Real Estate Finance: Demand creates unending supply
The European real estate market continues to boom, and the capital markets are busy fuelling the frenzy. From financing private equity-backed M&A to lending intended to feed hungry CMBS conduits, bankers are working hard to fund the growth of property companies and meet the demand from investors for new product. Paul Farrow reports.
M&A is a big driver in the European real estate finance market, and as the deals become bigger, banks are lining up ever larger financing solutions to back them. In many cases, the funding is lined up months ahead of the moment that the bidding consortium decides to go ahead.
In this environment, the focus is on a bank's ability to use its balance sheet for what Amanda Thomson, an MD in securitisation at Citigroup, calls "enlightened risk taking".
"If you can you warehouse M&A-derived positions, that is a very big advantage when it comes to winning new business," she said.
Citi has put its considerable funds behind some of the biggest deals in Europe, such as the German multi-family investment that resulted in 2006's €5.4bn Grand CMBS deal. And after €60bn of CMBS issuance in the European market in 2006, 2007 looks set to see further growth, much of it M&A-related, according to Thomson.
The dominant role of banks' balance sheets in real estate finance is increasingly clear, as the agency securitisation business offers tiny margins compared with principal lending – the difference is a factor of 10, according to one senior banker.
"In the main asset classes, the securitisation business is very commoditised, so the keys to a quality franchise are any combination of close FIG relationships, the ability to develop innovative or complex structures that support decent fees, and the ability to commit risk capital and provide the bridge money on sponsor deals," said Vineet Bewtra, who heads the debt principal finance and securitisation (DPFS) business at Dresdner Kleinwort.
The growing scale of real estate transactions has increased the need for joined-up banking, and investment bankers are trying to respond with integrated teams that cut across asset class divisions.
"We cover commercial real estate, principal finance and CMBS in one team, and we are unusual in providing debt, mezzanine and equity from the same deals team," said Wilson Lee, head of real estate at UBS Investment Bank, whose group has been going for just over a year.
At RBS, Stephen Eighteen heads the real estate finance business for Europe and Asia within global banking and markets division, which covers all non-UK business plus the larger and more sophisticated UK deals.
"Over the past 10 years real estate has become increasingly global, compared with the traditional approach in the sector where investors only operated within their local domestic markets. Nowadays, the global opportunity funds and more sophisticated investors take a global approach, so we organise ourselves to service their requirements across the globe, often working with the same client in six or seven different markets."
In many M&A deals the plan is to refinance the initial funding with an opco-propco structure. Often the target company has considered such a split itself and rejected it, but acquirers are happy to accept a much higher degree of leverage.
DK's Bewtra is a proponent of the opco/propco structure in cases where the sum of the parts is greater than the whole, but he emphasises the importance of being sure that this approach makes sense in each case.
"The key question is whether the reconstituted opco can pay the rent and still retain operational flexibility? It is important to keep the rental at around 65% of cashflow to allow scope for cashflow variation. The opco-propco solution is most appropriate where cashflow is stable, or volatile but within an acceptable range," he explained.
At DK, the team has been involved in several deals in the healthcare sector, including the financings of GHG, an acute hospitals business, PiC, a secure psychiatric hospital business, and Paragon, a specialty and learning disabilities business by private equity firms, and the recapitalisation of Care Management Group.
An important element in the expanding use of opco/propco structures is the growing demand for the resulting paper. Following their success in other countries, the advent of REITs in the UK has been well flagged, and bankers are confident that they will revolutionise the British sector.
"REITs will allow companies to rebase – lower – their cost of equity. They also give a separate outlet for private equity portfolios. France has already proven to be a fantastically successful market for REITs," said Leland Bunch, head of real estate securitisation at UBS.
According to Bunch, REITs will help to drive more securitisations as the structure offers no incentives to carry interest payments, and the CMBS market is the cheapest funding form.
"REITs will change the European real estate sector as aggressive bidders for propco assets given their tax advantages," agreed DK's Bewtra.
This could also see European property companies redefining themselves by sector of operation. The first sector-specific REITs are being listed in the UK. Local Shopping REIT (LSR) priced in late April, and Vector Hospitality is set to price in May.
"The big question is what happens in the medium term. Do property companies remain as conglomerates in terms of exposure to a variety of sectors, or do they become industry-specific, as has happened in the US and Australia," asked UBS's Bunch.
One banker cautioned that if Europe followed the US path, the era of the publicly-listed REIT could prove transitory.
"In the US, REITs have been an important feature for years. But given the limits imposed on them by the ratings agencies, they are now being taken private, where they can take on even higher leverage," he said. "We could see European REITs being taken private in a couple of years."
In the US, REITs are typically about six times leveraged, while in the private sector they can be up to 15 times leveraged.
Another new source of demand for property paper in Europe is the embryonic CRE CDO market. CRE CDOs have enjoyed huge growth in the US where there is a large amount of collateral to back them. By contrast, in Europe there is still a lack of collateral that offers enough duration for the product – the average life of collateral in Europe is two to three years, as opposed to eight to nine years in the US.
However, there is every confidence in the industry that CRE CDOs will provide another source of liquidity to the European real estate market. While CMBS conduits will continue take the senior pieces, CRE CDOs will take the lower-rated pieces.
"CRE CDOs will affect CMBS and ultimately all property financing," said DK's Bewtra.
Up to the end of Q4 2006, there had only been two CRE CDOs in Europe, and a lot of work needs to be done to get the sector established – not least by the ratings agencies.
One banker noted the lack of a CRE CDO methodology for Europe: "The ratings agencies are not treating the US and Europe alike. But they are under capacity constraints, and that is delaying their ability to work on this."
While real estate bankers are agreed on the importance of big-ticket M&A deals, there is an interesting division of opinion on the attractiveness of the conduit business. According to UBS's Lee, his bank is putting limited emphasis on developing a traditional small balance loan conduit business.
But Credit Suisse is aggressively building up its conduit business. "The conduit business is the majority of our CMBS business," said Don Belanger, head of Credit Suisse's real estate finance and securitisation group. "As a flow business it is much more regular than those large, lucrative but irregular trades."
In 2006, CS securitised US$6bn through conduits, and in 2007 Belanger forecasts that figure will rise to US$15bn. The bank operates under the Titan name, and – as a joint venture with Capmark – as Cornerstone Titan.
RBS's Eighteen argues that the conduit CMBS business will prosper and take an increasing share of the financing market in the next few years, but the major players will only survive if they can provide this service as part of a larger suite of products.
In the meantime, aggressive growth targets demand an increasing flow of loans to feed conduits, and as rental yields in Western Europe continue to fall, bankers are following their property company clients in looking to the emerging markets for higher yields.
"Our borrowers are looking further East, and we are following them," said Credit Suisse's Belanger.
David Basra, head of securitisation for EMEA at Citigroup, is clear about the potential of the emerging markets for future growth. Citigroup's Pantera conduit specialises in EM issuance, and according to Basra, the bank will be bringing deals from Russia and other EM countries.
In these less developed markets it is essential for a lender to make an equity investment, which once again emphasises the importance of having a big balance sheet and being able to use it.
"There are real opportunities in the less liquid markets like Russia, the Baltics and the CIS, where UBS is strong. That means that we can play in real estate markets where securitisation is developing, but where we can be an equity investor with the client," said UBS's Bunch.
"UK investors are pioneering now in South Africa, South America and India, so the challenge for all banks is to expand their origination platforms across the globe to service their requirements," said RBS's Eighteen.
If the real estate boom continues, it is in the emerging markets and the embryonic field of property derivatives that the most exciting changes are likely to come. RBS's Eighteen notes that there has been "lots of interest from clients in property derivatives, but there is an educational process required, and the market needs a lot more liquidity."