Europe has made significant progress towards a more diverse funding market, but is now facing serious headwinds as a result of the postponed implementation of liquidity requirements for banks, according to leading industry executives.

Europe has made significant progress towards a more diverse funding market, but is now facing serious headwinds as a result of the postponed implementation of liquidity requirements for banks, according to leading industry executives.

The deferment of Basel III rules for the banking industry may cripple growth for alternative lenders, Anthony Shayle, head of Global Real Estate – UK Debt at UBS Global Asset Management, told PropertyEU. Ultimately, this could drive the old continent back to a funding environment dominated by the banks, he warned at a recent Debt Investment Briefing held by PropertyEU.

Another threat to debt funds is posed by the likely return of an active CMBS market. Institutions may prefer to put equity in a liquid bond-type of investment instead of having it locked in more illiquid real estate debt. Here is an overview of some of the key issues that were discussed during the briefing. Aside from Shayle, the participants included Raphael Brault, head of Separate Accounts and Funds, AEW Europe; Philip Cropper, senior executive director, CBRE: Paul Stone, general manager North-West Europe at Aareal: Peter Lilja, director, Situs Nordic Services and Adolfo Ramirez-Escudero, president, CBRE Spain. The meeting was moderated by Richard Betts, associate publisher PropertyEU.

PropertyEU: The debt gap has become less important in the recent past but does that mean it has gone away?

Raphael Brault, head of Separate Accounts and Funds, AEW Europe: It depends on the market. Clearly in the core markets there is a financing surplus, while in Italy and Spain there are still some financings gaps. DTZ put the current debt gap in Europe at $42 bn and Spain probably accounts for one third of this. The market is also pretty segmented: it is no problem to retrieve financing for core product but when it comes to secondary assets it becomes more difficult.

Anthony Shayle, managing director, Head of Global Real Estate -- UK Debt, UBS Global Asset Management: ‘I do see substantial pockets of debt which are still short of capital in the UK. If you look at core product, there is a big volume of capital out there looking for a home but the availability of debt does dwindle quite rapidly for developments and less favourable regional investments.

Philip Cropper, senior executive director, CBRE: I think that in lots of situations, particularly for historic loans that need refinancing, the gap is on the equity side rather than the debt side. While 12 months ago there was still a significant debt gap, today all traditional banks are back out there again. There is still a debt gap in that you cannot borrow more than 75%. Often borrowers have a bit of the equity part missing to be able to refinance, therefore they have to bring in partners on the equity level. The question is whether borrowers trying to refinance are prepared to allow new equity in to enable them to recapitalize their position, because they do not want to lose control on their investment.

PropertyEU: What are the differences in financing among the different regions in Europe?

Paul Stone, general manager North-West Europe at Aareal: It is very hard to find debt in the Netherlands in certain sectors such as offices. In Denmark it is very difficult if you go outside of the city centres and most of the assets are owned by institutions which don’t need debt, so anything small or regional is a problem. In the UK the situation has changed in the past six months: investors are drifting out to the regions because core has become expensive.

Peter Lilja, director, Situs Nordic Services: Not only in the Nordics, but in most of Europe there is a well functioning financing market for core and all the lenders are pitching for the same transactions. We are getting closer to the US situation, where only 50% of real estate financing comes from the banks with the rest being provided by alternative lenders. That movement has started in Europe and will continue, but meanwhile debt funds’ expectations on yields have also changed and alternative lenders have become more competitive.

Stone: At Mipim, I had so many questions about our Madrid office and whether it is looking to lend. No one was talking about Spain a few months ago. Investors are looking at yields and chasing higher yields in Europe’s core markets.

PropertyEU: If you are seeing this level of demand for Spain, does this mean that you are starting to think about lending there?

Stone: Where there is more competition margins come down, so we are going to be selective but yes, of course, we want to carry on doing business with our key customers and if they are going to Spain we will follow their course.

Lilja: We are also opening an office in Spain in the next weeks. This is basically to do loan servicing but also to follow some of the debt funds investing there.

PropertyEU: As LTVs increase and debt providers move up the risk/return curve, how will this play out for the debt funds?

Brault: 70% loan-to-value has definitely been reached and lenders are up to 75% now, even the German banks. This change could have been expected even 12 months ago but not in such a short timeframe.

Cropper: Investors are chasing returns. If you are a debt fund, when margins come down you have to go to the next market. So we are starting to see debt chasing yields, by moving into more higher-risk jurisdictions which still offer the returns investors are looking for.

Shayle: Coming from the fund management side, I have to be honest with my investors. I don’t like the idea of playing fast and losing with my investors’ money by going up the risk/return curve. It is important not to pitch the fund’s returns too high, which is a temptation for everyone. Another, more ‘avant-garde’ solution is telling clients: we didn’t quite get the opportunities we planned, and we are therefore giving you back (a part) of the money. I wonder whether investors would value that actually more than going out there deploying capital seeking a risk/return that they never bought into in the first place.

Adolfo Ramirez-Escudero, president, CBRE Spain: The market is very dysfunctional, at least in Spain. There is clearly much more equity than debt available and, while I agree that the market is totally polarised, assets that are clearly more equity-intensive are positioned to offer once-in-a-cycle opportunity.

PropertyEU: What is the likely impact of regulation on debt and lending; will the debt fund market be crushed as the banking industry recovers?

Brault: Two years ago, all traditional banks in Europe were trying to shift money from traditional lending to the originate-to-distribute model. Today we see more banks coming back and keeping the loans on their books. Basel III will materialise at a certain point but banks for now are rebuilding their balance sheet. It is going to take more time to see a profound change in the market.

Shayle: We stand at a crossroads at the moment. Banks could return substantially and the market could move back to where it was in 2006 and 2007. In that case the fledgling alternative debt market could be crushed out of existence, that is a worrying possibility. We need to try and get a financing market as it is in the US. Postponing the implementation of regulatory control was ultimately not a good decision. The lack of diversity is what caused the significant amplitude of displacement of capital six years ago. The drop from peak to trough in 2007 and 2008 in the property market was due to the massive volatility that banks introduced in the real estate return equation. We stand at a crossroads, it is up to us - the industry - to decide, do we want to have a rich, diverse funding market which everybody can rely on or are we looking to go back to where we were a few years ago?

PropertyEU: What is the attractiveness of debt for investors and what could be the impact of a substantial return of CMBS structures?

Brault: The debt market still attracts capital. Clearly investors will consider venturing into the debt market if there is arbitrage in trading liquidity for higher margins. However, there might come a point where the margin compression that we are experiencing might make the arbitrage not as compelling.

Cropper: It is interesting to see that investors coming into the debt market are chasing slightly higher returns. They stress the fact that they are whole loan lenders, not just senior lenders, in order to keep the higher level of loan-to-value [i.e. mezzanine debt] and sell down the senior part. There are signs that the CMBS market might gradually come back, albeit in a new form. Investors are starting to talk about building pools and creating securitisation. Hopefully the underwriting will be a lot better than it was in 2006 and 2007, when in some cases it was atrocious.

Shayle: Institutions are doing the following: they see returns, they go after them, then the market moves a bit further on, and they follow it. They chase returns. What worries me is that once institutions start seeing liquidity distribution in the form of a CMBS, they will say ‘actually I don’t want an illiquid credit, I just want the bond-like type of investment’. If securitisation returns investors might move away from loans.

Lilja: On the other hand, institutions going for direct loans have control over the investment. More sophisticated investors will stick to direct lending because they are in control.

Brault: Long-term investors such as insurance companies do not mind trading liquidity for spreads. So I believe that there will be a segmentation of the market.

Cropper: Most people investing in real estate have a three-to-five year investment horizon while institutional investors would like to lend for 7 to 20 years so in this sense there is a mismatch in the market between lenders and borrowers.

Shayle: I believe there is a solution for this. We need to look at the US model where several funds start life as closed-end vehicles and then convert to open-ended at the end of their life. This is because in the early years the fund does not have the massive liquidity required to match redemptions [but it does later on]. This way debt funds can offer institutional investors an element of liquidity as well.

Virna Asara
Correspondent PropertyEU