Europe’s real estate lenders are continuing to supply debt but are increasingly wary of rising inflation and interest rates, delegates at the affiliate title Real Estate Capital Europe Borrowers and Lenders Forum 2022 heard last week in London.
“Certainly, lenders are being a little more cautious, and the main thing is the concern of the impact the volatility has on values of real estate, and so I think people are pulling back on loan-to-values,” commented Natalie Howard, head of real estate debt at UK manager Schroders, speaking on a panel at the event.
Howard noted a slowdown in activity as market participants ponder economic conditions ahead of the traditional holiday period across Europe. “I do think there is a little bit of sit-on-hands and wait-and see, certainly in terms of investing in real estate, renewing loans,” she said.
Looking forward, Howard argued lenders can take steps to mitigate uncertainty. “You need to underwrite more sustainable deals, so you can’t live with ‘this is valued at 2.5 to 3 percent [yield] now’. You need to underwrite as if the asset is valued at 5 or 5.5 percent. The second thing, which is key to our platform… is being a sustainable lender, so you naturally avoid the soon-to-be obsolescent, the tertiary, the stranded assets.”
Craig Prosser, head of UK real estate finance origination for German bank LBBW, expressed his belief the coming six to 12 months will be “very challenging” for the economy, with the probability of a recession in the UK elevated. “That uncertainty and recession risk is never very good for the banking market in general, not just for real estate, but for retail and corporate customers as well.”
Prosser said the rising cost of debt poses a challenge for lenders in managing interest coverage ratios. “If you take a prime City of London office at a 4.25 percent yield, geared at 60 percent at a say circa 3 percent cost of debt in January, the ICR was 2.5x. Now, say the all-in cost of debt increases close to 5 percent, the ICR is 1.4, so coverage ratios have become more challenging, even at say 60 percent loan-to-value. So, underwriters need to focus more on reserve accounts and lease events.”
As the cost of borrowing increases, equity investors and lenders will need to focus on rental growth prospects, Prosser added. “If your all-in cost of debt is close to 5 percent and if your cap rate is 4 percent, that’s a 2.5 percent cash-on-cash return if geared at 60 percent, assuming no rental growth. So, you need to be investing, or allocating debt into, the sectors where there are long-term stable cashflows and rental growth.”
For those pursuing high-yield lending strategies, economic headwinds represent a challenge and an opportunity. Jaime Martinez, head of alternative finance at Swiss real estate investment manager Stoneweg, said his firm looks for “high-single, low double-digit returns” typically.
“Certainly, I agree this kind of macro shock is heading us probably towards a recession, or at least a deceleration, and that is going to pose risks on asset valuations and that means underwritings will have to be more cautious. In the markets where we are present, southern European markets, there has been an increase in [lending] competitors which has translated into pressure on returns. So, now that is going to have to change. Otherwise, you end up pushed to do deals that shouldn’t be priced at those levels.”
He added: “I have to say though that this current environment of turbulence tends to be an opportunity for opportunistic lenders. This is creating dislocation, and this is something that represents opportunities for us. A situation where banks are going to be more cautious and more reluctant to get into situations is where we have to play a role, cautiously.”
Hanno Kowalski, managing partner with Berlin-based FAP Invest, considers the market as both a debt adviser and a lender. He believes Europe’s real estate debt market remains largely liquid despite the economic uncertainty.
In the senior loans market, rising rates have led to a significant change in pricing for those in need of refinancing, he said. “But on the mezzanine side, we don’t see such a drastic change yet, because there is competition, particularly for good deals. Capital is coming from the institutional investor side, so the funds have pressure to invest. Not lending is not an option.”
Kowalski added the economic situation is having a varying impact on different types of borrowers. “Investors that are equity-rich are still quite relaxed because they’ve been in the market for a long time, they’ve seen this before, and they’ve prepared. But some, particularly smaller, borrowers that do two or three developments at the same time are getting very nervous.”
Among the challenges facing sponsors, Kowalski added, is the rising cost of hedging. “We get emergency requests almost on a weekly basis, with people saying: ‘I looked at the cap or swap I need to do: the cost was €100,000 a week ago, and now it’s a million’. In the past they have been able to get a quote and leave it on the table for a few weeks. Now, they need to act to lock in the deal.”