New mezzanine lenders are offering solutions to the market, but worsening restrictions in senior financing are likely to further widen the overall European funding gap in 2012. Natale Giostra explains

At the start of 2011, the level of out-standing commercial real estate debt
across Europe stood at €960bn. As new issuance by the major debt providers in Europe has stagnated, it is believed that the funding gap grew marginally over the course of the subsequent 12 months. Causes attributed to this stagnation are downgraded capital values, the continuing financial difficulty experienced by the euro-zone and the high levels of sovereign debt many economies are exposed to. There is also the increasing fear over the financial health of some banks, the fate of the euro itself, and the impact of increasing financial regulation.

Last year a number of major debt providers suspended new lending in the market. The German pfandbrief bank EuroHypo is considered to be one of the most significant example. Its decision to halt all new lending follows the writedown of nearly €800m of Greek sovereign debt, and was part of parent company Commerzbank's wider strategy to meet the revised capital requirements of Basel III regulations. All euro-zone banks are required to raise a 9% tier-one capital ratio by the end of June 2012 and they are now taking the necessary steps to deleverage balance sheets to meet the new regulation. Those that are overexposed will have to take urgent action. Possible solutions range from balance-sheet restructuring and disposing of legacy assets, to a withdrawal from new lending, at least on a temporary basis. Either approach ultimately requires a reduction in real estate exposure, making it more challenging for those in the market that need to access debt.

With approximately €530bn (over half the total debt outstanding) of debt due to mature by 2013, the refinancing wall is a serious challenge. The events of 2011 have only added urgency to the question of who will be able to step in to fill the funding gap?

The weakening of sentiment displayed by established lenders in Europe has been matched by the increased confidence shown by non-traditional sources of finance. Wells Fargo recently announced it would begin to lend to real estate in Europe following an 18-month hiatus. The US bank's decision was based on its intention to diversify its exposure into international markets and the opportunity presented by the lack of competition in Europe, due to the predicament of traditional lenders.

Austrian bank BAWAG has also stated it is looking to lend around €800m during 2012, principally against German, French and UK assets. It said it would lend high up the capital stack into the ‘stretched senior' space, targeting loan-to-value (LTV) ratios of 60-75%. Similarly, AEW Europe also plans to launch a low-risk pan-european senior debt fund in 2012, followed by a mezzanine debt fund. The senior debt fund will target returns of 5-6%, while the mezzanine fund will target returns of above 10%.

Insurance companies have also begun to look for real estate debt investment opportunities arising because of Solvency II. The directive is still under revision but is likely to make real estate lending more attractive than direct investment due to the difference in the risk capital requirements.

We expect more insurers to enter the debt market and strengthen their commercial real estate lending platforms and to be able to offer very competitive terms under the Solvency II regime. We expect that over the long term, insurance companies could account for as much as one-fifth of the European lending market, similar to their position in the US. However, in the short term, the issuance of senior debt by insurers will not replace the capital once provided by the larger, more aggressive lenders.

Nonetheless, senior debt will not, on its own, provide sufficient capital to close the funding gap. There is now a greater need for alternative products, such as mezzanine debt, that can provide an effective solution for highly indebted borrowers holding reasonable quality property. Sitting between low-risk senior lending and full equity risk, mezzanine lenders recoup higher returns as they occupy the space directly above senior lenders on the risk curve. These lenders have been identified by many as the ‘solution' to the funding gap.

Currently, the opportunity for mezzanine finance to play a significant role in debt refinancing lies with outstanding debt on good quality property with high LTVs. These assets can attract senior debt, but often not at a sufficiently high LTV to replace all the maturing debt.

With the prevalence of LTV covenant breaches today, it is likely that refinancing of existing debt will remain the core market for mezzanine lenders. Here they can fill the gap between borrower equity and fresh senior debt of 60-65%, providing up to an aggregate LTV of 82.8%, potentially rising to as much as 90%, with the average overall returns required by lenders at around 15% per annum. This average disguises a significant range, with the cheapest single lender seeking 10% per annum and the most expensive looking for 20% depending on the characteristics of the property, the tenant, length of contracted rental income, the quality of the sponsor and the downside protection offered by the existing equity ‘cushion'.

While unrealistic pricing made it prohibitive for borrowers to even consider mezzanine debt as source of capital back in 2008 (where lenders sought opportunistic returns of 20-25%), increasing competition from mezzanine lenders and the lack of distressed or other investment opportunities has now pushed the price of mezzanine finance down substantially. Essentially, as mezzanine debt becomes more understood by borrowers, the pricing has become more accepted by borrowers and lenders alike.

In 2011, there were more mezzanine deals in the market compared with previous years. One of the more notable transactions of last year was the £61m (€46.8m) mezzanine loan provided by GIC, Singapore's sovereign wealth fund, at 75.6% LTV, as a structurally subordinated debt piece rumoured to be remunerated around 10% annual interest, paid current, to fund Blackstone's £480m acquisition of the Chiswick Park Estate in west London. The senior-debt portion was a £302m commercial mortgage-backed security (CMBS), the first European CMBS public offering since 2007, placed by Deutsche Bank.

The development finance space remains difficult in the current environment for both senior and mezzanine lenders, as the low returns do not match the high expectations of investors. The increased risk associated with development demands a high internal rate of return which, in most cases, is so close to an equity return that mezzanine finance becomes unattractive. However, the mezzanine debt market is slowly becoming more diversified, with certain players willing to take, and appropriately price, different types of risk.

It seems inevitable that mezzanine lending will gradually become more widely accepted by both fund and property investors, and a middle ground between investor expectations and market realities will eventually be found. As well as providing additional finance on more stable assets, lenders will target ‘riskier' assets with the appropriately priced debt.However, we expect that the lack of senior debt anticipated in the market this year could potentially challenge the execution of mezzanine deals until new players permanently enter the marker to fill the void left by banks. That said, many, like M&G Investments, are providing whole-loan facilities, with other mezzanine lenders bridging the senior debt with a view to refinancing this portion at a later stage and retaining the mezzanine piece.

In 2012 we expect a further reduction in the senior lending market liquidity, which will, no doubt, further widen the overall funding gap. This gap will expand at a faster rate in locations outside of the prime market, as lenders predominately target assets at the lower end of the risk curve, thus resulting in a geographical, sub-market funding gap.

Natale Giostra is head of UK and EMEA debt advisory, real estate finance at CBRE