The European real estate financing market has had a strong run over the past few years. Highly liquid conditions across Europe and the Middle East mean the asset class has become more attractive to lenders, and yields have fallen as a result. But with interest rates on the rise and US sub-prime woes putting nerves on edge, caution should be any lender's watchword. David Cox reports.
Real estate financing volumes in the European and Middle East syndicated loan market have grown exponentially over the past four years. According to data from Thomson Financial, EMEA real estate-linked volumes in 2005 were close to US$27bn, up from under US$2bn just four years prior (see graphic). And given that B loans and mezzanine loans support most property securitisations, bankers estimate the true size of the market at US$80bn–$90bn, and still expanding rapidly.
"The first quarter of 2007 has been phenomenally strong, with volumes up significantly across all sections of the market, and we expect this growth to continue," said a senior banker.
This boom in the market has been seen right across Europe and an oil-buoyed Middle East, with developed markets such as the UK, Spain, Sweden and Italy benefiting as well the emerging markets of Central and Eastern Europe, the Gulf and even Africa.
"On a macro level, property has been an attractive asset across Europe," said Harin Thaker, CEO for Europe at Hypo Real Estate Bank International. "But on a micro level, each local market offers specific opportunities that investors can benefit from."
In the wider corporate market, the super-liquid conditions in the European loan market over the past few years have allowed spreads to tumble to often uneconomic levels. Given that real estate financing is classic structured lending, it offers a good chance to book a higher-yielding asset. But this means the market is difficult to define because it does not fit into traditional loan silos of investment-grade lending or leverage buyouts.
In addition to the obvious attractions of price, the market is attractive as a good real estate financing team can look at a company and work out how to unlock value hidden in a property portfolio.
"Property is an area where a knowledgeable bank can combine a lot of different financing expertise and technology, such as lending, securitisation, hedging and derivatives," said a senior banker in the sector.
Real estate financings differ from general relationship lending where commercial banks face a challenge in their quest to find a decent returns. This is because real estate deals involve more than one financing instrument, and while banks still have to compete for mandates, lenders are usually well placed to win lead roles in other parts of the financing.
The combination of an extremely liquid loan market and falling returns means that the sector, once dominated by a few specialist houses, is gaining wider appeal. Institutional investors are becoming increasingly active as they have such huge amounts of cash to invest that even Europe's booming leverage market is unable to absorb it all.
"Over the past few years there has been a number of new players enter the market," said Hypo Real Estate Bank's Thaker. "US private equity funds have been especially active, but the ability to raise funds in Europe also means a number of new outfits have set up here as well."
There are problems
However, syndicating loans in the sector is not without problems. Moving away from a traditional investor base means real estate-linked loans can carry a similar syndication risk to many so called crossover credits – that is credits that fit neither a typical investment grade nor leverage profile. The danger here is that they are too structured for non-specialists but do not yield enough for the archetypal property investor. But it is exactly this type of challenge that enables strong arranging banks to earn their fees.
"There is a broad range of deals in the market now, and the increased liquidity means the market is more stable," said a senior banker. "However, this can make syndicating deals harder as various pockets of investors are targeting different areas of the market and the correct segment must be identified for a deal to succeed."
In addition, the increase in volumes means that investors now have an expanding universe of direct comparables and are so able to be more demanding their selection criteria.
Property financings that are spun out of leveraged buyouts are often attractive to institutional investors, especially if they lent to the buyout loan and are familiar with the company's credit story. Recent examples include the £1.15bn propco refinancing of the £1.43bn acquisition bridge loan that backed the buyout of Summerfield, and General Healthcare Group's £1.99bn acquisition bridge loan that an opco/propco refinancing and CMBS take out.
At the other end of the scale, in a year when overall loan volumes have been generally lean, one of the larger deals of the year has been in the property sector in the shape of Grupo Inmocaral's €7.3bn loan that is being arranged through Calyon, Eurohypo, Goldman Sachs and the Royal Bank of Scotland. Unlike institutional-targeted loans, this facility will be aimed squarely at Europe's banking community.
Outside the traditional developed markets, the boom in basic commodities has seen economies in the Middle East and Russia expand strongly, and these markets are now providing considerable opportunities.
In one of the more interesting deals of the year, MLAs Citigroup, Eurohypo and HSBC are out with a US$515m loan from St Martins, a property group owned by the Kuwaiti Investment authority, supporting the acquisition of Cevahir, the Istanbul shopping centre that is also the largest in Europe.
Only a year or so ago, such a syndication would have been considered hugely ambitious if not foolhardy; and though the asset is still something of an acquired taste, by the closing days of April the leads reported the loan was progressing well and was due to close on or through target.
Falling returns
Despite the increasing volumes in the sector, as in much of the wider loan market, demand is outstripping supply and yields are still shrinking. For example, bankers estimate that yields from the UK market are running at around 4%–5%, down from 6%–7% just two years ago. And while, the average tenor on a UK loan may stand at five years, liquid conditions mean most tend to be repaid and refinanced in about three.
"Spreads have returned to the tights that we saw a year ago," said Yossi Kraemer, head of ABS and REF syndicate at the Royal Bank of Scotland. "This is a reflection of the amount of capital in the financial system rather than any improvement in the underlying quality of the collateral."
These tightening spreads are part of a global phenomenon that has seen returns diminish across all asset classes. But the breadth of the property financing market means bankers remain generally optimistic that the sector can maintain its good run and make 2007 a strong year.
This is despite inflationary pressures that are looking likely to push interest rates up across Europe, a trend that bankers hope is unlikely to be sufficient to cause real disruption to the market. Furthermore, though problems in the sub-prime sector in the US have caused real problems in that market, there has been no analogous concern over credit quality in Europe:
"The events in the sub-prime sector in the US have made little impact on European spreads in the real estate sector as yet," said RBS's Kraemer.
"Though investors are maintaining their investment strategies, at the junior end of the capital structure many investors are asking more questions and increasing the level of due diligence before finalising their credit decisions."
Despite the positive feelings prevalent at the moment, bankers are cognisant that property is by nature a highly cyclical industry, and just because the market is rosy today it is important not to let lending standards slip.
Moreover, the rising interest rate environment coupled with lower spreads means the margin for error is reduced, and this means that even in seemingly benign conditions caution is more important than ever. So even though events in the US sub-prime market have so far not affected spreads in Europe, bankers warn that they have certainly hardened attitudes.
"Real estate has been an attractive asset class over the past few years, but it is a cyclical business. And in anticipation of a downturn it is important to maintain our focus on fundamentals and the underlying cash flow of the asset," said Hypo Real's Thaker.
"People are wondering if this is the time to slow down therefore, to identify the good assets. It is necessary to get your hands dirty to see where deals can offer real added value."