Real Estate Finance. Spring 2010

Transcription

1 Real Estate Finance Spring 21 EUROPEAN COMMERCIAL REAL ESTATE DEBT by Iryna Pylypchuk, Associate Director, EMEA Research & Consulting and Robin Hubbard, Executive Director, Real Estate Finance EXECUTIVE SUMMARY The Continental European commercial real estate (CRE) debt market as a whole is facing very similar problems to those already identified in the UK. The internationalisation of investment and lending in led to convergence across the European debt markets, as well as real estate investment. Across Europe there is, therefore, a large legacy of problem debt, with a significant build-up of maturities over the next three years. To help analyse this CB Richard Ellis has developed its Model, based on our data for the annual volume of transactions being completed across Europe and the type of investors involved. The results show a total of 97 billion of outstanding CRE debt at the end of 29. Of this, the UK and Germany represent by far the largest share, between them accounting for well over half of the total. As with our earlier analysis of the UK market, to further understand the outstanding European debt, it has been divided into five segments, based on three triggers date of origination, initial LTV and the quality of the underlying property (see chart below). Two of these segments High LTV debt secured on good quality real estate and High LTV debt secured on poor quality real estate are of greatest concern. Together they represent over 39 billion of potentially problematic loans, heavily weighted towards the UK and Germany yet again clearly distinguishing these two markets from the rest of Europe. In addition to the scale of the problem, there are two further factors that distinguish the rest of Europe from the UK. On average, the fall in capital values across Continental Europe has been somewhat less than that in the UK and the fact that again on average initial did not reach quite the same high level. In most countries, therefore, the scale of problem debt is not as great as that in the UK, although individual loans may be under just as much stress. Of the problem debt, that secured against poor quality property represents the greatest problem for the banks to work out. Current trends suggest a further separation in performance between prime and secondary property. Rising values may therefore re-float debt secured against prime over the next few years, but are much less likely to rescue that secured against secondary. While the problems may be the same, the solutions will differ significantly from country to country, depending on the health of the underlying real estate market, the degree of exposure to debt secured on secondary assets and cultural and legal differences. European Commercial Real Estate: Current Profile of Outstanding Debt billion 3 25 UK Germany Rest of Europe Total Size: 97 billion The support that lenders are receiving from government and from asset protection schemes means that they will be able to phase the work out of their problem debt over an extended period. A flood of secondary property onto the market is therefore unlikely Old Debt (Pre 25 issuance) Long-term Debt (Post 215 Maturity) Property Low Property High Poor Quality Property High

2 Real Estate Finance ViewPoint LONG-TERM AGENDA The credit crunch and the subsequent economic downturn have had a significant impact on lending activity in the European CRE market. The last two years have seen a marked turnaround from the boom in lending in to the constrained real estate financing market which we are in today. Combined with substantial falls in real estate values, this leaves both lenders and investors having to re-evaluate their thinking and more importantly an extremely large lending legacy to manage. With the exception of the UK, there is very limited information available on the overall amount and characteristics of outstanding European real estate debt. The most recent Europe-wide study carried out by the European Central Bank estimated 1.1 trillion outstanding as at the end of 27. However, it acknowledged that there were data inconsistencies from country to country. activity and capital value growth, particularly in just before the credit crunch hit. This triggered an upward spiral, as easy availability of cheap debt encouraged real estate investors to follow ever more aggressive borrowing strategies. In turn, this allowed them to pay higher prices, driving European CRE values to historic highs. The CB Richard Ellis European CRE Debt Model estimates that there was around 97 billion of European CRE debt outstanding at the end of 29. The UK and Germany account for well over half of this total, mirroring their typical share of European CRE investment activity. Further analysis shows that there are other characteristics that distinguish these two markets from the rest of Europe. Figure 1. Total Size: 97 billion In our previous study, released in December 29¹, we looked specifically at outstanding UK CRE debt; its size, quality and its impact on the UK real estate market. In extending this study to consider the wider European debt market, we have created a model of European CRE debt applying the same methodology as used previously. Our data on the total value of CRE investment transactions is used as the underlying driver of the model, as a substantial proportion of lending activity is triggered by new transactions. However, the experience of the CB Richard Ellis debt advisory professionals located across Europe also provided detailed insight into the behaviour of banks and lenders, as well as key lending measures, such as the level of re-financing, typical and loan maturity profiles. This approach, although theoretical, allows us to derive a pragmatic view of the outstanding debt and provide the most comprehensive overview of the European CRE debt market to date. It is important to stress that our study looks only at the commercial real estate market. It is worth mentioning that multi-family residential property also saw a boom in investment in 25-27, particularly in Germany. Much of that activity was also fuelled by high levels of debt, much of which was refinanced as CMBS and now faces similar problems to that in the commercial market. However, that lies outside the scope of this report. THE SIZE OF THE PROBLEM Commercial real estate lending has seen very strong growth over the last decade, and has risen faster than overall lending. This increase was fuelled by the boom period in the CRE market both in terms of investment Rest of Europe 42% [1] UK Commercial Real Estate Lending Report: A Two-tier Market is available from our website at Germany 24%, De Montfort University UK 34% Almost 1 trillion of CRE debt is clearly a very large legacy to manage and refinance tasks that lenders (and many European governments) will be trying to tackle over much of the next decade. A large proportion of the debt that was due to mature in late 28 and 29 has been rolled over or extended for a further couple of years. This extension policy has worked so far in preventing immediate defaults, although it is starting to show through in the build-up of short-term maturities. In fact, almost half of the total European debt outstanding is due to mature over the three years to the end of 212 averaging 155 billion per annum. The refinancing risk represented by these looming debt maturities therefore requires immediate attention. Page 2

3 Figure 2. European Commercial Real Estate Debt Maturity Profile billion UK Germany Rest of Europe Post 217 The picture for European CMBS In many ways Europe s CMBS market is a microcosm of the entire European real estate debt sector, only more so. Over 6% of the CMBS ever issued against European property (nearly $2 billion) was issued during the period, the peak of the market in value terms. It is also true to say that, although the circumstances vary between individual loans, the majority of this was issued at higher than average and on poorer than average quality real estate. Figure 3. European CMBS Issuance in Europe UK Germany Italy France Netherlands Pan European Others There was also a substantial amount of multi-country issuance. This represents around 19% of the total from and is made up of loans from around Europe. A significant proportion of this is secured against property in the UK and Germany, although it also includes significant amounts of debt relating to Central and Eastern Europe. The maturity profile of CMBS is very diverse. There is a substantial proportion that was issued with very long maturity. Typically this is based on sale-and-leaseback transactions where the owner-occupier took a very long lease on the property. In some instances the tenor of these loans is 15 years or longer. However, there are substantial amounts with a much shorter duration, many of which are maturing over the next few years. Rating agency Fitch, for example, are tracking some 55 billion of CMBS due to mature in The recent track record of CMBS maturities has been poor. Of the ten loans that were due to mature in January 21, according to Fitch: - three were repaid ahead of schedule; - two had their maturity extended; and - five are in standstill, or being worked out by the servicer or special servicer. While this paper does not seek to specifically address the issues surrounding CMBS, it is clear that this type of debt will generally tend to suffer more in the current market conditions. Furthermore, the inherent difficulties in rescheduling CMBS, with their multiple opposing investor classes, will prove a considerable impediment to full value recovery. Real Estate Finance ViewPoint THE HEALTH OF EUROPEAN DEBT Source: CMSA The geographic split is also quite interesting. Compared to the UK and Germany, CMBS issued on real estate in other European countries is negligible. By far the largest proportion is secured against UK property, accounting for nearly half (47%) of the issuance in 25 to 27. Germany also has a substantial legacy of CMBS from this period, at 21% of the total. At the other end of the scale, Spain represents only.3% of the single country CMBS issued over this period, mainly as a result of the attitude of local regulators who made it virtually impossible for the Spanish banks to get involved in the market. Undoubtedly the very large amount of outstanding European CRE debt has implications for real estate investment activity and pricing. In particular it curtails lenders ability to finance new transactions, as considerate amount of additional lending capacity is absorbed in refinancing or extending existing loans. However, not all of it is bad debt. When carrying out the UK analysis, a number of key measures were identified as most influential in determining the degree of impairment that a particular loan were likely to have: The level of initial leverage (as measured by loan-to-value); The point in the cycle when the property was acquired; and The quality of the underlying property. Page 3

4 Real Estate Finance ViewPoint These principals also hold true across the rest of Europe. However, the different structures of real estate markets, their size and the profile of value changes in govern the extent to which each country has a problem with its outstanding debt. 1. Level of initial leverage The higher the initial leverage of the loan, the more likely that loan is to be problematic today. As has typically been the case in the past, the earlier part of the decade saw a balanced distribution between low-geared core investors and those using higher leverage. It was not until around 25 that highly leveraged investors started to grow rapidly in importance. While it is true to say that the average leverage used at the top of the market increased significantly across Europe there were some stark differences. Markets dominated by local institutions and pension funds are more likely to have seen relatively moderate increases in the average LTV, even at the peak of the lending cycle. Norway is one example, where local institutions are prohibited from using leverage when investing directly. The French market too had a more balanced investor profile, with local property companies typically using more moderate levels of gearing than their counterparts in other countries. In the UK the average fall in capital value from the peak of the market in mid-27 to the trough in mid-29 was 44% according to the IPD Monthly Index. In the Eurozone, the CB Richard Ellis Capital Value Index, which tracks the value of prime property, showed a much more moderate 18% peak to trough decline. However, across the whole market value falls have been greater and our internal valuation-based indices suggest on average value declines of 2-25%, depending on the market concerned. However, this is just an average and does not mean that only loans granted at more than 75% LTV are at risk of impairment, with secondary property having typically seen greater value falls than prime. Figure 5. CB Richard Ellis Eurozone Capital Value Index 3% 25% 2% 15% 1% 5% % -5% Retail Industrial Office Figure 4. Outstanding European Commercial Real Estate Debt -1% -15% -2% Dec-1 Dec-2 Dec-3 Dec-4 Dec-5 Dec-6 Dec-7 Dec-8 Dec-9 billion In contrast, Germany, Ireland, Spain and the UK saw some of the highest levels of gearing used. In most cases this was driven by opportunistic funds and other collective vehicles, as well as the Irish private and syndicate investors. As a result, these markets are likely to have a higher proportion of problem debt arising from highly geared loans. 2. Point in the cycle when the property was acquired The timing of the origination of the loan is also very important when estimating the level of impairment. While some individual loans originated before or after the peak will be impaired, most problems will be in those originated in 26 and 27, at the high point in terms of real estate values. Page 4 UK Germany Rest of Europe Pre By Year of Issuance Quality of the underlying property The quality of the specific property used as collateral is also key in assessing the likelihood of a loan becoming impaired. It also influences the possible strategies that the lender should be considering to address the issue. Unlike the prime segment of the market, which is already starting to see some recovery, secondary real estate values have not, and we expect to see more declines in the near term. Our view is that over the next few years there will be even greater separation between the performance of good quality assets and secondary. Product shortage and strong investor demand during meant that European investors targeted a wider range of product and locations. This resulted in more lending against poorer quality secondary properties than in normal market conditions. Considering that most loans issued against such assets originated at the top of the market and at high, these will be particularly difficult to manage. The net result is that, regardless of geography, vintage loans are likely to be most badly affected by the downturn with some of the highest initial and sharpest value falls.

5 Real Estate Recovery: Separation of prime and secondary Looking ahead to the next few years a trend that looks to be of particular importance to the holders of existing debt is the further divergence in the performance of prime property relative to secondary. This is due to a number of factors on the supply and demand side of both the investment and occupier markets. The European economic recovery is expected to be weak, with total employment not getting back to its 28 level until 217 across the EU-15 as a whole. As a consequence the next few years will be characterised by relatively high vacancy and weak leasing markets, mainly driven by relocation and rationalisation. In the light of such a demand profile, occupation will tend to concentrate in newer space, with vacancy rates continuing to grow in poorer buildings. At the same time, a lack of new development starts since early 27 particularly in the office sector, but also for retail space means that there will be a shortage of new accommodation. The rental value of prime, new space is therefore likely to be increasing at the same time as secondary rents are being driven down by a continuing oversupply. In the investment market, the boom drew a lot of poorer property into the market that would not have been in the investment universe in earlier years. This is particularly true in Germany, which saw rapid growth in investment turnover, from less than 2 billion a year at the beginning of the decade to over 5 billion a year in Since then, the European market has reverted somewhat; the buyers currently active are mainly risk-averse, institutional investors. This change in the mix of investors limits the demand for secondary investments and the new types/qualities of property that were bought and sold at the peak of the market. However, it is exactly this quality of real estate that is most likely to be securing non-performing loans and where there is a ready supply of investment opportunities that can be put into the market by the banks. There is therefore a significant imbalance between demand and supply in the investment market. Strong investor competition is pushing up the value of prime real estate, but the capital value of secondary property is stable at best in most countries. The relative value changes between the two classes of property are well illustrated by the growth in the spread between prime and secondary yields. At the peak of the market, in mid-27, this had shrunk to only around bps. So if prime property was trading at 4.9%, good secondary investments would have been priced at 6.%. Nearly three years on, the CB Richard Ellis prime yield index for the Eurozone 2 stands at just under 6.%. However, the spread between this and secondary has jumped to 25-4 bps, reflecting yields of between 8.5% and 1.%. The current level of prime yields has already started to fall again, the average having dropped by 15 bps over the last nine months. We expect that in the short term prime yields have further to fall, particularly in Continental Europe. The spread between prime and secondary yields may therefore widen even further. [2] The index calculates a weighted average of the prime yields in the three main property sectors for around thirty cities in the Eurozone. UNDERSTANDING THE LOAN BOOK: SEGMENTATION ANALYSIS Undoubtedly the very large amount of outstanding European CRE debt has implications for real estate investment activity and pricing. In particular it curtails lenders ability to finance new transactions, as any additional lending capacity is absorbed in refinancing or extending existing loans. Figure 6. Segmentation of European Commercial Real Estate Debt Long-term Debt (post 215 maturity), 258 billion, 27% Poor Quality Property High 27 billion, 21% Total Size: 97 billion Old Debt (pre 25 issuance), 13 billion, 14% Property Low 185 billion, 19% Property High 185 billion, 19% 1. Debt originated pre-25: There are number of reasons why this debt is less problematic from a lender perspective. Firstly, most of these loans were issued before the boom in capital values and on relatively long tenors. It is also likely that most of the Page 5 Real Estate Finance ViewPoint

6 Real Estate Finance ViewPoint underlying property is of comparatively good quality. Another important factor to consider is that many of these loans were amortized, thus at least some of the original debt will already have been paid off, leaving both the borrower and the lender less likely to be out of the money. Interestingly, Italian lenders maintained the requirement for loan amortisation even at the top of the market in Finally, although some properties (particularly in the UK) will have fallen in value, most Continental markets have actually seen a small increase in the value of better quality property since However, according to CBRE s Model only 13 billion of the current outstanding debt was originated before 25, just 14% of the European total. 2. Debt maturing post-215: Longer-term loans maturing after 215 make up a significant proportion of the total, with around 27%. As around two-thirds of these loans were originated in it is likely that on average they were granted at relatively high. However, even at the top of the market, when underwriting standards were slipping, lenders remained more demanding when issuing loans with longer maturities. It is therefore more likely to be secured against good quality property with a good covenant. CMBS is over-represented in this segment relative to the market as a whole, particularly in the UK and Germany. Overall, lenders are unlikely to prioritise action on long-term debt, expecting that where it is currently impaired, growth in capital values over time will restore their security. However, they will need to ensure that the existing owners are incentivised to maximise the value of the asset where the value of any equity has been wiped out. 3. Low LTV debt secured on good quality real estate: This is the healthiest segment of the European debt market. As the pricing for good quality assets has already started to recover, loans within this particular segment should be relatively easy to refinance even in the current market. However, there are geographic differences in the way that 185 billion total is distributed across Europe. In the UK and Germany such loans account for 16% and 12% respectively, while it accounts for about 26% of the total in the rest of Europe. Such a result is not surprising, considering the differences in investor profiles. The very low proportion of low LTV debt in Germany, for example, was due to a complete turnaround in the investor base during the peak years. Core investors (such as open-ended funds) were largely absent on the buy-side and the market was dominated by more opportunistic foreign investors. 4. High LTV debt secured on good quality real estate: High LTV debt secured on good quality real estate has Page 6 a relatively high risk of problematic debt. Despite the prospects for value recovery for prime property, the very aggressive terms on which these loans were agreed mean that this will be insufficient to raise values back to a level that exceeds the outstanding debt. However, whilst it may be true that most of these loans are in technical LTV breach and may have little or no equity left, the good quality of the underlying real estate means that rental income is still likely to be generating enough to pay the interest due. Furthermore, because of the good quality of the underlying real estate lenders have a relatively wide range of options open when looking for solutions for a non-performing loan. At 19% of the total European debt, the share of High LTV debt secured on good quality real estate is more or less the same across the analysed markets. Weak development cycle: low supply of good, new stock A feature of the credit crunch was the way that it cut off the funding for development across the whole of Europe from 27 onwards, just as the development cycle was beginning to pick up. As a result, the peak in development activity in 28 was much weaker than in previous property cycles and the amount of space being completed is falling away quickly in 211 and 212. As the economy starts to pick up and occupiers start to look around to relocate from older buildings to new space, they will be faced by a shortage of supply across Europe. Vacancy in older, poor quality space will grow, while the rental values of prime space will be driven up. Figure 7. Office Development Completions in Western Europe, s sq m 8, 7, 6, 5, 4, 3, 2, 1, Office Development Completions (LHS) EU-15 Vacancy Rates (RHS) 12.% 9.% 6.% 3.%.% The bottom line, therefore, is that secondary quality assets will continue to decline in value and suffer weak demand characteristics in the mid-term be that from an occupier, investor or lender perspective.

7 5. High LTV debt secured on poor quality real estate: This is by far the most problematic segment of European CRE debt. All three health measures are signalling a problem high initial on loans secured against poor quality assets, mainly issued at the top of the market. Probably most of Europe s 27 billion debt in this category is already either in breach or soon will be. It is difficult to see much upside potential in the near term for this debt segment a great concern considering it accounts for over a fifth of the European total. Figure 8. Segmentation of European Commercial Real Estate Debt billion Old Debt (Pre 25 issuance) UK Germany Rest of Europe Long-term Debt (Post 215 Maturity) What is even more concerning is the degree to which some countries are exposed. Germany and the UK have a very high concentration of debt secured on poor quality property, each at around 3% of the total outstanding, compared with only 12% in the rest of Europe. This level of exposure is a reflection of the trends in the underlying CRE investment markets in The situation was particularly marked in the German investment market, which more than doubled in size over 26 and where national portfolios spread across a great number of locations, mostly secondary, became a market-entry strategy for opportunistic buyers. Debt in this category is most likely to find its way into the asset protection schemes or bad bank structures that European governments are considering to help manage out the banks bad loan books. THE OVERALL PICTURE Property Low Total Size: 97 billion Property High Poor Quality Property High The problematic debt is most likely to be in the Good quality high LTV and Poor quality property high LTV categories, which between them account for 4% of the total outstanding debt at just over 39 billion. It is important to note, however, that there are major differences in the loan books of different lenders, with some banks having very different profiles to that of the market as a whole. This is especially the case for lenders who entered the market relatively late from 25 onwards leaving them more likely to be exposed to the Poor Quality real estate High LTV category. As highlighted earlier, Germany and the UK have a particularly high exposure to these problematic debt segments, at 49% and 44% of the national total respectively. Government support will extend the restructuring of the European CRE debt problem The issues identified in this paper provide further clarity on the scale of the problem facing lenders (and CMBS noteholders). Most banks have recognised the issues in their portfolios and have spent the last year or so putting restructuring teams in place and trying to develop an understanding of where the worst of their problems are concentrated. In some cases, those banks most heavily impacted by the recession (remembering that banks do make credit available in other areas of the economy and not just CRE) had to seek government support. The National Asset Management Agency (NAMA) in Ireland and the Asset Protection Agency (APA) in the UK are the most high profile examples of these. Interestingly these two schemes are not structured in the same way NAMA is buying the bad loans from Irish banks, while the APA is providing a form of insurance on the value of the loans. Whichever route these and other governments choose to go, the common theme seems to be the desire to work out the problem loans in a way which recovers as much value as possible for the sponsoring government and ultimately their taxpayers! Governments will do whatever they can to avoid the politically unacceptable embarrassment resulting from the wholesale disposal of loans and/or the properties collateralising them, only to see the buyers make outsized profits in future at the taxpayer s expense. The consequence of this philosophy is the adoption of a strategy for value recovery that does not have a specific timescale attached to it, but is more concerned with the negative value implications caused by a flood of poor quality property entering the market. We therefore believe that the lenders with the majority of problem debt across Europe, whether they are supported by government agencies or not, will take a very measured approach to the work out of those loans, extending the timeframe of the recovery to perhaps up to ten years, depending on the speed of economic recovery in each jurisdiction. Real Estate Finance ViewPoint Page 7

8 CONCLUSION: OPPORTUNITY IS UNLIKELY TO ACCOMPANY DISTRESS Real Estate Finance ViewPoint CBRE s European CRE Debt Model clearly highlights the large amount of debt outstanding that was originated at high. Those loans secured against better quality property are likely to be re-floated by the market over time and will mostly require only relatively passive asset management to bring the original equity back into the money. Generally the owners will be more motivated to take part in any consensual restructuring and the lenders will be willing to support the owner to make it work for all parties. Much more worrying is the presence of the 27 billion pool of loans secured on poor quality property. While there will undoubtedly be some better quality secondary property whose value will be dragged up with the improvement in prime values, the majority of this pool will struggle to see significant capital value appreciation in the near or even medium term. In fact, active asset management will be required to ensure that values do not fall further as a result of shortening lease terms, rising vacancies, deteriorating condition, etc. It is precisely this boundary between good secondary and poor secondary where there is the most value to be recovered by the lender and where a new owner can make the most money one bank s distress is another vulture fund s opportunity. However, in today s market banks are not simply selling off loans for others to benefit from. With the help of government backing, equity issuance, and rapidly rising profitability, lenders are undertaking a much more methodical approach to recouping value. This primarily involves leveraging of their relationships with asset managers and capital providers. While the scale of the problem may be large, banks solutions span over a longer timeframe and they are able to control the process and the flow of assets onto the market. Despite generally weak market conditions there is still a lot of opportunistic capital hanging over from 27, as well as funds which have been raised more recently. Furthermore, hedge funds and other private equity players have increased their allocation to real estate. With this capital raised and seeking distressed opportunities, the demand is generally exceeding the available supply. Provided discipline is maintained by the banks, the work out will clearly take time, but the end result will be lower losses for the lenders and slim pickings for the vultures. Unfortunately there will remain a residual pool of tertiary property that will probably never recover materially in value and for which the best solution for the lender is simply to foreclose and recycle whatever proceeds arise back into their business. For more information regarding the ViewPoint, please contact: Iryna Pylypchuk Associate Director, EMEA Research CB Richard Ellis St Martin s Court 1 Paternoster Square London EC4M 7HP t: e: iryna.pylypchuk@cbre.com European Debt Advisory Network: DISCLAIMER 21 CB RICHARD ELLIS Information herein has been obtained from sources believed reliable. While we do not doubt its accuracy, we have not verified it and make no guarantee, warranty or representation about it. It is your responsibility to independently confirm its accuracy and completeness. Any projections, opinions, assumptions or estimates used are for example only and do not represent the current or future performance of the market. This information is designed exclusively for use by CB Richard Ellis clients, and cannot be reproduced without prior written permission of CB Richard Ellis. Page 8 Robin Hubbard Executive Director, Real Estate Finance CB Richard Ellis Kingsley House, Wimpole Street London W1G ORE t: e: robin.hubbard@cbre.com Natale Giostra Senior Director, Real Estate Finance CB Richard Ellis Kingsley House Wimpole Street London W1G ORE t: e: natale.giostra@cbre.com Robert Jan Peters Amsterdam t: e: robert jan.peters@cbre.com Dirk Richolt Frankfurt t: e: dirk.richolt@cbre.com Eleonora Pulci London t: e: eleonora.pulci@cbre.com Emilio Miravet Madrid t: e: emilio.miravet@cbre.com Luca Zaffaroni Milan t: e: luca.zaffaroni@cbre.com Philippe Deloffre Paris t: e: philippe.deloffre@cbre.com Copyright 21, CB Richard Ellis