Real estate in its economic and financial context – La Francaise REM

La Française Real Estate Managers’ CEO Marc Bertrand provides his view about the economic environment and on real estate debt.

Economic environment: rebound or relapse?
Whereas Q2 ended on a positive note, with French GDP growth for the quarter of 0.5% and indicators showing a recovery, Q3 saw economic growth plunge back into negative territory (-0.1%), on the back of a decline in exports and industrial production and stagnant demand. According to the Bank of France, GDP is expected to rebound to 0.4% in Q4, for full year growth of around 0.8% – 0.9%. Fiscal pressure, the level of unemployment and poorly controlled budgetary imbalances are all obstacles to a sustainable recovery. In this respect, the rating of French debt has again been downgraded by the US agency Standard & Poor’s.

In the eurozone, after the clearly positive data at the end of the summer, the leading indicators (PMI, IFO, etc.) point to a very fragile recovery, accompanied by a worrying slide in inflation. While Germany is slowly taking off again, Spain has finally emerged from recession. However, the region continues to be adversely affected by an unfavourable euro exchange rate which neutralises the competitive disinflation efforts of some countries. Meanwhile, the United Kingdom has returned to the growth path (0.8% in Q3) thanks to a very accommodative monetary and budgetary policy.

The global environment seems to be improving. While the United States and Japan are growing respectively at an annual rate of 2.8% and 2%, the most encouraging newsflow has come from the emerging regions, particularly for China (GDP, PMI).

Financial environment: a durably accommodative monetary policy
With year-on-year inflation of 0.7% in October, eurozone inflation is now at very low levels, leading the European Central Bank to reduce its key rate by 25bp, to 0.25%. Moreover, and even though it was not explicit, this action was aimed at correcting
the euro exchange rate, which reached USD 1.38 in October, which started to threaten the competitiveness of European exports. Consequently, Europe is in a very low interest rate environment, with the 10-year OAT yield falling back to 2.25% (vs. 2.70% in September 2013) and the 10-year Bund yield to 1.60% at end-November 2013. The slowdown in the issuance programmes of the eurozone’s southern states is likely to lead to the continuing easing of peripheral yields at the end of the year.

In the United States, the surprise announcement in September by the US Federal Reserve of the continuation of its liquidity injection programme at an unchanged pace resulted in a marked decline in interest rates, to 2.60% for 10-year US Treasuries
at end-November, vs. 2.93% in September. Moreover, the fact that there has been less legibility regarding economic statistics in the wake of the «shutdown» is likely to encourage the FED to postpone the scaling back of its asset purchases until the
beginning of 2014.

Property debt, shortly a fully-fledged asset class?
For nearly 2 years now, investors in property debt have been partially substituting the banks in the financing of property. This situation stems from demand fuelled by refinancing needs for debt reaching maturity, as well as new acquisitions, i.e. in French tertiary property an annual financing flow of €5 billion to €10 billion. It is also a response to the relative withdrawal of the banks, leaving room for institutional investors seeking alternative products generating attractive returns. As illustrated by the financing landscape in the United States, the trend towards banking disintermediation now seems to be a lasting situation.

How is the market organised?
Banks have kept their dossier origination role, but now tend to favour an “Originate to distribute” model resorting to investors grouped together in club deals. With the exception of insurers, which can intervene directly, these “alternative lenders” use collective debt management platforms offering portfolio sourcing, management and pooling.

Moreover, the market has already begun a segmentation process, based on the risk/return profile of financed assets (“core”, “core +”, etc.) as well as the types of debt (“senior”, “subordinated”).

A secure investment
While property debt offers the qualities of the physical underlying asset in terms of size, diversity and liquidity, the investor benefits from specific protection:
• In the senior debt segment, the level of leverage (around 50%), the amortisation and maturity (5 years) minimise the risk of non-debt servicing,
• Financial covenants (LTV, ICR, etc.) are drawn up in order to control the risk for its duration and act preventively in the event of a risk situation,
• Guarantees cover the underlying asset and the rents (Dailly assignment), with the security of the recording of the transaction by a notary,
• In France, the investment is made via a FCT (mutual securitisation fund), a flexible and inexpensive vehicle managed by an approved Management Company as well as by a Depositary and a Delegated Management Company.

Performance factors
For an investor, the property debt segment offers several advantages:
• A variable rate product offering a hedge against inflation,
• A “spread” reflecting a market configuration that is favourable to lenders,
• Favourable regulatory treatment, with a SCR (Solvency II) below 10%.

In an asset allocation, the return on property debt compares favourably with other products such as fixed income and constitutes an appropriate complement to physical assets in a property allocation. Choice of manager partner Against a durable backdrop of a maturing segment and the proliferation of players, the choice of manager partner based on the criteria of sourcing, knowledge of underlying assets and insofar as possible the alignment of interests, is naturally decisive.

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