Property Financing: Debt or Equity Gap?

The real estate sector is heading for a serious funding gap. Real estate companies wishing to borrow are expected to bring increasing amounts of equity capital to the table.

One of the most pressing issues the real estate industry faces—both now and in the years ahead—is the need to secure financing, especially follow-up financing. For many companies, the affordable long-term loans they took out during the low-interest cycle are successively reaching maturity. The shortfall in capital that will be required to refinance commercial real estate in Germany between 2024 and 2030 adds up to 25.3 billion euros. About 60 percent of this funding gap will need to be plugged by 2026, according to a projection by real estate service provider Colliers.

Just how these gaps open up at the ground level is illustrated by the following simulation: Let us assume that a solvent property asset holder financed an office property worth 100 million euros at a loan-to-value ratio of 65 percent in 2020. In other words, a bank facility of 65 million euros was granted to the borrower. Now, if the same borrower were to seek financing the same office property today, the latter would only be worth 80 million euros after a price correction of 20 percent. If, in addition, the bank were to lower the LTV ratio to 55 percent, the property asset holder would be eligible for a bank facility of not 65 but 44 million euros only. The 21-million-euro difference would have to be covered by equity capital. But equity is a limited resource, on the one hand, while the changed situation would further reduce the return on equity, on the other hand.

Interest Expenses Three to Four Times as High
At the same time, financing conditions have significantly tightened since the low-interest cycle: Interest expenses are roughly three to four times what they used to be. The rates charged for refinancing core assets are 3.5 to 4.0 percent at the moment, and 4.5 to 5.0 percent for non-core assets. In many cases, the rental income no longer suffices to cover the cost of debt.

To compensate for lowered loan-to-value ratios and diminished property values, banks often demand extra equity in return for follow-up financing arrangements. Since raising equity is much harder than borrowing, and since an adequate amount of capital is the precondition for leverage, there is every reason to speak not just of a debt capital gap but also of an equity capital gap.

Fresh equity is frequently obtained not from the original source but from external equity providers like private equity funds or joint venture partners. Whenever the need to refinance involves an investment fund, there is the option to ask for additional contributions from the institutional investors already committed. But if real estate asset holders lack the equity capital for additional contributions, the one remaining option is to sell off some of the portfolio assets.

Using Debt Funds Would Permit Higher Leverage
This brings us to the subject of debt funds as a hands-on solution that might help to offset the debt capital gap. For a long time, real estate debt funds were used for subordinated debt, especially in property development financing, meaning for junior and mezzanine tranches. Using debt funds was the only way to satisfy the return expectations of many investors in times of zero interest rates. Today, debt funds increasingly assume the role of senior-loan or whole-loan partners. Whole loans currently permit a loan-to-value ratio of about 70 to 75 percent, thus exceeding the leverage typical for bank loans by about 10 to 15 percent.

Interest on loans granted by debt funds are often—though not always—higher than the rates charged for bank loans. The difference has narrowed since the interest rate reversal, which in turn has made debt funds more attractive for borrowers. Another advantage is that loans from debt funds tend to be approved quicker and involve less red tape than bank facilities.

For investors, newly launched real estate debt funds whose new lending parameters match the benchmark rates achievable on today’s market promise a very good risk-return ratio. For example, conservative debt investors who invest exclusively in whole loan funds may currently earn annual dividends of up to eight percent at the fund level, depending on the fund’s risk structure. This is a higher rate of return than that of equity investments – further augmented by moderate exposure. The risk/reward ratio, which is significantly better than it was before the interest rate reversal, is further enhanced by regulatory advantages, e.g. as far as equity requirements for investors go.

For borrowers, the same factors are decisive for the granting of a loan with credit funds as with traditional German property banks: credit worthiness of the borrower, stable cash flows from the real estate collateral, asset quality, sustainability aspects and price stability within the respective use class. On the whole, real estate debt funds may not be able to close the funding gap, but they can certainly cover it to some extent.

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