The Orwellian double-speak employed by banks recently – their lips say they are lending to property while their hands withdraw it – has ended. Increasingly, they are admitting what everyone already knew – they do not want new property borrowers.
Many hope that new low interest debt will come from pension funds, insurance companies and real estate investment funds, in the form of senior debt.
However, there is little or no chance of plugging the debt hole left by banks. The solution to the real estate sector’s huge funding shortfall will, increasingly, come from a variety of sources.
Philip Cropper, head of real estate finance at CBRE, says: “The market as a whole needs to see more debt come into it. There is a huge amount of refinancing to be done and that is not all going to be done with equity alone.”
Banks are withdrawing more liquidity than they are putting in. The Scottish and Irish banks, which were the largest players in real estate debt, have in effect withdrawn to focus on core clients and reduce their property exposure.
Morgan Stanley Research in London published a report last month entitled Banks deleveraging and real estate. It identifies an estimated €400bn-€700bn (£327bn-£573bn) funding gap across Europe over an undetermined period, mainly from banks deleveraging and reducing their exposure to commercial real estate. It believes this top-end figure could be exceeded in a worst-case scenario, where a new crisis precipitates further falls in property values.
The report states that niche players, such as insurance companies, public and private equity and debt funds, will fill this gap only by an estimated €100bn-€200bn. Chillingly, it states: “We think banks with higher funding costs will find it harder to stay in CRE lending and may have to exit altogether.”
New players lining up
Enter property management funds, overseas banks, insurance companies and pension funds. Players such as Aerience, AEW Europe and Pramerica Real Estate Investors are currently raising funds. Henderson, AXA and Aviva, among others, are allocating existing funds for property senior debt.
CBRE Global Investors is also looking at raising a €1bn fund for senior and stretched-senior loans. “The market needs to be educated that stretched senior pricing is quite attractive, particularly if you control the senior,” comments CBRE’s Cropper.
Property investment manager AEW Europe, which has a Europe-wide portfolio worth €18.6bn, saw the opportunities afforded by the debt gap and, as Estates Gazette went to press, was due to gain approval from French financial regulators for a closed-end €500m senior debt fund, targeted at bank loan books in the €10m-€50m region, as well as some new lending.
Schalk Visser, head of investor relations at AEW Europe, says: “I don’t think banks will be permanently out of profitability. But for the next few years there are so many maturities coming up that any debt fund launching will get a slice of the pie.”
Preliminary discussions with insurance companies demonstrated to AEW that investors see opportunity in holding real estate debt, even secondary, rather than physical property. Its return expectations are relatively low – around 5% or 6% for the seven-year term – and its investor base will be largely institutional or of that scale.
“We will be doing prime and secondary. We will partner up with banks and take some secondary market loans off their hands, but we will also do new loans in the UK and Germany,” adds Visser.
There is a mountain of real estate debt that needs to be refinanced. If properties are now worth only 80% of what they were two years ago and banks intend to reduce LTV from 70% to 50%, then the equity gap that emerges will have to be filled with cash or debt.
If property borrowers do not look to refinance through debt, the only alternative is to accept the edict of the banks, which could allow a loan extension but equally be terminally punitive.
“That gap will be met by a combination of bank provision, the writedown of debt through equity being found and price reductions. Values are going to be hit,” says Cushman & Wakefield’s European head of corporate finance, Michael Lindsay.
He adds: “There is a lot of talk about debt funds, but I am not sure if there is a group of funds with definitive characteristics. Closed-end funds tend not to be focused on senior debt; most are mezzanine. What is prevalent are non-bank new entrants, like insurance funds.”
However, Lindsay believes there is enough hyperbole for dedicated funds to launch. “There is enough talk for something to happen this year, but it won’t move the dial much. It will be significant, but not enough to offset the withdrawal of bank capital.”
Various sources
The refinancing of existing debt and the day-to-day requirements of the property industry will come from various sources. Private equity and higher-interest debt, such as mezzanine structured finance and junior debt, have a vital role to play.
CBRE’s Cropper cites the assets likely to benefit from the emerging new debt market as those “falling into the IPD category – things that institutions would buy”. However, he believes the risk curve will be slowly moved up. “The debt markets will expand from prime to good secondary. But good secondary to poor secondary will take some time.”
Refinancing existing debt will be more expensive. Senior debt up to 50% LTV will be around 3%. Higher LTV, greater lease risk or secondary locations will cost around 5%.
“I suspect the figure will be around 400, 500 or 600 basis points. But that is not twice as much as banks will charge because they won’t lend,” says Fraser Greenshields, Ernst & Young’s head of property finance. “There is not a chance that these new guys will fill the lending gap left by the banks. A decent debt fund will be perhaps £1bn. There is maybe £10bn of new debt against hundreds of billions worth of maturities. The majority of loans coming up to maturity will struggle to get refinanced.”
The reality is that the gulf in available debt will not be filled until the banks fully participate again and that will not happen until the current aversion to risk subsides. They need to be able to sell down debt in the form of securitisation or debentures and that requires stability in the occupational markets.
“We are not there yet, but the US is and we are normally 18 months behind it,” says Cropper. Unfortunately, he made that comment before the dire US employment figures for March were released.
