According to a survey by data company Statista, 52 percent of industry experts expect a moderate increase in debt funding for real estate investments to come from alternative lending platforms this year. The resilience of longstanding themes, such as medical research, digital connectivity, senior care and education, as well as changing consumer habits, are driving this rise in alternative investing.
Real Estate Capital Europe sees seven key trends shaping the sector.
1. Rising inflation poses risk to lending strategies
Rising inflation rates can provide both risks and opportunities, said Andrew Gordon, head of European real estate debt at Invesco Real Estate. “It presents risks that I would split into shorter- and longer-term risks. Short term, one consideration is about the impact on borrowers’ ability to service their debt as interest rates rise. The other short-term risk is how cost inflation is going to impact development costs and capital expenditure. Those risks are front of mind when we look at deals.
“Longer-term risks, which can be harder to get to grips with, include looking at whether underlying tenants will continue to afford paying high rents.”
However, if firms can formulate a sound strategy to deal with rising interest rates, they will be able to take advantage of that and reap the rewards. “It comes down to picking the right asset, the right sectors and the right locations, because if valuation yields do come under pressure, the situation will vary across the market,” said Gordon. “Key to this is knowing the sector and the micro-location, underwriting the business plan and ensuring the borrower is capable of executing on that business plan.”
2. Extraneous factors are causing a shift
Global and geopolitical factors such as covid-19 and the war in Ukraine are resulting in soaring inflation and adding to a volatile lending environment. Richard Spencer, partner at Goldman Sachs Real Estate Asset Management, said: “These factors and volatility in public markets have impacted investor sentiment and capital availability in recent months. At the same time, investors feel increased pressure to shift capital out of the public markets in a rising rate environment.”
Andrew White, managing director at Goldman Sachs Real Estate Asset Management, added: “It is a really interesting time right now and a period that we have not seen in quite some time in terms of projected interest rate growth over the next two years.” He argues that in this environment lenders have an opportunity to gain from a rise in benchmark rates, as well as from rental growth in underlying sectors.
Meanwhile, lenders can make the most of downside protection. “To the extent that assets values do come under pressure as a result of rising cap rates or deterioration in overall demand, lenders stand to benefit,” said White.
3. Exploring solutions to assessing risk
When assessing risk across European debt markets, most property financiers use the loan-to-value ratio. Hanno Kowalski, managing partner at FAP Invest, argues that this type of assessment can lead to lenders missing out on debt opportunities, as well as cause misallocation of capital. “With this approach, countries like Germany and France are often underweight in a loan portfolio as lower LTV limits often result in return targets not being met,” he said. “At the same time, the UK and Spain are often overrepresented as – supposedly – conservative LTV caps still produce attractive returns.”
He also added that the LTV-driven assessment does not take into account that, while knowing the price of the property at the time of the financing, it is unclear how the property value will develop over the loan period.
Instead, Kowalski suggested using index solutions, which measure asset value growth as part of the loan indexation.
“This method provides an indication of how the valuation of the underlying property is likely to change during the life of the loan,” he said. “It also provides a more accurate basis for the evaluation of the risk-return structure in target markets, as well as a consistent method for comparing real estate across borders and to other investments such as corporate bonds.”
4. Focusing on mega-trends
Antonio de Laurentiis, global head of CRE private debt at AXA IM Alts, believes alternative lenders must identify which asset classes are going to be the most resilient amid the current period of volatility. “We are in an environment where you need to anticipate and not react. And that means you must have a long-term, look-through approach to the cycle,” he said.
To work out which sectors are most resilient, de Laurentiis said there are four main mega-trends that lenders must examine: urbanisation, the ageing population, digitalisation and decarbonisation. He argues that sectors and firms that perform well on all these fronts are the ones to invest in because they are the most likely to remain resilient.
5. Opportunities in new economy real estate
The pandemic has driven a change in the way people work and live, and therefore has provided opportunities within so-called ‘new economy real estate’. Ben Eppley, partner at Apollo Global Management, believes there is substantial scope for non-bank lenders to finance such real estate. “In the new economy space that we are looking at on behalf of the sponsors we finance, we have focused on warehouse and logistics properties, particularly anything benefiting from last-mile distribution, e-commerce and omnichannel retailing.”
Eppley added that the valuation for these assets has increased significantly since the beginning of the pandemic as more people started ordering online.
There are also opportunities within the life sciences sector, such as lab space, research and development space, and offices tied to biotech and research. Again, this is an area that experienced rapid growth due to covid-19, especially since there was an urgent need to develop an effective vaccine. “That sort of space has very specific property requirements, which, coupled with the limited supply, has increased the appetite among both tenants and institutional investors,” added Eppley.
6. Setting sights on continental Europe
More alternative lenders are now setting their sights on continental Europe, said Peter Hansell, Nuveen Real Estate’s senior director of European debt strategies. He added that banking regulation is creating demand for alternative finance: “Tighter regulation is forcing a greater focus on European banks’ risk profiles and their total exposure to real estate lending. It means borrowers looking for a slightly higher leveraged position or for slightly more complex capital structures are seeing opportunities to work with alternative lenders.”
Hansell also said that the alternative lending sector is now well understood by many institutional investors, and as a result alternative lending platforms are able to demonstrate experience and successful lending track records outside of the UK. “This combination of borrower demand and investor appetite is supporting the growth of the sector in continental Europe.”
7. New investors demand access to new strategies
The types of investors interested in allocating to real estate debt has changed over the last few years, and in turn this has brought about new strategies. Andrew Macland, head of European debt at PGIM Real Estate, said: “Early in the cycle, the people we would speak to within the investor market would typically be real estate specialists. Investors’ real estate teams would be considering how to invest in core-plus or value-add real estate, for instance, and those teams would then consider real estate debt as an option.
“In the past five years, that has changed. Within the investor universe, managers are now as likely to speak to people who cover infrastructure investment or fixed income as they are with real estate specialists.” As a result, Macland thinks investors are now taking a more holistic approach to solving the issues they have: “The type of investors we are speaking to include private credit teams that would now look at real estate lending as an alternative to some of those fixed-income corporate strategies.”