This article was sponsored by DRC Capital
DRC Capital, a commercial real estate debt advisory platform based in London, has seen a spike in enquiries following the UK general election in December last year – 50 percent more than in January 2019 – says the firm’s managing partner Dale Lattanzio, a sign perhaps of the market’s renewed confidence from having more clarity on the direction of travel of Brexit. Investors again seem ready to deploy capital. Lattanzio talks to PERE’s Noella Pio Kivlehan about how the real estate debt space has changed over the last year and offers up his predictions for 2020.
Describe the appetite for private real estate debt over the last 12 months? And which types of investors are particularly interested in this part of the market?
Private debt is gaining more acceptance as a true alternative to traditional bank lending across the European real estate markets. And by far and away the investors looking to gain exposure to private debt are the UK- and continental Europe-based pension funds, both corporate and public, and insurance companies.
But the trend we are really seeing playing out now is that the range of debt product offerings is broadening – alternative real estate lenders, like ourselves, are not only offering high-end mezzanine lending, but whole loan and senior lending. What is also changing is that the allocations from pension funds and insurance companies are no longer isolated to the real estate allocation; it is also coming now from fixed income, particularly into the senior strategies. This a natural evolution because the fixed income market and fixed income investors, given the low interest rate backdrop, need to look further afield for the kind of yields and incomes required for their portfolios.
What type of lending strategies are in demand, and why?
As the private debt market has matured in Europe for alternative lenders – it is now an established part of the financing market in the region – the ability to provide a one-stop solution to borrowers is increasingly requested. So, rather than go to a senior bank for a senior loan and an alternative lender for the stretch senior or mezzanine portion, borrowers are increasingly looking to alternative lenders to provide the totality of their requirements.
The reason for this is partly ease of execution and ease of dealing with a single lender as the project goes through its life cycle. It is just easier to have one lender to communicate with, particularly when it is a value-add opportunity.
The development of a one-stop shop model is again a natural evolution in the marketplace at this point – alternative lenders now provide 25 percent of all the commercial property lending in the UK market, for example.
Is it becoming more difficult to deploy capital?
It is harder for equity investors to find deals that will generate the targeted returns required, particularly as the market gets more competitive and the further along in the cycle we move. So this means looking for deals where more refurbishment or renovation work is needed to the underlying property asset and which can physically add value to the asset, because the market itself is not going in simply one direction anymore. This approach is becoming more prevalent and is increasingly important for borrowers that are trying to create a value-add type of return.
It is no longer enough now to rely on the income from property going up or yields compressing over the course of an investment to generate a return higher than the target. For alternative lenders, therefore, we will see this activity from equity investors translate into loan requests, so as they adapt we will see a change in types of lending.
How hard is it to lend in European markets today?
Recently, our business has been more active in continental Europe than in the UK. Transaction volume in the UK real estate market has been far lower than the historical norm over the last couple of years, and Brexit has certainly been a contributing factor. My sense is that it was not necessarily the direction Brexit was heading in – UK in or out of Europe – that was of concern to the market. Rather what the market needed was a clear direction either way, so that investors could commit capital on the basis of risks they can understand and underwrite.
DRC Capital has always been active in Europe. Since we began lending, roughly half of all the loans made have been on the continent. But I am seeing other lenders, which were previously more UK-focused, now growing their businesses in Europe. I believe this trend will only get stronger going forward.
This is not to imply that Europe is a safer bet than the UK market right now. There has been just more happening from our lender’s perspective, but I also believe we will see increased activity in the UK over the next year.
Are there particular property sectors currently attractive to lenders? And are there any parts of the market struggling to attract debt finance?
Industrial and logistics continues to benefit from great liquidity, with both equity and debt more plentiful – the need to serve the changing shopping habits of consumers mean investors are seeing good opportunities in this sector.
Offices, both in London and the regions, are also attractive. There is not tremendous over supply in this sector and nor has there been a lot of speculative development. Offices are in a healthier position than we have seen in different cycles historically, probably as a result of there being less development debt available.
Within residential, PRS (private rental sector) is a market that we can expect to grow in the UK, provided developers can find the sites that make economic sense. DRC Capital believes in the long-term need growth of PRS as the fundamentals for the UK mean more affordable houses are required either to buy or to rent. The BTR (build-to-rent) market is also a growth sector within residential for the same reason, but the problem with BTR is achieving scale because there is a lack of institutional-grade product available.
Retail is the sector struggling most to attract finance, particularly the shopping center segment of the market. That will probably continue throughout 2020 and is clearly a reflection of the growth of online shopping and the consequent decline in rents.
A fast view on green finance
ESG and green lending is set to play an increasing role in the private debt space
Dale Lattanzio: I have definitely seen an increasing emphasis on these issues over the last 12 months or so. Momentum is gathering pace and investors and other stakeholders are forcing through that change rapidly. Green finance has an important role, but the market needs to define clearly what that means and standardize green lending criteria.
Which country markets are interesting right now?
We have always been active in the UK market, however I think due to lower transaction volumes we have been less so over the past 18 months or so. I would expect that to change this year as we have more political certainty, and against that backdrop we feel there will be generally more market activity. For us, countries in western Europe of note are Spain, as well as the Netherlands; these are markets where there was significant bank lending that retrenched rapidly and the markets corrected deeply. The property markets are continuing a recovery and debt liquidity has improved, but is still behind some of the other markets. We are active elsewhere in the region, such as in Germany, France and Italy. We operate slightly more opportunistically in these regions for differing reasons. Property market fundamentals as well as banking conditions vary dramatically from country to country. I do not think our view will be altered this year; we will likely take a similar approach as we have historically.
Do you see more intense competition among lenders to win financing mandates?
The market is not overly competitive at this point because it is still developing with the non-bank lending element still growing, Borrowers have choices, but it is certainly not out of balance with debt being oversupplied. Further, the lenders operating in the market are all doing very different things. So, not every lender is offering the same products to borrowers – there is a lot of diversity in this part of the market and it is not yet concentrated.
I would expect to see more new entrants but this is still not something that is detrimental, as there is enough overall demand and opportunity.
DRC Capital’s Dale Lattanzio offers his thoughts on where private real estate debt is heading in the months ahead
Headwinds will continue to impact the UK retail property sector. Expect to see a similar trend to emerge across continental Europe as the internet continues to take market share in the region.
Alternative lending options will increase as a greater number of participants move to offer a broader range of product, both in the UK and across Europe.
Emphasis on green lending will grow with higher requirements on borrowers to ensure underlying assets are meeting or improving on ESG criteria.
Expect more activity in the UK than we have seen in the last 12 to 18 months, as some of the Brexit uncertainty is taken out of the market.