OUR INSIGHT #6
MARKET INSIGHT: REAL ESTATE DEBT MARKET
Real estate debt market
The debt markets continue to show an ever-growing pool of lenders, from banks and insurance companies, to private equity and debt fund participants. Along with this increased competition, we are seeing groups moving out from their traditional ‘sweet spot’ into other lending strategies, whether that’s bank lenders dipping their toes back into development funding – for some, the first time since 2008 – or what would traditionally be considered aggressive mezzanine and high leverage debt funds with platforms now targeting senior-only loans.
To add to the array of established parties and new entrants, recent financing processes we’ve undertaken have revealed key variances and points to consider beyond traditional margin and fee metrics.
In particular, we have seen a range of loan bases offered, with different lenders pricing relative to Gilts, SONIA and Bank of England base rate or on a fixed rate basis for the same asset and exposure. These variances can in turn create a wide differential in all-in pricing, with indicative reference rates ranging from 1.00% for base rate lending, to 2.25% for SONIA swaps. Furthermore, there is a degree of execution risk and uncertainty to be managed with each approach, which can lead to fixed-rate options providing the best balance of pricing and certainty. This is particularly relevant in the current inflationary environment, where we have seen the benchmark 5-year SONIA swap move from 0.4% a year ago, to 0.2% at the start of the year, and 2.0% today.
The proliferation of debt funds and higher cost of capital groups have also resulted in a further intricacy around pricing and competition, where many lenders are locked into a minimum overall IRR to meet fund criteria, but with greater flexibility around covenants and leverage to offer. This leads to groups competing over total loan proceeds and ease of operation, instead of pricing where minimum IRR levels are being hit.
Other points of interest from these discussions include the effect of rising base rates on secure long income investments, along with lender appetite for medium- and shorter-term income projects. For long income focussed investment, the opportunity to realise attractive cash-on-cash returns through ultra-low all-in financing has passed. And with swap rates moving by up to 200 basis points, this is now beginning to impact underlying asset pricing. For the medium-term income propositions, this is perhaps the one area currently undersupplied in the market, where the leasing and income profile doesn’t support traditional super secure senior lending. However, project underwriting similarly doesn’t support the cost of more intensive asset management-focussed funding, given the extended project timetable.
In summary, the real estate finance market continues to demonstrate a depth of liquidity and diversity of offering to support most investment goals. Yet the days of simple margin pricing analysis have well and truly gone. The ability to analyse and understand the key value and risk drivers for investment and asset management strategy and to overlay the optimum financing solution remain critical skills in successful real estate investment execution.
This is where we add real value to our investors.