Recovery is underway and new players are entering the market. However, a return of confidence remains a long way off, especially for secondary property, in spite of there being some good opportunities, as Lynn Strongin Dodds reports
The mountain of commercial real estate debt is slowly being whittled down but it could take years before a sizeable dent is made. There are multi-faceted solutions as well as providers who are offering variations on the equity, debt and mezzanine theme to plug the debt funding gap.
The latest research from property consultant DTZ, which canvassed lenders holding loans totalling $334bn (€230bn) in commercial real estate globally, estimates that the global debt funding gap will be $202bn over the next three years, down 17% on the approximate $245bn figure stated in its last report in November 2010.
The situation is much more mixed in Europe where both France and Ireland are still grappling with increases in their funding gap, while in Asia, Japan is in the unenviable position of having the largest absolute and relative gap globally. The country suffered a rise of $14bn to $84bn from late last year.
The UK is second in line at $42bn, although there was an encouraging 22% decline from last year’s $54bn. Spain is also high on the list albeit the gap is also narrowing at $28bn, 14% down on the $33bn in 2010 while in Ireland it stands at around $12bn. Other than France, which has a debt funding gap of $10bn, the remaining markets are all below $10bn.
“The gap is gradually being reduced but we have a long way to go especially in Europe,” says Nigel Almond, forecasting and strategy research at DTZ. “One of the main problems is that there is not a direct match between debt and equity available. There have been more consensual sales but both banks and borrowers do not wish to sell out at too low a price or release too much stock on the market at one time. The other issue is that although there has been a great deal of new equity raised, it has been mainly targeted at prime commercial property.”
The DTZ report shows that there is $403bn of new equity available for property investment over the next three years, up 7% from its estimate in late 2010 and almost twice the funding gap. However, investors are being selective.
As Philip Cropper, managing director of real estate finance at CB Richard Ellis, notes: “We have seen a lot of equity in the market and there are providers with deep pockets, but there is still a significant divide between the funding available for good-quality prime assets and poorer quality secondary or tertiary assets. For example, prime properties in central London do not have any problem finding funding. For other types of properties, prices need to be adjusted accordingly to reflect the secondary nature of the asset and to guard against the risk of falling rents and poor tenant demand.”
William Newsom, UK head of valuation at Savills, believes that “there are some hidden gems in the secondary market” and that investors should be more discerning when looking beyond prime, taking into account location, condition and long-term letability. Lenders also prefer clients with whom they have a strong relationship and who can add value to the properties.”
Newsom adds: “Overall, debt availability continues to be an issue for this market and we have witnessed a reversion to the historical model of the 1960s and 1970s when higher levels of equity were required. We are seeing different providers coming into the market including a new wave of mezzanine firms that can take advantage of low loan-to-value ratios in order to bridge the gap between senior debt and equity.”
Insurance companies and pension funds are also entering the fray in increasing numbers, although the former are not new to the game. Twenty years ago insurers were significant property lenders but were driven out of the market by aggressive pricing by the banks; today these organisations are set to lend around €60bn in European commercial real estate over the next three years, according to DTZ. They have already set aside €24bn for lending in Europe in this period, but that will more than double over the next three years.
Over the past year AXA, Allianz, Canada Life, Aviva, Met Life and Legal & General have announced plans to raise funds mainly due to the economics of investing in real estate debt under Solvency II. The regulation proposes capital charges of less than 5% on property loans compared with the proposed 25% charge for equity investments.
Nassar Hussain, managing partner of Brookland Partners, a real estate investment banking firm, says: “So far, we have not seen a huge amount of capital coming from insurance companies but that is about to change thanks to Solvency II and certain benefits that insurers will gain from owning real estate debt versus direct real estate. I also expect to see the re-emergence of the commercial mortgage-backed securities (CMBS) market in 2012, with the recent Chiswick deal being a sign of its recovery in Europe.”
The Chiswick deal was the first CMBS transaction since the financial crisis in 2007. It was a £302m (€334m) commercial real estate loan Deutsche Bank made to Blackstone for the £480m purchase of Chiswick Park in London in January. The £235m AAA-rated tranche and the £30m AA-rated tranche were both priced at par, paying 175 basis points and 275 basis points respectively over three-month LIBOR. The £37.2425m A-rated tranche was also priced at par and paid 375 basis points over three-month LIBOR.
Although the Chiswick CMBS was a welcome sign, industry participants are not celebrating. The European market is still haunted by the subprime deals that poisoned the US market even though they were virtually non-existent in the region, and many believe it will take time before investors can truly shake off that image.