Germany’s mezzanine finance market is becoming more agile, despite growing pressure on margins, according to the FAP Mezzanine Report 2019, published this month.
‘The market for subordinated financing is agile and dynamic,’ said Curth-C. Flatow, founder and managing director of the FAP Group, an independent consultancy for the procurement and structuring of capital for real estate investments and project development in Germany. ‘We are observing a stabilization at a high level. While the growth rates forecast by us have almost been reached, the average volume has increased. Companies, especially from the Anglo-Saxon region, which have withdrawn from the German mezzanine market, have been replaced by other international investors and funds. International interest in the German real estate market is growing, explicitly also for the debt segment. The growing number of market participants is currently leading to increased pressure on margins. Consequently, the expectations for interest rates and returns have been and are often disappointed.’
The 53 lenders who participated in the report have provided €5.8bn in mezzanine capital in the past twelve months, which generated a project volume of €38bn. For the coming year, they expect to provide €7.7bn in financing.
One lender upping its exposure to the mezzanine segment is BF.direkt. ‘We are launching a new debt fund with a target size of €200m, which will then finance 15 to 20 projects,’ its CFO, Manuel Köppel, told REFIRE. ‘We’ll offer both mezzanine and whole loans because we want to finance projects at different stages, including bridge loans and then switch to the mezzanine position at a later stage of the project. We also have our own pipeline which we can feed into the fund. However, we only want to finance projects that create value in some way, whether that’s development, redevelopment or value-add.’ (Further details have yet to be disclosed.)
The attraction of the mezzanine space is that it has become more flexible and more mature than it was two years ago, although there is also a certain pressure on margins. ‘The question is: what sort of mezzanine loan do you want?,’ Köppel said. ‘In the Big 7, you’re still looking at an 8%-9% coupon but in downtown Munich, it would be lower. The more core it gets, the more difficult the pressure on the margin is.’
There’s also a big difference in the size of mezzanine loans on offer. For example, you can get up to €2.5m via crowd funding, according to Köppel. ‘However, the €5m to €10m bucket is more interesting because that mezzanine tranche is too big for crowd funders yet too small for the larger institutional investors,’ he said. ‘Overall, there are more mezzanine players in the market than there were two years ago. But investors should have a close look at the position in the capital structure as some mezzanine loans are structured more like equity risk, instead of a junior debt.’
Euphoria has cooled but mood remains upbeat
The euphoria of the last few years has cooled and both investors and financers are becoming more reserved due to the evaluation of the market cycle, pressure on margins, the increased cost of land and construction costs. It is becoming increasingly difficult for investors to find suitable deals, to price them with an appropriate risk/return ratio and implement them within the specified budget. As a result, the number of deals is lower, but the volume tends to be higher, according to the report.
‘What we’ve seen recently is that some banks are being a bit more careful – we question the quality of projects, clients’ business plans etc. more because we think that we’re at the peak or close to the peak of the cycle,’ Michael Windoffer, head of real estate cross border lending at Hamburg Commercial Bank, told REFIRE. ‘In the last two-to-three months, there’s been a sense that everyone needs to be more careful than they used to be. We’re turning down some loans that we would have underwritten three-to-four months ago.’
In order to be able to realise deals, investors have once again become more willing to compromise, according to Hanno Kowalski, managing director at FAP Invest. ‘Requirements on “hard” equity capital are diminishing and are often compensated by guarantees or higher pre-sales quotas,’ he said.
Subsequently, the boundaries between the different forms of financing, in terms of interest rate expectations and hedging requirements, are becoming blurred and mezzanine capital is taking on a more important function: ‘Without mezzanine, there are no more deals; they are now a “normal” part of financing, practically a core product,’ Kowalski added. ‘Investors and capital providers are forced into greater flexibility. As a result, trust and security aspects play an even stronger role than in the past. Such funds are thus becoming more and more interesting from a risk perspective.’
Double-digit growth in new business
Despite the more muted environment, some lenders saw double-digit growth in new real estate business in the first half of this year. DZ Hyp led the way, with €3.7bn in new business, including extensions, an increase of 12% y-on-y. LBBW did €2.6bn in new business, up 30% in the same period, followed by BayernLB with €2.1bn, up 11%. MünchnerHyp witnessed the strongest growth, albeit from a low level, to €1.1bn, a jump of 120% y-on-y, according to JLL’s New Business Report, published this month.
Interest rates on subordinated loans under pressure
Interest rates on subordinated loans are coming under increasing pressure, with the spread of interest rates expanding. Typical interest rates in this category currently range between 5% and 14% (7% to 10% in 2018) for portfolio financing. For project developments, rates rise to between 10% and 15% (8% to 15% in 2018). The pressure on margins, however, has noticeably increased recently, especially at the lower end. The most noticeable pressure on margins is with premium properties or developments, according to the FAP Group.
In project developments, 80% of providers finance between 90% and 95% of the total investment costs (TIC). Depending on the strategy and risk tolerance of the provider, loan to capital ratios (LTC) of up to 100% continue to be supported. The majority of the providers surveyed focus on capital tranches of between €10m and €30m for portfolio financing. For project developments, 80% of those surveyed concentrate on capital tranches of between €3m and €25m, with the “sweet spot” being between €10m and €30m, according to the report.
Lenders up exposure to risk
As pressure on margins intensifies, some lenders are taking on more risk. Today, 64% of lenders offer project and portfolio finance, up from 54% a year ago, according to the FAP report. The prevailing pressure on margins in project development is also having an impact on lenders, resulting in an increased ‘blending ratio’ with existing properties, primarily due to liquidity and security considerations, according to the report.
Lenders increasingly focusing on ‘Big 7’
Interestingly, there has been a huge uptick in lenders focusing on Germany’s Big 7 cities, largely due to new, mainly institutional providers, with 43% of those surveyed focusing exclusively on the Big 7, up from just 7% a year ago. Only 19% of the lenders surveyed operate nationwide, compared to 55% last year. Around 74% finance in B region and 26% lend in C regions.
‘At this point in the cycle, it could be better to bet on the big horses than on B and C locations, not least because bigger markets are more liquid and you can exit them more quickly, if you need to,’ Windoffer said.
Office and residential financing across the board is at the top of the popularity ranking. As in the previous year, all of the providers surveyed finance existing office buildings. Student housing and co-living also increased, while hotels and boarding houses drop slightly. Losses were also recorded in retail, shopping centres and the logistics sector. The office and residential sectors are also considered safe havens when it comes to financing project developments. Both asset classes are financed by all of the capital providers.
‘Over the next 12 months, I think the German lending market will remain stable,’ Köppel said. ‘Institutional investors will increase their market share of the debt market and are deciding what to lend on. Many of them want to be in the real estate debt space.’
For now, caution will be key, according to Windoffer. ‘The economy is slowing down and it will probably turn into a recession. Going forward, lenders will become more and more cautious.’
