Whilst already a recognised sector in the US, the 2008 global financial crisis created an opening for alternative lending to real estate in Europe, where previously it was dominated by banks. Alternative players have also continued to grow as a source of lending in the US. On the verge of another global recession, we ask senior experts in the commercial real estate debt market to share their thoughts on the opportunity for alternative lenders and the challenges that they face in the current climate.
What is the current opportunity for alternative lenders in commercial real estate?
With the impact of Covid-19 on the global economy diminishing their capital sources along with the tight capital adequacy covenants imposed following the finical crisis, banks are less willing to lend, both within commercial real estate and other sectors. This lack of capital paired with the bank’s inability to raise equity, another fallout from the GFC, means that there is an opportunity for non-bank lenders, who are not restrained by these stringent capital requirements.
Whilst the lack of appetite from banks creates ample opportunity for alternative lenders, the current economic uncertainty has, of course, generated a lower transaction volume, with investors wary of disposing of assets in the current climate. Despite this, there are many equity firms showing interest in entering the debt market by building out lending platforms, and there is the opportunity for those able to raise successful funds to step in and take market share, just as groups like Blackstone did following the Global Financial Crisis. Where this capital will be deployed is another matter, and the allocation towards the UK, Europe, the US and Asia will depend on which market is most appealing as the crisis continues, particularly as the capital for real estate debt is incredibly portable, and will move to whichever jurisdiction can offer investors the best risk adjusted returns.
What are the challenges for alternative lending businesses?
One of the most pressing issues for lending businesses is achieving scale. With lower fees than equity shops and pressure from investors, debt teams tend to have a leaner structure when compared to their equity counterparts. This can present challenges when balancing deployment, capital raising and loan management, which can be a time-consuming activity. As such, there are few debt funds in the market that have had the ability to reach this scale, without access to balance sheet capital.
This challenge is particularly prevalent in Europe, where the real estate debt market is far smaller than in the US, before even taking into account the countries that debt funds are unlikely or unable to lend in. In addition, the split between currencies and the staffing costs associated with covering the whole of Europe, creates challenges for European lenders. This is where banks often have the edge, with vast infrastructure, expansive IT systems and offices across the world, as well as having employees who can work not only on real estate deals but also across other sectors.
One option for building scale is, of course, to join a parent organisation in order to access institutional capital, in the way that Venn Partners, Longbow and DRC have done in recent years and GAM only very recently with its acquisition by Invesco. This provides access to large and consistent capital sources, investors and infrastructure, that are all important for a successful non-bank lender, whilst allowing the parent company to expand its business lines and the services it offers to its clients. It seems increasingly important that a manager can offer both real estate debt as well as equity products to be a home for institutional capital.
Perhaps the most efficient business model for a lender is one with access to both permanent and fund capital, and offering a range of products across the risk curve, which could provide annuity income with low management fees as well as accessing the cyclical transitional assets, offering higher returns.
What are investors looking for?
As a relatively young and unconstrained market, along with the ample refinancing opportunities that will emerge over the next few years as the impact of pandemic is realised, the future of real estate debt looks bright from an investor perspective, with new investors continuing to create allocations for real estate debt.
Whilst investors seeking higher, double digit returns have shifted to deploy their real estate allocation into equity strategies and distressed opportunities, there still presents a compelling opportunity in real estate debt for those seeking lower risk returns. Insurance and pension funds who, even through economic uncertainty, are still increasing their capital through monthly insurance and pension contributions, need to deploy their funds, and debt strategies provide them with a low risk investment which compares well in a low interest rate environment. In line with this, there has been an increase in interest for senior debt funds, with lending teams raising capital for strategies which will target returns around the 4% mark.
Which asset classes present the most opportunity and risk to lenders?
Covid-19 has presented new challenges that were unfamiliar to those of the financial crisis. Whilst in 2008, offices remained open and fully leased, and people still took holidays and spent evenings in bars and restaurants, the pandemic has seen a dramatic reduction in travel and foot traffic, that has presented challenges for certain asset classes, particularly offices and those with operational elements.
Whilst the hospitality sector has been, along with retail and office, one of the hardest hit industries, there is an optimistic outlook for the sector in the medium term. Though our new, virtual way of working may see a reduction in business hotels, tourism driven hospitality in popular locations is unlikely to see much sectoral change in the medium to long term. The long term committed capital of debt funds, means that hospitality is still a sensible and attractive sector for lenders, and is proving easier to underwrite than assets in the office sector.
Whilst other sectors, such as PRS and PBSA appear to be weathering the pandemic reasonably well, the risk to these sectors is in construction and development activities. Lenders are aware of the impact that lockdown had on supply chains, with sub-contractors being hit hard financially by the outbreak. With the additional pressure of Brexit looming in the UK, the risk around development lending is high, and lenders are having to underwrite these deals with caution, even ensuring that there are numerous alternative sub-contractors available, should part of the supply chain fall through.
Will there be an opportunity for distress?
At present, we are too early in the cycle to see distress from banks or lenders’ debt. The government’s encouragement of forbearance has helped to prevent loans from becoming non-performing, but this initiative will not last forever. It is anticipated that we will begin to see distress coming out of lenders in Q2 of 2021, once the impact on the operational models and the increased income pressure come to fruition. Investors looking for high yield debt strategies show an interest in also being able to invest into NPLs, should the opportunity for distress emerge, and the view of equity shops is that they want to have capital to deploy when this happens, though what these distressed products will look like and how they will be sold, remains to be determined.
In contrast to the large packages of discounted distressed assets sold by banks and lenders following the 2008 crisis in response to the dropping of LTV rates, the current market has had a greater impact on the income of assets. Rather than leaving money on the table and selling at discounted prices, the view from our group was that this time round, banks and lenders are far more likely to take action quickly, and go through workout on a loan by loan basis in order to get the best recovery possible on the asset. For banks, this is process is accelerated by the capital adequacy laws, which mean that the amount of capital they have to hold against loans in difficulty is far higher than it used to be, which they will be keen to avoid.
In conclusion, the outlook for alternative lenders in the commercial real estate market remains positive, with investors continuing to dedicate capital to real estate debt strategies. Despite the reduced transaction volume brought about by Covid-19 as banks reduce their lending activity, the opportunity for non-bank lenders has been strengthened in certain markets and the long term capital commitments of debt funds creates long term opportunity, even within those sectors affected by Covid-19. The biggest challenge to debt funds lies, therefore, not within the pandemic, but instead around the issue of scale, and the need to access large amounts of capital, in order to stay competitive in the changing market.