The European commercial real estate debt markets are highly liquid, with a broad range of lending organisations competing for financing mandates. However, while more lenders than ever are supplying debt to the sector, many are chasing large, core financing deals. Europe’s largest and most established lenders often overlook borrowers seeking finance for smaller properties, which often have value-add business plans attached to them.
For David Arzi, the former real estate boss at private investment management firm Marathon Asset Management, this represents a golden opportunity. In June 2018, he launched Starz Real Estate, a platform that aims to provide loans across Europe to what it calls ‘middle market’ buyers of real estate.
The platform is backed by Sightway Capital, the private equity arm of New York-headquartered financial services company Two Sigma. Arzi had worked with Sightway chief investment officer Wray Thorn at Marathon and went to him first with his plan for Starz. In March, the platform raised additional capital from an unidentified third-party institutional investor.
Arzi says business in the first year has been brisk. Since last summer, the company has originated €230 million of loans across 10 deals. It plans to more than double that number in the coming 12 months as acquisitions lead to financing mandates.
“What’s happening now is that all of the big funds which bought non-performing loans from the banks in 2013 and 2014 are starting to sell real estate assets,” Arzi explains. “There is a natural turnover as their funds become five or six years old and they are in harvest mode.”
“For the secondary market, in baseball terms, you’re probably in the fifth innings”
He adds that the opportunities for non-bank lenders in Europe are myriad, provided you know where to look. When he arrived in London in 2012 from the US, Arzi was focused on buying distressed debt, non-performing loans and real estate owned assets. However, he spotted a gap in the lending market.
“I noticed that it was pretty easy to get financing for big trades,” he says. “If you wanted a loan of €150 million and up, there were a fair number of providers of that capital – mostly the big international investment banks. They were focused on financing the big private equity sponsors who were buying large real estate portfolios.”
What was not available, he found, was financing for assets below €50 million, particularly for deals that were slightly out of the ordinary. Arzi knew there was demand, but he needed a product to serve it. He was confident the proposition came at the right time in the cycle, with sponsors ranging from institutional investors to smaller owners of real estate in need of such finance.
Starz has done deals in primary European cities such as London, but it also targets secondary locations. The firm looks for situations where there is limited competition from other alternative lenders. Starz is generally positive about real estate fundamentals across Europe, despite concerns about the UK, where Brexit still looms large.
“In the rest of Europe, everyone is fairly bullish on the equity and debt side,” he says, adding that low interest rates and lack of construction will provide a floor to real estate values. “Even if Germany goes into recession, there will not be a huge impact on property values, because there has not been overbuilding. In most of the markets we are focused on, like the Netherlands and Spain, there is slow, steady absorption. Rents are pretty low outside of Amsterdam and the major cities and there’s no new construction, so its steady, slow growth across the market.”
The fact that Starz works across jurisdictions has also enabled it to follow clients across the continent as they find deals in an effort to diversify their real estate portfolios. “We have a lot of borrowers who are based in London and want to do deals on a pan-European basis, so we can follow them around while still staying in a pretty defined market.” The platform’s lending deals in its first year have been mixed to say the least. From a Spanish shopping centre, to residential in Dublin, to a hotel in Brussels, the firm has been quick to spread itself across sectors.
Arzi is joined on the team by ex-Deutsche Bank real estate bankers Heather Jones in the role of chief operating officer, and Limor Shilo, who heads up loan origination. With several decades of experience between them, plus 11 other staff behind them and two in-house lawyers, Arzi is confident the firm can tackle most European markets. But there are caveats to Starz agreeing to take on a financing. “We’re cautious on retail, just like everyone else, so for us it’s got to have some real speciality aspect to it,” Arzi says.
For example, the shopping centre that the company financed in Spain is located next to the University of Alcalá, near Madrid, which means 26,000 students are essentially housed next door. A cinema on the site, although not part of the collateral, also draws traffic. The borrower had purchased the centre via a non-performing loan from a Spanish bank. At the time, the property was only 30 percent leased. When the owner came to refinance, it was at 95 percent occupancy. However, the owner had trouble sourcing bank finance. Enter Starz Real Estate, which targets precisely such mismatches in the demand and supply of debt.
A similar situation arose in Italy, where the firm financed a building in which a tenant was paying a below-market rent, but which was due to step up its payments in the years to come. “Someone had to finance that rent shortfall and, typically, banks don’t want to do that,” Arzi explains. “We’ve done other deals where we have come in and there are tenants on long leases, but they are in their rent-free period, and the banks don’t want to finance that void, even though the space is occupied. I think it’s just their structural, ‘check the box’ nature.”
Arzi is keen to point out that Starz too has its risk parameters. “Would I go and finance a department store somewhere in the UK? Probably not. We’re looking either for properties in a special location, or need-based retail such as food, daily shopping and so on.”
Arzi adds that providing certainty of funding is a way to win business in the mid-market. He points to a situation in Dublin, where Starz stepped in as an incumbent bank lender looked likely to change its mind in a lending deal. Starz closed the deal in less than a month, which enabled the sponsor to execute its own deal.
The opportunity within office markets in second-tier cities is driven by structural shifts in the overall real estate industry, Arzi says. In such cities, older buildings are being converted to residential, leading to a dwindling amount of office stock. Similarly, he argues that the structural shifts in retail, most notably the growth in e-commerce, mean class B logistics properties are also of interest.
Even in the UK, with concerns about Brexit at the forefront of many people’s minds, Arzi is positive about certain sectors. “We’ve seen the number of transactions in the UK slow dramatically as people try to figure out which way the political winds are going. We have taken a wait-and-see approach. That said, we are looking at a middle-income private rented sector residential scheme, which we think is fairly Brexit-proof, and we’re also looking at a student housing scheme.”
Market sources say alternative lenders’ ability to offer finance at higher loan-to-value ratios than banks, and against properties with higher risk-return profiles, provides them with a competitive edge. Arzi says Starz will lend up to 75 percent LTV. “If borrowers don’t go with us, many take a senior loan and a mezzanine loan – we can provide that product in one.”
David Arzi: CV
1988 Joined Chase Manhattan Bank
1990-96 Worked on distressed loans at Chicago-based mid-market lender Heller Financial
1996-99 Ran the esoteric asset-backed securities group for Credit Suisse
2003 Moved to Marathon Asset Management, where he started its real estate debt lending business in the US and worked on its aircraft and asset-based lending and equipment leasing business
2012 Arrived in London to seek opportunities following the global financial crisis
2018 Appointed chief executive of Starz Real Estate
Starz will take more risk than the banks, but Arzi still considers it to be a relatively conservative lender. He says the firm will take some leasing risk, but that it would not, for instance, underwrite an office-to-residential conversion. Loans are typically priced between 375 and 500 basis points over LIBOR – more expensive than the banks, though the pricing reflects their higher leverage.
Some debt market participants have questioned how alternative lenders will continue to deliver promised returns to their investors as returns across the real estate market compress. Arzi argues that there has already been a great deal of spread compression in the market, and that the level going forward will be minimal.
Although Arzi says Starz will never be a bank-type business, he adds that the firm’s goal is to originate around €1 billion of debt per year. “We’ve closed loans with some of the largest private equity shops, for Angelo Gordon, for Cerberus, so it’s not just the small middle-market borrowers, it’s the largest private equity funds looking at the product too.”
In a competitive market, lenders often say it is crucial to offer a range of products to keep sponsors interested. Starz recently added a mezzanine loan product aimed at deals worth between €5 million and €15 million, and Arzi says the firm is keen to add other products to its mix, including one that competes more closely with the banks. Although non-bank lenders like Starz cannot offer rates as low as many senior bank lenders, Arzi argues there is a market for sponsors that want lower leverage loans, and fast. “We’re planning to offer a product that’s a little lower levered, at a tighter spread, and we’ll compete with the banks on timings. We’ll be offering similar rates, but a much faster execution.”
Looking ahead, Arzi expects significant opportunities across European markets over the next 12 months. “I think prime city valuations have probably peaked, just because cap rates have been driven down to really low levels in cities such as Frankfurt. But secondary markets in Europe are fairly overlooked. We think there is pretty good value in those markets, and I would expect to have continued cap rate compression as people get squeezed out of the core.”
With the exception of retail, he remains “pretty bullish” about rental growth across the board. “I think the fundamental property market looks pretty good. There’s not that huge development overhang that you typically see before the market turns, so I think that’s been a real positive.”
Arzi believes there is unlikely to be a wholesale return to the market by the traditional bank lenders, and that alternative lenders will account for an increasing slice of the market. He also thinks that increased banking regulation, as part of Basel IV, will create additional room for non-bank debt providers: “I think the new banking requirements coming down for risk-based capital probably prevent the banks from getting any more aggressive. I would think that, over time, banks will have to shrink their real estate portfolios, and Europe is pretty overbanked now. I would assume that there’s going to be a fair amount of bank consolidation in the market.”
Arzi maintains that the regulators are too nervous about a return to the bad old days to allow banks to dominate the market as they once did. “I think the market needs third-party providers. The ratio of banks here compared to the size of GDP is much bigger than the States, so I would think over time when the bank market starts to heal there’s just going to be a fair bit of consolidation in the system.”
Even if more non-bank lenders enter the market, Arzi isn’t concerned about the availability of deals in the future.
“There’s so much money on the sidelines. There’s a lot more capital looking to buy real estate than there is real estate to buy. I think for core capital city property, we are probably at peak pricing. But I think for the secondary market, in baseball terms, you’re probably in the fifth innings so you still have a fair amount of ball game left.”