Macro dislocation and turmoil in the banking sector are creating a vacuum in the real estate financing market, leading to an increased pipeline of lending opportunities.
Across Europe, real estate markets are strained to a degree not observed since the Global Financial Crisis, driven by a rapid rise in interest rates.
The interest rate challenge is compounded by the fact that in recent quarters, borrowing costs have surged (the Bank of England’s SONIA has increased 3.5% since mid-2022), and risk appetite waned (loan-to-value down by 10-15%), causing liquidity to evaporate from the market.
There is now a risk that the consequential liquidity shortfall could turn into full-blown solvency problems, particularly in structurally challenged sectors. For example, after interest rates rose in 2022, listed European landlords’ one-year probability of default spiked and remain elevated in 2023 at 2.47%, compared to 0.36% for the wider S&P Europe 350 index, as of 3 May. We are starting to see sizable restructurings or defaults in the office sector across Europe, in particular, ranging from a portfolio of offices and stores in Finland to office buildings in Canary Wharf.
We believe the degree of dislocation in the real estate debt markets was underestimated in Q1 2023, and that the market is under more duress than previously thought.
Many commercial banks increased their real estate exposure in the first half of 2022 and now have backlogs to sell loans in a higher-rate environment.
On top of that, they are generally experiencing lower loan repayments, as well as an increase in loan delinquencies caused by catalysts such as a drop in real estate valuations, maturity walls and technical defaults.
The rise in interest rates is affecting Europe more than the US because sovereign debt was negative in many European countries. European real estate public stocks are now down 43% since January this year, compared to 23% in the US.
Unlike during COVID, we expect this cycle to be longer-lasting as monetary policy cycles take a long time to play out, with private valuations due to converge towards public ones over time, creating meaningful levels of defaults.
Shift towards alternative lending
These factors combined have a significant knock-on effect within the European real estate market, and we anticipate a tangible shift in how real estate debt is funded as a result.
Unlike in the US, the European real estate market relies heavily on bank lending. In fact, according to the MSCI Europe Real Estate Index, in Europe, banks represent 90% of the outstanding real estate debt with alternative lenders representing only 10%, compared to 40% in the US.
We expect that to change. In our view, the lack of appetite from traditional lenders will lead to alternative lenders’ market share edging towards the 40% range over time as they fill the vacuum left by banks in Europe. Public debt markets reacted much quicker to higher interest rates, causing new bond issuance to fall, while the adjustment in private markets always takes longer to come through. We are starting to see banks either reducing LTVs or unwilling to participate in new transactions in Europe, as well as some of the banks starting to consider reducing exposure to their existing real estate loan books.
Add to that the wall of maturities and decreasing real estate valuations, and we anticipate a wave of real estate debt opportunities. Looking at figures from the STOXX Sector indices, we estimate that around €1.3trn of commercial real estate paper will mature in the next four years.
Unlike in the US, there is limited public market off-take for this credit paper in Europe – commercial mortgage-backed securities are limited due to regulatory clampdown, and there are no mortgage REITs / or mortgage CLOs.
The combination of these factors creates a €720bn lending opportunity (based on Bain Capital’s analysis) for alternative lenders in the next few years. We predict lender-friendly pricing among alternative lenders with little competition elsewhere.
Across Europe, we have seen a significant increase in real estate private debt opportunities as sponsors face
refinancings or need rescue capital. We are already starting to see the implications of this mostly driven by maturities or technical defaults (LTV or ICR covenants), forcing sponsors to amortise debt with equity.
The opportunity set has expanded significantly, with senior secured loans now being offered at 50-65% loan-to-values, priced between 9% and 11% while junior positions cost 12% to 15+%. In this environment where new real estate transactions are muted, we expect refinancings to drive the majority of real estate lending volumes.
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