Deeply in debt

Gazing out over London from a private dining room on the 38th floor of 30 St Mary Axe, or the Gherkin as it unofficially known, are four seasoned senior bankers specializing in European property finance.

As is usually the case in January, it is raining heavily outside, making London's skyline dull and uninspiring. However, with the first course of lunch finished and the wine open, the conversation inside is warm and colorful.

Just back from Christmas—a well-earned break given the amount of activity last year—the four fi-nanciers are full of stories about holidays and family. But now back at work, their email inboxes are brimming with client requests and the outlines of investment propositions. It seems nothing has changed in the new year, which looks to be as hectic as 2006.

Though they share the same pressures of work and are based within a short cab or tube ride from the Gherkin, each of the bankers come from strikingly different firms: a British banking institution, Rothschild; a European global powerhouse, Deutsche Bank; the investment banking arm of a British high street giant, Barclays Capital; and the world's largest financial institution, Citigroup.

The diversity around the table serves to highlight one prominent aspect of the European real estate capital markets relative to the US: its fragmentation. But fragmentation does not equal inferiority. In fact, the four bankers assembled here today exert that the real estate debt markets in Europe are more sophisticated than in the US, where, they assert, a “cookie cutter” approach predominates. The European approach, they proudly suggest, is a more “bespoke” level of service, one that not only requires more creativity in financing, but also creates more opportunity.

“There is an argument to say that European deals can be more highly structured, more sophisticated and innovative than the US.”

LIQUIDITY EVERYWHERE
While the epic deals seen in the US, from Harrah's to Equity Office Properties, have not reached Europe yet, there has still been a significant amount of activity, particularly in the debt markets. Last year, for example, Citigroup and Barclays Capital arranged a $5.4 billion (€7.0 billion) bond issued against the mortgages on 164,000 German homes, one of the biggest deals ever seen in Europe. Transactions like this helped European CMBS issuance reach $76 billion in 2006, according to Commercial Mortgage Alert, a new record.

Given all the activity in the market, the four bankers assembled around the table agree that the past 12 months have been extraordinarily fruitful. Business, to put it mildly, has been brisk.

Cyril Courbage, managing director responsible for Deutsche Bank's European commercial real estate financing, refers to the front page story in that day's Financial Times: Citigroup has raised $3.3 billion for a new private equity fund. “There is a lot going on and it is across the board,” he says. “Everyone is talking about liquidity.”

David Basra, co head of European securitization at Citigroup, agrees: “I don't see that liquidity going away. Last year was a credit bull run and just when you thought things couldn't get any bigger or better, they do.”

Basra is talking about Blackstone's $36 billion bid for EOP, which has recently become embroiled in a takeover battle with a rival consortium. What was once seen as a relatively good purchase by many observers is now being watched more closely as the price for the company continues to rise. In Europe, liquidity in the property markets is having an equally dramatic effect on prices. Yields across the continent have fallen to such an extent that some participants wonder how investors plan to deliver value.

Brendan Jarvis, head of UK real estate coverage at Barclays Capital, says: “Yields in the UK have got to the point where I guess, across the globe, UK property is probably the most expensive.”

Basra counters by noting that although yields are low, this does not necessarily mean that property is too expensive. It is when investors are not paying attention to fundamental issues such as location and rental growth that problems will occur.

If investors are keen to invest capital in real estate, then the banks have been at least as keen to lend them money. As exemplified by the record amount of CMBS issued last year in Europe, more debt is being provided in the capital markets than ever before. This subject is raised by Jarvis, who points out that it is not just the amount of equity capital that is contributing to the current state of the market. “Don't you think that the debt market has helped compress yields as well?” he asks the other three participants.

He explains how the European debt market can be divided into two groups of lenders: traditional providers of secured debt, who have always put aside a certain amount to lend in any one year, and the arrival of other firms keen to participate in the activity. While the additional entrants have created more competition, they have also created a more deep and liquid market that has enabled lenders to mitigate risk.

“In the last two or three years the phenomenon has been banks like Barclays and others have built conduit for CMBS,” Jarvis says. “CMBS issuance has risen exponentially over the last couple of years. I think that has taken away some of the exposure from traditional property banks who have been ever more hungry to keep lending.”

Andrew Radkiewicz, head of property finance at Rothschild in London, concurs. “Banks are using their balance sheets in a much wider capacity and leverage is going up,” he says. “I think four years ago no one was really looking at the whole capital structure.” He points out that banks are now providing more mezzanine loans, for example.

As Courbage notes, these trends have led to a fundamental change in the market, one that has not only allowed banks to be more aggressive, but also to become more comfortable with real estate lending.

“The fact is that most of the risk is ending up where it should end up, as opposed to on the bank's balance sheet,” says Courbage. “Whereas in Europe it stayed until recently on the bank's balance sheet, now the risk is going to where it should mostly go, which is the capital markets.”

DAVID BASRA
Co-head of European securitization Citigroup
Basra joined Citibank in London in March 1997 and is co-head of European securitization. He has focused on originating, structuring, arranging and marketing a number of asset-backed transactions. Prior to joining Citibank, Basra worked in real estate with DTZ Debenham Thorpe. He has an M.Sc in Finance from Brunel University.

BRENDAN JARVIS
Director Barclays
Jarvis is a director and head of UK real estate coverage at Barclays Capital based in London. He has worked with the UK's principal real estate clients for a number of years and has originated many high profile deals, together with numerous bank and capital market corporate financings. Jarvis joined Barclays Capital in 2000. Prior to this, he held various roles in Barclays Group for almost 30 years.

RISKY BUSINESS
Nevertheless, storm clouds may be on the horizon. The four bankers are part of an industry that has syndicated risk to others, but there are still potential weaknesses in the system. Interest rates have been increasing across Europe and in the UK, where the Bank of England has raised rates three times in quick succession, yet another increase could be on the way. For those who borrowed highly when interest rates were significantly lower, refinancing could be difficult.

“With loans that were made two years ago or three years ago when rates were 200 basis points tighter, is there refinancing risk in a year or two?” asks Courbage.

Radkiewicz describes how clients are now talking to him about debt cost reduction. “It is now coming up on the radar,” he says, noting that his clients are telling him, “‘I can't see that value increasing through yield shift, so I need to go back to basics and focus on cost reduction and asset management.’”

For some, going back to basics has not necessarily meant investing in straightforward property assets. Many of the bankers' clients are now looking at new development in areas such as London's financial district in the belief that rents are going to increase from 2008 onwards. Others have been moving towards investing in non-traditional assets such as hotels, nursing homes and pubs.

“If you are currently looking at assets and real estate you really need to be able to see either rents going up or other ways of creating value given today's pricing levels in some assets,” says Basra.

For others, the answer has not been in development or nontraditional assets, but in new geographies where yields have not yet fallen to the levels seen in Western Europe. Emerging countries such as Russia, Bulgaria and Hungary are increasingly on the radar screen of private equity real estate investors and their debt providers. Yet even as the debt markets mature in these countries, the four bankers around the table do not seem entirely enthused. Most of their business continues to be in established markets.

Courbage explains: “We, like everybody else, have followed our clients, so we have spent a lot of time in Germany, Italy and the larger Western European markets. We have also spent some time in Bulgaria, Romania and Russia. They are noteworthy because they are innovative but they are not necessarily noteworthy in respect of their volume or their relative volume in respect to the business. I suspect that less than ten percent of our collective businesses will have been or will be in those markets in '07.”

Basra points out that there are several others markets, in addition to Eastern Europe, that have gathered steam in recent years. “Whether you are looking at the residential sector or commercial sector, Spain has been very hot,” he says. “Scandinavia has been again very active and Germany has been really active.”

Germany has undeniably been the hot spot of Europe over the past 12 months, with investors pouring billions of euros into residential, office, hotel, retail and industrial properties. The German open-ended funds, in particular, have been repositioning local portfolios, notes Basra.

CYRIL COURBAGE
Managing director deutsche Bank
Courbage is a managing director responsible for Deutsche Banks's European Commercial Real Estate Group's banking and non performing loan principal activities. Prior to Deutsche Bank, Cyril spent seven years at Merrill Lynch in New York and London initially focusing on distressed debt and more recently as a director in the real estate principal investment group.

ANDREW RADKIEWICZ
Managing director NM Rothschild & Sons
Radkiewicz has headed up the real estate finance group at Rothschild in London for six years, having joined the bank in 1996. The group has responsibility for Rothschild's activities in the real estate sector, which comprises equity, mezzanine and senior debt, as well as CMBS. An economics graduate from Warwick University, Radkiewicz has over 15 years of property experience.

PEER PRESSURE
Each country in Europe, be it Germany or one of the emerging economies of the east, present their own particular economic, legal and accounting challenges. For bankers, they also present lending complexities that are not found in a more homogenous market such as the US.

With so many cross-border transactions to contend with, European real estate bankers frown upon suggestions that their markets are less sophisticated than the US. Jarvis points out that the origination of the CMBS market in the US has probably led to that impression, but it is a charge that all of the bankers understandably counter.

“In America why CMBS works well is that product type is very standardized. It is cookie cutting,” says Radkiewicz.

More complicated structures such as collateralized debt obligations are growing in significance in Europe, though not as much as in the US. But the bankers' argument is that clients are getting a bespoke service in Europe, tailored to their individual needs and the particular requirements of a specific deal in a specific jurisdiction.

“Banks are using their balance sheets in a much wider capacity…Four years ago no one was really looking at the whole capital structure.”

“There is an argument to say that European deals can be more highly structured, more sophisticated and innovative than the US,” says Radkiewicz.

“The junior markets have developed in a different way,” he adds. “There is a lot of balance sheet holding in Europe. In the States, so much is commoditized so CRE CDOS are natural phenomena.”

Basra asserted earlier in the discussion that some portfolios that traded last year, particularly in Germany, required creativity. “Europe is just a lot more exciting than the US because there isn't harmonization. And actually, from a banker's perspective, it's a good thing because it creates opportunity. If all of our markets were just super-transparent and debt markets were all commoditized, we would all be bored.”

“The question of sophistication is an interesting one,” says Courbage. “In terms of technology, the market in Europe today has the ability to tap into as much of the technology as in the US. The non-investment grade market has taken much longer to come off the ground.”

Basra argues that there are probably less than eight banks that dominate the entire US landscape. “OK, a Barclays, or RBS and HBOS are very dominant in the UK, but that may not be reflective in other places in Europe where other local players will have greater market share.”

CRYSTAL BALL
Although the four bankers come from very different firms, there is an interesting amount of agreement between them. When it comes to their predictions for the rest of the year, there is one message that seems to stand out. In the words of Jarvis, expect “more of the same.”

While Basra agrees, he nevertheless warns that diligence and caution will still be required. “What is going to be very important is to keep an eye on liquidity and see how the market reacts and absorbs negative news and any weakening in credit,” he says, citing last year's collapse of US hedge fund Amaranth, which barely caused a flicker in global capital markets.

“You really need to look at what you are lending against because if you are on the right side of fundamentals and liquidity goes away, there is a backdrop of positive support,” he adds.

Radkiewicz agrees. “How long is the bull run going to continue for?” he asks. “It's difficult to see it going negative in 2007, 2008.”

With that note of optimism, the discussion ends and the four bankers take the elevator back to the ground floor. After all, there is plenty of work to be done.

Yet as the roundtable participants leave, they might do well to reflect on the building where they have just spent the afternoon in. The German fund IVG Asticus is buying the Gherkin for a reported price of €913 million. At the time the building went on sale last year, there was a significant amount of skepticism that the office tower would fetch such a high amount. But this is a very liquid market, as the bankers know all too well. They are still writing the checks.