Real estate finance is as scarce today as it was in 2009. This year expect the European market to be dominated by cash buyers and opportunistic whole-loan acquisitions, write Barry Osilaja and David Lebus

The European real estate financing market has become severely constrained in the past several months as the impact of the European sovereign debt crisis has tightened its grip on many of Europe's major property lenders. The events at the end of 2011 have led to a liquidity squeeze in the euro-zone similar to that following the collapse of Lehman Brothers in 2008, resulting in co-ordinated central bank action to ease the availability of short-term funding.

Several factors have contributed to the lack of liquidity, and only by appreciating these is it possible to understand how the market might regain lost momentum.

Many of the major real estate lending banks across Europe have significant exposure to the PIGS (Portugal, Italy, Greece, Spain) countries, particularly Greek and Italian sovereign debt. It is clear from the table of lender exposure to Greek and Italian sovereign debt opposite that many of the institutions with major sovereign debt exposure are also major real estate lenders. However, it is worth noting that sovereign bonds only comprise 60% of the European bond market (source: AFME).

As a result, these figures are only the tip of the iceberg when trying to quantify the true exposure of European banks to the economies of Greece, Italy and other distressed European economies. More significantly, it does not take into account that most European companies receive the vast majority of their funding through bilateral loans rather than listed debt - which is the opposite of the situation of the US. Consequently, corporates and property lenders are more affected by the behaviour of banks than the capital markets.

It is not surprising that these factors have combined to significantly constrain the amount of lending that Europe's major balance-sheet lenders will advance, and cause others, such as Société Générale, to withdraw from the market in the short term, and in the case of WestImmo, entirely.

Capital adequacy has been a major issue for both regulators and banks since the onset of the financial crisis in 2007. Basel III regulations were drawn up in specific response to the failure of poorly capitalised financial institutions such as Lehman Brothers and Northern Rock, which were funding most of their longer-term capital requirements from short-term sources.

As the extent of bank exposure to sovereign debt has become clear, European regulators have taken a more conservative line on core capital reserves to be held by European banks. They are now required to reach a 9% core capital ratio by June 2012 as part of the euro-zone rescue deal. This is considerably more than the amount they are required to hold under Basel III. Additionally, there is specific pressure being brought to bear on German lenders by BaFin, the German regulator.

Perhaps the most significant recent withdrawal from the lending market from a real estate perspective is EuroHypo. Given their reputation as a leading cross-border real estate lender, the market has been particularly spooked by this, but it is symptomatic of the ongoing crisis, and should be viewed as part of a wider process of European banks acting on government pressure to reduce their debt exposure and increase regulatory capital, rather than a specific reflection on the paucity of real estate lending.

In for the long haul
In the immediate future, the hope of an improvement in the bank lending market seems forlorn. None of the traditional sources of bank funding are fully functioning.Balance-sheet capital is constrained, or is being withheld for regulatory protection. Banks are not lending to each other, as can be seen in the steadily increasing level of EURIBOR, at the same time as swap rates fall to record lows.

The Pfandbrief market is open, albeit volatile, but this is of little use for anything other than highly secure low loan-to-value (LTV) lending, unless banks are prepared to take balance sheet exposure.

Finally, the commercial mortgage-backed securities (CMBS) markets remain closed in Europe, despite making a brief return in the early part of 2011.

Where they have been issued, they are at prices that correctly reflect the strength of the underlying credit.

The current constraint in the finance market should not be viewed as a long-term phenomenon. While the wider financial markets are extremely volatile, and some lenders do have major issues that will take significant time to resolve, there is a sufficient weight of capital from new market entrants and relatively unaffected existing lenders to provide some weight of debt capital.

A number of more conservative European balance-sheet lenders remain open for business, and these will be increasing supported by a number of life insurers, who have been buoyed by new Solvency II regulations making it more capital efficient for insurers to lend on property as opposed to owning it.

A number of major European insurers are building platforms for senior debt-lending programmes across Europe. These include Allianz, Prudential and M&G Investments, Legal & General, and Aviva.

There are also new entrants from the US who are pursuing a European lending strategy, including Wells Fargo, MetLife and GE Capital. However, the market still awaits the saturation of capital from China, as postulated by some. It seems likely that markets where local banks remain relatively unaffected by the financial crisis, such as in Poland and Russia, there will be a greater availability of debt from local lenders.

There remains a depth of capital committed to mezzanine-style lending in Europe. This has been a trend for the past few years; however, there is now evidence of return expectations for these funds being lowered to levels that borrowers can afford to pay. There is also evidence of these providers seeking to provide whole-loan solutions for borrowers, either taking into account higher risk, or increasing LTV levels in return for higher cost of funds. Lenders such as Duet, Pramerica and LaSalle Investment Management have significant allocations for mezzanine debt.

The ongoing lack of debt will continue to restrict the growth of real estate capital markets across Europe. Furthermore, the onus will remain on financial institutions to improve their capital adequacy positions and reduce their debt exposure. However, one positive impact this may have for the market is to encourage banks to sell large portfolios of performing and non-performing loans.

It seems clear that European banks will also increasingly seek to improve their capital adequacy and reduce debt exposure by selling whole loan books. This is expected to be a major market across Europe in 2012, and will provide a certain form of liquidity in the market as a whole. Whether this leads to a general improvement in liquidity, especially of secondary assets, remains to be seen.

Additionally, it is likely that cash will become king again in 2012, as seen in 2009 when the financial system locked down, confidence fell and risk aversion increased.

As a result of the scarcity of debt, traditional property investors will struggle to compete with cash-rich purchasers. Consequently, increased activity is expected from private high-net-worth and sovereign-wealth purchasers seeking investments for conservation of capital, wealth preservation and stability of their global portfolios. In order to give sellers security, purchasers will be willing to pay cash now and refinance later.

Given the expected softening of secondary pricing, the pressure on banks to reduce their real estate exposure and the general lack of debt financing available in the market, 2012 could become the year of the opportunity fund. With secondary bid-ask spreads anticipated to narrow by the middle of next year, when vendor expectations will become more realistic within the new pricing environment, there is likely to be more opportunity fund activity in the direct market. Furthermore, most opportunity funds are well financed, which will give them a competitive advantage.

While the CMBS market is shut, it is possible that in 2012 capital markets will become more active again, helping the real estate markets regain some liquidity.

This is likely to take the form of part-flotation of ‘bad bank' vehicles established by lenders to warehouse non-performing real estate loans. This would allow institutions to realise value from their non-performing assets, as well as maintaining some share in the upside. Some commentators have suggested this may be one way in which the largest bad bank in Europe - the Irish National Asset Management Agency (NAMA) - may seek to raise some of the capital needed to repay its funding from the IMF.

Barry Osilaja is European director and David Lebus is associate analyst at Jones Lang LaSalle Corporate Finance