May 24, 2023
European property developers are looking for more flexible forms of finance, which plays to the strength of private debt, say Fiera Real Estate’s David Renshaw and Richard Howe.
The conditions are right in the European market for commercial real estate lending to become more like the US, say Richard Howe and David Renshaw, co-heads of real estate debt at the European division of Fiera Real Estate, an affiliate of global asset manager Fiera Capital, which has over $117 billion in assets under management.
Howe and Renshaw joined Fiera Real Estate last September from fund manager Cheyne Capital to set up and run a pan-European real estate debt platform. The open-ended fund, which is targeting 10 percent-plus net IRR, has already secured £100 million ($124 million; €113 million) in seed commitments and will be sector agnostic, focusing on senior secured loans. This is in addition to £250 million of commitments targeting higher yield UK opportunities across the debt platform. With banks becoming more conservative on refinancing, the stage is set for private real estate credit to take market share in Europe, Howe and Renshaw tell Private Debt Investor.
How would you describe the private real estate credit market in Europe? What challenges and opportunities are being created by the inflationary environment?
David Renshaw: The private real estate credit market in Europe is evolving rapidly, for many reasons, including the increased regulation in the banking sector. Still, the European private real estate credit market is relatively unevolved compared with the US, where non-banking institutions make up a far larger share of commercial real estate lending. We expect the percentage share of commercial lending taken up by private real estate credit to keep growing in Europe so that over time it looks more like the US market.
As a growing investment class in its own right, private real estate credit is attracting high-calibre investors. Furthermore, sponsors from large, established PE players through to real estate developers are becoming accustomed to dealing with private real estate credit counterparties thanks to our ability to structure deals flexiblzy, act commercially and react to execute funding requests within tight timeframes. Whereas a developer might previously only fund through a traditional bank, private real estate credit is becoming a viable and accessible alternative funding source, and we expect that to continue to grow.
Obviously, the current inflationary environment is causing uncertainty for both asset owners and lenders. There is a large volume of refinancing beginning to enter the market, with €150 billion of European commercial real estate debt estimated to mature by 2025, creating a big challenge around valuations.
Granular underwriting and stress testing is even more important today. Valuations in the private sector are yet to catch up with the devaluations seen in the listed space and certain sectors represent more risk than others. While yields have generally widened, we believe that as 2023 progresses and transaction volumes pick up – across refinancing and via forced asset sales – sector-specific valuations will find a more concrete landing ground.
In terms of opportunities, two pillars have been prevalent for several years: diminishing credit supply due to banking regulation and increased demand as a result of the asset class becoming more mainstream. Base rate increases have added to the opportunity set, allowing private real estate credit investors to make outsized returns for fundamentally similar levels of risk versus 24 months ago.
What is driving the ESG agenda in the asset class and how do you see the expectations of managers evolving there?
DR: In addition to more awareness and understanding of the climate emergency, regulatory and investor pressures have certainly been the largest driving forces behind the ESG agenda in recent years. This is particularly true for real estate debt, which has been lagging behind other private asset classes, particularly from a data availability perspective.
Regulatory disclosure requirements like those included in the Task Force of Climate-Related Financial Disclosure framework are placing increasing pressure on managers to provide climate data to their investors, but the response rate from private debt managers has been slow, thereby putting investor’s mandatory compliance with these regulations in jeopardy. The EU’s Sustainable Finance Disclosure Regulation (SFDR) has also been a huge driving force for more consideration of ESG factors within real estate debt.
Managers are definitely waking up to the growing level of expectation, as can be seen in the number of sustainability and responsible lending frameworks designed to monitor both a borrower’s and a real estate project’s ESG maturity and level of ambition. Going one step further, many lenders are starting to include loan covenants that address data sharing and other ESG-linked targets, as well as looking at preferential lending for those with stronger sustainability ambitions.
At Fiera, we are building responsible lending frameworks into our underlying loan and underwriting assessments to ensure that we back borrowers, sponsors and ultimately assets that have ESG at the forefront of their agenda. Our newly launched real estate debt fund is an Article 8 fund under SFDR and has a responsible lending framework at the heart of its investment agenda. ESG is now embedded across all our strategies at Fiera and we see that as another valuable point of differentiation versus our competitors.
How are the market dynamics in the banking sector playing into demand for private real estate lending?
Richard Howe: Clearly there was a period of market nervousness following the collapse of Silicon Valley Bank and the takeover of Credit Suisse, but we think that the banking sector is much better capitalised this time around. We also think that underlying credit has been more conservatively underwritten by banks, with generally lower LTVs than the last financial crisis. We expect this to lead to lower distress, although clearly a wider macroeconomic downturn and a recessionary environment could change the landscape.
Generally, we expect banks to become more conservative on refinancing and on underwriting new business, thanks to tightening loan standards and higher funding rates.
In the refinancing space, valuation pressures will lead to equity gaps that not every sponsor can meet. This is forecast at over €30 billion in Europe alone over the next three years and as banks advance less on an LTV basis today than they would have 12 or 24 months ago, the funding gap is exacerbated.
This creates an opportunity and demand for the private real estate lending space, where well-capitalised private credit investors can act selectively and achieve outsized returns on lower levels of risk. As ever, detailed underwriting coupled with careful sponsor selection will determine the winners as we expect valuations in certain asset classes to remain depressed and certain business plans to come under pressure. Understanding the correct valuation basis today will be key, and this is a journey we are going through as 2023 progresses.
What does the opportunity set look like for 2023 and beyond?
DR: The opportunity set for private real estate debt was already compelling, and we think investors will be big beneficiaries of the macroeconomic downturn. We see this in the number of new funds being launched to target real estate debt, including our new real estate debt fund.
That said, private real estate credit funds still represent only a very small portion of the overall commercial real estate lending market. Whilst 22 percent of capital raised in 2022 globally was allocated to real estate debt strategies, the overall commercial real estate funding market in Europe alone stands at around €1.8 trillion and private real estate credit makes up less than 10 percent of that.
With a refinancing wave pending, alongside bank credit contraction, private real estate debt investors will have the opportunity to make outsized returns via careful stock selection. We plan to approach the market conservatively, backing best-in-class sponsors and favouring business plans where value can be created over the life of the loan. We will also be laser-focused on asset selection and favour investment classes that can clearly demonstrate longevity, even in market downturns.
The advantage we have, having joined to build the real estate debt business in September last year, is that we do not have a heritage loan book to manage and we can be very careful in terms of stock selection. We propose to remain asset class agnostic, as we believe that certain assets in all asset classes will be able to achieve outsized return premiums.
How can private debt fund managers differentiate their offering in this climate?
RH: There are two ways to look at this. The first is from a sponsor lens, where the focus is really around speed and certainty of execution. Ultimately this is a competitive marketplace and one of the USPs of what we do is the service we can give around certainty for sponsors, which will become even more pertinent in refinancing plays. Private debt managers that can comprehensively underwrite transactions and meet tight deadlines will outperform those that cannot, particularly when dealing with private equity counterparties, and there is a return premium that can be charged for that.
In addition, providing flexible capital and structuring commercially is key, which means understanding the real estate to be financed and tailoring the structure of the loan to meet the needs of the client.
A broad-brush approach won’t lead to differentiation and it won’t lead to securing the best deals in the market. That doesn’t mean foregoing on forensic credit underwriting though – protecting and solving for downside risk events is as paramount as ever.
From an investor perspective, for our new fund a key point of differentiation has been that there are direct equity investors in our business, allowing us to look at every asset from a debt and equity perspective and lean on the intellectual capital of our colleagues.
Our sector specialists in office and industrial, for example, can really help us with the top-down and bottom-up analysis of every deal, and that is another USP we expect to take advantage of.