Mind the Gap!
There is a material funding gap anticipated in European commercial real estate and there needs to be solutions but what are the options for lenders and borrowers?
Let us call it what it is, a real estate crash! In Europe we are experiencing inflation adjusted price declines at least as bad, if not worse, than the GFC. According to research from Green Street1 in the 12 months trailing 1st May 23, their European property index was down 28% (21% peak to trough and 7% inflation) vs. 21% in the peak to trough of the GFC.
There are some differences this time; there always are. It is widely acknowledged that on average, senior real estate lenders in Europe have lent at more conservative LTV levels than in the run up to the 2008 crisis. In addition, private capital, particularly in the U.K. has provided an increasing proportion of lending on commercial real estate. Despite this, the fact that Banks tended to lend on “Prime” assets using historically low yields driven by unsustainably low interest rates, is and will, lead to high adjusted LTV’s and low and sometimes negative debt service in the new interest rate environment.
This is supported by analysis from AEW Europe2 showing key real estate markets facing a funding gap of €93bn for the 6 months 2023 through to 2026. Germany is the most affected country in the analysis (€36bn) followed by France and the U.K. (€19bn each). By sector, offices were the largest component of the gap at €39bn, followed by retail at €25bn and residential at €22bn.
So how is this gap likely to be filled? How will lenders behave towards borrowers? Will regulators play a stronger role in forcing Banks to act? And is the capital available to at least help plug the gap?
After a flurry of sponsors trying to achieve refinancings of over-levered positions at par in 2023, the relatively small number that do make sense, have or are getting done. For most other positions an array of less attractive options are being followed.
For lenders, the neatest solution in the absence of full repayment is an equity injection. If the existing owner of the asset is prepared to inject further equity to pay down senior debt to sustainable levels (typically driven by ICR considerations) then providing further time for the sponsor, by extending the loan maturity, is a mutually advantageous solution. However, given the material value movements that have been seen, in many situations even if sponsors have liquidity there is a rationale decision about whether investing further capital is the right investment decision, particularly given the material increase in new swap rates, meaning a material proportion of cash flow will be flowing to the lender.
If new equity is not forthcoming, a second potential consensual solution is some form of subordinated capital from a new lender/investor. By way of example, described below is a situation we have observed that neatly illustrates the position.
A bank or club of banks has lent 55% loan to purchase price 6 years ago on what could be considered a prime asset. The asset typically would have had a strong remaining lease length (10 years let’s say) at the time of origination but there has been no amortisation. The asset now has a remaining lease length of 4 years with a binary re-letting risk. Through a combination of lease length reduction and market movements, the value has dropped say 25% so the senior lender is now at 73% LTV, still money good but unless the tenant renews their lease, their loan is likely to be at or above vacant possession value even after a full cash sweep. This risk currently priced at c.2.00% margin. The Sponsor may well be happy to invest in capex if the tenant signs a new lease, but that decision is 2 to 3 years away and a lease extension is currently uncertain. This is now not a risk the Bank or regulators should feel comfortable about having on the balance sheet at this leverage point but are likely to be comfortable extending if they are at a reduced basis.
So what key factors are important for a potential subordinated lender that could make a transaction possible?
- Probability to increase collateral value through asset management, greater asset level income through capex or leasing activity or material improvements to income duration for example;
- How competitive the senior lender terms are for example, a low margin, good inter-creditor rights for the subordinated lender and allowing excess cash to service subordinated debt are key considerations;
- Exit liquidity, is there a specific reason the collateral cannot be refinanced today and what will need to change for a full refinance to be achieved – it cannot be just that interest rates will be lower; and
- Return on the injected capital.
Quantifying the supply of capital available is difficult with many equity investors opportunistically able to provide subordinated loans and specialist funds having raised dry powder prior to the new fund-raising drought. We suspect that supply of the right deals will be the constraining factor rather than capital availability.
We believe “core” lenders where real estate lending is a long-term business will do everything they can to avoid pushing a borrower into a forced sale, not least as they may find themselves holding the keys leading to the lender being forced into appointment of an insolvency practitioner and further cost and value destruction. A consensual sale is somewhat of a misnomer, as with such constrained liquidity for acquisitions, the price is unlikely to represent fair value for the asset over the medium term.
So having exhausted a refinancing, new equity, third party subordinated capital and consensual sale options, lenders are left with the unappealing but potentially correct option of accepting a discounted payoff (DPO) from the sponsor or trying to sell the loan at a discount.
Conclusion:
Things do not typically move that quickly in these type of market situations, particularly in continental Europe. 2023 has largely seen lenders and borrowers kicking the can down the road, lenders taking stock of their books and assessing any need for provisioning. The merry go round of the par refinance continues to happen but with values falling and loan on loan financing largely lacking or very expensive the whole loan market has not been eager to play.
Strong assets with solid sponsors who are willing to back their existing investment will attract subordinated capital if the metrics and the situation stacks up. Our suspicion is that given the material over-valuation of prime assets, it won’t be easy to make subordinated capital work in existing capital structures but there will be exceptions and attractive deals to be done.
What needs to happen is equity holders will need to be forced to take the leap to sell, accept that they overpaid for assets and allow the whole market to rebase and rebuild. In some instances, that may also require existing lenders to take a hit. We do not anticipate this will be a quick process and it remains to be seen what combination of asset and loan sales or DPO’s will occur and how long it will take. Regulators certainly seem more alive to concerns that banks hold sub or non-performing loans on their books for too long which should help to create a degree of pressure.
We expect capital, both debt and equity ready to deploy, to be patient, disciplined and opportunistic in 2024 and a golden age for subordinated debt seems unlikely.
1https://www.greenstreet.com/insights/blog/this-downturn-is-the-real-deal
2AEW revises debt funding gap forecast to €93bn (recapitalnews.com)
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