European CRE Finance Market: Is There Light at the End of the Tunnel?
September 24, 2020
By Hugo Raworth
- Transactions are limited to core low-risk assets
- New origination is largely restricted to existing borrowers and well-performing assets as lenders monitor performing loans and de-risk challenged positions
- Well-capitalised banks and insurance lenders are already cautiously returning, but LTVs have fallen, and margins are up
- Logistics remains a star performer, retail is undergoing an unprecedented evolution and a new sector combining retail warehousing and logistics is emerging
- Online shopping continues to grow in popularity, but the rate is not consistent, giving retailers in certain jurisdictions more breathing space
- Political and economic headwinds have the potential to make the next 12 months or so very challenging for real estate, though we could be back at pre-COVID lending rates by this time next year
Across Europe the market continues to hold its breath, with transactions limited to core low-risk assets. While traditional lenders remain active, existing loan portfolios provide a necessary distraction from new lending, as market participants focus on monitoring performing loans and de-risking challenged positions. New opportunities are tougher to get through credit committee, and therefore new origination is largely restricted to existing borrowers and well-performing real estate least affected by the pandemic. Loan-to-value ratios have dropped by approximately 10 percent, and margins are up by between 30 to 200 basis points, depending on lender and loan security. For higher-risk assets, the margin will of course be even greater.
Pension funds, insurance companies and other equity investors are willing to invest across Europe, but price realisation remains an issue, with limited post-COVID completions and, perhaps, unrealistic pricing expectations from both buyers and sellers. Despite the considerable weight of capital out there, continued uncertainty around income risk and future performance is making many investors take a wait-and-see approach. Total returns across Europe were in negative territory in Q2 for the first time in this property cycle.
As much of Europe grapples with a second wave of COVID infections and the wait for a vaccine continues, the likelihood of a surge in activity in Q4 is diminishing. New restrictions in the United Kingdom, the election in the U.S. and the looming prospect of a hard Brexit do not help. All in all, the political and economic headwinds have the potential to make the next 12 months or so very challenging for real estate.
Bright Spots in Certain Asset Classes
Is there light at the end of the tunnel? Certainly, there are significant challenges facing all market participants, including occupiers, lenders and investors. However, the market is not without bright spots. Logistics remains a star performer buoyed by the expansion of online retail in 2020, turbo-charging an already stellar performance driven by high occupier demand, lack of supply and weight of capital.
Prime central business district offices, especially in cities such as London, Paris and Berlin, continue to perform well, driven by historic low vacancy and continued undersupply of new space. Although transactions have been limited, early indications are that for hot spots around Europe, the pandemic has yet to put a dent in values.
Don’t write off retail either. The market is undergoing an unprecedented evolution, accelerated by the impact of the pandemic, but there are winners as well as losers across the sector. While the press tends to focus on struggling operators, many firms have benefited from the lockdown, such as grocery stores and retailers focusing on outdoor leisure, pets, do-it-yourself (DIY) projects and gardening. Other companies are performing well despite the pandemic, including Halfords, Boohoo, Next and DFS, to name a few. Bricks-and-mortar real estate will remain an integral part of many retail operations alongside an online presence.
Uneven Growth in Online Shopping, A Rise in Retail Warehousing
In the UK, online sales as a proportion of total retail have risen during the pandemic from 25 percent to 35 percent. Inevitably this has created further challenges for high-street occupiers. However, it’s worth highlighting that the rise of internet shopping has been less prevalent across other parts of Europe, remaining as low as 10 percent in some jurisdictions. Although online shopping continues to grow in popularity, the rate is not consistent, giving retailers in certain jurisdictions just a bit more breathing space.
City Centre high street retail is likely to improve significantly post-pandemic, as investors convert pure retail properties to mixed-use developments, encouraging vibrant, pedestrian-oriented communities with local retail and amenities conveniently on the doorstep.
Retail warehousing is another sector showing green shoots of recovery. In many ways the sector is witnessing a renaissance, as retailers recognise the benefit of convenient access and parking, as well as the ability to manage online inventory and shop front from the same premises. With more storage and last-mile logistics being coordinated in these premises, we are likely seeing the emergence of a new real estate sector, as retail warehousing merges with retail logistics. Long overdue? Perhaps. Based on the current difference in income risk, including logistics under the same umbrella as light industrial in a post-COVID world certainly seems counter-intuitive.
A New Credit Crunch?
With limited lending from traditional banks, are we seeing a new credit crunch, led by a reluctance to lend because of market risk, as opposed to an inability to lend, as was the case back in 2008? Maybe, maybe not. Certainly, there is a desire to lend for the right product, but continued market risk means that credit committee approval is only forthcoming for the lowest-risk assets underpinned by solid and sustainable rental income.
The withdrawal of traditional insurance and bank lending (outside prime) has also created an opportunity for enterprising debt funds. While their cost of capital is higher, they have been able to provide some much-needed liquidity to the market, particularly higher up the risk curve. Going forward it’s likely that debt funds will continue to play a larger part in the market, with traditional lenders retrenching to lower-risk opportunities. The market has already witnessed a small number of these funds successfully win larger mandates, traditionally dominated by larger bank and insurance lenders. It’s not impossible that we might even see some of these funds club together to finance larger portfolios before the end of 2020.
In all likelihood, once the shadow of the pandemic recedes, and economies begin to recover, the cost of traditional property finance will come down as asset values and income risk becomes easier to quantify. Well-capitalised banks and insurance lenders are already cautiously returning to the market. It’s entirely possible that we could be back at pre-COVID lending rates by this time next year.
Light at The End of the Tunnel
No doubt there are challenging times ahead. However, for now, the market is showing some signs of resilience, if not recovery. Clearly there are still many economic unknowns and we are in uncharted waters. However, lenders are well capitalised and lending rates are rock bottom. Investors have money to spend and commercial real estate still offers great returns in comparison to other investments.
It’s worth reiterating that the current economic difficulties have been caused by a health crisis, not a financial crisis. It’s no surprise that with the easing of lock down across many western economies, growth bounced back dramatically. This demonstrates the underlying resilience of economies buoyed by years of economic growth, and government support on a scale unheard of in modern times. So while things remain uncertain, there is light at the end of the tunnel. The big question is, how long will it take to get there?