As banks scale back their exposure to commercial real estate, opportunities are opening up for institutional investors. However, this is dwarfed by the scale of the refinancing challenge. Lynn Strongin Dodds reports
Early last year there were signs of a thaw in the property lending market but sentiment froze over in the second half because of impending regulations and the scarcity of good-quality properties. Banks retreated and new entrants, such as insurance companies and mezzanine players, stepped into the breach. While they will play an important role, their efforts are likely to be dwarfed by the mountain of refinancing the industry faces.
According to Natale Giostra, head of UK and EMEA debt advisory real estate finance for CB Richards: "There is currently €960bn of outstanding commercial real estate debt in Europe due over the next 10 years. About half of that will be within the next three years. Not all of these borrowers will look to refinance. It will depend on the asset but quality properties with low loan to values will be the easiest to attract senior lenders, although this type of property only accounts for 25% of the market."
Banks had been active in the first six months of 2010 but they have made little progress in deleveraging and there has been even less lending on new properties, according to Joe Froud, managing partner at Columbus Capital, which is part of Schroder Property. "Last year really was a story of two halves, with the lending market recovering more strongly than expected in the first six months. We had competitive tender processes for our deals but this changed in the second half when over half, particularly the German banks, which had been the most active, left the market. I think this was mainly because of Basel III and the requirements of capital that it will impose."
A recent study by Savills, the global property adviser, confirms these trends. It reveals that the big-ticket lenders - those that had actively sought and achieved at least £100m (€118m) total new lending, in typical loan sizes of above £20m - had been whittled down to just 12 last October, from a high of 30 in June.
Michael Acratopulo, head of origination at EuroHypo, says: "There have been three major headline themes playing in the background - regulation, liquidity and capacity. They explain what happened in 2010 and what is likely to occur this year. Banks are taking a long, hard look at their business to determine which markets they want to be active in and where they want to either exit or reduce their activities. This is partly due to the market but also because of regulation. It is no surprise that when Basel III was announced in June we started to see more constrained lending. DG Hypo (Deutsche Genossenschafts- Hypothekenbank), for example, announced that it was cutting its lending activities outside Germany by mid-2011."
Although the details are still being hammered out, Basel III will require banks to increase their core tier-one capital ratio to 4.5%. In addition, they will have to carry a further ‘counter-cyclical' capital conservation buffer of 2.5%. Any bank that fails to meet the new requirements is expected to be banned from paying dividends to shareholders until it has improved its balance sheet. This will affect the ability of banks to -refinance outstanding debt and to provide capital to new borrowers in the investment market. The cost of capital for banks will rise, which will, ultimately, lead to more expensive loans for borrowers.
Margins have dramatically increased from a low of 75-100bps during the halcyon real estate boom days of 2006 to today's 175-350bps range. Ric Lewis, chief executive and chairman of Tristan Capital Partners, says: "It depends on where you are on the risk spectrum but a blended rate of 325-350bps for a combination of mezzanine and senior debt is not uncommon. I do not expect that range to change because there is not enough liquidity or competition needed to cut spreads."
Dirk von Thuelen, financial officer Invesco Real Estate and part of its debt financing team, adds: "Banks have increased their margins to reflect the requirements of Basel III. I think they might rise slightly, beginning this year, before coming back due to the uncertainty of the pricing impact of higher equity reserves in the debt market. Deals are still being mainly financed by banks but I think the introduction of Solvency II is driving insurance companies to look at alternative investments. Real estate debt requires a lower capital charge for insurance companies versus direct real estate investments."
The new set of regulations, due to be implemented by 2012, are akin to Basel III in that they aim for a better match between the capital that insurers hold and the risks they take. The finer details have not been worked out either but there has been a flurry of activity this past year with insurance companies launching funds. It is not their first foray into the property lending world. They were active participants 20 years ago but were driven out by their more aggressive bank competitors. It is ironic perhaps that they are back working alongside them to fill the funding chasm.
The most recent and one of the highest-profile entrants is AXA Real Estate Europe's leading real estate manager, which is raising €350m for its first dedicated debt fund from a number of European insurance companies as well as its parent insurance group. The fund, which will originate senior loans on a wide variety of properties, will not use leverage and is targeting €1bn of total commitments. The fund will provide senior loans either directly or acting as a syndicate behind a bank and will focus on investments that are backed by good-quality income-producing properties. Investment will be across Europe, although initial investment to date has been focused on the UK, which has enjoyed a strong increase in the price of prime real estate over the past year.
Isabelle Scemama, head of commercial real estate finance at Axa Real Estate, notes: "Banks are under pressure from regulators to better manage their balance sheets and as a result there is less capacity in the lending markets. As long-term investors, insurance companies are a good alternative because our liabilities match the type of real estate lending. However we do not have the capacity to solve the refinancing issues, although I think insurance companies and other non-bank lenders have an important role to play. I believe Europe will eventually follow the US example, where around 20% of real estate transactions are underwritten by long-term investors such as insurance companies."
Overall, figures from property adviser group DTZ reveal that growth of non-bank lenders, including insurers in European commercial real estate lending, has been slow and steady, rising to 24% in 2010 from 13% in 1997.
Amy Aznar, head of special situations at LaSalle Investment Management, notes: "I think there are opportunities for non-bank lenders to fill the gap for high-quality assets. At the moment, while there are a number of groups positioning themselves to offer alternative financing, it has not been significant enough to move the needle to normalise the market."
Andrew Macland, managing director of Pramerica's mezzanine team, notes: "Senior debt lending across all sectors is scarce and focused on well-capitalised borrowers and prime properties at low LTVs. It is difficult to see high volumes of senior lending being restored to the market without new entrants, particularly from the big insurance companies. The CMBS market, which has returned liquidity to the US market, is unlikely to do the same in Europe, where we have seen just a couple of bespoke deals over the last 12 months. In any event, at the peak of the market in 2007, CMBS made up for less than 20% of commercial property lending in the UK [less than 10% across continental Europe] and any return of this market will focus upon prime properties, with fewer borrowers, not the large conduit deals of the past.
"Mezzanine will not be provided by lending banks in the short term, if at all, as the regulatory changes [Basel II & III] make it very capital inefficient. New sources of capital to replace this have emerged, predominantly from ungeared equity funds, seeking to fill the gap provided by lower LTVs [60-80%]."
Giostra adds: "The lending market will become more interesting and diversified. We will see more insurance companies coming in once they figure out how Solvency II works because the new rules makes it easier for them to invest in property. However, it will take time for them to build the right infrastructure, develop risk management systems as well as hire the right people. I also expect mezzanine finance to play a larger part, but it too is an emerging industry in property lending."
Giostra notes that since the collapse of -Lehman Brothers, there have been about 100 new mezzanine funds. "Typically, these are either specialist debt investment funds, property investors seeking real estate exposure not available in the direct investment market due to scarcity of quality investment stock or non-discretionary asset managers backed by either high-net-worth individuals or institutional investors."
Giostra believes the main attraction of mezzanine lending is the higher returns that are generated from certain types of investments. In addition, regulation will make the debt more attractive than direct real estate investment, and it offers companies a good opportunity to diversify their investment portfolios and balance risk exposure."Mezzanine lending will gradually become more widely accepted by fund investors, who will need to accept lower returns in exchange for moving down the risk curve, and by property investors, who will need to assess accurately the multiple capital sources available at different levels in the capital stack. This process has begun, and it is likely that there will be a significant uplift in the participation of mezzanine lenders in the real estate debt markets in 2011 and 2012."
The year started with Duet Private Equity announcing its plans to launch a quoted mezzanine debt fund later in 2011, which will be the first of its type to be quoted on London Stock Exchange's main board. The fund, which is targeting a gross internal rate of return of 15%, aims to invest in income-producing commercial real estate assets, primarily in the UK and Germany.
Other notable mentions include M&G and Pramerica. Last year, the former launched a €140m fund to provide mezzanine finance on top of its lending business while the latter raised £150m from institutional investors to provide financing for new acquisitions, particularly for small and medium-sized investors in the UK and Germany, as well as refinancing of existing good-quality deals and funds.
A variation on a theme is LaSalle Investment Management's £100m UK special situations fund to invest in mezzanine and preferred equity positions in order to facilitate real estate recapitalisations, restructuring situations and new acquisitions. Aznar says: "It is not a pure mezzanine debt fund but one that also uses preferred equity as well as hybrid structures. However, we believe mezzanine debt is a nice complementary strategy for pension funds that are looking for risk-adjusted returns."
Giostra adds: "Mezzanine will not be the only solution to the funding gap, as new senior lenders will also be required. As the number and type of lenders in the market increases, financing will become more complex, with transactions potentially involving several debt sources. Each lender might be driven by different investment criteria, risk measurements and funding models making negotiation of terms more difficult. There is a clear role for specialist debt advisors to aid borrowers in the assessment of new opportunities and navigate these complex negotiations."
Lewis is more circumspect about what type of impact non-bank lenders will have on the property lending market. "There is no panacea cure because alternative sources of funding cannot provide the capital that is needed. I think their contribution will be a raindrop in a sea of -refinancing. I expect banks will continue to extend their loans and one of the biggest challenges will be whether they can grow their way out of the economic downturn before interest rates rise. I do not think they will increase in the short term but over the next two to three years."