Lending is becoming increasingly diverse, but does a resurgent banking sector undermine the appeal of institutional debt funds? Russell Handy reports

There is little doubt that debt funds are making their presence felt in the lending market. More than $15.9bn (€12.3bn) was raised in the first half of this year, according to Preqin. With close to 60 funds in the market, more capital was raised in the first half of 2014 than in all of 2013.

Cushman & Wakefield’s corporate finance team found that, of 182 lenders in Europe in the first half of this year, alternative lenders – including insurance companies, property companies, private equity and debt funds – accounted for 40% of the total.

Such volumes raise questions. Can – and will – all of the capital be deployed? And with banks back on the block, how can debt funds compete? An even bigger question facing investors is whether or not debt pays.

Last year, Norway’s Government Pension Fund Global said it was making its first foray into real estate debt in a co-investment programme with AXA Real Estate. Norges Bank Investment Management (NBIM), which manages assets for the NOK4.76trn (€586bn) sovereign wealth fund, is targeting large senior loan investments of up to €600m in the UK, France and Germany. The three countries continue to attract investors and lenders: Cushman & Wakefield says the countries are top targets for real estate lending, securing 60% of all loans in the first half of this year.

AXA RE has also tapped Denmark’s pension funds for a debt vehicle, raising €485m from Sampension, TDC Pension, AP Pension, JØP and DIP this year. The Kronborg fund is investing in large senior loans across asset classes including offices, retail, logistics and hotels. AXA Real Estate clients have also committed to the fund, which is also focusing on the UK, France and Germany. In April, Charles Daulon du Laurens, AXA Real Estate head of investor relations for real asset finance, said bank “disintermediation” was offering investors a chance to diversify their traditional credit allocations.

De Montfort University says the real estate lending sector is becoming “more competitive”. For example, TIAA-Henderson Real Estate is marketing its first real estate debt fund in Europe, with UK regional assets in focus.

A new entrant to the sector, TH Real Estate is focusing on both the fairly crowded space in London as well as lending opportunities outside the UK capital, its head of European debt operations, Christian Janssen said. “That’s where there’s still opportunity,” Janssen said, adding that lending restrictions were limiting activity from traditional banks beyond the UK capital. “Banks typically held that territory but in the last two years, we’ve seen insurance companies and debt funds growing their market share.”

LaSalle IM was one of the first real estate fund managers to move into Europe’s lending market following the crisis. The €750m LaSalle Debt Strategies II fund (a mezzanine and whole-loan fund targeting UK and Germany) and £440m LaSalle Residential Finance venture (solely focused on UK student housing, residential, and hotel development finance) are its latest vehicles.

With commercial real estate suffering no shortage of equity or debt, the UK in particular is faced with a situation where there is more appetite than product available. “Conceptually, many institutions have appetite to invest in debt, but some have been frustrated by the ‘access challenge’,” says Laxfield Capital co-founder, Emma Huepfl. “The reality is that winning business is difficult in a highly competitive market.”

With more competition to come, Preqin estimates as much as $25bn is being targeted by debt funds, with increased confidence among investors for debt. Preqin’s head of real estate products, Andrew Moylan says the increase in fundraising for debt funds reflects significant growth in institutional investor appetite.

With increased competition among lenders, Huepfl says some debt funds have gone back to their investors and reviewed their strategies – as a response to the market. “As spread compression bites, you either compete on price, or maintain yield through higher leverage or financing a broader range of assets on more flexible terms,” she says. “That means some debt funds have had to seek consent to change their investment parameters.”

Joint managing partner of ICG-Longbow Martin Wheeler says lenders do not need to be the “cheapest or the most aggressive on leverage. If you back a global sponsor and win a mandate then that means you are potentially the cheapest on the planet. That’s not a great selling point to our investors.”

Instead, he says, debt funds should offer borrowers the “certainty that they’ll get what they require. In an increasingly lively bidding environment, speed of delivery counts,” Wheeler adds.

Philippe Deloffre, general manager of CRE debt funds at Acofi Gestion, says that most of the firm’s business last year was done with a direct approach to borrowers. Acofi has been providing senior loans backed mainly by French insurance firms, a tactic which also appeals to the firm’s French rivals AEW Europe, La Française and Banque Postale. “This year, outside a handful of larger deals, the French market is more about smaller deals – and that’s made it more competitive,” he says.

Increased competition is resulting in margin compression – at a time of low interest rates. In Germany, one observer said he had noted double-digit margins on a loan provided this year. “Borrowers in the past couple of credit-starved years were pinning their hopes for easier debt funding on the arrival of new, so-called, alternative lenders, insurance companies and debt funds,” says CBRE’s head of real estate finance, Dirk Richolt. “But it is especially this segment of credit supply that will consider the latest developments in the capital markets a blow to their business plans, as they have been sought and promised fixed nominal returns.”

In a market with “ever-lower base rates and credit margins”, their ability to be on par with competition, CBRE says, “dwindles quickly”.

Richolt says favourable conditions on capital markets are making the loan market “very accommodating”, turning it into a borrower’s market and not a lender’s market.  “Banks have started to concentrate on the loan-origination side of the business and find themselves competing ever more aggressively for a quite limited supply of opportunities.”

Neil Slater, head of product finance and structuring, real estate at Standard Life Investments, sees a “significant shift” in spreads in the UK, to as low as 130bps for core London property and 175bps to 225bps for a core office property in Manchester.  “If you go back 24 months, people were talking about more than 300bps,” Slater says. The firm moved into senior debt last year.

James Tarry, fund manager for real estate debt at Aviva Investors, says: “Real estate finance is not an isolated asset class. Corporate debt and high yield are also seeing margin compression too. There’s no doubt margins are compressing, but it’s at the top end of the property market – there’s still a lot of opportunity beyond that.”

Speaking in June, Hermes Fund Managers chief economist Neil Williams said that he did not envisage interest rates peaking at more than around 3% this cycle. Williams sees little impact from a widely foreseen 25bps rise in UK interest rates towards the end of this year.

Margins, says M&G Investment’s head of senior mortgages, Paul Dittmann, may compress further. His firm is, he added, still writing loans at above 2011 levels. 

The prospect of more senior debt funds launching has not materialised, resulting in lower pressure on margins this year. “It’s not impossible, but it’s hard to say that further compression will occur,” Dittmann says.

Wheeler, meanwhile, says the UK offers both borrowers and lenders the perfect criteria. “It’s not very often you get low interest rates, growing GDP, rising employment and low inflation,” he says. “We’re not hearing any alarm bells for overheating.”

For Dittmann, the debt sector is experiencing a quartet of correlating trends. “We’ve seen margins tighten from their 2012 highs, cap rate compression, the regional real estate bottom out and banks returning to the market,” he says. “However, compared to corporate bonds spreads, commercial mortgages continue to provide an excellent investment opportunity. The market pendulum is swinging back to normality.”

Investors in debt, says Huepfl, are “comforted by the liquidity in the underlying asset class”. Laxfield has accompanied MetLife and Singaporean sovereign wealth fund GIC into the debt sector.

From an investment management perspective, Slater says debt “makes a lot of sense and still has the potential to provide ways of meeting investment needs. The class provides regular yield and low probability of default. That’s exceptionally interesting. We continue to see strong interest in commercial real estate debt and real asset debt, including infrastructure, from insurance investors and particularly from pension funds.” 

Return of the banks
A study by De Montfort University has found a diverse lending landscape in the UK, with the role played by ‘non-bank’ lenders such as insurance companies and debt funds more pronounced. 

Wheeler says with banks reducing their exposure to real estate and old CMBS structures unlikely to be replaced, there is a gap to fill. “This is really where the debt funds and insurers have the ability to step in,” he says.

Huepfl, however, says banks never really went away. “I never really saw them as not being in the market – in our experience, there’s always been a bank in the bidding process,” she says. “They continue to be a strong part of the overall spectrum.” And Slater says the return of banks has “made things more competitive”.

There is little doubt that, as investors turn to the regions and secondary locations, banks are in a good position to assess the case for lending beyond capital cities.

Aviva Investors’ senior debt fund, says Tarry, is lending in the UK regions where rental levels are improving and there is less yield compression than in central London. “We are as comfortable across locations as we are across sectors,” says Tarry.

Wheeler says: “We’re increasingly seeing the clearing banks in the UK regions. There aren’t a huge number of debt funds out there.”

David Hutchings, Cushman & Wakefield’s head of EMEA investment strategy, says improvements in finance availability and the low cost of debt are undoubtedly helping the core markets of France, the UK, Sweden and Germany. “This impact will continue to spread to new markets as competition to lend grows and banks and other lenders focus on building new loan books rather than just dealing with legacy issues, particularly as the ECB stress tests fall behind us,” he says.

But with restrictions on their lending, banks are no longer in a position to write loans at loan-to-value (LTVs) ratios of more than 80%. Tarry says the “new norm” for senior lending is most likely around 65%. Borrowers chasing high LTV terms are more likely to use a range of sources of finance.

With larger deals becoming more common in France, the need for mezzanine has increased, according to Deloffre. “This year, we’ve seen some very large ‘mega deals’,” he explains. Several sizeable transactions have closed in Paris – including the respective €1.3bn and €700m sales of Coeur Défense and retail asset, Beaugrenelle, as well as BlackRock’s €426m sale to NBIM of Le Madeleine in the central business district in July. “The size of the volumes opens the door to mezzanine,” Deloffre says.

In the intensively competitive UK, borrowers are also likely to require more than one level of finance. “The market is going towards large, trophy deals – where a combination of senior and mezzanine loans serves a purpose,” Wheeler says.

LTV ratios in France, Deloffre adds, are typically not going beyond 65%, on average.

Allianz Real Estate’s head of European real estate finance, Roland Fuchs agrees. With LTV levels reaching their “natural limit”, Fuchs says, mezzanine debt lenders have a role to play. “The gap will be filled by them. Stretched senior lending stops somewhere around 70-75%. If further leverage is needed, then that will be mezzanine loans rather than senior loans of up to 90%.”

However – and despite offering higher returns than senior debt – mezzanine finance, which ICG-Longbow provides along with senior and whole loans, risks being squeezed. “There is a ‘health warning’ that mezzanine could get squeezed by all kinds of capital – be that equity or senior,” Wheeler says. “You can’t be rigid in how you approach debt. Our second fund was initially conceived with mezzanine in mind, but we now see a bigger opportunity for whole loans and senior.”

Dittmann says the ability to write the whole ticket has given M&G a “competitive advantage”. As of March, M&G raised £1.5bn from Europe and the US for two junior commercial mortgage funds. A total of £605m was raised for its Real Estate Debt Fund II, aimed at the European mezzanine sector, while the Real Estate Debt Fund III closed at £750m. By June, M&G had written €1bn in western Europe.

Savills senior director, William Newsom, has questioned why insurance firms have not provided more finance or taken market share. “They distinctly offer long-term, fixed debt so that should be brilliant for borrowers,” Newsom said, having counted five new insurance companies offering finance in the UK, compared with nine in mid-2013. As 2014 ends, Newsom’s tally might simply indicate that insurers looking to enter the debt sector have already done so.

Tarry says while the flow of newcomers has slowed, there are still a few names looking to enter real estate debt. “The commercial real estate debt landscape now offers a multiplicity of lending sources.” 

Short versus long-term lending
Newsom has noted a lack of appetite for long-term debt among borrowers, who are now typically looking for short-term debt of less than five years. Despite the notion that institutional lenders are more likely to provide long-term debt as a consequence of their liabilities, Janssen says TH Real Estate’s debt platform is comfortable lending on five-year terms. “We have a variety of capital types and can do either fixed rate, lower leverage and long-term or floating rate, higher leverage and shorter term,” he says.

Tarry says Aviva Investors’ senior debt fund offers loan of five to 10 years, leaving anything above that level for its annuity book lending. Launched last year, the fund, says Tarry, has already been deploying capital in the UK, with fundraising due to complete by early next year.

Slater says Standard Life Investments can offer borrowers a range of terms, from three years up to 15 and 20 years in some cases.

Dittmann says the diversity of investors in its funds gives M&G flexibility. “Diversity of investors gives us the capability of offering both long and short-term money,” he says.

The investors Allianz represents, Fuchs explains, dictate loan terms, underpinned by a belief that debt provision is an investment for the long haul. “We have wide range of investors in the group,” he says. “The life insurance businesses, for example, will typically prefer seven to 10-year debt – while other entities will look more at the three to five-year period.”

Fuchs says that if risk and price levels became unreasonable, the lender will stop. “We are not here to lend at any price or simply to gain market share,” he says. 

Lenders will only respond to the needs of the market. With more lenders from a wider range of backgrounds and a similarly diverse investor landscape, real estate finance is more fragmented than ever.