Listed companies’ ability to access a diverse pool of capital will give them a competitive advantage among investors. Alex Moss and Fraser Hughes report
In this final article in the series we look at the opportunities presented to ‘four quadrant’ investors in the debt market. Focusing on the UK, we look at the scale and structure of the existing market and the opportunities and structures that are being created to refinance the traditional debt mountain.
The primary source for analysing the existing market is the De Montfort University report, which details the structure and maturity of the lending market in the UK. The headline figure is that with almost 70% - £160bn (€180bn) - of the UK’s senior and CMBS due to be repaid in the next five years, how long can the bank strategy of ‘extend and pretend’ continue, and with a lack of debt availability at loan maturity, what are the refinancing options?
According to a report by DTZ in May, debt in Europe is made up of 75% bank loans, 18% covered bonds and 6% CMBS. In North America the split is a little more diverse - 55% bank loans, 22% CMBS, 21% insurance companies and other institutions and 2% covered bonds. We expect Europe to become more diverse, perhaps mirroring the North American split, as securitised options replace traditional lending. The intentions of a bank such as the Royal Bank of Scotland (RBS) and Ireland’s National Asset Management Agency (NAMA) are likely to shape the way investors gain exposure to property debt, replacing bank lenders.
For example, RBS has a £1.6bn loan portfolio (Project Isobel) up for sale, with Blackstone, Lone Star, Starwood Capital and Westbrook Partners all shortlisted investors. If successful, the deal could lead the way to RBS winding down its £44bn of non-core property loans. RBS and its advisers have fine-tuned the structure to ensure that the bank takes the smallest possible write-down. Rather than selling down the equity in the portfolio in one go, RBS will sell down between 25% and 50% of the equity into a fund-like structure, and retain the remainder itself. This will be secured against the highest-risk, highest-return portion of the loan portfolio. Then RBS will sell down the remainder of the equity, preferably to institutional investors, over a period of months. This will allow it to reduce the write-down it takes and smooth it out over several quarters and also sell parts of the portfolio to investors with a lower cost of capital.
As it stands, Solvency II is likely to encourage EU insurance companies to switch from direct real estate allocations, which will be subject to a 25% capital requirement, to investment in real estate via lending. UK insurers’ holdings of secured debt have declined to an historical low of 2% of total assets. UK insurers could lend up to £30-45bn to real estate in the UK. However, the current lack of platform, processes and in-house real estate lending expertise could act as a constraint.* In an IPD survey, 18 EU insurers shared a commitment to property, both as a risk diversifier and a secure income delivery. Insurance companies AXA, Allianz, Canada Life, Aviva, Met Life and Legal & General have announced their intention to be active in originating senior debt and of being participants in syndicated loans throughout the UK and Europe. Insurers will play an important but limited role.
The UK CMBS market remains fairly stagnant and the pipeline of potential transactions remains extremely thin. Some CMBS instruments have secured extensions or have been restructured and changes in pricing are making new CMBS issues potentially viable. In the US, investor demand for CMBS has re-opened the market, with enhanced levels of transparency, reporting and mark-to-market relative to the UK. It is estimated that US$35-50bn will price in 2011.* US CMBS 3-5 year AAA spreads are currently sub-200bps - the European equivalents are currently just under 400 bps. Re-cap spreads were 14-16 bps during the peak! For the UK to progress, investors will demand more conservative structures and greater disclosures. New UK CMBS are likely to contain single assets only, such as the Chiswick Park £300m (three tranche) CMBS marketed by Deutsche Bank. The AAAs are priced at 175bps over LIBOR.
According to Credit Suisse there are 38 UK funds trying to raise around £10bn of equity for mezzanine investors. Twelve funds have achieved a first close - securing £2.2bn, with target returns in the range 7-20%: only 11% of the equity is earmarked for the UK. Recently, GIC agreed to loan £60m to Blackstone as part of the Chiswick Park transaction. Mezzanine will play a minor role, although it is an increasingly popular asset class.
German Pfandbriefe operate under stringent regulations. In 200 years there has not been one default. UK covered bonds attract a substantial amount of their demand from euro- or dollar-denominated investors, but they do not offer much granularity in the product for investors. The Bank of England supports the development of the UK covered bond market in a bid to help lenders raise the funds required to lend. Developments in this area will not reduce bank’s exposure to real estate but at least place some liquidity in the market.
For listed property owners the debt capital markets have become more popular. Issues have picked up in 2011 as companies seek to refinance existing facilities and rebalance their debt capital structure. Figure 2 shows the level of debt and equity issuance by listed European real estate companies since the beginning of 2009.
At the more exotic end there has been interest in derivative instruments generally, and within the debt market specifically, CDS spreads. However, these are shorter-term trading instruments predominantly suitable at times of financial crisis, although on a company-specific basis they have attractions.
In summary, investors have re-examined their real estate strategies in light of the financial crisis, Basel III and Solvency II. The over-riding theme is to group together real estate departments that have operated independently, to bring all real estate disciplines under one roof and use alternative forms of investment vehicles to optimise portfolios. We expect public debt to play a bigger role in the future and the bond and convertible bond market in Europe to grow. Liquidity in the secondary market will deepen as more investors become involved.
The lending markets will remain difficult, with the availability of debt decreasing and costing more. We expect more influence from the insurers as the banks try to navigate their way - by choice or design, bank lending will not return to historical levels.
Overall, listed real estate companies will enjoy a competitive advantage in accessing a diverse pool of capital and in offering investors attractive opportunities on both the debt and equity sides of the balance sheet.
* Taken from Credit Suisse presentation at the EPRA Reporting Summit
Fraser Hughes is director of EPRA; Alex Moss is head of Macquarie global property securities analytics