Real estate lending was widely expected to become more attractive to insurers under Solvency II, but there are now even doubts about this. John Forbes explains
The introduction of Solvency II and similar follow-on regulations will have a major impact on how European life insurance companies and defined benefit pension schemes consider real estate as an asset class.
The most immediate effect will be in 2013 as insurance companies prepare themselves to be regulated by Solvency II from 1 January 2014. Beyond that, the impact will be broadened as Solvency II-type regulation is also planned to be introduced for defined benefit pension schemes.
Looking further out, the effect is likely to be even more far-reaching. The regulation might help accelerate the demise of traditional retirement products. Unit-linked life products, defined contribution pension schemes and other new products will increase their dominance as more primitive species face extinction. The real estate industry is not yet well adapted to the new environment.
In the short term, there is continued uncertainty as to exactly what will come into effect on 1 January 2014. The most immediate concern for the real estate industry is the treatment of real estate lending by insurers.
With the pressure on banks causing them to retreat from real estate lending, many in the real estate industry had hoped that the attractive risk-adjusted returns for property senior lending would attract insurers into the market. As widely covered in the real estate press, a number of large insurers have established teams to enable them to expand into lending. Fund managers looking to raise debt funds were also targeting insurers, potentially opening up the opportunity to those too small to set up their own teams.
Unfortunately, the treatment of real estate lending under Solvency II, which had been looking attractive, is now significantly less appealing and less logical.
The draft implementing measures for Solvency II dated 31 October - which were never formally published but which have been widely circulated - introduce a significant change to the proposed treatment of commercial real estate lending. In earlier draft provisions, a specific treatment of property loans was included that took account of the value of collateral, using the property shock to adjust the value of the collateral. This provision is now restricted to residential mortgages.
Under the 31 October draft, other real estate lending has been removed from the counterparty default risk module and included in the general provisions for corporate bonds under the spread risk module.
The starting point under this provision is a credit rating by a nominated credit rating agency. This does not reflect normal commercial practice in property lending as individual commercial real estate mortgage loans are not rated in this way.
Furthermore, it is not clear how collateral should be taken into account. In the absence of any clear provision that would allow collateral to be taken into account, the assumption is that it should be ignored. If this interpretation is correct, it means there is no distinction between a real estate loan secured by a mortgage over a property and an unsecured loan, which would seem to be an odd place for the regulation to end up.
In late March, the European Economic and Monetary Affairs Committee (ECON) voted on its compromise amendments to ‘Omnibus II' of the Directive, the text of which was made available in mid-April. Following publication, Solvency II has now moved into the ‘trialogue' process to achieve consensus.
The directive itself does not deal with the market shocks, which are covered in the level-two regulation. The detail of the level-two regulations will need to be brought forward after Omnibus II is finalised. In view of the already very tight schedule between now and when insurance companies need to be fully compliant (by 1 January 2014), there will not be much time for debate and discussion.
If this unfavourable treatment of real estate lending is adopted, what does it mean in practice? Smaller insurers using the standard model will clearly find real estate lending - other than residential mortgages - less appealing than under the previous iterations of Solvency II. For larger insurers seeking approval for their own models, the position is less clear. What will the regulator accept and approve?
Although the treatment of debt is clearly a major concern for those looking to launch debt funds, it has a broader impact for the real estate industry as a whole if the availability of senior debt is curtailed.
There is more positive news for real estate investment managers regarding the treatment of real estate funds. One of the major concerns had been whether real estate funds would be treated as transparent or opaque. Real estate funds cover a broad spectrum; the nature of the investment vehicles varies considerably, as does the way in which they are financed, the levels of gearing and indeed the nature of the underlying investments.
For an open-ended vehicle with low levels of gearing and core real estate as the underlying asset, the transparent treatment would seem most appropriate. At the other end of the spectrum, a closed-ended private equity real estate fund with high levels of gearing and underlying assets with significant operating risk - for example, hotels - is difficult to distinguish from any other form of private equity fund.
Choosing either approach and applying it to all real estate funds would be highly inappropriate for one end of the spectrum or the other. Defining some form of segmentation through regulation is unlikely to be successful.
The treatment now proposed is that real estate funds are treated as transparent by default unless this is not possible. Some clarification is still needed as to who decides what is "not possible" and the criteria to be used. Generally, however, the outcome seems to be a pragmatic one.
Somewhat perversely, reducing the attractiveness of real estate lending may increase the attractiveness of direct and indirect equity investments in property. In general, the capital cost is likely to make insurers look more closely at their returns from investments. Although moving to lower-risk assets to reduce the market shock is superficially attractive, in the longer term the lower returns will be a deterrent.
Aside from the fundamental question as to whether Solvency II and similar legislation will change the behaviour of insurers and pension funds in the way they perceive real estate as an asset class, fund managers and others will also need to address the reporting implications.
This is again an area of uncertainty. The European Insurance and Occupational Pensionss Authority (EIOPA) published its ‘Consultation Paper on the Proposal on Quantitative Reporting Templates' and ‘Draft Proposal for Guidelines on Narrative Public Disclosure & Supervisory Reporting, Predefined Events and Processes for Reporting & Disclosure' on 8 November last year.
This was a consultation that ran until late January, after which EIOPA has been considering the feedback received and expects to finalise the package in the summer.
These snappily titled documents are a significant step forward in the process that will determine the public and supervisory reporting obligations of the insurers, which will in turn determine the level of granularity of reporting at the fund level.
As indicated above, the assumption is that real estate funds will be treated as transparent, so this reporting will need to be in respect of the underlying investments of the funds. Under Solvency II, insurers will have to demonstrate to their supervisors that the data they use are sufficiently complete, accurate and appropriate for their specific needs. External data, -including information from asset managers, will need to meet the same standards of quality, detail and verification as required of internally sourced information.
The key word in this regulatory requirement is ‘demonstrate'. Insurers will expect documented assurances from their asset managers that the quality, consistency and reliability of the risk information they supply, and the governance and control procedures that underpin this, are up to scratch.
John Forbes is real estate funds partner at PwC