The world is changing at pace, with this increasingly being true of the UK’s property market. But a key question often overlooked is whether the UK’s debt market is managing to keep up, writes Simon Mower.
In the past 18 months alone, we have seen a marked increase in the growth of “alternative” real estate businesses, including serviced offices, serviced apartments or co-working spaces, to name just a few.
Behind the boom, these businesses seek to better align themselves with a different type of occupier – one which approaches the use of space differently and rewards flexibility and a more customer-centric approach. While proving popular, growth in this area can also be attributed to the widening gap between supply and demand, so it’s fair to say the prospects for future growth of alternatives look strong. But what is happening in the debt market behind the scenes?
The UK’s real estate debt market has remained liquid, despite being slightly tempered by Brexit and the macroeconomic events of the past year. For the senior debt market – comprising mainly of banks and insurance companies – things remain highly competitive, particularly for traditional and established business models. Likewise, given the ability to de-risk positions against tangible prelets or pre-sales, lenders appear to prefer to be more traditional when it comes to development financing. Alternatives however, aren’t quite as straightforward and have been relatively underserved by comparison.
These rather nascent markets leave limited means for comparison, which unfortunately also mutes appetite. Letting data, for one, is often in short supply, making it difficult for valuers to substantiate support. Indeed, I often witness a very material expectation gap between the “red book” and equity valuations of these alternative assets.
Elsewhere, the customer-centric approach may well prove more popular with occupiers, but it inadvertently means that there is an intangible element in the build-up of rent and value that can’t be benchmarked. For example, amenity space, service wrapper, impact of technology and exclusivity of residence are all things that are hard for a credit investor to quantify.
Asset-first focus
The default position for lenders is to focus on the asset first, and then the business operating it. However, this drives lenders towards using vacant possession or alternative use value as a baseline, which isn’t reflective of these new business models. Similarly, these new asset classes don’t appear to fit squarely into one single lending desk at banks. For example, serviced apartments could sit anywhere between the real estate and hospitality desks.
All of these are understandable issues for an industry that has managed risk for decades. Indeed, such an approach has been viewed as best practice in a sector which has de-risked and de-leveraged since the credit crunch in 2007. But a key challenge I would put to the banking sector is that, in order to keep up with the ongoing evolution of property markets, the financing markets need to be equally flexible, or at least more so. A new opportunity does not necessarily mean an increase in risk.
Current options for alternative borrowers either take the form of using bank debt – which can be limited – or to make use of alternative lenders and the debt funds who can provide greater flexibility, albeit at a higher cost. But as the alternative market continues to make headway, a deeper pool of liquidity will be required. In fact, these ventures are often more heavily equity funded by comparison to more traditional asset classes, so where are the funds going to come from?
There is no silver bullet to help lenders overcome the obstacles presented by this new direction of travel, particularly given the increasingly regulated environment, but in my experience there are several core themes that will need to be understood.
Firstly, cash flows will remain king, and given that valuations of bricks and mortar currently underestimate the value of these alternative markets, I believe we will see more focus on debt yield metrics as opposed to traditional loan-to-value covenant measures.
As already alluded to, the operating business should become as important as the asset in the eyes of the lender. A track record of managing occupancy and rental levels can offer valuable precedent to demonstrate the impact a quality management team can have on a portfolio of assets, so this shouldn’t be overlooked.
First impressions
A fear of the unknown is always best overcome by experience, and lenders simply need to increase their understanding of these developing business models. Like a new friendship, first impressions do of course count, but so too do the prospects of a long term relationship. Both borrowers and lenders need to be thinking how they can help each other over a duration, rather than base their understanding of one another on a transaction-by-transaction basis.
Growth in alternative real estate assets is only likely to continue and become ever more critical to lenders’ real estate books, so it’s time to get ahead of the curve. Far from shying away from the unknown, we need to embrace the change of occupancy habits. This as an exciting time for real estate, and the debt market behind it.
Simon Mower is lead on real estate debt advisory, KPMG UK
