Interest rate rises have transformed real estate lending, causing the cost of debt to rise sharply, and delivering an unwelcome jolt to borrowers accustomed to the era of cheap credit. Lenders and sponsors in the mid-market now face a radically different business environment compared with 12 months ago.
The mid-market segment is not strictly defined, with market participants typically identifying it as €10 million to €20 million at the smaller end, defined by the point at which borrowers begin to access institutional capital market solutions, and €75 million to €100 million at its upper limit, the threshold at which big sovereign wealth, insurance company and private equity credit players begin to take more of an interest.
Many institutional real estate investment sales and development projects fall within that size bracket, but it is nonetheless a market that has historically been comparatively underserved by lenders, says Manja Stueck, managing partner, Europe debt, at manager BentallGreenOak.
“Underwriting a €20 million ticket is the same amount of work as a €100 million one. Not everyone has the team and the capacity to do it, and neither do they all want to do it. Now, with increasing interest rates and the other challenges we are seeing, it is even more work.”
Hitherto, most mid-market deals have utilised bank finance, and traditional lenders still provide a significant proportion of the available credit. In the UK, for example, the real estate mid-market remains well-served and liquid, says Jason Constable, head of real estate for Barclays Corporate Banking.
“Traditional UK clearing banks remain very active, accounting for 41 percent of market share of new loan origination in 2022,” he says. “However, we have seen a sustained trend of attrition as alternative lenders made up of challenger banks and institutional lenders – predominantly debt funds, which have grown origination tenfold since 2012 – and insurance or pension-backed asset managers have continued to grow in prevalence in recent years as the private credit market has evolved.”
“Mid-market borrowers which have historically been able to rely on their relationship banks will now probably have to widen their search a little”
Regulations requiring banks to hold a minimum amount of capital on their balance sheets in relation to the risk-weighted profile of their assets, have limited their scope for lending, notes Adam Buchler, managing director at debt adviser BBS Capital. “As values fall, and leverage increases, it means that banks have to reserve more capital, and as a result, they have less with which to lend.”
Banks’ declining influence
While banks have become increasingly cautious over originating large loans, there is more liquidity for mid-market tickets, says Clark Coffee, head of European commercial real estate debt at US-headquartered investment manager AllianceBernstein. Current market conditions have led them to concede more territory in the segment to alternative lenders, however.
“If they used to be able to do 10 loans a quarter, now they can perhaps only do five, and they will focus on the deals that have the best mix of sponsorship, collateral and business plan. They are giving up tremendous amounts of market share,” adds Coffee.
Stueck says: “Local banks that covered the mid-market quite well are just not that active right now. In Germany, for example, these banks were active even in development finance. They offered attractive leverage at pricing we would not have been able to compete with. Mid-market borrowers which have historically been able to rely on their relationship banks will now probably have to widen their search a little.”
However, Buchler argues that far from being underserved, there is a growing cohort of potential mid-market lenders from outside the banking sector. “If anything, I would say the mid-market is better supplied from the perspective of the number of lenders than the larger ticket deals. Part of that is because some of the larger players, which typically only target loans of over €75 million or €100 million, are struggling to deploy because of low deal volumes, so they are starting to stretch their criteria to do smaller loans.”
Debt finance comes at a much higher price than before, however, which has had a significant impact on borrowers, says Constable. “The market is in the process of transitioning from what has historically been a benign interest rate environment to one that has seen rates expand materially over a short period of time. This has put pressure on existing covenant structures, constrained debt and leverage capacity, increased consequential refinance risk and driven a greater focus on interest rate risk mitigation strategies.”
Real estate markets are in the process of repricing as higher interest rates exert pressure on yields, says David Arzi, chief executive officer at Starz Real Estate, a lending platform that targets the European mid-market: “We are already seeing that in the public space with the REITs coming under pressure.”
For mid-market borrowers that acquired assets at the peak of the market and whose loans are now maturing, falling values make refinancing challenging. “A lot of the property types that are having the most problems refinancing, like multifamily in continental Europe, have good underlying dynamics. However, they traded at such low cap rates, sometimes as low as 2.5 percent, that now, when their debt rolls, they are underwater,” says Arzi.
The “wave” of refinancings likely to hit European real estate in the next two years is well-documented. Asset manager AEW estimates a “refinancing gap” of as much as €51 billion could open up between the original volume of loans due to mature in the UK, France and Germany between 2023 and 2025, and the amount of new financing available to repay it.
Deal count falls
Meanwhile, uncertainty over how much further values will fall, together with the prospect of further interest rate hikes, have suppressed investment activity. AllianceBernstein’s pipeline of potential financings for new acquisitions has fallen by around 75 percent compared with last year, says Coffee: “For the moment, the vast majority of volume in the market is refinancing. The name of the game for the next two to three years is largely going to be helping sponsors to get out of repayment situations with existing and incumbent lenders.”
As the maturity dates on those loans approach, lenders, keen to reduce risk, are squeezing loan-to-values at the same time as falling values are eroding the equity available within the capital stack for many investments. Meanwhile, the cost of debt for some borrowers will increase several-fold.
“A lot of the refinancing that is taking place today, other than for the most core prime assets where there is still bank liquidity, is dilutive to equity’s target returns,” says Coffee.
“But because the alternative is crystallising that investment to repay the loan in the current difficult market, refinancing is probably still a more attractive option. Right now, the credit market is charging a bit of an ‘option premium’ for the ability of that sponsor to extend its time horizon and wait for better days when rates are expected to come down and transaction volumes will go up.”
Borrowers will increasingly be required to inject additional equity into the capital stack, says Stueck. “The question is, particularly in the mid-market segment, will the cash be there? With larger sponsor groups, often there is more of an option to move cash around and allocate it differently. Some mid-market borrowers may not have that capacity.”
Affordability is a pressing concern for both borrowers and lenders engaged in refinancing. The leap in borrowing costs has put interest coverage ratios (ICRs) under pressure. Coffee observes that an ICR that was 1.5 in a zero-interest rate environment can easily become less than 1.0 today.
“There has to be some value-add component to bridge the gap between the income today and some future amount that sizes correctly to the debt”
Starz Real Estate
“It’s tough for lenders too, to make the numbers work at 5.5 percent base rates plus the lender’s spread,” says Arzi. “There has to be some value-add component to bridge the gap between the income today and some future amount that sizes correctly to the debt. We are looking at financing assets where there is scope to add value and create some growth. If you do nothing with the asset, I am not a real believer that rents are going to grow.”
In such circumstances loans increasingly need to be structured to provide additional security to lenders that interest will be paid. It is easier for sponsors with a substantial pool of discretionary capital to accept those types of levers in a loan structure, says Coffee. “The more institutional the sponsorship, the easier time they have finding solutions, because they have more tools in their toolkit.”
Fortunately, the profile of mid-market borrowers has become increasingly institutional. Buchler says: “The mid-market encompasses private property companies and investors, but also institutional borrowers, particularly private equity, which perhaps a few years ago would have participated in larger deals. They are now quite active in the €50 million to €75 million range, because a lot of them are adopting investment themes that comprise amalgamating a large number of smaller assets.”
Coffee says he is doing deals with sponsors in the mid-market that he would not have been able to engage with historically because they would have been able to find liquidity through the banking market. “The retrenchment of bank appetite is allowing us to charge higher returns and to take less risk by reducing LTV. But probably the most important benefit, is the average quality of our sponsor, our collateral and our business plan has gone up materially in today’s environment.”
There are attractive opportunities available for lenders to finance mid-market borrowers that are willing to inject capital to upgrade assets so that they meet higher energy efficiency and ESG standards, says Stueck. “If you don’t feel it can be caught up to today’s requirements, then that’s a tough ask. But if it is in a great location with a great sponsor, and they have the cash to put in, we will certainly be looking to support these business plans. As a lender, if you can create value somewhere, that’s quite defensive.”
Investments with an operational aspect, such as hotels and self-storage, have a strong appeal for lenders right now, suggests Arzi. “In this market it is a good trade-off to take a little more operational risk in return for much greater cashflow.”
He expects investment activity to pick up when investors feel that interest rates have peaked and they can feel more confident about where pricing will settle, possibly around the first quarter of 2024. “We are pretty excited about the amount of transactions that are going to come out of this repricing.”
At present this remains a complex business environment in which to finance mid-market real estate transactions, however. “I often hear from lenders that they have to sift through a lot of deals before they see one that really makes sense,” says Buchler. “There is the ICR issue, plus every loan that is refinanced needs to be valued, and value is something that people are still struggling to put their finger on.”