Spezialfonds are becoming a German success story, but even they are not immune to the lack of debt in the market, says Henning Klöppelt

Real estate Spezialfonds, which are reserved for German institutional investors, are enjoying a continual inflow of equity. Spezialfonds providers are therefore operating in a favourable market environment.

However, even these products are not unaffected by the wider conditions in real estate financing.

That is because - alongside the individual focus and targeting of institutional investors - their business model is also based on the availability of sufficient lending on the right terms.

In view of the historically low interest rates, the overall lending environment remains attractive. However, loan margins are far more expensive than they were in the years before the financial crisis. The impact on banks' ability to issue credit and the consequences of stricter regulation of the financial sector can be clearly felt on the real estate market.

The stricter regulatory framework is forcing banks to substantially increase their tier-one capital as a proportion of loans issued. Because little capital is available to banks, many institutions have been forced to reduce their lending volumes and a few of the players have suspended new business completely.

It is unlikely these institutions will return to the market with the sort of volumes as in the years leading up to 2007-08. Other players, such as Westimmo and Société Générale, have little or no market presence. Across all banks, there is a retreat to the country of origin and a few further core markets.

The situation for traditional real estate financing has improved slightly compared with the height of the financial crisis. Banks with sufficient access to capital have announced that they either plan to increase their new business or have already done so.

However, the competition this has triggered - reflected in the price of commercial real estate loans - is not comparable to the boom years before the crisis. For example, banks are demanding from borrowers not just the underlying bank and risk margins, but also a hefty liquidity premium.

While in 2007 margins of between 50 and 75 basis points were paid on high-end commercial real estate loans, today it is between 100-150bps (including liquidity premium), depending on the risk class. The poorer the rating of the respective bank, the higher the risk and liquidity premium, and therefore the more expensive the loan. This means borrowers are paying to rehabilitate the banks.

At the same time, real estate companies in the current environment must continue to accept that banks are more stringent when monitoring factors such as the loan-to-value ratio, real estate cash flows, risks, collateral, and potential liability of the borrower, and are thus imposing correspondingly high reporting requirements.

As soon as financing leaves what is generally regarded as safe territory - whether in terms of structure, volume or the characteristics of the property - it becomes difficult.
It remains possible to obtain loans for high-quality properties in Germany, the UK, and Western and Northern Europe. It is more problematic, however, in Southern European countries such as Portugal, Italy or Spain.

Here, the supply of credit is very patchy and margins range from 250-300bps. By way of comparison, in Germany they are between 100-150bps.

If the current system looks relatively calm, the entire real estate investment sector faces a challenge in the coming years for which no adequate solution has yet been found. Loans issued in the boom years before 2008 are due for extension in the short or medium term. Given the considerably lower availability of lending, difficult negotiations await borrowers.

Henderson Global Investors predicts that in the period from 2012 to 2014 alone, €450bn in real estate loans will expire. As of November 2011, around €92bn had to be raised to close the gap between expiring loans and available bank lending, according to an estimate by real estate service provider DTZ.

The financing gap is as wide as €33bn in the UK, and should not be underestimated in countries such as Spain, €22bn, and Ireland, €11bn).

How the gap can be closed remains an open question. Many of the loans were issued in the boom period from late 2005 to early 2008 and are unlikely to find new lenders in their current structure - at least, not among the banks, which are mostly focused on reducing risk and volumes. The search for alternatives is therefore now in full swing.

Insurance companies are making a visible impact in the real estate financing market. Their market share already stands at 14% in the UK. Experts predict they will provide as much as a fifth of all real estate loans in 2012 when it comes to major portfolio transactions.

Allianz Real Estate, for example, issued loans of around €20bn globally in 2011. Approximately €15bn of these were in Germany, although only just under €500m were senior loans, the rest going to private mortgage providers.

The same thing that is hindering the banks seems to be playing into the hands of the insurance companies: the new regulatory requirements. The relevant directive for insurance companies, Solvency II, could provide an incentive to become more involved in real estate financing, possibly even at the expense of direct investment in real estate.
The decisive requirement here is that every investment must be backed by a certain amount of capital. This means that from a risk standpoint it could make more sense to lend the capital than to invest directly in property themselves.

It is questionable, though, whether insurance companies will be able to close the gaps that have emerged. So far it is primarily the major established providers that are active in the real estate market and well positioned with their specialised property teams. With their relatively small units, however, they are not yet able to create the capacity required for mass-market business.

High-volume financing is proving particularly difficult. In the UK, banks and insurance companies are therefore already forming joint consortiums to finance transactions.
There is a further argument that suggests insurance companies will be unable to completely close the financing gap in the real estate market. Because of their risk profile, they are concentrating their property market activities on loans with long-term fixed interest rates and on core properties. This means they are of limited use when it comes to expiring loans.

Well-capitalised debt funds are more likely to be able to step into the breach. Their business model is to convert their equity into loans. They usually confine themselves to financing individual properties, providing either mezzanine capital or senior debt financing.

Their structure means they can offer favourable loans in the current market environment. However, there is no long-term experience with this product and it remains to be seen how this market will develop.

In view of the upcoming wave of refinancing, the parties involved will need creativity and skilful negotiation if they are to successfully re-finance expiring loans. The alternative - property sales at unfavourable prices - would not be a satisfactory solution for anyone.
The topic will also continue to occupy providers of Spezialfonds over the next two years. As the loans in this segment are of a manageable size, however, we see the current situation as being difficult but not critical.

Providers of good products will continue to find good financing when it comes to new business - albeit at a higher cost.

Spezialfonds remain popular clients, but they should bring with them a good capital basis and a strong pool of investors. Leverage will then continue to generate good performance.

Henning Klöppelt is managing director at Warburg-Henderson