Banks have been steadily withdrawing from commercial real estate lending in Europe since the Global Financial Crisis, partly due to stricter regulatory requirements. High inflation rates, rapid interest rate hikes and a fragile economic outlook are accelerating this trend as we go through a phase of asset repricing in Europe. The result is a materially widening funding gap in the commercial real estate market and hence a potentially much larger market share for real estate debt funds. For investors in private real estate debt there is a compelling opportunity to benefit from higher returns on new loans at lower leverage levels and tighter security structures.
New market environment
The new interest rate environment is putting pressure on real estate valuations and creates a risk on upcoming refinancings of maturing loans from 2018/19. The all-in cost of debt has more than doubled since the beginning of the rate hikes in 20221 , and this has been impacting the availability and pricing of new real estate loans. Moreover, lenders are lowering the LTVs they are prepared to offer on new loans with the Interest Coverage Ratios often being the bottleneck in the debt sizing.
On the other hand, there are no signs of a systemic credit crunch, as seen in 2008/09 because leverage levels are generally lower and debt funds have provided borrowers with much more choice and flexibility than previously existed. However, the banks continued retrenchment from real estate lending is accelerating across Europe because of the impact of rate increases. For many borrowers, debt funds have now become a natural solution to the widening funding gap.
The case for private real estate debt
From a lenders perspective, the current market environment represents a compelling opportunity to move down the risk curve by providing loans at lower LTVs on a repriced asset basis, whilst achieving higher returns than before the rate hikes. Moreover, debt strategies are currently yielding higher returns than many equity strategies whilst being of course less risky. According to the INREV Investment Intention Survey 2023, private real estate debt has emerged as the preferred strategy for investors and will remain so for the next two years in Europe. Real estate debt investments provide attractive risk-adjusted returns with a high recurring income component, downside risk protection, and diversification benefits as investors can relatively easy gain exposure to a variety of real estate sectors and geographies across Europe.
In comparison to listed bonds issued by REITS or publicly traded property companies private real estate debt offers some key advantages. Private real estate debt investments are typically secured by the underlying real estate collateral. In contrast, listed bonds are typically unsecured. Additionally, private real estate loans may offer the potential for higher returns than listed bonds due to the illiquidity premium associated with the financed assets. In addition, as bonds are traded their market valuations involve a higher degree of volatility, whereas private real estate loans are typically valued on an amortised cost basis subject to impairment tests.
Esg considerations in lending
Despite the fact that lenders are not supposed to manage the assets provided the loan is performing, they are taking a more active role regarding ESG considerations. Direct origination of loans allows for thorough ESG assessment of the business plan of the sponsor of the transaction. In addition, it provides the lender the opportunity to negotiate specific ESG loan criteria and covenants that can be monitored consistently after funding. An obvious example is the target ESG certification of a property, as it will have a positive impact on the future liquidity and value of the asset. As such, the focus on environmental and social characteristics will improve the relative performance and value of the collateral and hence lowers the loan’s risk position.
1. Edmond de Rothschild REIM, 15.08.2023
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