The time is right for alternative lenders to prioritise Europe

Against a backdrop of market volatility, real estate banks are retrenching. By contrast, a wave of managers such as KKR, abrdn, CIM and Chenavari are launching credit strategies targeting the continent. The move is not entirely new – we have seen a trend of new capital coming to continental Europe for quite some time. The current turn in the property market, however, is creating fresh opportunities for alternative lenders.

“New credit strategies are coming into play because, in general, it is more attractive to be a lender in the current environment,” says Brad Greenway, co-head of debt and structured finance at property consultant JLL. “We are starting to see circumstances across Europe where you can get 10-15 percent returns as a lender – that is equity-like returns – creating significant appetite and liquidity within the lending market.”

Current returns are one of the most compelling reasons to invest in real estate debt across the continent, market participants canvassed by Real Estate Capital Europe agree.

“Returns on real estate debt are very attractive now both on an absolute basis and on a risk-adjusted basis. They are expected to outperform real estate equity and it still offers a premium above fixed income,” says Henri Vuong, head of debt investment research at manager PGIM Real Estate.

The reference rate component of real estate debt pricing has gone up due to increasing interest rates, while the margin component – based on how lenders foresee the credit profile – has also widened, largely because of the uncertainty around the markets that was created by the Russia-Ukraine war and subsequently high inflation, Vuong explains.

“Normally, in market cycles, you get interest rates rising and margins coming down. This is one of the very rare times in history that you see both expand at the same time,” she notes.

Because interest rates are higher than they have been for the past 10 years and are expected to come down in the next two years, lenders without a backlog in the region will be able to lend with a much higher coupon during this period.

“For a new fund, you could really use these two years to scale up your debt portfolio. And, as interest rates come down, you naturally benefit from an aftermarket price adjustment – your loans are worth more because your interest rates are higher than those that are paying lower interest rates,” Vuong argues.

Room for everybody

Private debt strategies ranging from senior to high-yield are finding new opportunities amid less bank competition.

In the high-yield debt space, mezzanine and whole-loan lenders are capitalising on the current market volatility. Capital value decreases resulting in higher loan-to-values and higher interest rates pushing down interest-coverage ratios are posing limits for senior lenders when it comes to refinancing.

This is creating a large funding gap in the market. According to investment manager AEW, in the next two years, the shortfall between the original principal volume of real estate loans due to mature and the amount of new financing available to repay it is expected to total €35 billion in Germany and France, the two largest real estate markets in the continent.

“We are seeing more demand for whole loans, mezzanine loans and preferred equity instruments by borrowers for refinancing situations whereby there has been a negative movement in valuations,” Greenway says.

“As most traditional senior lenders cannot meet the required levels of debt at the time of the loan maturity, alternative lenders with the ability to provide whole loans, or mezzanine loans, or preferred equity instruments, will capitalise on these situations”, he adds.

Opportunities in the senior space are also emerging for non-bank lenders. Industry sources agree that banks continue to be active in this space but, due to volatility and the current regulatory environment, they are being more cautious on leverage, lending at 50 percent LTV or lower. Banks are also more risk-averse when it comes to value-add or development loans.

Claudiu Gheorghita, Hilltop Credit Partners’ chief investment officer, joined the alternative lender in January from Nomura to oversee its expansion across asset classes and into the European market. He says an “incredible” amount of private equity dry powder is waiting to be deployed into value-add and opportunistic strategies across the continent, which will require senior debt.

“That sort of capital, at loan-to-cost ratios of up to 65 percent, used to be serviced by bank debt,” Gheorghita says. “Going forward, I think this debt will be very difficult to find from bank sources, so we see a clear need to fill that gap with an alternative solution that provides senior leverage to private equity funds keen to deploy capital as the cycle turns.”

“We see a huge opportunity in the next 24 months to fill this gap,” he adds.

Increasing returns

Senior lenders in the core-plus lending space can today earn between a 300 to 400 basis points premium return for taking the same, and sometimes less, risk that they would have taken 12-18 months ago, Greenway notes.

Alternative lenders targeting higher returns can also capitalise on development projects that have stalled, as developers are hit by high costs and banks are averse to providing a high leverage solution to complete the project.

Debt funds with the ability to underwrite both real estate and additional collateral for operating businesses will seize this opportunity, Gheorghita says. “The ability to find flexible solutions such as creating a hybrid security between the real estate and an operating business that the asset owner has will be very interesting. We will see a lot of demand for this in the next six to 12 months.”

Across all types of debt strategies, market participants expect to see continued liquidity in the continent – the opportunity is huge. According to PGIM, non-bank lenders in the region currently lend almost $189 billion, in a market where 90 percent of real estate lending comes from banks. As banks’ appetite for real estate lending shrinks, the potential opportunity could total $445 billion and $712 billion if non-bank lenders reach the same market share as the UK and the US, respectively.