Insurers no white knight for debt markets
Insurance companies have begun to provide much needed liquidity. But do not expect them to solve the funding gap, writes Lynn Strongin Dodds
A picture has emerged over the past two years resembling something like a cavalry of European and US insurance companies riding into the UK, while banks beat a hasty retreat. It is unlikely they will be able to save the refinancing day, but they are a welcome sight. Views differ on the final tally, but industry participants expect other larger players to eventually join the fray.
"We are seeing a huge structural change in the property financing market," says William Newsom, head of UK valuation at Savills. "There is a move to a whole new generation of non-traditional lenders with the insurance companies being the most significant group. They are not only big-ticket lenders, but they potentially can be huge liquidity providers."
According to the recent Savills annual report of UK real estate financing, the annual volume of lending will jump by more than 25% to £35bn (€44.2bn) this year and to £50bn by 2016. Six of the 16 lenders equipped to issue loans of more than £100m are insurance groups, including AIG, MetLife, M&G/Prudential and Legal & General, all of whom are relative newcomers to UK lending. AXA Real Estate Investment Managers, on the other hand, has been active in the country slightly longer, arriving in 2005, and the veteran of the group, Aviva, set up its property lending shop in 1983.
Savills' figures show that the top four to five insurers accounted for 15%, or roughly £4bn of the total amount lent in 2011, up from around 13% in 2010. They have been equally as active in 2012, with MetLife, which wrote more than £500m of business last year, funding two deals, together worth just under £140m. This included its second largest UK deal - £118m of a two-club £187m facility with DekaBank to fund Moorfield and SEGRO's £315m acquisition of Hermes Real Estate ‘s UK Logistics Fund.
Meanwhile, Goldman Sachs funded Blackstone's £325m Devonshire Square estate purchase from Rockpoint and ADIA with a £220m senior loan partially syndicated to AXA Real Estate. Aviva, on the other hand, arranged a £145m senior loan on a 20-year secured fixed-rate basis for South African investor Natie Kirsh's £283m purchase of the City of London's Tower 42 Estate. The insurer also joined forces with Canada Life in a £209m long-dated senior debt transaction for Picton Property Income. The funding will be used to repay the UK commercial property fund's existing CMBS facility and maturing bank loan totalling £185m.
"We chose to run with two insurance companies due to a combination of factors," explains Michael Morris, CEO of Picton Property Income. "They offered a better proposition in terms of pricing, with long-term gilt rates currently close to record lows and a maturity profile which better suited our operational requirements. Insurance companies are at present able to undertake larger transactions on an individual basis which is helpful and also over a longer period - generally over 10 years compared to the banks that are generally looking at five years and below. We chose Canada Life and Aviva because they each have over 20 years of experience lending on real estate in the UK market and have built a strong track record."
Lack of experience, though, is not stopping other insurers from throwing their hats into the ring. For example, Legal & General Investment Management (LGIM) made its maiden venture with its £121m loan for Unite, the UK student housing developer, while Cornerstone Real Estate Advisers, part of the Massachusetts Mutual US life insurance group, has recently launched a European commercial real estate lending group and has chosen UK-based Laxfield Capital as its partner. The group will help Cornerstone in sourcing, structuring and managing UK property-secured senior loans, with an initial target lot size of £25m to £75m.
Expectations are that over time insurers in the UK will account for 20%, the same market share held by their compatriots in the US, which has a long history of disintermediation and where real estate lending accounts for a major chunk of the total fixed income market. Insurers will have a harder time breaking into Europe, which is still dominated by the banks, and which DTZ estimates comprise 94% of loans and commercial mortgage-backed securities (CMBS). There have been a few deals, though, including Allianz's first property loan of €325m with a syndicate of banks to Germany's prime CentrO shopping mall in Oberhausen, while AXA Real Estate, one of the largest players with a lending capacity of around €5bn to invest over three years, is thought to be in talks to acquire €1.2bn of European performing real estate loans from French bank Société Générale.
Despite their growing presence, this is not the first foray insurers have made in the property lending market. "Historically, insurance companies had quite a large market share in the UK," says Emma Huepfl, director and co-founder of Laxfield Capital. "This changed as the banks became more competitive in the 1980s, but now it is the other way and banks are withdrawing."
Natale Giostra, head of UK and EMEA debt advisory at CBRE, says: "There are fewer commercial banks open for business, because it has become too expensive due to stringent capital constraints from incoming European banking regulations which reduce their appetite for commercial property lending. I think we will see an increase in the number of new players, such as the insurance companies and debt funds, coming into the market with the UK being the natural first stop. As they get more comfortable they will move to other major cities in Europe."
In the meantime, the bank exodus, which has included heavy hitters such as Lloyds Banking Group, Société Générale and EuroHypo, will continue. Their wings have been clipped by the onerous capital reserve requirements under Basel III, which in Europe is being implemented under the Capital Requirements Directive. In the UK, the Financial Services Authority (FSA) also plans to introduce slotting - a risk-weighting model for income-producing real estate loans which could have an impact on UK banks due to the amount of additional capital.
Under the FSA's proposed regime, banks would have to compartmentalise their commercial real estate books into five categories or "slots" - strong, good, satisfactory, weak and default - and attach different risk-weightings to each category, within a complex matrix. Property loans that borrowers are unable to refinance "on current terms" would automatically be classified as "weak".
According to DeMonfort University, close to £114bn of UK commercial property loans currently fall into this category, implying that UK banks would have to raise an additional £30bn in fresh capital. That is just under half the £62bn the banks received from UK taxpayers in the bailouts in October 2008 and February 2009.
By contrast, insurers are in a much stronger position. They do not have any legacy positions, plus they have significant capital that needs to be invested over the long term to match their liabilities. They are, though, much more conservative in nature and the majority are only focusing on high-quality, prime locations. They are also much more likely to structure loans with fixed rates of interest and discourage early repayments. The US has much more flexible terms because it is a long-established competitive market, but some see the UK following suit as it develops and matures.
According to Isabelle Scemama, head of commercial real estate finance at AXA Real Estate, there are several attractions. "Insurance companies and pension funds consider commercial real estate loans as a way to access stable and predictable returns that provide diversification in their fixed income allocation. It is a way to gain access to assets that once were owned by the banks and to reduce their exposure to financial corporate bonds at a time banks have to deleverage," she says.
"The premium is also here today. We can get an additional return of between 150bps and 200bps on real estate loans compared to similar risks on the bond market. Such a premium is a key driver in a low interest rate environment."
Solvency II had initially been seen as a strong motivating factor for insurance companies to move into the real estate lending market. But its significance has diminished over the past 12 months. This is because although the regulations are still being finalised, there are now question marks as to whether real estate lending will be treated favourably. Under the new proposals, insurance companies will be subject to an annual 3% capital charge on loans of up to five years, after which incrementally reduced additional annual capital charges on longer duration debt will be incurred. This compares to the original proposals, which would have allowed insurers to lend up to 75% loan-to-value (LTV) with zero capital charge.
For Ashley Goldblatt, head of real estate lending at LGIM, regulatory advantage was never the stimulus for commencing lending. "Solvency II was not the reason we decided to go into real estate debt. If you can't make the case for lending from a basic economic rationale, you shouldn't do it at all, because you never know how long any regulatory regime will stay in place. We always looked at Solvency II as the cherry on top of the icing on the cake."
Although the advantages are clear, the main obstacles are finding the right core properties as well as the expertise to analyse the deals. "It is important to have the right combination of skills," says Scemama. "You need people who can look at transactions from both real estate and fixed income perspectives. They not only have to be able to assess the quality of the properties in an underlying portfolio, but also assess the risk of the loan structure."
Looking ahead, there is no doubt that insurers will increase their presence, but most participants see them as a complement and not a substitute for the banks. "Insurance companies will play a significant part but they are only a component of what is needed as they tend to be very conservative, only interested in prime or super-prime properties and focused on longer-term debt," says John Feeney, head of real estate debt at Henderson Global Investors. "I expect to see new entrants from the US and Europe, but one of the main problems the market faces is that there are very few institutions ready to fund the huge overhang of lower-quality assets."
Paul Dittmann, head of senior commercial mortgages at M&G Investments, says: "The European CMBS market at its peak was originating €70bn per year. It is hard to envision in the near future insurance companies replacing this volume. It is estimated that Europe and UK will need to refinance approximately €200-250bn of commercial mortgages per year. In the past 20 years, European and UK insurance companies haven't been originators of commercial mortgages but are focusing on this market.
"We expect insurance companies originating up to €10-15bn a year in the next few years as they build their platforms. They have a finite amount of capital to invest and it is a drop in the ocean if you look at the entire refinancing needs of Europe and the UK."
Goldblatt agrees. "I do not expect insurers to be real estate knights in shining armour," he says. "If you add up all the balance sheet capacity in that sector, they can't possibly replace banks - even taking into account the flood of money that is talked about coming from these non-traditional providers."