BRIEFING: ‘Super profits’ erode as lending spreads narrow

The wide lending margins that attracted a new wave of alternative real estate lenders, including insurers and dedicated debt funds, in the aftermath of the global financial crisis have narrowed considerably, PropertyEU’s recent debt finance investment briefing heard.

‘There has been a significant shift in the dynamic of investors in the past three years,’ Anthony Shayle, managing director and head of global real estate and UK debt at UBS, told the audience gathered at the company’s German headquarters in the Opernturm in Frankfurt. ‘The super profits that lenders experienced in that period have eroded away as lending margins have come down. Average margins for senior debt are now around 3.5% compared to 5-6% in the peak years. Margins for mezz debt have come down too,’ he added.

Nevertheless, on a risk-adjusted basis, senior debt funds still offer good returns and a ‘highly attractive opportunity set for investors, Shayle said. UBS typically seeks loans below €40 mln, he added. ‘For the banks, there is still a clearly defined role in the market, particularly in vanilla lending on straightforward assets. If you go up the risk return curve, you need to have more of a real estate bias. There’s an opportunity for non-banks in non-standard sectors, like hotels, data centres and development. Most banks would have more trouble looking at these assets as they tend to be smaller scale. These can be interesting products provided you understand the underlying real estate. Otherwise it’s difficult to make a decision about the risk-reward profile.’

The smaller loan size bracket is an interesting space to be in, agreed Daniel Mair, partner at EY’s German restructuring practice. ‘There is less competition from the likes of Blackstone and Blackrock and you can get healthier returns without more risks than for the big tickets. So there is less risk and there are better opportunities.’

Prime risk?
A lot of investors think there is no risk involved in financing a prime asset, but Mair questioned that premise. ‘There are not many prime assets left so lenders are taking more risk with secondary locations. But it’s less risky to finance secondary locations than over-priced prime assets,’ he argued.

M&G’s Paul Dittmann also sees a strong argument in favour of large lots sizes. ‘It generally takes the same capacity to arrange a loan for €30 mln as for €100 mln. The key is to be disciplined.’

The big question is when will interest rates rise, according to Roland Fuchs, head of Allianz Real Estate Finance. 'The question is to what extent they will rise and in which markets. We are now in a comfortable situation, the spread provides a certain cushion. But we have to be cautious. We don’t know the exact timing and the extent of rise. But it’s difficult to believe that they will stay at the current rates.’

It will be quite some time before any major increase in interest rates materialises, according to EY’s Mair. ‘In the US, the FED (Federal Reserve Bank ed) is kicking the can down the road and it will continue to do that for a few more years. In the UK and Ireland, the central governments took more radical measures but in Europe, quantitative easing is just starting. Europe is taking very small steps and the money supply will stay at a zero or low interest rate for many more years. I don’t see any black swan that might be coming. It will come, but I don’t think it will come from one of the central banks. And until the black swan does come along we will remain in a stable environment.'

Questionable recovery
One of the elephants in the room is the question whether economic recovery is consolidating or not, according to Shayle. ‘Many factors in the real estate sector are driven by exogenous factors. We’re seeing a significant inflow of funds from Asia into the UK and Europe, but what will be the impact on already keen cap rates. The key issue which we should all be considering is what happens if economic growth figures start to wobble if income growth has already been paid for and is not coming through.’

Exercising discipline in terms of LTV levels is key to maintaining decent cashflows when interest rates do start to rise, Fuchs said. ‘Insurance companies like Allianz are not typically in the business of lending, but we know real estate is a cyclical business. We invest in real estate in general, both direct and indirect, and we know it’s important not to overshoot the initial equity. Lending at a moderate LTV provides some sort of a cushion, it provides an interesting alternative. At times when markets turn around, you have a risk buffer. That prevents an immediate write-down when rates rise.’

Monitoring debt yields to LTV is key, agreed M&G’s Dittmann. ‘We would be worried about the refinancing position in five, seven, 10 and even 20 years time. You need to keep your eyes open with regard to how long it can take and how bad it can get.’