The growing scarcity of bank lending in the commercial property sector continues to create opportunities for alternative debt providers seeking to generate secure income. Now, a slowdown in property price growth has further improved prospects for the asset class, says Vincent Nobel, Head of Real Estate Debt.
The new lending landscape: The disintermediation of the European real estate lending market, catalysed by the financial crisis and its aftermath, continues. This market is no longer dominated by clearing banks, though they maintain large lending books. Instead, more loans are being provided by specialist fund managers sourcing capital from pension funds and insurance companies. These lenders have long time horizons that are better suited to the relatively illiquid nature of commercial mortgage debt and can execute loans with greater speed and flexibility – which is often welcomed by borrowers.
In our view, this opportunity is sustainable in the long run as banks are likely to maintain less-leveraged balance sheets in the face of capital-adequacy regulation such as Basel III, the Capital Requirements Directive (CRD) IV and the “slotting” regime specifically determining how much capital UK banks must hold against their commercial real estate (CRE) loans.
Why the UK? Investors contemplating whether to add or increase commercial property exposure must consider how to access the market. With the rapid rate of CRE price and rental growth since the financial crisis, direct ownership has been a very popular option, with 63% of UK commercial properties owned by investors at the end of 20131. However, the rate of rental growth is now beginning to slow, with average prime yields falling between September 2013 and September 2015 and hitting record lows in some sectors, reducing the opportunity set for new entrants2. Despite this, there is still strong demand for real estate and the UK is one of the most well-regulated and structurally undersupplied markets in the world.
The senior debt opportunity: Investing in senior loans, where returns are entirely driven by income rather than capital growth, provides access to UK real estate without being immediately exposed to possible declines in capital value. Lenders in the UK also benefit from operating in the most creditor-friendly jurisdiction and one of the most liquid markets in Europe.
The risk-reward profile of this type of debt is also very attractive for institutional investors. Loan-to-value (LTV) ratios for senior debt investments are typically between 60%-70%, compared with 70%-90% for mezzanine debt. For senior loans in particular, leverage has remained about 10%-20% below pre-2008 levels, persisting at a more sustainable level than loans originated prior to the financial crisis.
Loan margins vary depending on the supply of capital and the credit risk of the individual investments. Senior loans can carry margins of 250-300bps in the current market versus 600-800bps for mezzanine loans. With total returns from direct ownership expected to average 4.5% per annum over the next five years3, we believe senior real estate debt provides an attractive low-risk alternative.
Our integrated approach: The Hermes Real Estate Senior Debt Fund aims to generate net returns exceeding LIBOR plus 2% by investing in loans with equivalent risk to corporate bonds rated A- or BBB. It is managed within a 22-person real estate investment team managing £7.4bn of assets. While the six-person Hermes real estate debt team uses its expertise in credit investing to evaluate loan structures and borrowers, we work intensively with our real estate equity specialists to independently assess underlying properties, tenants and business plans. This dual expertise enhances our insight into key deal parameters, allowing us to provide loans for experienced borrower groups that manage properties that demonstrate strong long-term fundamentals. It also enables us to act swiftly and decisively to execute deals and continuously maintain meaningful dialogue throughout transactions.
In 2015, we saw more than 146 loan opportunities worth in excess of £10bn, and selectively allocated a combined £250m to eight of these transactions.
- 1 Understanding UK Commercial Property Investments’, Investment Property Forum, June 2015.
- 2 ‘Quarterly Marketbeat: United Kingdom’, Cushman and Wakefield December 2015.
- 3 Property Market Analysis, 2016