16 Nov 2016
Geopolitics driving global markets
As published by CREFC Europe: borrowers and lenders focus on their own universe amid era of unpredictable geopolitics
The current geopolitical landscape is too unpredictable and in too much disarray that it is a fool’s mission to try and plan for what might happen next, delegates at CREFC Europe’s autumn conference were told.
In a wide-ranging and panelist-packed 80-minute session on the Monday afternoon, comprised of four borrowers and lenders apiece, the assembled speakers discussed:
- geopolitical upheaval and the impacts on CRE markets;
- the future regulatory landscape;
- the current environment for CRE finance in the UK and Europe;
- the rise and rise of finance intermediaries;
- the trouble with CMBS;
- the Bank of England’s enduring appetite for an industry-developed CRE loan database in the UK; and
- private equity funds raising preferred equity to replace third party mezzanine.
Among the many highlights and soundbites of Monday’s panel session, were:
- upcoming inflationary pressures will cement the status of cash flow as “the asset for the next five years”;
- for banks, the lower for longer environment era will be offset by rising regulatory capital requirements and, in turn, the cost of capital over the medium term;
- banking regulation “in and of itself has not been as crippling to the CRE lender-borrower relationship although the cost of proving that you have complied with the regulation has been significant”;
- while the market has become much more intermediary-led “it is still not an intermediary-led market” according to one panellists while another said “frankly the investors are being short-changed by outsourcing that skill set”;
- the dearth of CMBS issuance this year has been driven by has been driven by a lack of supply of appropriate financings conducive to securitisation and enduring competition among balance sheet lenders;
- consolidation among traditional banks will likely emerge, driven by banks’ low profitability levels and rising costs of regulatory compliance;
- …. but the death of the banking model has been greatly exaggerated;
- the notion that alternative lenders are wholly unregulated is a over-stated;
- a CRE loan database is inevitable: either the market must develop it voluntarily or the Bank of England will step in;
- post-Brexit, a gap in the capital stack has emerged which presents a significant opportunity for some of the debt funds;
- … this is creating some mis-pricing with lenders sometimes guilty of trying to impose pricing floors onto borrowers who reply: “Don’t try and fit your capital to our business plan, this is our business plan do you have appropriate capital and can you price that risk?”
- sophisticated investors are now raising their own preferred equity as a substitute for mezzanine, boosting equity returns while allowing investors to keep total control;
- debt markets have increased in sophistication and depth greatly in an overall much better functioning market to the benefit of all sides.
Dan Smith, executive director at Fortwell Capital, and Ian Marcus, senior consultant at Eastdil Secured, co-chaired the ‘borrower and lender’ panel which began with a review of the unpredictable geopolitical landscape.
Geopolitics driving global markets
“Our concern about the geopolitical situation is the impact it is going to have on the occupier market,” began M7 chief executive Richard Croft. “The politics around Europe, the UK and the US is so confused you cannot plan for what you believe is going to happen next. Since Trump has become President-elect, he has already rowed back on many of his more outlandish statements, so I don’t think any of us really have a clue what he is going to do.
Croft said that in that unpredictable environment it made sense to “focus on your own universe, do the things that are important” which he said comprised “primarily income distribution and almost ignoring the geopolitical scenario”.
He added: “Trying to plan for it now is a fool’s mission”.
Panelists expressed concerns over what may happen with rental growth and whether we will remain in this ‘lower for longer’ era, or will inflationary pressures start to feed through to bond yields? A second reflection is whether this fiscal stimulus, which appears to be around the corner, will lead to government infrastructure spending. If so, how do real estate investors benefit from that?
Croft added: “Our view is, on the balance of probabilities, assuming we are lower for longer, that means that cash flow is more important than ever. Cash flow is itself, I think, going to become the asset for the next five years.”
Co-chair Ian Marcus argued that the reaction of bank shares to Donald Trump’s shock political victory implied his presidency could be a net positive, particularly if he rows back on bank regulation. Marcus asked what the read-through for lenders might be.
Roman Kogan, head of CRE Europe at Deutsche Bank’s London office, reasoned that it is difficult to draw a direct linkage between, for example, the scaling back of Dodd-Frank and how CRE borrowers and lenders interact on a day-to-day basis. However, he said: “I think regulation in and of itself has not been crippling to the CRE lender-borrower relationship. Though the cost of proving that you have complied with the regulation has been significant. Kogan added that the infrastructure associated with the cost of proving that banks do not violate certain regulations “is immense” and contributes to “incredible costs on banks” which eats in to capital and has a clear impact overall.
Chris Bennett, senior manager at DekaBank’s London office, said banks are intensely focused on the regulatory regime change to Basel 4 with debate ongoing between “central bankers and bank boards as to what amount of regulatory capital that needs to be held against loans”. He added: “We may be lower for longer as one component of the overall cost of finance but probably over the medium-term cost of capital is going up.”
Catherine Webster, strategic finance and investment director, at Quintain, the formerly listed London residential developer and manager now backed by Lone Star, moved the discussion onto the current financing environment. Webster discussed Quintain’s just completed £800m residential development facility with AIG, Wells Fargo and CPPIB. Our previous lenders, when we were a listed company, were traditional UK and Irish balance sheet banks – none of whom could unfortunately help us because as a development facility over five years, the facility fell in to a higher risk slot,” Webster explained to delegates. Quintain also spoke to a number of Eurozone lenders “who were all happy to lend to us until June 23”.
“We ended up in a great place,” Webster continued. But she told delegates that during the preliminary stage, “some sources of capital tried to come back and change what we wanted saying: ‘this is what we can give you because that is the floor that I can price to so maybe you should consider increasing your risk profile’, which we declined to do.”
Webster’s reply to such lenders was: “Don’t try and fit your capital to our business plan, this is our business plan do you have appropriate capital and can you price that risk?”
“There is still some mis-pricing out there” she added.
The level of sophistication of borrowers has picked up, allowing investors access to a much wider range of debt capital, argued Colin Throssell, chief financial officer at TH Real Estate. “Given the political landscape towards de-globalisation, there is no one-stop-shop anymore – that’s why the intermediary market has become such a success.”
DRC Capital’s Rob Clayton and Deutsche Bank’s Roman Kogan agreed that the rise of intermediaries was significant, particularly among the resource-constrained borrower side of the market. “The market is becoming more intermediary-led, but it is still not an intermediary-led market,” concluded Clayton.
The problem with CMBS
Deutsche Bank’s Kogan was asked to explain the collapse of CMBS over the last 12 months. “The CMBS market is there if the financing transaction meets the requirements of what the markets can absorb,” he began.
Kogan told delegates the lack of issuance this year is owed to two factors: supply and competition. He said there has been a shortage of €250-€300m acquisition financings by private equity funds looking for a one bank solution. Secondly, the level at which investment banks need to underwrite in order to execute profitably – given the risk factors and time delays involved in issuing a CMBS – is still difficult to achieve given where balance sheet lenders can underwrite the same risk.
In addition, Kogan said the real money investor base has unmistakably shrunk, which has been regulatory-driven to a significant extent. “Solvency II stands out most which has certainly pushed the insurance market, which as we all know is moving more into the direct lending space, has effectively removed itself from the CMBS market. When the capital treatment for lending direct at 70% LTV is better than 25% LTV AAA in a CMBS bond, it is pretty obvious where the capital is going to flow,” he told delegates.
Kogan: “We debate this all the time at Deutsche Bank: is it a lack of investor demand or a lack of supply? I would still say it’s a lack of supply. It is still more difficult to originate for CMBS in this market given where balance sheet lending pricing is. If the deal fits the framework of what the CMBS market expects, deals will get placed. But it is tough to originate them.”
The death of the bank is greatly exaggerated
To be successful, you have got to have a sustainable lending model that works in more than one market environment, HSBC’s Steve Willingham, global co-head of event financing. “While the intermediary market has done very well and will continue to have more influence, there is still a place for relationship banks for clients who want to do something strategic and quickly.”
Willingham pointed to capital market bond issuance and listed investors seeking to raise new equity, as examples of sustainable bank capital services. “This has a place. We have to be more nimble and have the right resources but I don’t see the bank model dying just yet.”
Deutsche Bank’s Kogan concurred. “I’m not ready to write off banks yet either. The macro and regulatory environment has been difficult for the banking market as a whole, I don’t think it has necessarily been more difficult for the real estate financing arms of banks, which I think across the board are relatively in good shape. “CRE lending provides capital to the real economy, which from a regulatory and political perspective should be encouraged.”
CRE loan database is inevitable and welcomed
Ian Marcus turned the debate to the Bank of England’s interest in the CRE industry developing a loan database in the UK. As one of the seven recommendation by the cross-industry real estate finance group in the report, A Vision for Real Estate Finance in the UK, in May 2014, it was a little controversial at the time.
Marcus told delegates: “There has been a perception of enormous focus from the central bank and the regulator’s perceptive on the residential market, and less on the commercial sector, but be warned they are watching very closely. The one recommendation of the seven put forward by the Vision report was that the Bank continually bang the table on about, and they are doing it nicely, is this potential loan database. They feel they haven’t got enough information of the sort of quality and consistency to help make decisions.
When subsequently asked by Marcus to vote on whether the Bank’s insistence of a loan database was interference, only 17% of CREFC’s delegates thought it was.
“I agree it is inevitable,” said Steve Willingham of HSBC, one of the banks which has been at the forefront of aiding the Bank of England’s efforts to mitigate risks in the finance sector arising from a future real estate market crash. “If we don’t play ball it will be enforced by regulation” Willingham said. “If it is done the right way and the legal construct is right I don’t have an objection but the compliance and systems effort is huge.”
Marcus suggested the Bank is more concerned generically about the unregulated lenders, the alternative lenders, including peer-to-peer lenders. DRC Capital’s Rob Clayton, the panel’s resident alternative lender rebuffed the notion that funds like his own were unregulated. “It is pretty clear that a database is coming, there is no problem with that. On the issue of regulation of alternative lenders, we are regulated by the FCA.”
“All of our investors are professional institutions: they give us money long term, we lend it short term. We don’t have any leverage at all. We invest our personal money in the deals that we do. And there is no timing mismatch – like banks used to do where they borrow short and lend long – we do the opposite. So while it is very easy to tar us all with the same brush that is why we have a different set of regulations to the banks.”
Mezzanine lenders facing threat from PE funds raising own internal preferred equity
Panellists all, at least, agreed that the market environment for CRE finance had changed post the referendum. There has been a general retrenchment in senior LTVs, creating a funding gap between 55% and 65% LTV which in part is being filled by mezzanine providers who are capitalising on the retrenchment of senior lenders to move deeper into the capital stack with a safer piece.
Third party mezzanine is not for everyone, however. “We like mezzanine we just don’t like mezzanine providers,” said M7’s Richard Croft. “What we do is raise pref equity in our funds which effectively acts as mezzanine – lenders think it is equity, borrowers think it is mezzanine. There is no inter-creditor agreement and it has no security over the asset it just acts as preferred equity, boosting the returns of the equity but we retain total control.”
That is definitely the trend, agreed panelists. The message was that underlying investors are definitely more motivated to lend private equity investors mezzanine capital instaed of going to debt funds in roder torecieve a risk-adjusted return from the equity and the debt component.
Sophisticated investors can raise mezzanine capital cheaper directly, than through the third party fund market while avoiding the often frustrating requirements in mezzanine providers’ inter-creditor agreements. But mezzanine can also be erosive to bank returns, even structurally subordinated mezzanine requires banks to increase their regulatory capital.
“We keep talking about regulatory capital being one of the drivers of our lending business, and it really is,” said DekaBank’s Chris Bennett. “It is dictating probably to a heavier extent than we would want. We would represent a part of the lending environment that when looking at risk and return and seeks a lower risk and accepts a lower return and anything that is damaging that return is damaging to our overall business.
“I would, therefore, support a scenario whereby investors were raising their own in-house mezzanine capital and not attaching it to the debt.”
DRC Capital’s Rob Clayton concluded with: “Has the alternative lending space been impactful? Yes it has. People have choices now. Having alternatives to banks is healthy. As we’ve heard, some equity is arranging a preferred piece. The mezzanine market has moved on so that inter creditors are now no longer an issue. We are working in a more functioning market place now. If we go back six or seven years ago, this would have been a very short conversation: few had any capital.”
Sanjay Sethi, Associate Partner & Head of Capital, Brockton Capital
Richard Croft, Chief Executive, M7
Catherine Webster, Strategic Finance & Investment Director, Quintain
Colin Throssell, Chief Financial Officer, TH Real Estate
Chris Bennett, Senior Manager, DekaBank Deutsche Girozentrale
Roman Kogan, Head of CRE Europe, Deutsche Bank AG London
Rob Clayton, Partner, DRC Capital LLP
Steve Willingham, Global Co-Head of Event Financing – Infrastructure & Real Estate, HSBC Global Banking & Markets