Britain’s decision to leave the European Union has caused considerable political uncertainty which will impact the commercial real estate sector. As the pound slid to a three-decade low in the aftermath of the vote and the IMF downgraded the UK GDP growth forecast for 2017 to less than 1.4% the months ahead are likely to pose fresh challenges.
In the short run, we expect real estate volumes to be restrained and asset valuations to suffer. Investment in commercial real estate is likely to continue to be subdued in the second half of the year, following a record year in 2015 when €246bn was committed to the European commercial property market. For alternative lenders, in the short term, we expect to see selective opportunities to finance attractive real estate transactions that will emerge from this new environment.
Certainly, the alternative direct lending industry has developed a depth and maturity to help it cope with the current re-shaping and evolving financial and property landscape post Brexit. The industry, which started developing post the financial crises of 2008 is coming of age. There is a wide range of alternative direct lenders offering financing solutions across asset classes, leverage levels, duration and type, including bridge and development financing.
Pre 2007, the European commercial real estate finance market was dominated by banks, able to provide leverage at high levels and low margins. One of the factors driving the present growth of the alternative lending industry and one which we expect to continue post Brexit, is the structural change to the CRE market driven by bank deleveraging post 2008 and the new capital regulatory requirements on banks. The wave of new regulations introduced in recent years, such as the Basel III regulation in Europe, and the FCA’s ‘slotting’ requirements in the UK, have made it more challenging for banks to lend in certain sectors and beyond certain leverage points. This has led to banks’ retrenchment from commercial property lending activities.
This environment and the demand for financing have created the necessity of new capital for the industry, which provides opportunities for alternative lenders – according to estimates, over 50% of current outstanding European debt is due to mature by 2017. Some estimates suggest that non-bank lending was close to €150bn of commercial property lending in Europe over the last few years, increasing its market share of the overall lending activity in the sector.
In the low-yield, post-Brexit environment, commercial real estate is likely to continue to appeal to investors. Our view is that the current climate is markedly different to the external shock of the 2008/09 financial crisis. Leverage levels in commercial real estate are lower, occupational markets are more resilient, and markets are less exposed to the shocks of financial distress.
Lower valuations should create an opportunity for investments with better fundamental values at attractive pricing levels. Given the sharp devaluation in sterling, this could be of particular interest to international investors looking for exposure to the UK market.
Certainly in the short run, there will be concerns about market volatility and political uncertainty, which will impact transactional volumes and asset valuations. Nonetheless, we think the attraction of London as an international business and social hub should remain compelling, underpinned by low corporate tax rates, strong infrastructure, a favourable regulatory environment and an abundantly talented workforce. It is worth noting that most of the UK’s cities voted to remain within the EU and, as such, should be urging policymakers to maintain the best possible relationship with their European peers under any new arrangement. British cities have a strong reputation for being pro-business, pro-investment, and pro-growth.
Today’s debt funds, prevalent in major European markets such as the UK, Germany and France, are creating a complementary lending offering to traditional bank lenders and tend to focus on areas where mainstream lenders are often less interested or able to participate. Debt lenders are attracting borrowers by offering bespoke, efficient and flexible financing than traditional lenders.
Alternative lenders also have the ability to be more responsive to changing circumstances among their borrowers. This agility enables them to provide loans typically much faster than traditional players. Moreover, they are increasingly embracing loan syndications – either syndicating loans among themselves, or teaming up with banks – to remain competitive at the upper end of the market.
Also, direct alternative lenders are varied in terms of the sub-sectors in commercial property that they target. Lending for alternative UK real estate such as student accommodation and hotels recently exceeded that for traditional projects such as offices for the first time. Loans secured against hotels, student accommodation, rented housing and mixed portfolios recently made up half of the total commercial property loan requests for the first time. Though the statistics included banks as well as non-banks, such as insurance companies, debt funds and private equity houses, the latter group were well represented in the figures.
That is not to disregard the challenges that direct lenders may face post Brexit. It is difficult to anticipate at this stage precisely what form the UK’s new relationship with the EU – and the rest of the world – will take, and the intervening period may be fraught with some uncertainty. Nonetheless, subject to short term volatility and a cautious investment environment, we expect the role of alternative lenders in commercial real estate to continue to strengthen as the industry develops and matures.
Paul House, managing director and head of the Commercial Real Estate business at Venn Partners