Debt funds limbering up as funding gap widens

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With banks in full-scale retreat on the financing front, and likely to remain so for the immediate future, any way out of the current financing logjam is going to be accompanied by debt funds and other alternative finance providers. The big question for most investors will be just how much they can afford to access funding - but access it they certainly must, with waves of refinancing looming and little appetite from the banks to underwrite lending on anything but the bluest of blue-chip opportunities.

Many debt funds that REFIRE is in contact with are flexing their muscles for the chance to capitalise on the structural changes and current disruptions in European real estate financing to achieve attractive risk-adjusted returns. For the moment, the lack of meaningful deal flow is still making it impossible for all lenders to be confident about the direction real estate values are headed, with much depending on what the European Central Bank will do to stop its tightening, and what impact this will have on valuations. So far all-in real estate borrowing costs have soared to more than 4.5% over the past eighteen months, and troubles in the banking sector, including at Deutsche Bank and Credit Suisse have dealt a blow to banking and real estate.

Many debt funds are confident they have the right products to fill the yawning funding gap, without having to take mezzanine tranches to generate an adequate return, while lending at lower levels of leverage and charging higher margins than previously.

A recent study by investment manager Empira Group points to how debt funds are well poised to profit from this heightened need for financing. Despite the current lull in investment, Empira expects overall financing volumes from alternative lenders to rise. Head of research Steffen Metzner cites a lack of supply, particularly in the housing market, partly caused by stricter demands on sustainability.

Banks are now also facing a stricter regulatory environment. "Basel III has tightened the requirements for banks' risk management, thus pushing certain loans off banks' balance sheets. Project developments, for example, are now rather unpopular with banks, especially when it comes to properties that are difficult to value due to a lack of comparable properties in the bank's rating system," said Metzner. These would include properties in the retail, leisure and hotel sectors, he added.

With this more restricted outlook, dealing with banks may have other disadvantages for borrowers. "Banks usually take a very schematic approach to credit assessment and sometimes have very rigid limits up to which loan-to-value ratio they would go. Anything that is no longer on bank balance sheets basically should look for other sources of financing," said Metzner, whose company is itself a debt financier.

The alternative financiers such as debt funds have the advantage of being more flexible, can make speedier decisions, are not constrained by rigid LTV limits and can provide more tailor-made solutions to customers. These advantages invariably come at a price. But that price is attractive enough to have drawn many new entrants, domestic and foreign, into the market. Low yields on direct investment on the equity side has also enticed many fund providers to switch to lending their own money on others' projects.

REFIRE recently visited Edmond de Rothschild REIM in Frankfurt, who is putting together its third fund, with a view to deploying up to €600m over the coming years, to add to the €350m it raised for its first two funds since 2020, both now closed to investors. The new fund is targeting a net IRR of 9% (unlevered), and a target portfolio loan-to-value ratio of 70%.

Ralf Kind, the head of real estate debt at EDR REIM, said the goal was to build a diversified pan-European credit portfolio with a focus on first-lien secured whole loans, which will be extended to experienced and well-capitalized borrowers. "High inflation rates, rapid interest rate hikes, and an uncertain economic outlook are widening the financing gap in the commercial real estate financing market. As a result, the market share of real estate debt funds will continue to significantly increase in the coming years. Investing in real estate debt offers an attractive opportunity for investors to benefit from higher interest rates, lower LTVs, and tighter credit security structures," he said. A significant pipeline for the new vehicle is already in place, he said.

Also launching its first pan-European debt fund is Frankfurt-based manager Prime Capital. The firm is looking for €500m in equity for its first co-mingled real estate debt fund. It is no stranger to the European property debt marked having invested more than €800m through separate mandates, but the new Prime Capital Whole Loan Fund is now seeking to procure whole loans and senior loans ranging from €15 million to €20 million across Europe – primarily Eurozone markets such as Germany, France, Benelux and the Nordics (excluding Denmark) – with a loan to value of 70-75%. It is targeting returns of around 8%.

The Fund is evolving out of previous mandates which were focused on mezzanine lending because of what executive director Dennis Davidoff described as "a huge demand from sponsors towards the strategy or a solution for the financing problem, closing the financing gap between senior and equity... Through a whole loan you only need to talk only [with] one player. Our strategy is to lend very fast but diligently to bring reliability into the process and we’re seeing a huge demand from sponsors,  which are willing to pay a higher interest rate to get this kind of product."

Davidoff told Real Estate Capital Europe that the new fund came about when one German investor, already a Prime Capital customer, said it was looking for a pool of investors to join with it in investing in commercial real estate debt. That investor has since become a significant investor ins seed capital to the fund, he said.

Prime Capital, with €5 billion of assets under management, is looking to add equity from other European institutional investors, on top of its mainly German investor base.

Many of the debt funds are pursuing a strategy of middle-risk for middle-returns, with all keeping a wary eye on ESG conformity. Christophe Murciani, Head of Commercial Real Estate Debt Funds at Sienna Private Credit, summed up the current market: "At the moment, it's all about securing the necessary liquidity for real estate companies. Medium-sized borrowers in particular need help to get their older buildings up to speed," he says. The investors' money is there, he says, and at this stage it is less risky for them to invest in real estate loans than in real estate itself.

At the end of 2022, Sienna Private Credit managed around €2.5 billion in assets. In addition to loans to companies and for infrastructure projects, financing of commercial real estate throughout Western Europe is a key pillar of the business. "We typically finance between €20 million and €60 million per project," says Murciani. "That's a little less than an investment bank would take on, but more than a typical German savings bank could handle."

Sam Mellor, Head of Europe Real Estate Debt at Barings, said it had become more difficult to find suitable assets to finance, particularly in view of ESG-compliance. Its strategy is to focus on financing buildings that are already ESG-compliant, or could be transformed into one within two to three years. While rising interest rates have a negative short-term influence on real estate prices, he said, "We cannot overlook the long-term effects of having to meet ESG criteria. The number of buildings that fail to do that is huge."

Barings can draw on years of experience of investing directly in real estate, and turned this experience into transferring its knowledge to the financing side of the business. Between 2012 and 2022 it extended loans of nearly €5bn in Europe, mainly in the form of senior financing, and mainly in multifamily, logistics and special housing with a social component.

Another potential new arrival to the European debt market is the Canadian group Slate. It made its US debut just over two years ago when it paid $2.3bn to acquire New York-based Annaly Capital Management. It is now thought to be looking to hire staff to kick off similar operations in Europe. It already has an equity platform in Europe buying cash-yielding assets critical to the supply chain, such as grocery-anchored retail centres, healthcare assets, and affiliated warehouses and logistics centres. So far it has invested more than €2.1bn across Europe, and operates five offices in the region.

Also in the starting blocks, in anticipation of growing potential for debt lending, is the Frankfurt-based Silverton, with €1.4bn of assets under management. The company had earlier planned to enter the debt space some years back, but its plans got scotched by COVID. It now plans to launch a €200m whole loan and mezzanine debt fund in 2024. The fund will target the mid-sized market for refinancing in Germany and provide loans of between €5 million to €30 million in a variety of sectors across the country, excluding project developments.

Anticipating further price falls in Germany, along with attractive entry points into the market, is PGIM Real Estate. REFIRE sat down recently with Andrew Radkiewicz, PGIM's Global Head of Debt Strategy, to discuss the company's renewed drive into the German debt lending market. To boost its push, PGIM made an additional hire of a lead originator based in Frankfurt in mid-2022, whose job is to grow the European debt platform, particularly in Germany.

Radkiewicz sees Germany not just as a growth market for real estate debt but also for PGIM's direct investment in real estate, as embodied by its €375m European Core Plus fund. With the pullback of the German banks from lending against property, he sees opportunities in senior debt lending, moving in to the piece of low-risk, traditional lending to the capital stack. On PGIM's strategy, he said: We're not going for the medium risk/medium returns approach. We either finance existing buildings where both credit and property risk are low. Or we finance developments and redevelopments. That's where the credit risk is higher, so we want to get outstanding returns there."

With funding gaps starting to appear everywhere, the trend is back to secured lending, he said, while banks are hampered by higher equity demands, with capital recycling for the banks taking more time. PGIM is actively on the hunt for local champions and international investors looking for repeat business.

"I think the current cycle of interest rate hikes is coming to an end. However, Europe is lagging in the response of valuations to the interest rate cycle. Therefore, we also expect further declines in valuations, especially in Germany, where valuation processes take some time," he said.

Incidentally, according to Radkiewicz, the three megatrends that are currently affecting the real estate world as a whole are precisely those that are relevant to real estate finance. "We call them the three Ds: digitalization, demographics and decarbonization." Decarbonization, he said, affects all asset classes and, of the three Ds, probably has the greatest impact on any real estate strategy because it affects demand from both tenants and investors. "80% of large corporations have committed to climate change and 39% of their carbon footprint is in their buildings used for business."