Taking the lead from the US, the European commercial real estate debt markets have evolved significantly over the last decade with a variety of products, strategies and lenders serving the industry. In more recent years, non-bank lenders have increasingly focused on Whole Loan debt strategies that benefit from 1st ranking mortgage security over the underlying asset, but lend at slightly higher LTVs than the levels at which Banks and Insurance lenders are able to given their more conservative regulatory constraints.
From the lenders perspective, Whole Loans retain the benefit of a senior mortgage and are typically provided by a single lender. These characteristics are an important risk management feature of these loans. The senior mortgage secures the priority ranking on all recoveries and as a single lender, there is greater flexibility to manage the loan over its life.
Another advantage for lenders is that Whole Loans typically amortise over time reducing the principal outstanding, and when taking into account the interest income over the term, from an original capital deployed perspective, lender exposure to the original underlying asset value reduces significantly over time as amortisation and interest is received.
From the borrower perspective, Whole Loans provide the ability to achieve higher leverage with a single lender solution. This is particularly important given the current and future macroeconomic environment with most borrowers facing higher LTVs with their maturing loans.
The attractive characteristics of Whole Loans are found across the globe and geographic differences can offer some further diversity when investing in this strategy. The US is the largest and most established market, with a single legal framework and sophisticated borrower, lender and advisor base. Capital can be deployed quickly and efficiently, which leads to a more competitive pricing environment with multiple providers of loans and in general a tolerance for higher risk taking.
In Europe, the market is still in the process of maturing with a wide variety of different legal systems and market structures making it not as efficient as the US. While pricing power is better for lenders, it is arguably more difficult to source opportunities in Europe, meaning the origination reach of the debt manager becomes much more important. Less competition generally leads to a bit more return for the equivalent risk when compared to the US.
Finally, Australia is an interesting emerging opportunity with a lender friendly legal environment similar to the UK and a narrow heavily regulated banking sector. Historically, non-bank lenders in this market have focused on higher return opportunities, leaving the Whole Loan space underserved.
The supply/demand imbalance is expected to be very much in the favour of lenders for the foreseeable future as a result of 2 key factors:
- First, there is a large volume of debt maturing over the coming years across all the geographies that will need to be refinanced. Given the contraction in credit from banks hitting just as maturities are peaking, borrowers are more likely to seek financing from alternative lenders with capital to deploy. In general, these lenders can improve the quality and terms of their loans because of the reduced competition from the traditional lenders.
- The second factor compounding upcoming maturities is the dual effect of lower underlying property values and the increase in base rates. This results in reduced available leverage for a given property and increases the funding gap. The dramatic rise in base interest rates across most developed economies over the last 12 months means actual affordability of interest is in most cases the limiting factor in the amount of sustainable debt a property can carry. Borrowers lacking further equity to pay down existing debt will be driven to seek alternative financing strategies such as Whole Loans.
These two factors will result in Whole Loans playing a big part in the market opportunities emerging in real estate debt globally. Investors looking to tap into Whole Loans can gain geographic diversity and benefit from different market dynamics globally.
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