The Past, Present and Future of RE Debt , 26 May 2022

 This in-person event held at PGIM Real Estate’s offices aimed to provide a better understanding of debt as a real estate investment class. The session was expertly chaired by Stefanie Hanstveit, who looks after property debt syndication at Wells Fargo, and opened with Dominic Smith, a debt researcher at CBRE Investment Management. He set out the case why providing debt, or credit as he called it, can deliver a more attractive return than what can be achieved by an equity investor. Dominic commented on the huge range of returns available, depending on risk appetite, from 2.25-3.75% at the lowest end of the risk spectrum to 9-15% at the top end.

 Currently, investors in RE debt can earn favourable premium to equity and to fixed income on a risk-adjusted basis. CBRE IM modelled how much of the equity return a credit investor ought to receive at different levels of risk to enable an understanding of what type of loan would provide relative good value. For example, for London offices you get 90% of the equity-level return for delivering 55% LTV whilst having full downside protection in a capital market quadrant with lower volatility. Dom’s forecast’s by sector for 2022-2026 by 3 levels of LTV showed we have returned to a phase where credit returns forecast sometimes exceed equity returns forecasts, especially for the more complex assets or more risky types. Also, in 2022 the average total cost of debt started to exceed the MSCI UK average NIY.

 Peter Cosmetatos, Chief Executive of CREFC Europe, discussed how RE debt provision has changed over the years. Securitization of loans via CMBS only started 2005, and grew substantially to 2007. In the GFC it became clear that the liquidity of European CMBS bonds was not as expected due to their complex structure, and this market segment got a bad name in Europe. The Solvency II framework put in very high charges and the CMBS market thus all but disappeared in Europe, unlike in the US. On the positive side, the debt provider landscape has diversified significantly since the GFC.

 Debt providers might end up lending modest amounts at the best point in the market just after a crash, and lend most at the top of the market when people are bullish. What was a 70% LTV can quickly become 110%, and losses might appear over the whole lending cycle. Regulators acted on these concerns. Banks pulled back from the riskier end of the spectrum due to increased regulation, a gap quickly filled by Non-Bank Lenders (NBL). The attractive risk-adjusted returns provided by RE debt proved especially attractive in an environment with chronically low interest rate and returns whilst investors searched for yield.

 Peter called for more clarity in situations where leverage is used by debt providers for the lower LTV portion of a loan. There is currently not enough visibility of this practice that can lead to complexity in a loan work-out situation. Diversity of funding sources in the UK is a source of resilience. The Continent is not as diverse in the debt provider landscape yet. Peter stressed we are in a rising interest rate environment where there is fragility, in part from using leverage, which means we should pause to think about risks in the market.

 Mathew Crowther, a seasoned RE debt fund manager at PGIM Real Estate, then set out the outlook for the debt market. The last decade was an incredible time for lenders due to a supportive interest rate environment. The future offers weaker growth, higher inflation and rising interest rates. This will place pressure on returns, narrow spreads available over bonds, and reduce liquidity a little and raises a number of questions. Can rents grow enough to cover rising interest rates? Is it still accretive for borrowers to borrow? Inflation-linked income offers some insulation against inflation. Logistics, living sectors, data centres and life sciences benefit most from long term structural trends.

 Mathew highlighted the ESG focus in the sector. ESG drives demand for certain office assets, providing selective tactical opportunities, but is also a big risk factor. Legislators do not seem to understand the RE market well enough.

 Liquidity is expected to drop only a little, as there is a significant amount of dry powder looking to invest in RE equity and debt, limiting the decrease of spread over bonds. Looking across the main sectors it was noted that spreads are widening in Q1, with residential, office and logistics yielding the highest debt cost margins in the UK, Northern Europe and the Nordics respectively. This shows how across Europe the market differs. The UK is bit more insulated from upside pressure on property yields as due to Brexit yields here are more elevated. In continental Europe the reset is starting to hit now, whilst faced with lower yield spreads and low-to-negative bond rates. Mathew stated a key concern is where interest rates are going. In the panel discussion Dominic added that we are less levered now than pre-GFC, so ‘it will be different this time’, but distress will come to those on floating rates.

 Apwinder Foster, Head of Product Strategy, DRC Savills Investment Management, who joined the panel discussion suggested that, like the US, Non-Bank Lending in the UK can reach parity with bank lending in the next 15 years as the credit market here is still relatively immature. She predicts NBL will focus on transitional assets, and banks on stabilised assets, with collaboration between the two sectors for required asset upgrades. Dominic Smith has calculated that 15-35% of value needs to be spent on CapEx for such upgrades on 60-75% of stock across Europe to reach an EPC B rating.

 Apwinder was joined by the other panellist in expressing concern on the future of secondary and tertiary assets and locations without policy intervention to help pay for the required retrofitting. We are likely to see self-selection to low hanging fruit otherwise, and are at risk of achieving the opposite of levelling up. The panellists were critical of the incentive structure for banks to lend on shiny new buildings – with all the related embodied carbon issues – rather than on assets you can take from ‘brown’ to ‘green’ by upgrading. Currently within SFDR article 9 investments, ‘brown’ to ‘green’ investments do not qualify, which is the opposite to what is required. NBL is likely to lead the charge to improve sustainability.

 Cleo Folkes