Real estate, alternative real assets and other diversions

Lending Smart In 2018 Where will debt providers go to out-perform?

Investor's Notebook

Comparing returns, and risk, for debt markets across Europe has historically been nigh-on impossible due to a lack of data. But new research from CBRE will help existing and new lenders determine strategy from a position of greater understanding. The data show that returns vary significantly across markets, and – contrary to perceived wisdom – there are pockets of Europe where typical lending terms are looking increasingly stretched, meaning lenders should proceed with care.

The European real estate debt market is, we estimate, roughly a €1trillion industry. As with so many huge industries currently, it is also undergoing a significant period of disruption – in this case as incumbent operators grapple with legacy positions and (often) new or increasingly onerous regulatory regimes, while challengers come into the sector to try to gain market share. With the market in flux, and with all participants seeking to make allocation decisions from a position of deep understanding of the rewards on offer and the risks involved, it is vital that a market that historically has not been well provided with publicly available data gathers all the tools it can.

To this end, we recently updated and expanded our European Debt Map, which now details Q4 2017 lending terms for senior, whole loan and mezzanine debt on prime office, retail, logistics investment (and, in the case of office, development) assets in 20 capital cities across Europe. With the popularity of real estate debt getting ever stronger among both traditional lenders and new entrants to the sector, this publication provides truly crucial data, not available elsewhere, on which lenders can develop their strategy. It speaks of a market in rude health, offering extremely attractive returns, but one where lenders should operate with a note of caution in some markets where risks have increased.

Interactive CBRE European debt mapclick to launch map.

Figure 1 shows the cost of debt, split into component parts, for prime office lending in 20 capital cities across Europe. For borrowers this represents typical financing costs, but for lenders this represents typical returns.

  • Of the larger markets (in terms of investment market size), returns are considerably higher in London (2.65%) and Rome (2.22%) than in Berlin (1.42%) and Paris (1.52%).
  • Of the Western Euro-denominated markets, the highest returns are to be had in Dublin (2.72%), Madrid (2.52%) and Lisbon (2.42%).
  • CEE, as might be expected of less liquid emerging markets, sees the highest returns; Bucharest and Warsaw at c5%, Prague at c4% and Budapest and Bratislava at c3%.

The level of return on offer is only part of the consideration for lenders, risk being the other. Broadly, lenders would want to avoid the risk of a default on interest payments (an “income-driven default”) and the risk of capital loss in the event of an LTV default (a “value-driven default”). It is possible to quantify and compare the extent to which these risks are present in each of the 20 capital cities by looking at the Interest Cover Ratio (income-driven default) and the Debt Yield (value-driven default).

Figure 1 Cost of senior debt, prime capital city offices, Q4 2017

Source: CBRE, Macrobond. Assumes cost of debt comprises local five year swap rate (as at Dec-17), margin, and arrangement fee (apportioned over the life of the loan).

Figure 2 shows the Interest Cover Ratio (ICR) for prime capital city office lending in 20 European capital cities. The ICR reflects the amount of times the income from a property covers the interest on the debt on a property. A higher number is thus lower risk, and any number above 1.0 indicates that income is greater than interest payments.

Figure 2 Interest Cover Ratio on senior debt, prime capital city offices, Q4 2017

Source: CBRE. Calculated as ratio of property yield (income) to interest payments (total cost of debt multiplied by LTV).

On this measure, lending terms across all cities appear very low risk – a reflection of lower cost of debt (especially interest rates) and often moderate LTV levels – and would support the argument that lending has remained disciplined so far in this cycle.

  • Eight cities (40% of the total) have an ICR of 3.00 or above, including Berlin (3.64), Paris (3.29) and Rome (3.00). The other five – Brussels, Copenhagen, Helsinki, Amsterdam and Madrid – are all mature Western markets.
  • Three cities have an ICR below 2.0. Two are CEE markets, Warsaw (1.47) and Prague (1.70), the third being Oslo (1.74).
  • The remaining nine cities, including London (2.36), have an ICR between 2.00 and 3.00.

Figure 3 illustrates the Debt Yield for prime capital city office lending in 20 European capital cities. The Debt Yield adjusts the property yield for the LTV (so, for example, a property yielding 3% with debt of 60% LTV would have a Debt Yield of 5%) and effectively measures the yield at which the lender could be said to have “bought” the property, should it pass to the lender in the event say of a capital default. A higher number may be considered lower risk therefore: if the lender “buys” at a higher Debt Yield, there is less downside risk than if they “buy” at a lower Debt Yield.

  • Seven cities have a Debt Yield below 6.00%. These include Berlin (5.00%) and Paris (5.12%) of the large markets.
  • Six cities have a Debt Yield above 8.00%, including all five CEE markets – Prague, Budapest, Warsaw, Bucharest and Bratislava – and Lisbon.
  • The remaining seven cities have a Debt Yield of 6-7%, including Rome (6.67%) and London (6.25%).

Figure 3 Debt Yield on senior debt, prime capital city offices, Q4 2017

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