Development projects most at risk as financing costs rise

Development projects are most at risk during the current crisis, delegates heard at Real Asset Media’s Debt Finance & Investment briefing, which took place yesterday at Norton Rose Fulbright’s offices in Frankfurt.

“All the insolvencies we’re dealing with are developers and construction firms,” said Stefan Schramm, partner, Norton Rose Fulbright. “We thought we would see insolvencies later, at the beginning of next year, but they have come earlier than expected.”

The only positive is that now, unlike in the GFC, there are “many players with plenty of dry powder who are willing to invest,” he said.

“The combination of rising yields and the increase in funding and construction costs will cause some stress to the sector,” said Assem El Alami, head of international real estate finance, Berlin Hyp. “The bulk of development projects are not profitable anymore, so they have to choose whether to go ahead and build at a loss or abandon the project. There will be quite a shake-up in the sector.”

Interest rate rises and higher building costs are hitting small and medium companies hardest.

“On the development side we won’t see the big boys defaulting but the small and medium guys,” said El Alami.

The casualties are already mounting. “There’s a huge amount of work to be done because a lot of small developers are already underwater,” said Oliver Platt, managing partner, Arcida Advisors.  “We have to treat every borrower fairly and provide new capital where there are difficult situations, to help this part of the market find some stability.”

Senior lenders are being more cautious and conservative in the current uncertain climate and they shy away from financing product development.

“Many project developments are not bankable anymore and they’ll be stranded, but we’ll always be there to finance a solid bankable asset,” said John Krant, managing partner, Salux Real Estate.

There is less propensity to be bullish in the market, so the availability of financing will shrink and the costs will increase.

“We don’t know where prices, costs or leverage will be so we have to incorporate a buffer for market fluctuations which will make financing more expensive,” said El Alami.

The situation is unlikely to change until there is less volatility in the market and until valuations reflect changed conditions more accurately.

“What’s preventing us from lending is lack of visibility,” said Debora Sobel, head of European debt origination, Allianz Real Estate. “Values also need to be adjusted. If the adjustment is quick, then activity will pick up much faster.”

Refinancing the name of the game as transactions pause

Next year is likely to start with a whimper rather than a bang, experts agreed ““We predict that transaction volumes will be 40-50% lower than what

we have seen in the last few years,” said John Krant, managing partner, Salux Real Estate. “We expect the market to be very subdued for the next six months.”

‘Wait and see’ seems to be the default mode as there is little visibility as to what the future holds.

“We predict that transaction volumes will be 40-50% lower than what we have seen in the last few years,” said John Krant, managing partner, Salux Real Estate. “We expect the market to be very subdued for the next six months.”

‘Wait and see’ seems to be the default mode as there is little visibility as to what the future holds.

“There is huge uncertainty but if you wait too long it might be too late,” said Oliver Platt, managing partner, Arcida Advisors.

The uncertainty is compounded by the fact that the current crisis has multiple causes, he said, from rising interest rates to the war in Ukraine and from the impact of home working to the growth of e-commerce.

“The majority of requests used to be for acquisition financing,” Krant said. “But now that’s changed and most are refinancing requests. Whether it’s banks or mezzanine funds, people want their money back.”

Refinancing seems to be the name of the game as more people are seeking to buy more time.

“I think H1 in 2023 will be very quiet on the acquisition front,” said Debora Sobel, head of European debt origination, Allianz Real Estate. “Now it’s all about extensions, which are being pushed back to next year. It will be very interesting to see how they are addressed when the time comes.”

Lenders are keen to get their money back and are unlikely to encourage this trend. “You cannot expect the banks to prolong or extend, because there’s too much pressure on capital,” said Platt.

Banks have learned the lessons of the GFC and are in a better position, as their own policies became more stringent and regulation imposed higher capital ratios, leading to a healthier market.

“Senior lenders are not in big trouble, as they have not been seduced by big lending volumes and high leverage but have been quite disciplined,” said Assem El Alami, head of international real estate finance, Berlin Hyp. “We’ll see how private debt and alternative providers manage the current situation.”

A consolidation is to be expected in the sector, said Krant: “We’ve seen a lot of loan requests coming in now and no one knows where valuations are going to be. As the equity risk kicks in, a lot of mezzanine lenders will have to take a haircut next year”.

The current crisis is changing the financing landscape. As banks become more conservative, the funding gap will become bigger and will need to be bridged.

“From a lender’s perspective it’s a good time to lend”, said Sobel. “We focus on large tickets, €200 million on average, and some of our competitors are retreating from that space, which creates more opportunities for us”.

Strong demand for European non-listed RE debt strategies

There is strong demand for European non-listed real estate debt strategies, delegates heard at Real Asset Media’s Debt Finance & Investment briefing.

“Interest rates will normalise at a much higher level than we’ve been used to over the last 10 to 15 years and that means that debt strategies are becoming attractive for their risk return profile,” said Iryna Pylypchuk, director of research and market information, INREV.

In 2021 capital raised for European non-listed real estate was €12 billion, a record high. “I believe the numbers for 2022 are likely to go up further,” she said.

The ongoing structural shift to non-traditional lenders has been accelerated by current market conditions, servicing the financing gap left by banks.

“It’s a healthy development, as the lending market space should be diverse in terms of choice of lenders, it makes it more competitive,” Pylypchuk said.

The US remains the largest, most mature and most diverse market. The private debt side is only about 3% of the market but insurers play a large role. In Europe the UK is clearly in the lead: non-listed funds account for about 10% of the market, compared to 4% for Continental Europe.

“In the UK in H1 2022 non-bank lending surpassed that of banks and building societies for the first time on record, according to research by Bayes Business School,” she said. “Europe is also evolving rapidly and will accelerate further.”

The European debt universe has doubled in size in the last seven years, with the number of vehicles (mostly closed-end structures) increasing from 37 in 2016 to 80 in 2022, while target equity has increased from €25 billion to €51.3 billion’s worth of assets.

“There’s a lot of senior lending out there,” said Pylypchuk. “About 87% of the total is in the senior lending space or the mixed senior, subordinated and preferred equity space. Given current market conditions, senior is going to be the choice when it comes to loan generation.”

The funds that specialise in senior lending tend to be larger in size, €650 million on average. Multi-country strategies dominate and represent around 70% of the total.

“It’s a faster, opportunity-driven market, where you can execute more quickly because the regulatory and reporting requirements are not strict,” she said. “But the regulators are starting to realise that it’s a growing space and are looking into it.”

There is also a great strategic opportunity for ESG-focused debt propositions because the European commercial real estate market is under enormous pressure to decarbonise and it’s not easy for traditional lenders to move into that space.

The key challenge is the lack of transparency, particularly in the mezzanine segment.  INREV is addressing this issue with its Debt Vehicle Universe database that seeks to increase visibility for investors. “It’s a window into that world,” said Pylypchuk. “More data means more knowledge and a better understanding of the market.”