The biggest opportunity is in senior lending. But this may also prove to be the biggest challenge, says Richard Lowe.
Looking for a snapshot of how the commercial real estate lending market in Europe is developing? Two news stories last week provided just that. Soon after Commerzbank performed an unexpected U-turn and announced Eurohypo’s planned exit from real estate lending, Cornerstone Real Estate Advisers revealed it had hired Laxfield Capital to help it establish a financing presence in the UK.
Both developments are reflective of a structural shift. Europe has been dominated for some time by bank lending, estimated to have had a market share of roughly 95%. In contrast, the US has had a far more diversified lending market since the savings and loans crisis, with bank lending representing closer to half of the market, the remaining share filled by securitised debt, insurance companies and private debt funds. You could argue this is a more robust setup.
It is common knowledge that banks are retrenching from the market, restricted by regulations and their own balance sheets. The CMBS market in Europe might not be returning in earnest anytime soon, but insurers are clearly becoming more active, and third-party debt funds are attracting a lot of interest from institutional investors. A glance at Savills’ latest list of Top 10 lenders in the UK shows the shift has already begun. If European lending is not necessarily going to replicate the US model, it is at least going to become similarly diverse.
The likes of Aviva, Allianz and now Legal & General will continue to execute large, long-dated debt deals, but the interesting area to watch is the mezzanine and shorter-term senior financing space, where there is an opportunity for third-party institutional debt funds to become a significant collective presence.
Cornerstone’s agreement with Laxfield is ostensibly a way for its parent company MassMutual to begin providing senior debt in the UK, something the US insurer has done for some time on the other side of the Atlantic. But the longer-term game plan is to establish a third-party debt funds business investing more broadly across the capital stack.
There are a number of other fund managers either actively seeking to raise capital for debt strategies or looking to move into the space. The challenge for them - and, by extension, investors - is that the opportunity is not clear-cut.
The first handful of European debt funds to successfully raise capital from institutions were marketed as pure mezzanine plays - that is, filling the 15-20% gap in the capital stack above the 60-65% senior debt slice. But that was two years ago. Today, typical senior loan LTVs are in the region of 50-60%, requiring the mezzanine slice to be stretched to 10-25%. This development was highlighted at a recent roundtable hosted by M&G Investments, a fund management house also in the market to launch new debt funds.
M&G has been active in the senior debt market on behalf of its parent, Prudential insurance company, but its first debt fund for third-party investors was a mezzanine strategy. M&G is looking to launch another mezzanine fund, but more significantly it is looking to run a senior debt fund for third-party investors.
The company is not alone in identifying the opportunity in senior. Henderson Global Investors is in the market with two debt funds - one junior, one senior - and John Feeney, head of real estate debt at Henderson, admits the latter is likely to be the larger opportunity in terms of volume.
But herein lies the problem. If the bigger opportunity is now in the senior debt space, what does this mean for return expectations? They are likely to be lower, is the obvious answer. It also poses asset allocation problems. It is easier to argue that mezzanine investments fit within a pension fund’s real estate exposure, but senior debt is often more akin to traditional fixed income investments, albeit with less liquidity.
Returns for senior debt may be very attractive relative to the risk being taken, but will they be compelling enough for real estate investors? There is a risk this opportunity falls between two stalls for asset allocators.
See the September/October issue of IP Real Estate magazine for more analysis on European real estate debt investment strategies.