, has seen privately owned businesses, including property companies and developers, as active participants in the mid-market, historically. But he is now also seeing large private equity funds and other institutions becoming major participants. “They are not necessarily deploying by acquiring £100 million-plus portfolios. Instead, they are often pursuing aggregation strategies by backing specialist operating platforms. The average deal size might be between, say, £20 million and £40 million, but structured with a facility that allows them to then aggregate additional assets and build scale without rewriting the entire facility.”
Lanni has been lending in the UK mid-market since 2015. She outlines what that means in practice for a lender: “There are not that many buildings in cities outside of London where the loan size will exceed £50 million. So, it does not really matter to me whether you are a private equity sponsor buying regional offices, or a private family office buying local sheds, it is the underlying real estate that ultimately defines the size of the mid-market for us.”
The state of play
The roundtable participants discuss the mid-market as a segment to which some lenders are attracted, but others are reluctant to focus.
Buchler sees new entrants to the mid-market. “Challenger banks that were set up over the last few years and some smaller debt funds started off doing mostly small deals with a maximum ticket of maybe £10 million to £15 million. Now they are doing £50 million, or sometimes even £75 million-plus to serve the institutional private equity sponsors that are operating in that space.”
“Many borrowers are in risk-off mode, and investment selection will be more targeted and discriminating”
Conduit Real Estate
Jay says lenders across the market are increasing their target loan size. “For many lenders we speak to, minimum loan size has crept up,” he says. “It is a lot easier to place loans above £70 million or £80 million than it is smaller transactions.”
Jay believes many lenders are therefore overlooking a segment of the market, by loan size, that generates huge borrower demand. He believes the apparent contradiction is explained by the need for debt funds that have raised vast pools of capital to deploy it profitably, given smaller loans require similar resources to larger ones.
“Since 2008, a lot of debt funds have raised loan-on-loan capital. They are unable to originate loans below certain levels, because a loan-on-loan provider is less willing to lend that smaller quantum of debt. If the overarching loan is small, then the senior lender’s position would be smaller still.
“For many banks, it still requires an element of underwriting that would be inefficient for the lender considering the size of the loan, coupled with the fact it defeats the purpose for some lenders who do it, because they harbour ambitions for significant deployment targets. To make it work, the total loan should be more than 70 million pounds or euros.”
Lanni concurs that the reliance on loan-on-loan finance, together with the increasing cost of such capital in a higher-interest-rate environment, is constraining some lenders. “They have materially been affected by the cost of loan-on-loan financing, to the point where they either cannot be competitive or just do not want to quote because they cannot make the return work.”
Jay questions why very few European mid-market lenders are funding their activities through securitisation structures such as collateralised loan obligations. “Technically that’s your quickest route to exit, and it has been done profitably in double digit returns. So why are more managers not securitising their book?”
Lanni responds: “There are challenges from a disclosure perspective with lots of underlying borrowers, and it is super-expensive to put a CLO in place. You are also left holding just a skinny piece of the debt, which is not ideal if you are looking to deploy more material amounts of capital into commercial real estate debt.”
It’s not easy to go green
Availability of value-add finance to improve mid-market assets can be problematic, suggests the roundtable
The real estate industry faces a daunting challenge to refurbish and reposition buildings so that they meet stricter sustainability standards. Buchler quotes research by Savills, which estimates that 87 percent – more than a billion square feet – of UK office stock will need to be improved by 2030 to meet new minimum standards for energy performance. But is debt finance available for them to do so?
“This is weighing heavily on borrowers’ minds. They need a cost-effective solution, but the market is not really well provided-for at the right price,” says Lanni. “Traditionally, heavier capex-led situations would appeal to debt funds. But right now, there are challenges around their cost of capital.”
In some cases, “manage to green” projects may be difficult to underwrite because of the degree of value-erosion suffered by non ESG-compliant assets, says Beltai-Menth. “With some buildings where lots of work is needed, investors could be buying at prices where they need to put half the value of the building in as capex.”
Nonetheless, where the right ingredients are in place, mid-market value-add projects to improve the sustainability of offices, or convert them to life sciences use, are “very workable”, suggests Buchler. “We have found that with well-capitalised sponsors, good assets and a robust business plan, there is good liquidity for debt, although it comes at a cost. It is going to be a real growth sector.”
Supply chain issues and inflation have created uncertainty over the costs involved in such projects, causing market participants who do not need to act now to pause, says Lanni. “If you own the building already, you have to do it. But right now, value-add sponsors are right to be taking a breath while they see how the cost implications pan out.”
While the participants agree that the mid-market appeals to some lenders more than others, Lanni says it is an increasingly competitive space, due in part to the increased presence of financial intermediaries helping sponsors source capital. “We are in as competitive processes in the £10-50 million space as lenders in the £50 million-plus market,” she says.
Catella’s Beltai-Menth says the German residential build-to-rent market, in which his firm is active, remains liquid from a debt perspective. But with loan pricing increasing steeply, potential sponsors are choosing to use their equity for acquisitions instead.
“So many things are going on – inflation, increased interest rates, recession risk, and war – that it is hard to figure out what will happen in the next six to 12 months”
Catella Residential Investment Management
“There is now a minimal differential between buying with all-equity or with leverage,” says Beltai-Menth. “In some cases, the higher cost of borrowing can even have a negative overall effect. Plus, there is the extra work and cost involved in putting the debt finance in place, so those like us who can do it are increasingly buying with equity and maybe putting debt in place later. Borrowers seeking mid-market financing at the current higher prices tend to be developers with capital that is tied up, so that they are seeking financing for their next project, or sometimes those that require bridge financing or mezzanine debt to reduce their exposure to development risk.”
As is the case across the industry, sponsors in the mid-market face strengthening headwinds posed by factors including inflation and rising interest rates.
“Many borrowers are in risk-off mode, and investment selection will be more targeted and discriminating. If they have deals in train, they might price chip, on average between 8 to 10 percent today. But if they do not need to start a deal today, then they are going to wait,” says Jay.
He believes that the market could bounce back swiftly, however. “The two macroeconomic factors that are precipitating the pretty dire situation we are in today are the war in Ukraine and China’s zero-covid policy. But the moment that one, if not both, of those are resolved, people have raised lots of money to deploy, and they are going to be bidding on the same assets, pushing up prices. For the right deals, we are advising clients to capitalise on the short window of shallow market competition.”
It makes sense for borrowers pursuing some strategies to wait out the current turbulence. However, they are in the minority, argues Lanni. “If you are doing a very large value-add business plan where you are facing construction cost inflation, labour shortages and challenges around the cost of debt, and you are worried about whether investment yields will continue to hold up, I can see why you might pause. But that is not the vast majority of the market, which is people making everyday investments. Some 70 percent of our market trades at sub-50 or 60 percent loan-to-value. Sponsors and mid-market lenders can assimilate the risks, price them in and carry on.”
Cost of finance
The discussion turns to debt terms in the mid-market. While risk has increased, not all lenders are widening margins, says Buchler. “Borrowers are already suffering with a material increase in the underlying rate. If you look at the five-year swap rate, it’s now 2.5 percent. Not long ago it was less than 0.5 percent. So that has already been incorporated into the cost of finance. For borrowers to absorb an increase in margins on top of that is difficult, particularly in a market with so much liquidity and competition.”
Meanwhile, the LTV ratios that many debt providers are willing to offer have reduced as they seek to manage risk, he adds.
Margins for loans against residential deals at LTVs of 30 to 50 percent have remained steady, says Beltai-Menth. “But we are seeing some repricing in other asset classes, such as hotels, as lenders try to find the right risk-adjusted level of pricing.”
The participants agree that there is capital available to provide mid-market borrowers with a variety of options. “Lenders can be competitive in different parts of the market depending upon how they raised their capital,” says Lanni.
“If this little period has taught us anything, it is that losing momentum can materially change things”
CBRE Investment Management
Those that have raised capital from investors that view real estate debt as an alternative to corporate bonds are coming down the risk curve and offering competitive rates at relatively low LTVs, while for more complex value-add lending there is capital available from debt funds that have raised capital from real estate-focused investors, which need to achieve higher IRRs and are prepared to take on more risk in order to deploy.
In a period when interest rates will no longer remain predictably low, borrowers need to give more consideration to whether they should opt for fixed-rate, or floating-rate debt, says Buchler. “We recently closed a residential development deal. We had multiple bids with various fixed and floating options, so reporting to our client required modelling the SONIA forward curve to provide a like-for-like comparison. As the SONIA rate rose, fixed-rate lenders really started to become much more relevant. These situations allow advisers like us to earn our salt, because there are so many different options that need to be analysed so that they can be compared.”
Retail sector no longer a falling knife
The participants discuss the in-favour asset classes for mid-market lending
Living sectors remain a post-pandemic winner, says Beltai-Menth: “Build-to-rent and build-to-sell residential used to be a niche asset class. But especially since covid, people have been really jumping into it.” However, as prices have risen, the industrial sector’s appeal to lenders has waned, observes Buchler. “It’s challenging to underwrite logistics with an exit at sub-4 percent. It will take some time for expectations to change and for activity to return in that market.”
Retail is making a comeback, according to Jay: “The question was: are you catching a falling knife? Not anymore, and lender appetite is starting to thaw. We have arranged a number of retail financings at pretty sensible leverage and pricing levels, particularly as the real estate is enormously cash generative. Investors are not necessarily buying to convert retail into residential, although that will happen still; they are buying more prime retail property at 8 percent and poorer located properties at 15 percent, but off recalibrated rents, which provides them with a really strong cash flow.”
Hospitality has also bounced back, notes Lanni: “We have seen a billion pounds’ worth of loan requests over the course of the last six months just in the hospitality sector.”
Buchler concurs: “Hospitality is now past the covid shock, and lenders are starting to appreciate the fact that it can be a good opportunity because there is the prospect of outsized returns due to the limited number of players still in the market.”
“Quite a lot of hotels will struggle to meet the energy performance requirements that will soon be in place,” adds Lanni. “Many hoteliers who have got through the pandemic will not want to put their hands in their pockets again to make improvements and could need capex-style financing.”
As the discussion draws to a close, the participants consider the outlook for mid-market lending. Making predictions is no easy task in such a volatile period says Beltai-Menth. “It’s a bit like playing whack-a-mole. So many things are going on – inflation, increased interest rates, recession risk and war – that it is hard to figure out what will happen in the next six to 12 months. When you take a decision, you do it because of what you know then. But you also know darn well that the next day it could be exactly the opposite.”
In a rapidly unfolding situation, a clear focus on execution is essential to continuing to do business, says Lanni. “If I were a borrower, right at this moment in time, I would want to get everything I have got on the table closed as quickly as humanly possible. If this little period has taught us anything, it is that losing momentum can materially change things. Sponsors should not be sweating the small stuff in loan documents. There is continued opportunity here, but we have all got to be sensible about the way in which we execute.”
“Borrowers are already suffering with a material increase in the underlying rate. For them to absorb an increase in margin on top of that is difficult”
Many loans underwritten in recent years in a low-interest-rate environment at yields that represent historic lows, especially for core property, are now coming up for refinancing in a period when the cost of borrowing is increasing, notes Buchler. “What happens when the interest coverage ratio does not support that refinance at the current cost of borrowing? Either there has to be an equity injection into the capital stack, or there is a forced sale. I would be surprised if this doesn’t start to shake up some elements of the market. And it will provide an opportunity for those who are liquid, and not burdened by existing issues of that nature, to take advantage.”
Lanni agrees that for some assets an equity gap will open up. “But right at the moment, we are not really seeing an equity shortage in the market, as long as it makes sense for investors to inject it,” she says.
“My gut sense is that there will be a bit of an outward shift in valuation yield. But I do query whether we will see a sustained material shift in margin. As a lender, you still have to offer a product that is sellable and accretive to returns. I do not know to what extent, but valuation yields and all-in costs of debt are both going to have to give a bit.”
Lenders need to be more cognisant of the opportunities available in the mid-market space, says Jay. “There is not a deep enough bench of lenders to service it, and many of them are only increasing their minimum ticket sizes. Recently, a lender that focused on loans between £10 million and £50 million asked us to show them deals of over £50 million only. We can do that, of course, but they will face a lot more competition than they would for a smaller ticket, where there are fewer people to call. Indeed, the deal economics are often better and the hit rates often higher.”
Partner, Conduit Real Estate
Jay is a co-founder of Conduit Real Estate, a UK and European debt and special situations capital advisory business established in 2020. He previously worked for a London-based pan-European investment manager and was responsible for capital raising across their equity and debt strategies, as well as debt origination on behalf of a sovereign wealth fund. He has a keen interest in proptech.
Managing director, BBS Capital
Buchler set up BBS Capital, an independent real estate debt advisory business, in 2003. The bedrock of the business is arranging and structuring finance for pan-European property investment and development projects. Since 2012, it has added an investment management function. Buchler – with partners Joanne Barnett and Nick Spencer – has led many complex, highly structured and high-profile advisory transactions across the capital stack.
Chief investment officer and co-head, EMEA credit strategies, CBRE Investment Management
Lanni joined CBRE IM in 2019 when the company acquired real estate debt specialist Laxfield Capital. She oversees the investment policy, transactions and strategy for the investments team, as well as capital deployment and investor relations. Lanni is also involved in strategic management of the fund portfolio and managing the fund teams.
Head of debt finance, Catella Residential Investment Management
Beltai-Menth joined CRIM in December 2020 as head of debt finance to co-ordinate its European residential funds and asset financing strategies and requirements. Beltai-Menth has 22 years of industry experience and was previously responsible for European fund, real asset and corporate financing within the PATRIZIA corporate finance division. CRIM is the residential investment management division of Berlin-based Catella Group.