As seen in the Autumn issue of Real Estate Capital, September 2021.
The pandemic has been a catalyst for many borrowers to seek alternative sources of real estate debt as they move beyond established relationships with banks. According to fund administrator Sanne, this has led to the emergence of new property credit funds across Europe, armed with capital that would previously have been deployed in equity investments.
Some pure equity players have moved into the debt space, while firms that already played in that space are increasing their allocations to debt.”
Real Estate Capital caught up with Miller, Simon Vardon, global head of real assets at Sanne, and Deepak Drubhra, co-founder of London-based debt advisory firm Westfort Advisors, to discuss the trends driving European real estate debt fund strategies and the key regulatory and structuring issues facing their clients in the closing months of the year.
Simon Vardon: Low interest rates have made it challenging to generate returns in the fixed-income space, so investors have been allocating capital slightly higher up the risk curve to real estate. However, in a lot of core markets, yields are relatively compressed, so some of those investors are now looking at the debt side as well as equity investments. Moving into debt is a natural progression for investors who understand the underlying real estate, because they can get comfortable with lending against the asset.
Deepak Drubhra: Also, overseas capital is flowing into Europe because investors are seeking to take advantage of the dislocation in the lending market caused by covid-19 and the retreat of the banks. In addition, there is some sector-focused capital from institutions that want to increase their exposure to certain asset classes and see good opportunities in the current climate right now to do that through credit rather than equity.
DD: Managers who were previously focused on equity investments are now moving into the credit space because they can achieve better risk-adjusted returns, together with good underlying security. We have also seen a lot of insurance funds and global asset managers set up direct debt lending platforms. Previously, some of these firms would have invested into other debt funds, but now they have significant exposures to CRE debt, they have decided to originate and manage their own funds. Banks withdrawing from the market have created a debt funding gap for alternative lenders to fill so the new market entrants are entering a competitive environment.
SV: Managers which run opportunistic strategies or special situations funds on the equity side tend to have a broad enough remit to undertake debt strategies too. They are increasingly doing so because they understand the underlying real estate well, so lending against it seems to be a natural additional sleeve within their funds.
Keith Miller: Over the past 12-18 months, alternative lenders have shifted towards senior funding at sensible loan-to-values, looking to pick up the slack left by the banks. And sponsors are increasingly comfortable looking to them for credit. Given recent events, the market probably should have been heavy with defaults, enforcements and workout situations. However, the private lending community has been incredibly constructive in how it has worked with borrowers during that period, which has helped to establish its credentials as a primary source of finance.
DD: Covid-resilient sectors have been the focus for debt providers: beds, sheds and meds. The office segment is polarising lenders but there is still strong demand for good-quality, well-located offices with strong income profiles or value-add potential. We are also seeing a great wall of capital looking for distressed or underperforming hotels. A significant proportion of new entrants are pursuing whole loan or development strategies. Development financing is mainly targeting the residential sector, whether it is build-to-sell, private rented housing, purpose-built student accommodation or later living. There is also a strong appetite for prelet logistics or office developments that have been de-risked for the lender. And, on the whole loans side, debt funds have been able to fill the funding gap left by the banks, providing finance at 60-65 percent LTV. Meanwhile, on the special situations side, managers that were previously equity buyers are looking at recapitalisation strategies. If the borrower defaults, these lenders feel they are well-equipped to take back the keys and manage those assets
KM: There is a lot of dry powder in the debt market. It is very difficult to put capital to work and the market is highly competitive. It is also difficult for new managers to come in and raise capital at the moment. They are all competing for the same capital at a time when we are emerging from a period of uncertainty. Consequently, there has not been an enormous number of fund closures across the debt space in recent months. Those that have done well at raising capital are generally very experienced managers with very good track records, whether on the debt side or in their previous equity investments.
DD: A lot of new entrants are running lean teams, so getting comfortable with the legal frameworks across different European jurisdictions can be challenging and therefore they focus on a single jurisdiction. Underwriting standards have been maintained throughout and there is a sharp focus on sponsor track record and capabilities. While there have been some adjustments to margins and leverage levels, debt providers are being very selective about the types of deals they will do. If anything, lenders are coming down the risk curve and are able to consider deals where they were previously uncompetitive.
DD: Government measures have preserved value over the past 18 months, but as those are lifted there will be a lot of stress and potentially distress coming into the market. In the UK, the Coronavirus Business Interruption Loan Scheme loans have supported a lot of borrowers, particularly in the hospitality space. They will come off their zero-percent pricing and there will come a time when borrowers will look to recapitalise not only that CBILS element, but the rest of the stack as well. We have also seen lenders offering covenant waivers, six-to-12 month loan extensions or standstills to existing arrangements. But, at some point, those borrowers will need to refinance their loans, which will create increased opportunity for alternative lenders, particularly as banks look to minimise exposure to certain sectors or are unable to refinance the existing leverage.
KM: Money has been raised over the past 12 months to target distressed opportunities, but when that will be utilised is another question. There was a widespread expectation that we would be seeing a lot of workouts at the end of 2020, and that has not happened. Instead, we have come out of the worst of the pandemic in a pretty healthy state across the debt spectrum. That is not to say there will not be certain situations which come up fairly soon because the cycle has played out a little bit further, or due to the withdrawal of government funding.
SV: The biggest issue is the post-Brexit marketing of funds into the EU, now that the UK is no longer covered by the AIFMD [Alternative Investment Fund Managers Directive] marketing ‘passport’. The default model is to use an EU-domiciled fund and AIFM, and Luxembourg has emerged as the domicile of choice for many of those vehicles. Another option is to go offshore and use jurisdictions like the Channel Islands, which have a long history of using national private placement, as well as some neat and simple fund products. If AIFMD compliance is not a critical need, that can reduce quite a lot of cost.
The other main regulatory issue is the hybrid mismatch rules that were introduced in response to the OECD’s BEPS (base erosion and profit shifting) project. Advisers will be looking carefully at managing the risk of potential mismatches arising where there are cross-jurisdiction funding flows. ATAD II (the anti-tax avoidance directive) will look to address that and to trigger corrective tax adjustments. However, it is better to structure funding arrangements mindful of ATAD II rules so that managers avoid getting tangled up in tax regulation.
DD: A big driver for ESG has been the motivation of limited partners. They are asking more questions about ESG when selecting which platforms to invest in. ESG is becoming a paramount question at every credit committee, even on the value-add side. Some lenders are beginning to incentivise their borrower clients to meet ESG targets, usually through margin adjustments. Meanwhile, on the valuation side, ESG is becoming a consideration alongside location and asset quality, so it will be incentivised not just in the debt, but also as investors come to buy and sell real estate, it will be a factor in the price.
KM: We see a lot of managers currently carrying out internal education around ESG while putting structures in place for long-term reporting for when the EU Sustainable Finance Disclosure Regulation comes into force. That has led to a surge in demand for ESG advisory services. Debt is probably a little later to the game than equity, but it is catching up.
SV: We are just beginning to glimpse an opportunity to combine environmental and societal improvements with investment in a way that is quite exciting. This is true across all the private asset classes. In the credit space we are already seeing examples such as ESG clauses being added to debt agreements and lending arrangements being labelled as ‘green’ where the underlying project has positive environmental characteristics.
On the world stage, Europe is some distance ahead of the US and Asia when it comes to ESG, so I am eager to see where we will get to in the next two years.