This article is sponsored by Aukera Real Estate and FAP Group, and supported by Berlin Hyp and Catella Residential Investment Management
According to the participants on Real Estate Capital Europe’s Germany roundtable, held in Berlin in July, the impact of the past year’s eurozone interest rate rises cannot be underestimated.
“Investment volume has decreased by two thirds,” says Assem El Alami, head of international real estate finance at mortgage bank Berlin Hyp, “and prime Berlin office yields have risen from 3 percent to more than 4 percent, leading to a loss in value of around one third. The market is in a mode where everyone is trying to find the right price.”
Data from CBRE shows €13 billion of investment closed in Germany in H1 2023, a 64 percent decline from the same period in 2022. Yields increased across almost all asset classes, the property consultant said, with net initial yields for prime offices in six of Germany’s top seven cities now at 4 percent or above.
As rising rates force capital values down, El Alami is aware all eyes are on how bankers will react. “People are looking at the traditional lenders and wondering if there will be increased [property] sales.”
However, he does not expect a large number of forced sales on the back of loan-to-value or interest coverage ratio covenant breaches. The reason, he explains, is because German bankers’ underwriting focus in recent years has been on debt yield with most having insisted on a minimum of 6 percent.
“LTV is no longer the central focus of risk management as it was before the global financial crisis,” he says, “although the past year has pushed some loans into stress, of course. As a Pfandbrief bank, we have a. conservative risk strategy, so we have hardly had any risk cases so far. If they do happen, we always look for solutions in partnership.”
Debt yield – a property’s net operating income, divided by the total loan amount – does not change according to interest rate movements or market value.
This, El Alami explains, means lenders will look beyond immediate LTV or ICR issues when assessing the strength of their loan books, resulting in fewer bank-induced sales.
Dearth of deals
The borrower side of the industry is represented by Didier Beltai-Menth, the Berlin-based head of debt finance at Catella Residential Investment Management, part of Sweden-headquartered manager Catella.
The market slowdown has had a clear impact, he says. “In any given year, we would transact around €2 billion. So far this year, we have transacted maybe €200 million. There is not enough incentive for owners to sell. But we call this a transition phase, rather than a crisis, because many people are waiting to see what happens to values.”
Head of debt finance, Catella Residential Investment Management
Beltai-Menth sources debt financing for residential funds managed by the Berlin-based residential arm of Stockholm-headquartered real estate manager Catella Group. Catella invests across Europe through its residential funds. Prior to joining in December 2021, he was in the corporate and real estate finance team at German manager Patrizia. Prior to that, Beltai-Menth worked in investment banking and corporate private equity.
“We call this a transition phase, rather than a crisis, because many people are waiting to see what happens to values”
When opportunities do arise, using debt does not always make sense. “We still have liquidity in our funds, so we can buy with equity if we find the right properties. In some instances, we would be buying assets with negative leverage, so we tend not to use financing for them. But that is only because we are in the fortunate position of having liquidity.”
The past nine months have brought challenges for alternative lenders too, says Patrick Züchner, chief investment officer of Essen-based debt manager Aukera Real Estate. “We can only finance what there is demand for, and demand was way down, with 80 percent of it focused on refinancing.”
Despite growing sponsor demand for refinancing, Züchner is wary of writing loans in potentially stressed situations where leverage is high, or future property value is uncertain. “The bulk of refinancing requests will not work in this environment. It is not debt funds’ role to solve the industry’s problems – our role is to find the best risk-adjusted returns for our investors.”
Current conditions are generating some attractive opportunities, he adds, including lending to developers in need of replacing construction loans on projects that are near to completion. “They can either sell or find a new loan of the same size as the development loan. So we can enable the sponsor to spread its exit across three years – we call this ‘bridge-to-exit’. It is a good source of lending because construction risk is low, and the assets are usually sustainable.”
Curth-C Flatow – managing partner of FAP Group, in the offices of which the roundtable is taking place – describes rising rates as “a systemic gamechanger” for the German market. FAP operates two businesses – debt advisory, and lending through a debt fund. From this dual perspective, Flatow has witnessed a significant impact.
“Nobody knows what market value is,” he says. “International investors that we give debt advice to are waiting because they are not convinced that we have reached the bottom.”
Anyone who lived through the GFC will note similarities, he says. But he adds there are also fundamental differences. “The banks were criticised for requiring 6 percent debt yield in the low interest rate times, but they were right to do so. Our view is the banks will not have so many problems as during the GFC. They have done their homework in the past.”
Flatow is, however, concerned about the impact of rising rates and falling values on the mezzanine market, which has flourished in Germany in recent years. He acknowledges FAP itself provides mezzanine through its debt fund but says it has done so at an average LTV of below 80 percent. However, he says some in the market have lent at significantly higher LTVs.
“We are seeing problems for mezzanine lenders,” says Flatow. “We have so many enquiries from overleveraged investors and developers seeking refinancing or restructuring, and that will cause serious problems and write-offs for lenders that have provided the highest portions of debt.
“Many parties have profited from a very good market phase and have generated huge returns for their investors by providing mezzanine. They include London-based funds, Korean pension funds, hedge funds, and even some banks. We’ve seen 100 percent LTV, as recently as 12 months ago.”
Managing partner, founder, FAP Group
Flatow, a former banker with Switzerland’s Credit Suisse, founded Berlin-based FAP Group in 2005. FAP was initially founded as a debt advisory business, although it has since expanded to become what Flatow describes as a ‘debt platform’, including a debt fund and a loan syndication department. FAP Finance is the firm’s advisory section, with FAP Invest its lending platform. The group’s sole focus is real estate debt.
“The market will need write-offs. We are convinced market values are not where they will be in six months’ time”
Sponsors in Germany have put less equity into deals than in other European markets, agrees El Alami. “A developer in France, for example, would rarely work with less than 30 percent of equity. Here, beyond the senior loan, there is often mezzanine, preferred equity and private equity. In my perception, the market in Germany is partially overleveraged, compared to other European countries. However, this leverage is not on the balance sheets of senior lenders.”
The gradual increase in leverage, El Alami believes, was the result of a post-GFC “catch-up story” in Germany as values began to soar after 2012. “It was not only about yield compression. It was also about creating value and a lot of assets were built. Berlin today, for example, is completely different from what I saw in 2010.”
Beltai-Menth has also witnessed risky use of leverage. “Some borrowers tried to max out their returns by turning to debt funds and hedge funds that can offer 100 percent-plus financing. This worked for a while as the market went up, but it’s a different story when it is coming down.”
Flatow points out that many borrowers, including listed property companies, have used leverage conservatively and will not face problems. “However, there is a certain group of mid-cap investors and developers that used these instruments to leverage limited equity to enable them to do more projects.”
This segment grew during the cycle, agrees Züchner, and borrowed from funds willing to provide high LTVs.
“There are several debt funds in the market that manage German institutional money that are facing write-offs.”
According to German business publication Handelsblatt, the Verius real estate financing fund, a property debt vehicle, was frozen in November 2022 after the value calculation for the fund was suspended.
Flatow says troubled situations could have a ripple effect across the market: “Such problems destroy investors’ confidence in real estate debt as an asset class because they see these firms collecting billions and they ask who else might be in that situation. It is understandable.”
In addition to sponsors struggling to repay high leverage portions of debt as property values fall, the participants agree a further looming stress is the need for capital expenditure to improve assets’ sustainability. “ESG [environmental, social and governance] is maybe less about value creation than it is about value protection,” says El Alami.
“If you don’t do anything about it, value will go down and leverage will increase. Right now, many assets in need of refinancing are probably servicing their interest. But because yields have gone up, and there is a need for ESG capex, therefore there will be increasing pressure on some investments.”
Beltai-Menth is not convinced many owners will make the necessary investment into ESG upgrades. “Average rent is very low for many listed players, so if you do the maths around ESG and capex, it doesn’t always add up. However, for long-term value retention there is probably no way around it.”
But those that do not, may find access to debt capital difficult, says Flatow. “If you do not have a clear ESG strategy, many lenders – banks and non-banks – will not even look at a deal. Many want to see an ESG strategy for the sponsor at the corporate level, as well as the asset.”
Talk turns to how, given the challenges discussed, maturing loans will be repaid in the coming years. In January, manager AEW said Germany faces a €23 billion refinancing gap in 2023-25 due to declines in capital values affecting the amount of leverage lenders are willing to provide, as well as the impact of lower ICRs on loan amounts.
Chief investment officer, Aukera Real Estate
Züchner joined Essen-based alternative lending platform Aukera Real Estate in April 2022, after holding the CIO role at Düsseldorf-based lender Caerus Debt Investments from 2012 to 2021. He was previously head of real estate at the asset management arm of German insurer Gothaer Group. Aukera was founded in 2020 and has so far raised more than €1.5 billion for real estate credit strategies.
“The bulk of refinancing requests will not work in this environment”
However, Beltai-Menth says lenders’ shift in emphasis in recent years from LTV and ICR to debt yield will enable them to assess potential loans despite uncertainty around rates. “Obviously, LTV will be an issue if the asset value has decreased by, say, 30 percent. Sponsors won’t get the same leverage they initially had, and they might need to put more equity in to refinance the debt.”
According to El Alami, banks will be willing to deleverage loans over extended periods, potentially reducing the refinancing gap. He resents the implications of the term ‘extend-and-pretend’. “By extending loans, we stabilise the market. There is no pretending – these are situations where loans are in difficulty, and we extend to find a solution.
“The funding gap is not a value issue – it is a cashflow issue. The risk is around payment default and that comes from cashflow. If my average LTV stands at 57 percent, and decreasing values bring it to say 65 percent, that eats into risk-weighted assets and my capacity to lend more. But it is not a problem from a risk perspective. With 65 percent LTV, I would always try to find solutions, such as cashflow sweeping or trapping, to gradually deleverage the loan.”
However, the need for sponsors to reduce their leverage, plus the need for them to invest in their asset’s sustainability, will inevitably result in some being required to inject equity into their investments, El Alami says. “Deleveraging and ESG are the two highly connected issues that will put a strain on cashflows.”
In situations where sponsors need to find capital to plug a refinancing gap, Flatow says a wave of new parties are stepping into the market to provide it. “There is clearly enough debt capital available to top up leverage from the banks, but at lower leverage points.
“We have been approached by sponsors that need to repay their mezzanine lenders, either because their loans have matured, or covenants have been breached. These sponsors do not have additional equity to repay their loans, and new mezzanine or junior debt is not available at the leverage they require. Therefore, they are seeking preferred equity. This might be a solution for some, but I doubt it will be a broad solution.”
Assem El Alami
Head of international real estate finance, Berlin Hyp
El Alami joined German mortgage bank Berlin Hyp in 2010, returning to the German capital after time in France where his roles included head of real estate finance in the country for German lender BayernLB. El Alami leads international origination, co-ordinating a team located across Amsterdam, Warsaw and Paris, and an international key account team in Berlin. The bank has a loan portfolio of around €29 billion.
“Deleveraging and ESG are the two highly connected issues that will put a strain on cashflows”
Flatow admits there will be pain ahead for some. “The market will need write-offs. We are convinced market values are not where they will be in six months’ time.”
And Züchner believes debt funds will play only a limited role in plugging the refinancing gap. Several, he says, have announced the intention to provide whole loans. But fundraising to the volume needed for such loans will be difficult. “This lack of equity from the institutional world makes it challenging for the debt fund industry to be the solution provider for the financing gap.”
Despite the stresses that market volatility is causing, the roundtable participants believe the German market is experiencing a period of transition to a higher rate environment, rather than a full-blown crisis. Distress, they agree, will be limited.
Construction lending is the area El Alami is most concerned about. “The correction in land values has wiped out some significant numbers of mezzanine lenders, and also some traditional senior lenders may find themselves in difficult situations.”
Flatow agrees. “Some developers are sitting on plots of land they bought just to acquire pipeline. They managed to achieve aggressive leverage and that is causing a problem because in simple math higher rates mean the land value is falling. On the other hand, we hear from developers we are advising that construction costs have begun to ease in the past few months.”
To round off the discussion, the participants share their thoughts on the coming year for the market. A mix of concern and optimism for better conditions ahead were voiced.
For Züchner, the concern is on the fundraising front. “Our business model is all about funding from institutional investors. But the fixed-income departments within the investors have gained importance again. Even for short-term investments, publicly traded bonds are the flavour of the day because interest rate rises have increased bond yields. This could impact both real estate debt and equity. The bottleneck for me is convincing investors to allocate their capital other than in bonds.”
“Despite concerns, I’m somewhat optimistic,” says El Alami. “For core assets, residential and offices, we are quite near to the right pricing. For the investment loans on our books, if necessary, I am sure we will find solutions that do not put stress on our portfolio. I think this is the case for most German lenders. I’m a bit more concerned about construction loans, but this will be good news for debt funds, as it may open up new opportunities for them.”
“It will be challenging,” agrees Flatow, “but the opportunity is we are coming back to a rebalanced market environment. And a solid and more sustainable market environment is an opportunity from an equity or a debt perspective. Although there will be write-offs in the next 12-18 months, the need for more capital will lead to a further diversification of lenders, such as whole loan and mezzanine providers.”
“It’s going to be tough,” says Beltai-Menth. “But this is a transition phase until there is a balance in the market. I think high inflation is here to stay, so the market needs to adjust to working in a higher-rate environment.”
Ultimately, he adds, a considered approach to investing and lending will be necessary. “People will need to do their homework and work out what works, and what doesn’t.”
Multifamily and offices in the lead
Apartment buildings and offices are major components of German loan books. However, while the former asset class remains popular, buyers and lenders are more selective. But the office sector, which is experiencing problems globally, divides opinion.
According to data from consultant CBRE, multifamily housing comprising 50 or more units represented the largest component of H1 2023 investment volumes in Germany, at €3.1 billion, equating to 24 percent of transaction volume.
Catella’s Beltai-Menth says Germany’s residential sector is in a relatively strong position, although core purchasing opportunities are hard to find. “Prices are still high, and assets need to be ESG-compliant because we are investing also for Article 9 funds.
“Residential markets in the UK and the Netherlands, for instance, have seen some correction, and activity, at least in the UK, has somewhat picked up again. Germany tends to be a bit slower to correct. Many believe values need to come down more, but I think this will be limited, as there is a lot of liquidity and investor demand for ESG-aligned core housing.”
Offices represented the second largest component of H1 2023 investment, at €2.8 billion, or 22 percent of overall real estate volumes, including multifamily, according to CBRE.
Attitudes towards offices vary by type of organisation, says FAP Group’s Flatow. “Our clients on the advisory side can be divided into two: US-headquartered managers, which have blacklisted offices, and the rest which are selective. We would lend against offices through our fund, but as we recently converted the fund to Article 9, sustainability is crucial, meaning standing offices can be difficult to finance right now.”
Berlin Hyp is still comfortable with the office sector, says El Alami. “It’s the biggest part of our new loan production and our portfolio. But we take a critical look at every project, and our portfolio is focused on Germany’s ‘A’ cities, so location is critical. Offices in secondary locations will have issues.”
Züchner says Aukera would finance offices as a ‘bridge-to-exit’ for developers with schemes close to completion. For standing assets, Aukera would possibly offer short-term financing, although Züchner is cautious about the sector. “Our financing costs are higher than banks’, so the product may be more value-add,” he explains.
Across all sectors, a flight to quality is evident in property buyers’ focus on Germany’s top cities. The undisputed hotspot, according to CBRE, is Berlin – the location of Real Estate Capital Europe’s Germany roundtable – with €2.8 billion of H1 investment volume.
Photography: Alexander Klebe