Traditionally, banks in Europe were the largest providers of debt finance. According to Morgan Stanley, in 2012 banks and banking products accounted for 90%-95% of the market in Europe. This represents a significant stake compared to the United States, where banks and banking products account for 55% to 57.5% of the market.
Before the global financial crisis, Europe registered a significant expansion in real estate debt. This was mainly because traditional lenders were able to provide debt at historically low margins and to transfer risk to third parties via securitisation. In mid-2007, the possibility to securitise commercial real estate loans ended in the United Kingdom, as secondary market volumes slowed down, leaving banks with low-yielding, over-leveraged properties.
Therefore, investors started to seek better risk-return investments with less volatile yields. In an economic framework of weak debt supply and low yields, capital markets started to play a major role in financing real estate debt. This led to an interest and appetite in Commercial Real Estate debt (“CRE debt”) as an attractive and competitive investment, especially in Europe.
Commercial real estate debt investments: profile and pricing
A CRE debt investment is similar to a fixed-income bond investment, as tenants provide regular interest payments. It can be tailored to match the risk-profile of the investors.
The attractiveness of a CRE debt investment is the predictability of its return and the hedging against the property market value’s volatility. Usually, the rent generated by the property is higher than the debt repayments, and the value of the property is higher than the outstanding loan amount. Therefore, CRE debt investments offer attractive, predictable returns with a conservative and risk-adverse profile.
According to the Cornell Real Estate Review’s Acquisition of Distressed Commercial Real Estate Debt, the main factors driving CRE investments prices are:
- loan exit strategies;
- terms of the loan;
- underlying collateral cash flow;
- value of the loan;
- borrower financial strength; and
- guarantees and collaterals.
In addition, the target rate of return is an important factor as it reflects the risk of the property itself, as well as the market and the loan resolution strategies.
Change in the European Debt stock
Since the beginning of the financial crisis, the number of loans on CRE has increased significantly, i.e. by €23 billion, in Europe. The main driver of this increase is a change in the profile of the investors. Until 2013, the main players in the market were institutional investors investing in prime locations. After 2013, high risk investors entered the market in search of high returns (this was especially evident in the Spanish and Irish markets). Such investors generally make a strong use of leverage in order to maximise returns.
In addition, Europe experienced a structural change in the debt market itself. Since 2013, new players such as institutional investors have begun lending activities, as a result of which there have been more long-term loans against prime real estate on the market. This, coupled with the cut in interest rates by the major central banks, led to a significant drop in interest margins and in the cost of debt. The graph below confirms this trend, showing that only 55% of the European CRE stock debt is now linked to lending rolled over after 2007. The remaining 45% is related to loans agreed on after 2007.
Source: CBRE Capital Advisors
According to the most recent market studies, market activity, especially for non-core and non-performing loans (“NPLs”), is expected to pick up significantly by end of H12015. Sales are expected to reach €150 billion and investors have already raised around €100 billion (or €300 billion if you calculate to include potential leverage means).
Despite the entry of several property investment companies into the loan sale arena in recent years, distressed debt purchases continue to be dominated predominantly by US based private equity (PE) funds. PE firms were involved in 81% of all transactions completed in 2014; property investment companies accounted for just 10% and the remainder can be attributed to a combination of lenders, asset management agencies, and others. PE is especially dominant in the largest transactions. Of the 22 transactions over €500 million in 2014, all of them involved PE buyers (as illustrated in the graph below).
Source: CBRE Capital Advisors
In summary, we can pick out a few key observations:
- This de-leveraging activity will, we expect, continue to strengthen in Europe. Banks will continue to de-leverage their balance sheets in order to meet capital ratio adequacy, leverage ratios, and new regulatory frameworks.
- Certain countries, such as the United Kingdom and Ireland, are already reaching the end of the de-leveraging cycle.
- The sale of CRE loans will probably continue for at least one year.
- Peripheral countries such as Italy and Spain are likely to be the key markets for future loan sale activity.
- Prices for distressed real estate debt are expected to increase, as there is a growing demand for this type of investment.
- Debt investors raised €100 billion for Europe, with leverage—meaning that they have €300 billion in cash ready to invest.
For information please contact me or Paolo Barrotta.