Lending is returning and CMBS has awoken but for the short term equity rules, says Thierry Leleu
In Europe, commercial real estate debt is a big driver of overall market liquidity, but the past five years have highlighted some important differences between Europe and the US in how debt has been deployed. Understanding these differences in the context of current measures being taken by different nations to support the commercial real estate market is an important step in the process of explaining the current lack of distress and planning for the future.
In Europe, the actual amount of debt issued and the degree of leverage used was far less than in the US. There was also a significant difference in the use of commercial mortgage-backed securities (CMBS) versus on-balance-sheet debt. Historically, the European commercial real estate (CRE) debt market has been dominated by on-balance-sheet lenders. It is only over the past three to five years that CMBS became such a sizeable component. There is currently $100bn (€66.4bn) of European CMBS maturing through to 2016 compared to $600bn in the US.
Banks, especially in the UK, still have to reduce CRE debt, though the speed of de-levering has created far less distress than expected, aided to some extent by low interest rates, government rescue packages and the unwillingness of banks to face the dire situation of their portfolios.
There is a correlation between total levered transaction activity during the peak years and the amount of distress we see now. During 2006-07, transactions totalled $415bn in the US, four to five times the level in any other jurisdiction. This means that, even taking into account the larger value decline overall in the UK, the US has seen much more distress than Europe.
There are signs that lending is increasing as some banks, in Germany for example, are offering loans on new transactions at attractive risk/return levels.
As for the UK, according to Goldman Sachs, bank lending to UK property companies grew 20% a year between 2000 and 2007. It even grew by 9% over the year to March 2009, most likely reflecting lenders granting extensions to their borrowers and borrowers drawing down on existing unused facilities.
According to the De Montfort University ‘UK Commercial Property Lending Report' (2008 year-end), 69% of UK CRE bank debt matures before 2014, while the majority of CMBS loans mature before 2013. These maturities are probably sufficient to handle the expected reduction in CRE debt over the next five to seven years, but also suggest that, to maintain lower levels of real estate exposure, banks won't be encouraged to provide many new loans to property companies.
A number of factors have conspired to reduce the pressure and urgency on banks to de-lever. Among them, the ability to work out bad CRE loans and ‘overlook' LTV covenant breaches, very low floating loan rates, bank rescue packages and a ‘re-opening' of broader capital markets. To date, banks have been reluctant to foreclose and continue to grant borrowers extensions, further limiting occurrences of distress. CMBS loans will, however, remain problematic due to the complexity of restructuring them. There are, after all, a multitude of creditors involved and differing interpretations of servicing documents.
Banks are still getting to grips with understanding the composition of their balance sheets, so there is limited appetite to manage LTV defaults. Banks in the UK are expected to write down $39bn of commercial mortgages, on a base of $344bn, implying a cumulative loss rate of 11%, compared with Euro-zone banks' $40bn, on a base of $1,272bn, implying a much lower loss rate of 3%. The US falls in between, with banks expected to write-down $100bn, on a base of $1,114bn, implying a loss rate of 9% (source: IMF).
Governments across Europe have offered tremendous financial sector policy support to help ease the global banking crisis, with the UK leading the way globally, according to the IMF. UK policy support equates to 52% of GDP compared with 19% in the Eurozone and only 9% in the US. However, as governments continue to finalise the various stimulus programmes, the worst-hit banks are likely to remain in a holding pattern. There will probably be more incentive for banks to move loans off their balance sheets as the capital requirements of holding high-risk loans increase due to regulators pushing capital ratios up.
As there is currently little appetite among lenders for large loans and the capital for large loans will probably remain scarce, equity will remain the major source of financing for a while.
That said, there is some activity in the debt market. Lending to property is returning, albeit in smaller volumes with LTVs capped at 65%. Spreads are higher, with funding for well-established operators now available at an all-up cost of 5.5-6% (a five-years swap of 3.7% and a 200-225bps spread). Much of this activity is dominated by German lenders taking advantage of the Pfandbrief covered bond market.
The CMBS market has also awoken in the UK, with $2bn issued since June, while $26bn has been issued in the whole of Europe since August 2008 (80% of this volume was structured and traded back to European governments as part of liquidity support measures), significantly higher than in the US ($0.9bn) and Japan ($2bn). Over 70% of the new CMBS volume are deals structured and traded back to central governments as part of liquidity support measures.
It appears that banks are less interested in refinancing opportunities, but are lending mostly against new deals where a clearing price has been found and a buyer is putting some real money behind the transaction. On lower risks and higher spreads this is a very profitable business - particularly if the loans are repo-ed with central governments.
As economic conditions stabilise and real estate yields begin to peak, it is likely that there will continue to be growth in transaction activity, albeit dominated by cash-rich equity buyers in the short term. In the medium term, as bank de-leveraging continues, a return to lending will play an important part in underpinning property values.