There are no overwhelming challenges or headwinds impacting the real estate debt market in Europe at the time of writing in March, but there are several key observations that can be highlighted, which make today’s debt environment significantly different from the past.
While technically late cycle, amid the longest bull market for real estate in recent history, debt markets are not exhibiting ‘traditional’ late-cycle characteristics – primarily loose underwriting and pricing compression in early-late cycle or ultra-conservative underwriting and pricing expansion in late-late cycle. Indeed, instances of these conditions are periodically apparent, but they are still only anecdotal and not yet ‘market.’
The current debt markets in the UK and Europe are currently highly liquid, functional and competitive, and the observations below suggest they should remain that way for the foreseeable future.
First, the availability of capital vastly outweighs the amount of attractive investment opportunities in the market. Global dry powder in the equity markets now stands at a record $300 billion, according to data by Preqin and HFF, and while highly disciplined is ready to deploy even into small market corrections. This is resulting in transaction volumes approaching record highs. The outcome of this has been shorter and shallower cycles – mini-cycles if you like – over the recovery’s decade-long expansion.
It is also no longer accurate to label real estate an alternative investment sector, having been named the 11th Global Industry Classification Standard (GICS) back in August 2016, and independently it now makes up a meaningful and critical investment class of around 15-20 percent of institutions, family office and retail investors’ portfolios. Similarly, real estate debt is a better-defined investment class, so most institutional investors do not have the choice but to support a credit strategy.
Structural shifts in how lenders are monitored – think bank stress tests, Basel III and Basel IV, for example – and the tranching of debt, so that appropriate risk resides with investors most likely to be able to survive a downturn, should mean the current real estate debt market is sustainable for a very long time and is also able to withstand significant internal or external shocks.
Another observation is that a more diverse lending base should further allow for the sustained health of the debt market. In the UK, for example, there has been a marked shift in annual volume by ‘alternative’ lenders from around 10 percent to 20 percent in just three years, according to Cass and HFF data, and the universe of lenders has increased to some 250 plus sources, including domestic and international banks, insurance companies, alternatives and debt funds and investment banks. And because of the pure amount of capital available to deploy, these sources are embracing diversification, choosing to lend across all real estate investment strategies from core to opportunistic.
These trends also mean that there has been a rise and acceptance of the role of debt advisors in helping sponsors navigate the vast amount and various sources of debt capital to optimize their borrowing strategies.
My final observation of the European debt market is that there is a focus on financing lower cap-ex assets such as logistics and residential. Higher cap-ex assets like retail are either out of favor or in favor but at lower gearing levels, which applies to office and hospitality properties.
Five predictions for European real estate debt in 2019
- Expect a retail bounce, with more interest in the sector from both debt and equity investors. The US enjoyed this bounce about six to nine months ago.
- A continued drift toward covenant-lite loans for best-in-class sponsors, creating extra protection for borrowers in a downturn.
- New entrants – around three to five per quarter – will join the debt markets, including additional equity players creating credit products.
- Further expansion of traditional sources carrying out non-traditional lending –think debt funds pursuing more core pricing and insurance companies pursuing more value-add and opportunistic plays.
- Pfandbrief banks continuing to take less risk. This could increase margins and drag up other sources’ debt pricing, although more capital than deals will counter this and win, resulting in margin compression.