Institutional appetite for real estate credit opportunities is growing amid an imbalance in supply and demand. Those institutions that actively provide credit are able to generate returns akin to those for equity investment while also occupying a more senior position in the capital stack. Investors therefore have a cushion against valuation declines along with increased returns in this environment of rising rates and margins.
The increase in demand for credit is being driven by an expected wave of refinancing creating a steep debt maturity wall: €150 billion of debt in European commercial real estate companies is set to mature by 2025. In addition, business plans formed in 2017 to 2019 are taking longer to realize, creating a need for gap financing to deliver on those plans.
On the supply side, credit is more limited as traditional banks pull back their exposure. Where borrowers are forced to refinance at a loan-to-value ratio lower than the one at which they first borrowed, or when the value of the asset has fallen since the loan was originated, a funding gap emerges. In addition, interest cover ratios for legacy loans due to refinance in 2023 dropped below 1.6, down from a 10-year average of 3.25, across all sectors. As a result, the debt funding gap in Europe alone is forecast to be greater than €32 billion over the next three years.
Lenders and borrowers will have to be creative to restructure the capital stack to reach sustainable LTV and ICR levels. They will have to look beyond maturity extensions and modifications to incremental capital in the form of recapitalizing, preferred equity and/or junior debt.
Given the requirement for incremental capital and the rising rate environment, all-in financing rates doubled in 2022 and reached 6.3 percent in the UK. Rates and credit spreads are back to levels not seen in a decade.
Most banks are unable to ‘kick the can down the road.’ Unlike during the global financial crisis of 2008-09, banks do not have the luxury of lower interest rates, while the regulatory environment is also more stringent. As a result, the demand for, and volume of, mezzanine debt will increase, resulting in excellent investment opportunities for nimble lenders and those institutions committing capital to real estate credit funds.
James Jacobs is head of real estate for Lazard’s private capital advisory group