Demand for finance across Europe is such that traditional lenders cannot keep up and react fast enough, leading to a fast-growing private lending market. Nicol Dynes reports.
Private real estate debt has emerged as a sought-after class among investors. Newly initiated funds have been growing at a rate of about 20 a year and total private real estate debt volume in Europe is now estimated to be €80 billion.
“Demand for this product is very strong,” says Martin Bassermann, chairman of the board at HFS Helvetic Financial Services. “There was a decline in 2020 due to covid, but in 2021 the market has come back and the year closed on numbers comparable to pre-pandemic levels. Capital allocation potential remained high during covid as financing demand was strong.”
The reason for the sector’s growth is that traditional banks cannot cover the demand for financing, partly because of more stringent regulations and more restrictive policies in the credit approval processes of the banks.
The sheer volume of real estate development taking place is also a factor. “One million residential units are needed in Germany’s Top 7 cities alone, so there is higher demand on one side and less banking availability on the other,” adds Bassermann. “Traditional banks don’t cover the required capital demand so there are excellent opportunities to invest.”
Investors have found that private debt is a stable asset class, with low volatility even in uncertain times, and that it generates good risk-adjusted returns. A look at the US market, which has a much longer history and broader data base, reveals that commercial real estate debt delivers higher total returns than real estate investment (see page 44).
Germany versus the US
Another comparison can be made between the German and US markets. In Germany 80% of the financing is still done by banks and 20% by private debt funds and instruments, while in the US the majority of deals are done through private debt.
“The upshot is that there is a lot of growth potential in Germany and in Europe as a whole,” says Johannes Märklin, member of the management board at Corestate Capital Group. “Banks will only take a small part of the volume of financing requests, so other sources of funds are needed and will continue to increase”.
There is a significant potential for growth as a market of €80 billion in Europe is still small.
“Of the €80 billion I guess around €20 billion is in the UK and €60 billion in Continental Europe,” says Assem El Alami, head of international real estate finance at Berlin Hyp. “To put that figure in context, it is equivalent to two loan books of a bank like ours.”
The demand for alternative financing for real estate will continue to be strong over the next few years, but it will complement rather than replace traditional bank lending.
“The financing environment will stay difficult for the next two or three years, so alternative lenders will play a more important role going forward,” says Martin Braun, founding partner of Nexus Capital Advisors. “Traditional lenders have become more selective, they only finance investments that tick all the boxes and they are not interested in non-core products, while investor demand is very strong.”
Demand has kept up throughout the pandemic and is likely to keep growing as things return to normal. Covid-19 has had no impact on pricing either. There is also a need for short-term bridge financing while players wait for bank lending to be approved, so speed is of the essence. “Investors, developers and real estate players buying portfolios need quick and reliable financing,” explains Märklin. “Banks will only take a small part of this volume, so other sources of funding are coming and will continue to increase.”
Good year for banks
Despite the pandemic, traditional banks have had a good year as well. According to new figures, senior lending rose 60% in Germany last year. “2021 was much better than we anticipated,” says El Alami. “Now it’s almost back to normal, with very little impact on our portfolio. We lent very little on hotels and we have very little shopping centre exposure, so 2021 was a good year for Berlin Hyp.”
‘The play between interest rates and inflation has become very complex and difficult to foresee and there will be some volatility.’
Assem El Alami, Berlin Hyp
In such a vibrant market there is not only room, but a need for both traditional and alternative forms of financing: it is not an either/or situation, says Märklin: “Private debt is not a substitute for bank financing but it’s complementary. There is a very big opportunity for us where banks don’t participate and we forecast that institutional investors will deploy even more money on the private debt side in 2022.”
Corestate expects domestic capital as well as foreign investors from North America and Asia, including high net worth individuals, to be more active in the European market in general and in Germany in particular next year. “We have been told by a couple of Asian investors that they are pulling out of the US and focusing on Germany instead,” says Märklin. “Germany is and will remain the largest real estate market in Europe.”
Non-performing loans are set to stage a comeback in Germany, but it will be a trickle rather than a wave. “Covid has been a catalyst, bringing tenants and banks under pressure,” says Oliver Platt, managing partner at Arcida Advisors. “The German market system is robust, so we are not looking at large portfolios but at around €40 billion of single assets being sold off in 2022.”
In a stricter regulatory environment, some banks are keen to clean out their books and to find solutions to their distressed assets before they reach NPL level. “I believe the German banks will watch their default-prone NPL situations before they reach the 5% threshold and will find solutions to manage distressed assets or sell them off, so they can focus on financing solid assets,” says Platt.
More distressed opportunities
If the market environment changes, construction costs go up and rental growth slows down, then there are likely to be more distressed opportunities. “German banks have been very disciplined but may want to get rid of loans because they don’t have the capacity to deal with them,” says Braun.
There are also concerns about changes in the interest rate environment and in prices creeping up. “The play between interest rates and inflation has become very complex and difficult to foresee and there will be some volatility,” says El Alami. “Some asset types are under stress but I don’t think there will be a big wave of cleaning up by the banks.”
It will not be a wave because German banks are solid and robust says Platt, but “there will be opportunities here and there”. “After all, there is no vaccination against distressed loans.”
‘The financing environment will stay difficult for the next two or three years, so alternative lenders will play a more important role going forward.’
Martin Braun, Nexus Capital Advisors
The focus on ESG is likely to lead to more distressed assets, experts agree, as it will not be possible to repurpose all existing buildings to make them green. “Some will specialise in these conversions,” says Braun. “But there is a lot of work to be done as it’s around 75-85% of the market, so inevitably there will be stranded assets.”
As sustainability is on everyone’s agenda now, institutional investors will concentrate on the ESG-compliant and taxonomy-compliant parts of the market. Despite innovative solutions and technology coming to the rescue, older assets represent a challenge.
When it comes to distressed assets, “the best way forward is to find a solution with the debtor rather than go through foreclosure procedures,” says Platt. “You can tick all the ESG boxes, turn a distressed property into a green building, work to get the borrower back on their feet, help the community fulfil their urban development plans, work with local tradesmen and so on. ESG is a perfect fit for NPLs.”