By Paul House
Historically, European commercial real estate lending was driven by the banking sector which enjoyed over 95% market share in the industry. The period leading into the financial crisis was one where the drive to increase lending for lending’s sake caused the bank market to develop unsustainable leverage both within their loan books as well as with their own balance sheets.
A lasting impact from the crisis was a decrease in the total number of bank lenders as several of them collapsed, the adoption of a much more prudent approach to lending, given the industry’s experience of losses, as well as more rigourous regulatory oversight. This backdrop caused a reduction in the supply of credit to the market, creating a situation where credit margins were attractive enough to draw institutional capital to the space, as well as an opportunity for alternative lenders to grow and add value to the market place.
The excesses of the 2007-2008 crisis are still with us today. We have a market where there continues to be need for recapitalisation within the industry. While billions of pounds of troubled loan positions have been dealt with, there continues to be imminent and sizeable loan maturities that need refinancing. In particular, the large volumes of non-performing loan portfolios that banks have sold to private equity firms are themselves in need of restructuring and recapitalisation. In this context, the opportunity for alternative lenders to step in and address the resulting supply-demand imbalance continues to remain attractive.
Alternative lenders are sourcing capital from, among others, institutional investors who have understood the positive risk-return characteristics of commercial real estate debt funds. The benefits include a steady cash flow return on invested capital and an attractive risk/adjusted returns profile in the low yield environment. Additional advantages are the low correlation with investment grade corporate credit and the downside protection of the asset backed nature of the real estate lending.
The UK’s vote to leave the EU has certainly increased financial market volatility and political uncertainty. While it is too early to arrive at any conclusions on the ramifications of this vote, we expect to see low transactional volumes in the second half of the year (already evident in the first half of the year) and real estate asset valuation dampening, especially in core central London office and prime central London residential property.
While the market place is more challenging, we believe that the context for success within the real estate debt investment opportunity still remains. Mitigating factors to the recent market volatility and uncertainty include the leverage levels in the commercial real estate market being lower than during the financial crisis of 2007-2008 and interest rates being well below those experienced in the initial period of the crisis.
While occupational markets will require additional scrutiny, the corporate world is more resilient and less exposed to the shocks of financial distress. The attraction of London as an international business and social hub is, in our view, likely to remain. It is a market that is transparent and enjoys a creditor-friendly legal framework and is likely to retain high levels of professional talent. The move to lower the corporation tax rate as recently outlined by George Osborne’s proposed reduction in business taxation to below 15% should support investment into the UK.
The devaluation of sterling could also attract interest from international investors overseas. Downward adjustments to real estate valuation may create investment opportunities for borrowers into deals with better fundamental values at attractive pricing, while in the continued low yield environment real estate is likely to continue to appeal to investors.
In this context, we expect demand for commercial real estate financing to remain, and alternative lenders to continue to play an important role as they underwrite selective investment opportunities with strong fundamentals. We should expect institutional investors to be an important source of funding for the ongoing demand for real estate debt.
Paul House is managing partner and head of CRE lending at Venn Partners
