Global uncertainty and creeping pessimism putting dampener on German lending market

Increasing uncertainty in global markets mixed with creeping pessimism is putting the brakes on the lending market in Germany.

‘Europe is at a crossroads,’ said Assem El Alami, head of real estate finance at BerlinHyp. ‘We have Brexit uncertainty and upcoming elections in France and Germany. If the French elections go well, it will send a positive signal to the market.’

Subdued sentiment in Germany’s commercial real estate financing market is taking its toll. In the first quarter of 2017, the German Real Estate Finance Index (DIFI) fell below zero for the first time since 2012, tumbling 16.4 points to -12 points. Increased pessimism is due to both a negative assessment of the past six months as well as pessimistic expectations for the next six months, according to JLL and ZEW’s recent DIFI report.

‘As our DIFI Report shows, people are more pessimistic about the upcoming six months, especially regarding financing retail and residential properties, due to falling sales in retail properties last year and stagnating retail rents in city centres in the ‘Big 7’,’ said Markus Kreuter, head of debt advisory at JLL in Frankfurt. ‘Residential deals fell by 50% last year, due to the lack of product coming to market. As a result, none of our participants expect financing conditions for these two sectors to improve over the next six months.’

Other barometers paint a similarly gloomy picture, including the quarterly barometer issued by the Stuttgart-headquartered financing consultant BF.direkt on German real estate financing sentiment earlier this month (March). Indeed, just 22% of the 120 respondents were optimistic about Germany’s lending market in Q1 2017, less than half of the 47% that were optimistic in Q4 2016.

The survey is carried out every quarter by market researchers BulwienGesa for BF.direkt, who interview 120 individuals across a range of different bank types, but who are directly responsible for lending to real estate companies.

There are ‘three main clusters’ of lenders in Germany today, according to Kreuter: those who won’t lend at an 80 bps margin and complain when someone else does for 79 bps. Then there are lenders who will take on a bit more risk, whether it’s city centre hotels in the ‘Big 7’ or alternative assets, to achieve a loan margin of between 120 bps and 150 bps. Lastly, there are the value-add/opportunistic lenders who will go up the risk curve but who expect loan margins of 170-220 bps.

Is the German market headed towards a replay of 2007?

Some advisors are becoming concerned that the German lending market could be headed towards a replay of 2007: ‘If, as at the moment, the number of core properties for sale is limited, it follows that the opportunities for core lending are as well,’ said Kreuter. ‘Although it looks as if last year could be a record year for German banks, the problem is going to be if we start heading in the direction of 2007.’ Kreuter cites office properties for sale recently with less than two years left on the lease and vacancy rates in excess of 20%, which are in B locations.

‘When more of that starts coming to market, we’re at the edge,’ he said. ‘We’d have a fatal collision caused by investors once again becoming desperate for higher returns and lenders going along with it. We’re not there yet but it could be a problem next year, if lenders haven’t learned their lessons from 2007.’

Lenders seek new ways to differentiate

A huge part of the problem is that loan margins have tightened to such an extent in Germany over the past two years - they have slumped to as little as 80 bps on a loan backed by a core asset in a ‘Big 7’ market – that lenders are being forced to find new ways to differentiate themselves from their competitors. One such way is to provide cross-border financing, including Germany as part of a cross-border portfolio, according to Christian Schmid, managing director of business and syndication management at Aareal Bank. ‘Our strengths lie in the expertise and ability to structured complex financings, the expertise for the financings of hotels, shopping centers and logistic properties,’ he said.

For El Alami, the ability to differentiate is crucial: ‘However, there are several ways to do that other than pricing, such as the flexibility of covenants,’ he said. ‘If they allow an investor to work on the portfolio, it will work in the lender’s favour. We can also differentiate ourselves on big ticket deals because not all lenders want to underwrite them.’

El Alami also notes that ‘core margins can’t compress anymore’: ‘On average, they have fallen by 20 bps in the past two years. There’s not much more to squeeze which means that some lenders are tempted to squeeze their risk profile. We’re not.’

However, there some signs that loan margins are starting to bottom out, according to Schmid. For long-term lenders there is some good news: loan margins on longer term loans of around 10 years or above have started to increase to around 150 bps or above, which will be welcome news to alternative lenders such as insurers who have often found it a challenge to make adequate returns.

Value-add assets come out of the shadows

As core loan margins tighten, many lenders are turning their attention to value-add assets, according to Norbert Kellner, head of debt capital market real estate at Helaba.

‘Value-add will be an essential aspect this year,’ Kellner said. ‘When we underwrite loans on value-add assets we do it only with experienced partners. We wouldn’t follow opportunistic investors we’ve not worked with before. To differentiate ourselves, it’s important to be able to underwrite complex transactions that we can later syndicate into the market. Timing is also key, given the huge competition out there. As a lender, you have to be able to act as quickly as your clients.’

‘Green’ financing on the increase

‘Green’ financing is gaining momentum, according to El Alami, who said that BerlinHyp wants to lend more on sustainable properties this year. ‘Last year, we introduced a scheme whereby we offer investors a discount of 5-10 bps on their loan term if the underlying asset is certified as sustainable. Green financing accounted for around 20 % of our new business last year.’

However, green financing is ‘still embryonic’, according to Antonio de Laurentiis, head of CRE Finance, at AXA IM – Real Assets. ‘On the equity side, AXA IM – Real Assets is very committed to sustainable investment and we are starting to investigate it on the debt side,’ he said.

Lenders swell their loan books

Despite ongoing uncertainty in the market, lenders are still managing to underwrite significant loan volumes. BerlinHyp underwrote € 6b in new business loans last year, an increase of 10 % on 2015. It hasn’t released a forecast for this year. Aareal Bank, for its part, underwrote € 9.2b in new business last year, according to Schmid, and expects to do between €7b and €8b this year. Helaba underwrote €10.4b in new business last year, beating its goal of €8b. It would like to underwrite an additional €8b this year.

Risk presents biggest challenge

Risk and having the discipline not to take on too much of it is the biggest challenge facing the sector, according to El Alami: ’We’d prefer to lend less this year than to lend on riskier assets. It’s about controlling the risk,’ he said.

Kellner agrees: ‘Overall, I think that discipline among senior lenders in Germany is still strong and that deals are carefully structured, although lenders have to figure out how much risk to take on, which can be a challenge. Another challenge is regulatory requirements and the impact they have on equity costs.’