September 2017

INSIDE VIEW: Building on firm ground

Construction_workersUK and European economies are on a relatively solid footing, says Jon Rickert, investment director at GAM, and private commercial real estate lending will prosper.

Private credit investors have been bridging the gap in recent years between what the commercial property financing banks are able to offer and what borrowers need to complete transactions.

The constraints on bank lending have come from both new regulation and legacy issues dating back to the financial crisis.

And, while the UK and European commercial real estate (CRE) markets have remained relatively stable in this climate of political and economic uncertainty, the weight of that uncertainty will undoubtedly put pressure on values and rents.

Private credit offers investors protection against those downside risks and high current income yields. Private credit investments generate attractive risk-adjusted returns relative to both direct property investing and other fixed income alternatives.

Steady values
UK CRE values and rental levels have remained relatively steady since the Brexit vote in June 2016, although weaknesses are evident. The volume of investment property sales was strong in the first quarter of 2017, but was clearly inflated by a few very large transactions. Rental levels for retail properties improved in the first quarter, but it is unrealistic to expect that growth to continue in the face of declining UK consumer spending.

UK office rents increased overall, but London experienced a decline as a result of softening occupier demand and an increase in the supply of new space under construction. The bright spot has been the industrial-warehouse sector, which has benefited from a very low level of speculative development in the last ten years.

This is all consistent with our expectations immediately after the Brexit vote – a modest decline in property values driven, mainly, by weaker tenant demand as occupiers assess the impact of Brexit on their businesses.

Bank lending criteria in the UK has continued to tighten as one would expect in this environment, with banks reducing loan-to-value ratios and taking a more cautious position on secondary locations and properties with short-dated income profiles. Even after accounting for the increasing market share of non-bank lenders (up from virtually zero to around 25% in five years), total lending in the UK has remained relatively flat over the last few years.

Data from De Montfort University shows that prior to 2008, it was common for banks to advance loans at 80% or more of a property’s value. That ratio has steadily declined since 2010 as capital ratios and enhanced regulatory oversight have made CRE lending less attractive. Loans are now more typically advanced at or below 60% of a property’s value.

This is not good news for direct property investors, but it is positive for those invested in loans secured by those properties.

Loans are inherently protected from declines in values. They receive interest and, in some cases, the repayment of principal each quarter. Furthermore, the limitations on banks to lend at loan-to-value ratios much above 60% means alternative lenders can charge a premium relative to the additional risk. Returns from direct investment in the property itself, however, will suffer materially if values fall. CRE private credit investments are likely to outperform direct property investments in a CRE market downturn.

The picture in Europe
Eurozone economies posted relatively strong GDP results for 2016. The economic recovery in some of these economies is notable; 2016 GDP growth was 3.2% and 5.2% in Spain and Ireland, respectively. Broadly speaking, the eurozone economies have found their footing with healthy domestic demand, improving labour market conditions and strong export growth.

Further, voters in the Netherlands and France elected governments with pro-European platforms and rejected the rhetoric of populist politicians. While issues remain with EU political and economic integration, support for the ‘European Project’ appears to be reinvigorated.

This strong economic backdrop translated into continuing improvement in most European real estate markets. It is worth noting, however, that many European banks lag behind their US and UK peers in terms of deleveraging and cleaning up balance sheets. Non-performing loan ratios in most European countries remain elevated. These issues will continue to limit bank lending capacity and risk appetite.

We expect the uncertainty created by the Brexit negotiations to gradually weigh on the UK economy over the next couple of years. Europe will be affected, too. However, the circumstances that have characterised so many real estate market downturns – excessive and aggressive bank lending, negative yield spread and overbuilding, to name a few – are not apparent.

The UK and European economies are on a relatively solid footing; banks have been reducing their exposure to commercial real estate and continue to employ cautious underwriting standards. With the exception of London, speculative development is relatively limited and bank lending to fund that development remains severely constrained. The most likely scenario is for values in the UK to maintain a flat to slightly downward trajectory over the next two years. We expect values of European real estate to remain stable and, in some cases, experience growth over the same period.

Impact of bank deleveraging
An important catalyst for the creation of the CRE private credit investment opportunity has been bank deleveraging. Banks have been transferring loans to specialist investors that are able to deal with the borrowers and assets on a more commercial basis. The subsequent refinancing of those assets requires lenders that can take a more pragmatic approach than traditional bank lenders are currently able to. The UK has led the way in this regard, followed by Ireland, and we are now seeing the process gather steam in other European jurisdictions, where borrowers are increasingly turning to alternative lenders for finance.

The combination of relatively stable CRE markets, in-progress bank deleveraging programmes and constrained bank lending criteria creates opportunities for non-bank lenders to generate returns that are comparable to direct property investments, if not superior on a risk-adjusted basis given the downside protection inherent in loans. Investments in loans secured by CRE provide an attractive combination of a high current income yield and downside protection. In our view, this investment environment will not change soon. Indeed, one can expect CRE private credit investments to continue to generate attractive absolute and risk-adjusted returns for the next several years.

©2017 funds europe