3 min read 27 Feb 23
Uncertainty continues to reign in the current macroeconomic environment. Investors now find themselves operating in a world of higher interest rates and double digit inflation, with a potential global recession on the horizon.
The World Bank expects global growth to decelerate to just 1.7%1 this year – its third weakest pace in nearly three decades after the global recessions caused by the Global Financial Crisis (GFC) in 2009 and the pandemic in 2020.
In this macroeconomic environment we believe European commercial real estate (CRE) debt continues to offer attractive return potential with downside protection. CRE debt benefits from a significant equity cushion and structural features that can offer additional protection. In our view, the defensive qualities of the asset class, along with predictable cashflows, provide an attractive alternative to traditional real estate equity.
Following a trend that emerged in the aftermath of the GFC, traditional bank lenders have continued to retrench from real estate lending amid increasingly onerous regulatory capital requirement, leaving behind a supply/demand imbalance in the space.
“This enables non-bank lenders to grow their market share, while the current market disruption and volatility could also further reduce bank lending volume in real estate,” explains M&G Real Estate Finance Co-Head, Duncan Batty.
Approximately €200 billion of CRE debt is due to mature in the UK, France and Germany during 2023 and 2024 alone2.
“In challenging market conditions, we expect bank lenders to reduce lending volumes and risk levels. This could create a refinancing gap, providing a deployment opportunity for non-bank lenders,” notes Batty.
Increases in interest rates and base rates can be harnessed by lenders to boost all-in returns. However, rising rates are also placing upwards pressure on real estate yields, with the potential to impact real estate equity returns. CRE lenders are better placed to withstand value declines and maintain returns, since the debt position represents a percentage of a building’s value, providing a buffer against value depreciation.
“Rising interest rates can also impact the ability of the underlying borrower to meet its interest and debt service obligations, particularly if income from the property does not increase in line with rate rises,” says Batty.
Cashflow underwriting can potentially help to project a level of rate rise that may be tolerable. If further protection is required, negotiation of an interest rate hedge with the borrower can further mitigate risks from a rising rate environment, as central banks manoeuvre to combat inflation.
Rising interest rates may also contribute to a structural lending gap – creating an opportunity for alternative lenders. “Looking forward, the pressure rising interest rates are putting on interest cover ratios could also reduce bank lender appetite given their more rigid interest cover requirements,” Batty notes.
Inflationary risks can manifest in a number of ways in CRE lending. “For example, rising costs can reduce net operating income generated by the underlying property and impact the ability for loan interest to be serviced. In assets requiring capital expenditure, rising construction costs may impair a developer’s ability to fund a scheme to completion,” Batty states.
CRE loans can help mitigate some of these inflationary risks, in our view. For example, income from the underlying real estate may have some inflation linkage (through RPI or CPI-linked leases) which could possibly help offset rising costs – though it would be unlikely for the inflationary impact on income and costs to perfectly align.
Real estate debt risk mitigation techniques can include negotiating cash reserves with a borrower to provide support if operating margins were squeezed, and ensuring that fixed price building contracts and appropriate contingencies are in place to mitigate against construction cost rises.
Senior CRE lending offers investors access to the least risky part of the capital structure. Senior loans are made at conservative loan to value (LTV) levels, having stabilised at between 50% and 60% following a substantial drop post-GFC.
Conservative LTV levels mean that significant falls in the value of underlying real estate assets can be withstood before principal is exposed, potentially minimising the effects of falling property values. Senior lenders also benefit from first ranking security over the underlying real estate and priority access to cashflow from the property.
Loans can be structured to achieve an investment grade style risk profile and typically require interest to be paid in cash on an ongoing basis.
Senior CRE debt secured against typical income producing assets can offer investors a spread premium relative to similarly rated corporate bonds. These returns could be further enhanced by investing in transitional and development loans, where financing is less prevalent, interest is typically capitalised, and specialist skills are required to underwrite, structure and monitor transactions.
Mezzanine CRE debt occupies an intermediate part of the capital structure, ranking ahead of equity and behind senior debt but with the potential to generate higher returns on an absolute basis. Given that mezzanine occupies a debt position in the capital structure – with LTV levels typically ranging from 60% to 80% – returns could also benefit from an equity cushion. The equity owner bears the first loss in the event of real estate value deterioration, whereas mezzanine debt returns could remain stable in an environment of falling real estate values.
We believe the opportunity to generate higher potential returns through mezzanine lending is particularly attractive. Reduced risk levels by senior lenders could allow mezzanine debt to attach at a lower risk point, improving recovery risk whilst generating higher returns from increased base rates.
The value of investments will fluctuate, which will cause prices to fall as well as rise and investors may not get back the original amount they invested. Past performance is not a guide to future performance. The views expressed in this document should not be taken as a recommendation, advice or forecast.