Debt funds alone cannot rescue commercial real estate
Commercial real-estate losses will not greatly damage big banks in Europe, but the banks themselves could inflict real damage to commercial real estate.
Even before this March’s banking market volatility, commercial real estate was in trouble.
Deal flow collapsed in the last quarter of last year, with investment volumes dropping 60% globally compared with the year before, according to CBRE research.
In the UK, Europe’s hardest-hit big market, capital values dropped by 13% in 2022 and by 4% in the three months to the end of February. But the lack of deal flow has made it impossible for lenders to be confident about real-estate values.
In the UK, despite a small rise in January, the monthly commercial real estate investment volume in February was still less than half the five-year monthly average, according to Colliers.
The reason, of course, is the sharp change in monetary policy: above all, uncertainty about when central banks will stop tightening and what impact that will have on values.
Due to higher rates, all-in real estate borrowing costs have doubled to 6% in the UK and rocketed to 4.5% in Europe in 2022, according to AEW Research.
Until now, European banks have continued lending to some deals and their loan margins had only been inching up, according to AEW.
One large real-estate investor reveals that his firm recently agreed funding for a portfolio of stable assets with German banks at a margin only about 50 basis points higher than 18 months ago.
Now the collapse of Silicon Valley Bank, emergency rescue of Credit Suisse and renewed questions about Deutsche Bank could make the situation much worse, dashing the hopes of those who thought the market might revive in the spring.
Recent events in the banking sector have so far not led to an increase in the swap rates against which banks and debt funds price real-estate loans. But they have hit confidence in banking and in real estate.
This will inevitably reduce the availability of real-estate funding, resulting in lenders asking for much thicker margins, especially for riskier investments by shaky sponsors, as well as for any sort of new development finance.
Commercial real estate has been a focus of the concern around Deutsche Bank, specifically its exposures in the US. The intense scrutiny of that situation is another disincentive for banks to take on more new real-estate exposure – be it in the US or elsewhere.
For investors with no pressing need to deploy money, the greater yield available in safer and more liquid assets will add to the incentive to sit on the side-lines
Can the non-bank sector step up?
Previously, many assumed non-banks would suffer most from the turn in the rate cycle. They have grown rapidly over the past 10 years, particularly in the UK, and have tended to take higher leverage than banks.
Now that there is greater focus on the banks’ health, it could be an opportunity for the debt funds. Whereas the latter previously had to take mezzanine tranches to generate a sufficient return, they may now be able to lend at lower levels of leverage and higher margins than before.
Private debt funds, however, cannot alone make up for greater bank risk aversion, which will impact the entire market – including the debt funds’ back books. Even in the UK, private debt funds and insurers have each contributed only a little over 15% of outstanding real-estate lending in recent years, according to Bayes Business School.
Local and international banks account for the rest.
Globally, dry powder in closed-end real-estate funds stood at $386 billion at the end of last year, according to JLL. Yet for investors with no pressing need to deploy money, the greater yield available in safer and more liquid assets will add to the incentive to sit on the side-lines.
Many borrowers will be hoping for forbearance from their lenders as market movements increasingly see them breach interest-rate and loan-to-value covenants. And defaults will inevitably rise as weaker borrowers come to refinance and discover that they cannot access anywhere near the same debt quantum as before, leading to forced sales.
There are already more reports of borrower distress leading to sales of properties in London’s Canary Wharf, potentially at insufficient values to cover the outstanding debt.
Market insiders observe a recent hardening of investor sentiment towards the office segment, which was already facing a structural downturn as it became clear the world is not going back to pre-Covid working practices.
More cuts in the tech sector after the SVB collapse come at the worst possible time, adding to the lack of confidence among lenders that offices can shore up their rates of occupancy.
This could be worse in the US, in cities such as San Francisco, due to structurally lower office occupancy rates. And SVB has accentuated risk perceptions at the regional banks that are so crucial for real-estate lending in the country.
But things might not be much better in Europe, even outside the UK, which at least enjoys more diversified pools of capital than elsewhere in the region thanks to a greater share taken by non-banks.
Negative eurozone rates and high competition among banks saw real-estate yields fall to particularly low levels in Germany until last year.
Sentiment among German real-estate lenders has fallen to a record low on rising liquidity costs and low deal volumes, according to an index compiled by German real-estate adviser BF.direkt.
It is no surprise that real-estate investors, many of whom bought at yields below today’s risk-free rates, are only selling if they must. While many are still hoping that a monetary-policy pivot is on the horizon, it is becoming increasingly hard to find anyone who thinks that is imminent.
If change is eventually brought about by a deeper crisis in the banking sector, it will bring no relief to real estate.