After a frenetic period of activity, the market seems to be pausing for breath, with margins and financial covenants stabilising or even hardening.
Expectations of an impending (if not necessarily imminent) correction are mounting, but while the commercial real estate lending market is competitive, it bears little resemblance to 2005-07, and feels much less vulnerable. The banks are back, but they are not as dominant as they were, and there is little sign of really risky lending.
Regulation has played a key role. Slotting means high regulatory capital charges for both high-risk and safe lending by UK banks. As a result, they generally want to distribute to others much of what they originate. This is happening mostly through the syndication market, where demand is much stronger than for securitised property debt. And that demand isn’t just from other banks.
These days, property debt isn’t just leverage for property owners – it’s also an investable asset class in its own right.
Before the crisis, the main way non-banks could gain exposure was through commercial mortgage-backed securities.
Today, they can enter the syndication market – or they can choose from a range of loan or bond products (which may or may not be tranched or rated), or they can allocate capital to a broad range of debt funds (which may invest in new loans, or in European banks’ seemingly unlimited stock of non-performing loans).
A recent research paper from Standard Life Investments reveals that the European commercial real estate debt market increasingly resembles the much more diverse US market. Citing DTZ research, the paper notes that non-bank lenders and CMBS each account for more than 20% of the North American market, but less than 5% of the European market.
Standard Life sees a “unique cyclical opportunity” for non-banks to grow to 20% in Europe too by 2020, allowing investors to add diversified returns alongside their REIT and direct real estate investments.
Perhaps reducing the attractiveness of European property debt is the “lack of information to guide decision makers in European markets”, which forces Standard Life to base its research mostly on US data. Non-bank debt investors will surely insist on robust, comparable data, allowing them to analyse lending risks and returns and benchmark managers’ performance.
Ever since debt funds emerged on the scene, people speculated on whether they would be able to survive the inevitable return of the banks. A report from Berlin-based Scope Ratings offers some interesting and timely insights about both the popularity of debt funds and the challenges they face.
According to Scope, both insurers subject to Solvency II and certain other insurers and pension funds subject to domestic German capital regulations will benefit from lower capital charges for allocations to debt funds, if certain conditions are met. The conditions are different under the two regimes, but relate mostly to credit quality and fund managers’ ability to provide loan-level data and analysis. So regulation is again key: as well as reducing some banks’ competitiveness and the attractiveness of CMBS for regulated investors, it is positively encouraging institutional investors hunting for yield to look to debt funds.
But while debt funds continued to attract capital in the first half of 2015 (with capital raising beating 2014 totals), they have also continued to struggle to deploy it. Ever since the rapid improvement in market activity began a couple of years ago, many have faced a choice between reducing promised returns and going up the risk curve. Lender competition amid what Scope terms a “scarcity of compelling assets” means that only 29% of capital raised between 2010 and 2015 had been invested as at end June 2015. Even worse, Scope notes CBRE debt analytics research showing that cyclical losses render long-term commercial real estate debt returns unimpressive.
Scope’s advice to debt fund managers is to exploit their nimbleness relative to banks and other large institutions, while building operational systems that can deliver the loan-level credit analysis and data investors need for regulatory purposes. Beyond that, it is a matter of reducing target returns, focusing on higher LTV lending and broadening target regions and asset types.
If different types of lenders specialise in different ways, developing products and strategies that give them a competitive edge as this cycle progresses, the resulting structural diversity should benefit borrowers – and hopefully improve financial system resilience when the inevitable correction comes.
Peter Cosmetatos is chief executive of Commercial Real Estate Finance Council Europe
