This article is sponsored by Three Stars Capital Partners
Founded in 2009, Milan-headquartered Three Stars Capital Partners provides debt and equity advisory services to a range of local and international clients. Over the past 12 months, the business has helped secure over €1.5 billion of financing in transactions ranging from €20 million to €450 million. Chief executive Mauro Savoia assesses the changes that have transformed the environment for real estate lending over the past year and explains how those themes are playing out in the European market.
How has the real estate lending landscape changed as we leave behind the era of low interest rates?
It is impossible to get cheap credit anymore, so it has become more difficult to finance deals. Meanwhile, the volume of asset sales has fallen dramatically. In the past year, there has been a shift by lenders towards quality. Loans are still available, but at a much higher price and at advance levels that make sense, keeping in mind refinancing down the road. Even banks have raised margins while lowering LTVs. The net effect is that pricing from alternative lenders is not very different from what’s demanded by traditional lenders today.
However, if a sponsor can get a loan from a bank, they decide to do so in most cases, because even the cheapest loan from an alternative lender is going to be priced wider than a loan by a commercial bank.
Now everyone is focused on refinancing, and there is a huge wall of loans that will mature between now and 2025. Two consequences of the higher cost of borrowing will be repricing and a rise in the number of non-performing loans (NPLs) and special situations. Not every owner will be able to refinance, and when we see some forced sales, that will inevitably put pressure on prices.
We have not yet seen a major repricing of assets, however. Sellers do not want to take a haircut on the price, and they argue that the assets will perform well over the long term. But those very same people will not buy anything unless it is at a sizable discount. Right now, we are in a ‘holding your position’ phase. If investors can afford to do so, the best strategy is probably to wait, so three-quarters of the deals we see right now are refinancings rather than acquisition loans.
What are the big concerns and challenges for your clients right now?
The best possible option for borrowers that have a loan maturing soon, if they are locked in at good margins, is to try and roll over the existing financing on a year-by-year basis. When this is not possible, they will need to secure a new loan. However, their interest payments will increase greatly. The cheaper the financing was when they bought the asset, the more complicated this phase becomes; if they borrowed at a very low margin, their financing cost will double or triple. Often these loans relate to core assets and leverage is usually low.
On the other hand, for a value-add or opportunistic situation, the problem is usually one of IRR and exit, not with the loan, because if managers have improved the asset and increased their income, the loan that they have in place is probably sustainable even at a higher interest rate.
With a fully stabilised asset, when the loan comes to maturity, the borrower might have to put some equity in so that the new loan is sustainable. That can be difficult for funds that have completed their investment period, which creates a new niche of opportunity for investors to come into the capital stack and provide a short-term loan to top up the senior loan, for which they can be very well paid, making double digit returns.
It is difficult to persuade a bank right now to lend on an asset class or do a type of financing that they do not really favour. Some prefer to fund yielding properties while others like to do construction loans at a low loan-to-cost ratio. There is great caution around development funding, though. With construction costs increasing and labour in short supply, it is a difficult environment for clients with developments underway.
What is the expected trajectory of interest rates in the future?
There are two possible scenarios I see. The first is that there is a recession and interest rates will start to fall. But the first thing the market will see is the recession, not the rates going down, so in that period, investors will be even more cautious than they are now.
The second is that there is no recession and rates will stay higher to bring down inflation. I think some form of recession is inevitable, and I am surprised that we have not seen stronger signs of one yet. But in either case – recession or higher rates for longer – there will be a repricing of commercial property at some point.
What can debt advisers do to help borrowers and lenders navigate these changing times?
Our main role is to optimise capital solutions for our clients, so right now that is more vital than ever. Advisers need to look for money in places where sponsors have not been able to find it, or they did not need to go to until a year ago. Banks are much more cautious in giving new loans, and the ECB has made it also relatively painful for European banks to do real estate loans.
Firms like ours know who is active in the market and who has capital to deploy. Being able to offer tailored solutions also means advisers can act more swiftly, and because there are so many uncertainties in the market, timing today is more important than ever. It is about finding the best solution in the shortest possible time.
Are some asset classes more favoured by lenders?
Luxury hotels are assets that nearly all lenders like to finance and we can certainly see the reasons for that. We have a strong pipeline of deals (over €1 billion) and have arranged several other deals in the past 18 months in this asset class.
Foreign lenders, especially American ones, don’t like offices, but Italian banks are still comfortable with the sector for the right asset. Lenders would definitely finance a city centre office building in Milan, for example, because there is little or no vacancy in the CBD and occupiers are hungry for space. An office on the outskirts would be a different matter.
Logistics has repriced more than other sectors, so there is more activity. Prime logistics space with top-tier tenants is still sought after by lenders, but speculative building is difficult to finance.
The residential sector – particularly small-scale projects in city centres – is loved by Italian lenders, and the banks are still active in that sector. For larger projects, which are more complex and time-consuming, they are more cautious, and they are reluctant to provide all the financing up-front. Student housing is also popular at low leverage with Italian banks, and at medium leverage with debt funds.
Do current market conditions present a buying opportunity?
There are assets coming to the market that would usually attract a big crowd of investors, but right now many of them are closed for new acquisitions, which is an opportunity for potential buyers who are less concerned about interest rate risk and who take a long-term view. That makes this a good moment for smaller or non-institutional investors to secure deals that would previously have been difficult to achieve. In the past, they may have lost out in a bidding process to bigger investors who might be perceived as slower, but more certain.
Higher-yielding finance is still available to do deals. In today’s market, the money that they can get from an alternative lender is only a couple of percent points more expensive than bank lending.
Cash buyers are also well-placed to make acquisitions, although they may prefer to invest their equity outside of real estate – in government bonds, for example – where they can now make healthy risk-adjusted returns. At a moment when capital appreciation is in question, they may prefer to deploy their liquidity into assets that are more liquid and which yield comparable income.
What local financing options are available to real estate investors in Italy?
Italy only has two large banks, Intesa Sanpaolo and UniCredit, plus two or three other medium-sized banks and a lot of smaller ones. None of the smaller banks write loans of €20 million or more, and the big banks have a substantial exposure to real estate already, so right now it is difficult to get an Italian bank to finance a large deal unless it is very strategic for the bank.
For a €100 million loan on a real estate asset, there are only two parties that can do it, and they usually want to syndicate a piece of the loan. That can create difficulties because they will want to syndicate it before they give the borrower the money, ie, while they are structuring the loan. The borrower has to agree to all the requests and accept all of the conditions from both banks.
Some foreign banks have been established in Italy for a while, including large French and some German banks. But they usually focus on big tickets of at least €50 million, and they are quite selective. However, when they find a deal they like, they are inexpensive compared to other solutions. There are also the large US investment banks, but they usually just follow their big clients to Italy to do €200 million-plus tickets.
Debt funds are very active in Italy. Because of local regulations, they have to use slightly more complicated structures, but alternative lenders are a great solution for many deals. While they are a little more expensive, they offer greater certainty of process than local banks and much quicker execution.