European debt funds stepping up to plug funding gap

Non-listed real estate debt funds are taking advantage of the current funding gap in Europe to increase their share of the lending market, as new figures from the Amsterdam-based INREV show.

Data from various INREV sources - including the INREV Debt Vehicles Universe and the INREV Quarterly Fund and Asset Level indices – show just how much the landscape for the European non-listed real estate debt market is shifting.

The ECB's policy of 'higher for longer' and a more restrictive bank lending climate have made the lending market more complex, with the move to quantitative tightening, after a decade of easy money, proving a shock. The extent of the current funding gap is now becoming more obvious. From INREV's Vehicle Universe alone, about €36 billion worth of assets is expected to come to the market over the next ten years from the closed-end fund liquidation pipeline. The funding gap for the broader market is estimated at about €94 billion.

The INREV Asset Level Index reveals that debt service coverage ratios (DSCR) have experienced a notable decrease from their peak. In 2021, the average DSCR stood at 9.67, meaning that rental income was 9.67 times higher than the debt servicing payments. This dropped to 5.11 in 2022, and to 3.17 at the beginning of 2023. These are not fully definitive figures, but they do indicate the recent direction of travel.

Offering some comfort, however, is that the average leverage in the non-listed European market is much lower than levels seen during the global financial crisis (GFC) over a decade ago. The average level of gearing in both core and value-added real estate funds has dropped to historic lows – falling to 22.2% and 38.52% in the first half of 2023, respectively. This is well below their equivalent post-GFC peaks of 57.1% and 39.7%.

Still, as the European non-listed market has continued to grow, the absolute level of debt has also increased from €45 billion in Q3 2009, to €67 billion at the end of Q2 20231. With traditional lenders maintaining caution as stricter banking regulations (most recently Basel III) limit their lending capacity, and high regulatory capital requirements make operations more expensive, there is increased room for European debt funds.

This is underlined by the latest Q3 2023 INREV Consensus Indicator Survey, with 34.6% of respondents indicating a move to alternative lenders in their search for financing – a notable increase from an already elevated 29.1% in Q1 2023.

Additionally, evidence from the NCREIF / CREFC Open End Debt Aggregate revealed that the correlation of US debt returns to core real estate returns in the US is low to moderate. In other words, private real estate debt and private real estate equity strategies are likely to be complementary, which is also likely true for the same components across the European market.

Iryna Pylypchuk, INREV Director of Research and Market Information, said: ‘At times of change, there are always opportunities, and it looks like non-listed real estate debt funds are proactively accessing this timely opportunity to step up. The evident growth of non-listed debt funds increases diversity of lending sources and promotes healthy competition in the European non-listed real estate lending market. In turn, it should also bring more stability.’