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European CRE Debt: Secured Income with Downside Protection

10 July 2018

European commercial real estate (CRE) direct lending strategies have gained in popularity among investors, primarily due to the high level of secured income and downside protection. GAM Investments’ real estate debt team believes the pan-European market offers an expanding and evolving opportunity set, with the most attractive countries currently Ireland, Spain and the Netherlands.

European commercial real estate (CRE) direct lending investment strategies have increasingly gained in popularity among investors primarily due to the attractive level of secured income and added portfolio diversification benefits. These investment strategies directly originate private real estate loans, which generate stable interest income and provide substantial downside protection. CRE loans are secured by underlying properties which are occupied by rent-paying tenants; both the value of the properties and the diversity of the tenant income are key risk mitigants. In our view, the asset class’s unique appeal should continue to grow beyond the current market cycle.

Attractive yields relative to other assets

Returns from European CRE loans are comprised of the fees charged to borrowers at origination and upon repayment, as well as the interest on the loans, which is paid quarterly. Considering the interest component only, spread patterns for CRE loans have held up much better than for publicly traded debt instruments, making them highly attractive on both an absolute and a risk-adjusted basis. Senior CRE loans have consistently outperformed publicly traded corporate bonds with a similar risk profile on a spread basis, as illustrated in Chart 1 below.

Chart 1: UK senior real estate loan margins vs investment grade corporate bond spread

Source: BofA Merrill Lynch (A and BBB rated GBP corporate 3-5 year asset swap spread) and Cass Business School 'UK Commercial Real Estate Lending Report, December 2007'. For illustrative purposes only.

Further, returns on CRE loans are attractive when compared with direct property investments. The consensus forecasts for UK commercial property over the next five years published by the Investment Property Forum, an organisation made up of UK CRE industry participants, is a total return of 4.8% per annum, inclusive of rental income.

This is particularly true when one considers both the high level of secured income and the downside protection offered by loans. While the performance of CRE markets will vary across jurisdictions, the general view in European real estate markets is values and rents during the next five years are unlikely to grow at the pace experienced over the last five years. The downside protection offered by loans underlines the attractiveness of the asset class relative to direct property.

Leverage is low relative to historical levels

Loan-to-Value (LTV) ratios in the European CRE loan market have fallen since the 2007-8 global financial crisis (GFC) and are now at a reduced level. Prior to the crisis, banks regularly lent more than 80% of the underlying property value. Today, banks are much more conservative.

Additionally, prior to the GFC, commercial banks provided circa 95% of all European CRE loans. Competition among banks resulted in increasingly aggressive lending practices; LTV ratios regularly exceeded 80% of the collateral value and financial covenants were either watered down or disposed of in their entirety. When the cycle ended the result of these aggressive practices was disastrous – bank loan portfolios, overexposed to CRE loans relative to the historical average, deteriorated and the ratio of non-performing loans (NPLs) to total loans (the “NPL Ratio”) increased to historically high levels, as illustrated in the chart below.

Chart 2: European Union Bank Non-Performing Loan Ratio

Source: International Monetary Fund, Global Financial Stability Report, as at 23 February 2018

Pension funds and insurers picking up spare capacity from banks

Consequently, banks were forced to scale back lending operations. As a result the market was compelled to open up to meet its funding requirements and a new breed of non-bank lenders, such as debt funds, insurers and pension funds, entered the market in force, spotting a unique investment opportunity that had previously been largely unavailable.

This change in the market is structural rather than cyclical. The issue of NPLs is a cyclical one and is being addressed; however, at a structural level change is being driven by bank regulatory requirements for higher capital, particularly around certain types of activities like CRE lending.

An expanding and evolving opportunity set

The opportunity for non-bank European CRE lending began in the UK as banks there initiated programmes to dispose of, or otherwise deal with, NPLs. The opportunity then expanded across Europe as banks in other countries executed similar programmes and as regulatory capital rules made CRE lending less attractive. The opportunity set is now a European one, with Ireland, Spain and the Netherlands becoming the most attractive markets for CRE loan investing.

A pan-European approach offers substantial benefits in addition to overall diversification; CRE values in most European markets are still lower than the last peak. For example, CRE values would need to fall more than 25% in Ireland, Spain and the Netherlands to equal the lowest point in value in the last 20 years. While there is no guarantee that values will not fall below the lowest level witnessed in the last 20 years, the inherent downside protection available in CRE loans should comfort investors in our view.

A combination of attractive returns and downside protection

The structural shifts in the market for CRE lending have created an opportunity for investors to achieve attractive, secured income returns from an asset class that provides substantial downside protection. CRE loans provide a unique and highly attractive risk/return substitute or addition to other forms of strategically held fixed income debt. The opportunity created by the structural shift in the CRE lending market means that it is becoming a mainstay of many investors’ portfolios.

Important legal information:
The information in this document is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained in this document may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information. Past performance is not an indicator of future performance and current or future trends.
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